Taxation of China Representative Offices. Part I: China Taxation

A representative office (RO) is a Chinese business entity that allows a foreign company that has been established for at least two years to engage in the following activities in China:

1. Conduct research;
2. Liaise with China contacts;
3. Promote the parent company;
4. Coordinate the foreign company's China activities; and
5. Make travel arrangements for parent company representatives and Chinese clients.

An RO is not allowed to engage in the following activities:

1. Directly engage in any business for profit;
2. Sign contracts on behalf of the foreign parent;
3. Represent firms other than the foreign parent;
4. Collect money or issue invoices in China; or
5. Buy property or import production equipment.

ROs are also subject to onerous restrictions regarding local hiring.

However, despite all of the drawbacks, it sometimes still makes sense to form an RO in China.  But how are they taxed in China, and what are the US tax implications?  Today, I'll address the China taxation of ROs, and tomorrow I'll write about the U.S. tax implications.

I.  China Taxation of ROs

The most recent China guidance on the taxation of ROs was issued by the State Administration of Taxation on February 20, 2010: Guo Shui Fa [2010] No. 18 ("Circular 18"), Interim Measures on Tax Administration of Representative Offices of Foreign Enterprises.

Circular 18 provides that ROs are required to pay Enterprise Income Tax (EIT) at a 25% tax rate, Business Tax (BT) at a 5% tax rate, and Value-Added Tax (VAT).  Additionally, the RO may be exempt from paying EIT under the US-PRC tax treaty.

     a.  VAT

It is unlikely that an RO will have any VAT liabilities because it should not be in the business of buying and selling goods.  However, if it does have VAT liabilities, then VAT must be declared and paid according to China's VAT regulations.

     b.  EIT and BT

ROs are required to calculate their taxes based on legal and valid accounting documents.  However, if an RO cannot accurately calculate income, costs, or expenses then the Chinese tax authorities may choose to calculate the RO's EIT and BT based on either (1) the expenses method, or (2) the deemed profit method.

Both methods use the deemed profit rate as a variable.  Circular 18 states that the deemed profit rate is no less than 15%, and could possibly be up to 50% depending on the industry.  All examples below use a deemed profit rate of 15%.  Furthermore, all examples use an income tax rate of 25% and a BT Rate of 5%.

          1.  Expenses Method
This method will be used by China's tax authorities if the RO can accurately calculate expenses, but not income.

Calculating EIT and BT based on the expenses method requires the calculation of the deemed turnover or deemed gross revenue of the RO.

Deemed Turnover = Total Operating Expenses / (1 - BT Rate - Deemed Profit Rate)

EIT Payable = Deemed Turnover * Deemed Profit Rate * EIT Rate

BT Payable = Deemed Turnover * BT Rate

Example: Total Operating Expenses = 100 

100 / (1 - 0.05 - 0.15) = 125 Deemed Turnover

125 * 0.15 * 0.25 = 4.69 EIT Payable

125 * 0.05 = 6.25 BT Payable

          2.  Deemed Profit Method
This method will be used by China's tax authorities if the RO can accurately calculate gross revenue, but not costs or expenses.

EIT Payable = Gross Revenue * Deemed Profit Rate * EIT Rate

Example:  Gross Revenue = 100

100 * 0.15 * 0.25 = 3.75 EIT Payable 

      c.  Tax Treaty EIT Exemption
The RO will be exempt from EIT, but not BT or VAT, if it qualifies for exemption under the US-PRC tax treaty, and if the RO files with the appropriate tax authority.

The RO will be exempt from EIT and taxable only in the US under Article 7 of the US-PRC tax treaty if it is NOT a considered a permanent establishment (PE) in China under Article 5 of the tax treaty.  Article 5, paragraph 4 is the relevant paragraph for analyzing whether an RO is a PE, and is reproduced below with provisions that are seemingly related to ROs in italics:

4.  Notwithstanding the provisions of paragraphs 1 through 3, the term "permanent establishment" shall be deemed not to include:

1. the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise;
2. the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery;
3. the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;
4. the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise;
5. the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character;
6. the maintenance of a fixed place of business solely for any combination of the activities mentioned in subparagraphs (a) through (e), provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.

Paragraph 4 looks like it was custom crafted to prevent ROs from being treated as PEs and subject to EIT.  However, a familiarity with tax treaties, as well as the Technical Explanation of the treaty, reveals that paragraph 4 is actually the same as in the US Model Tax Treaty.  Accordingly, do not expect the Chinese tax authorities to give ROs a free pass into the non-PE classification, and do be prepared to advocate for that position.

There is one other possible exemption that operates independently of whether the RO is a PE for tax treaty purposes according to Article 7.7 of the tax treaty.  If the RO is promoting the sales of ships or aircraft in China, and the RO can accurately calculate its taxes based on valid and legal accounting documents, then income attributed to the RO from sales by the parent company of such ships or aircraft could be exempted from EIT under Article 12.3 of the tax treaty.

     d.  Conclusion
An RO for a US company may be subject to EIT in China, it will be subject to BT in China, and it will be subject to VAT in China.  Tomorrow, we'll examine the U.S. tax implications of RO taxation in China.