By Dezan Shira & Associates
China’s value-added tax (VAT) reform on May 1, 2016 was China’s biggest tax overhaul in 20 years. The reform changed the tax rate on representative offices’ (ROs) business activities, reducing the rate from five percent to three percent. The reduced tax liability on ROs may cause foreign investors to restructure their business practices to capitalize on the reform’s benefits. This article provides a brief introduction to China’s taxation rules on ROs, and looks at the VAT reform’s potential impact on ROs’ tax structure.
ROs in China
In China, ROs are established by foreign enterprises seeking to conduct marketing operations and test the water in the Chinese market. ROs are often considered more efficient than wholly foreign-owned enterprises (WFOE). This is because ROs do not have registered capital requirements and have a relatively simple set-up process. Although they carry the smallest administrative burden, ROs are not capitalized legal entities and are restricted to conducting non-profit making activities such as business liaison, promotion, market research, and auxiliary functions for their parent companies.
Even though ROs have no operational income, the value they generate is still subject to taxes in China. In the past, the continually heightened tax burden on ROs concerned foreign investors, leading them to question ROs’ overall efficiency. These concerns resulted in an increased number of ROs being converted to WFOEs. Under the VAT reform, the tax breaks may create incentives for foreign investors to further develop ROs established in China.
Taxation Regulations on ROs
According to China’s State Administration of Taxation (SAT), ROs are required to file tax on commission fees, service charges, and price differences between the import and export of goods generated from liaison or agency business both within and outside of China. Income from market research, business intelligence collection, and coordination and consulting services for clients residing in China are also subject to tax filing.
The three tax calculation methods used by ROs are:
- Actual Taxable Income Method: used if ROs maintain accurate and adequate accounting books and records of income and expenses;
- Expenses-plus Method: used if ROs cannot provide sufficient documents on income sources but have maintained verifiable records of expenses; and
- Actual-income & Assessed-profit Method: which may apply for ROs who have verifiable proof of income, but no complete records of expenses.
Due to the nature of their businesses, the Expense-plus Method is the easiest way for ROs to calculate their tax because it is difficult for them to determine the accurate amount of annual turnovers.
VAT Reform and Its Impact on ROs’ Tax Structure
As of May 1st, ROs are classified as small-scale VAT taxpayers and subject to a single three percent VAT rather than to both BT and VAT. Before the VAT reform, ROs were subject to corporate income tax (CIT) at a 25 percent rate, VAT at various rates across industries, and a five percent BT which applies to the sales of fixed assets, land and natural resources usage rights, and other services that do not fall into the VAT regime. Following the VAT reform, ROs are required to file CIT and a three percent VAT based on deemed revenue, a two percent tax reduction compared to the previous tax scheme. In addition, the equation used to calculate deemed revenue is now changed to “Cost or Expenditure/(1-Assessed profit rate).”
Since the promulgation of the “Measures for the Administration of Taxation on Representative Offices of Foreign Enterprises,” ROs have gradually lost their status as an efficient investment vehicle in China from a tax perspective. In 2010, the minimum assessed profit rate increased from 10 to 15 percent and is facing a risk of higher rates determined by local tax authorities. In addition, Chinese tax authorities have abolished tax exemptions applied to non-profit government organizations and ROs engaged in performing market research and consulting.
The taxation rules forROs are further complicated by the VAT reform. Previously, VAT only applied to the sale of goods – a business activity prohibited for ROs. This contradiction may create legal obstacles while implementing VAT on ROs. BT and VAT originally applied to distinguishable services; the unification of the two creates ambiguity – all services used to be categorized in BT will now be classified into the VAT regulated regime, making VAT an abstract definition.
While the VAT reform may make ROs one of the biggest beneficiaries from tax cut, transferring directly from BT to VAT remains a difficult task for taxpayers. Since VAT reform is still at the early stages of implementation, no regulations governing the tax cut have been publicized, leaving the actual tax benefits a mystery.
This article was first published on China Briefing. Since its establishment in 1992, Dezan Shira & Associates has been guiding foreign clients through Asia’s complex regulatory environment and assisting them with all aspects of legal, accounting, tax, internal control, HR, payroll and audit matters. As a full-service consultancy with operational offices across China, Hong Kong, India and emerging ASEAN, we are your reliable partner for business expansion in this region and beyond.For inquiries, please email us at [email protected].