Taxation of a Representative Office and Permanent Establishment in China

China has signed many Double Taxation Agreements (“DTAs”) over the course of the past decades. However, the Chinese treatment of a so-called Representative Office (“RO”) seems to be in breach with the DTAs that China has concluded, even if that specific DTA is in line with the OECD model tax convention.

Generally, the wording of Chinese DTAs is in line with the OECD model, which is a worldwide accepted international model for DTAs. Nonetheless there are inconsistencies between the tax treatment of entities which may not be qualified as a Permanent Establishment (“PE”) according to Chinese DTAs, and the tax treatment in practice. Mainly this is related to a lack of information and practical guidance related to the establishment and taxation of a PE. In fact, there are neither governmental offices nor hotlines providing a clearer explanation of the PE concept in China. This means that the officials in the relevant tax authorities have to deal with the PE on a case-by-case basis.

According to DTAs, the term PE means a fixed place of business through which the business of an enterprise is wholly or partly carried on. The PE definition mentioned in DTAs has the purpose to allocate taxation rights when an enterprise of a contracting state has business profits originating from the other contracting state, in case the enterprise has a sufficiently strong nexus to that country. Particularly, the profits of an enterprise which is a resident of one state are taxable in the other state only if the enterprise maintains a PE in the latter state and only to the extent that the profits are attributable to the PE (OECD Model Tax Convention art. 7).

According to the OECD model, the term “permanent establishment" shall – in short – be deemed not to includethe use of facilities and the maintenance of stock or a fixed place solely for the purpose of storage, display or delivery of goods or equipment of the enterprise, and does not include the maintenance of a fixed place of business solely for the purpose of carrying on any other activity of a preparatory or auxiliary character (OECD Model Tax Convention Art. 5).

In 2006, in order to provide a clarification of the term “permanent establishment", the State Administration of Taxation (“SAT”) had promulgated a Circular (Guo Shui Fa [2006] No. 35), with a focus on the analysis of the activities with a preparatory or auxiliary character. The identified criteria are based on whether the fixed base or place not only provides services to its head office but also has business relation with other entities, or whether its business nature is identical to that of its head office and its business operations are an important part of those of its head office. In these cases, the activities of such fixed base or place shall not be considered as preparatory or auxiliary activities and therefore a PE shall be recognized according to Chinese national law.

In practice, the form of representation of foreign companies commonly established in China is the RO, which is a fixed place of business subject to tax in China according to Circular Guo Shui Fa [2010] No. 75 (Agreement between China and Singapore for the Avoidance of Double Taxation and the Prevention of Tax Evasion, which is considered as general guidance for all DTAs signed by China).

The RO is a non-legal non-profit administrative arrangement, which refers to the representation of a foreign enterprise within the territories of China (Order of the State Council [2010] No.584). The RO is defined by the activities in which it is engaged and its business scope is limited to non-profit activities. A RO can therefore legally only engage in market research, display and publicity activities related to company’s products or services. Based on national regulations, the RO in China is considered to be a PE if the office has been or will be maintained in China for over 183 days, or “for a period or periods aggregating more than 6 months within any 12-month period” (Guo Shui Han [2006] No. 694).

Before 2010, ROs established within China by foreign governments, international organizations, no-profit institutions and civil groups, could apply to the local offices of SAT a tax exemption on Corporate Income Tax (“CIT”) by providing relevant documentation (Guo Shui Han [2008] No. 945). After 2010, the local Tax Authorities have no longer accepted any application for tax exemption and, in accordance with the new measures, had to clear all the ROs previously approved for tax exemption by reviewing their taxability. Consequently after 2010 no request for exemption of CIT has been approved and therefore all the ROs are now regarded as a (taxable) PE according to Chinese national regulations.

The definition of a PE according to Chinese national law deviates from the definition of a PE according to the OECD model. According to the OECD model, a Chinese RO would in most cases not qualify as a PE. However, as explained above, according to Chinese national law a RO will qualify as a PE if it is maintained for over 183 days, and as such will be subject to local taxes.

According to the Chinese national regulations the RO shall maintain accounting books and accurately calculate its taxable turnover according to the expenses incurred and payable income tax and file for record with the competent taxation authorities (Guo Shui Fa [2010] No.18). If the RO fails to provide complete accounting records or calculate its income and expenses, the Chinese Tax Authority has the right to calculate the monthly tax based on ROs costs times a predetermined profit ratio which normally ranges between 20% and 50% and which shall not be less than 15%, as stated in Circular 18.

Since DTAs prevail over national regulations, it seems that China is neglecting the DTAs by forcing ROs to pay taxes while China does not have a taxation right based on the DTA. At the same time, the jurisdiction of the head office could also impose taxation if the RO is no PE for treaty purposes. Therefore, it may be considered to avoid setting up a RO in China if the aim is to utilize the DTA benefits and, instead, to actually establish an entity in China in order to prevent double taxation issues.

Please note that in addition to the above, it may be possible to come to a solution via a mutual agreement procedure between the relevant authorities. For example, according to article 25 of the DTA between the Netherlands and China, in case of a breach of the DTA it is possible for a taxpayer to contact the authorities of the country of which it is a resident. A Dutch corporate taxpayer which does not have a PE in China, but is nonetheless taxed over part of its income in China, may contact the Dutch authorities. The Dutch authorities may then consult with the Chinese authorities in order to come to a solution. The mutual agreement procedure is mentioned in article 26 instead of article 25 in other DTAs such as the Spanish and German one.

In recent years, China has entered into new DTAs in order to align European countries such as Netherlands, France, Germany and Switzerland with respect to the withholding tax rate on dividends and the threshold for recognition of a permanent establishment. In particular in the new DTAs the following provision was included: “a building site or construction, assembly or installation project, with a fixed place, constitutes a permanent establishment only if it lasts at least 12 months”. The threshold to consider a construction site as a permanent establishment was increased from 6 months to 12 months. Please note that certain DTAs, such as the Italian and the Spanish one, have not been changed. All the changes in the DTAs are evidence that the Chinese government is taking proactive steps to simplify processes, improve efficiency and boost the economy.

Finally, we note that the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (“Multilateral Instrument" or "MLI”) does not seem to have an implication with respect to Chinese PEs as China has indicated that it does not want to apply any of the articles of the MLI regarding PEs to the DTAs that China has concluded.

This article was written in collaboration with Marta Snaidero and Giovanni Pisacane of Greatway Advisory (GWA).

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