China: Clearer rules for treaty resident individuals claiming benefits under double tax treaties 

Sep 2009

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In brief    Many foreign individuals with investments or operations in China are subject to Chinese tax with respect to their China-sourced income. Some of these individuals should be eligible to enjoy the favourable income tax benefits (hereinafter as "treaty benefits") under double tax treaties ("DTAs") concluded by China with the countries / regions where the foreign individuals are tax residents ("treaty residents").  However, there has been no clear and unified administrative rule for the treaty residents to follow to claim the treaty benefits.  Foreign individuals have been relying on diverged practices adopted by different local-level tax bureaus in the locations where they derived the China-sourced income.    In order to address the needs of such treaty residents and Chinese local-level tax bureaus, and to counter any abusive use of treaty benefits, the State Administration of Taxation ("SAT") issued a circular Guoshuifa [2009] No.124 entitled "Administrative measures for non-tax residents to enjoy treatments on income under DTA (Trial)" on 24 August 2009.  It is the first time that the Chinese tax authorities have introduced such comprehensive and detailed administrative rules for treaty residents to claim treaty benefits.  Circular 124 will take effect from 1 October 2009.

Circular 124 will apply to both treaty resident enterprises and individuals.  This alert will address the relevant requirements as provided in Circular 124 in relation to those treaty resident individuals who derive China-sourced income from personal services and are eligible to claim benefits under DTAs.  While there are many note worthy issues brought about by Circular 124, this alert will concentrate on the issues relevant to "dependent personal services" (virtually, employment services), which are of most interest to foreign employees working in China as well as their foreign company employers.
  
Background concerning Chinese domestic individual income tax ("IIT") and treaty benefits
  
According to Chinese domestic IIT law and regulations, an individual who is not domiciled in China (collectively called "foreign individuals" for the purpose of this discussion) shall be subject to IIT with respect to their income derived from China.  Different rules are applied to personal income for the purpose of determining the source of the income, calculations of taxable income and IIT, exemptions and deductions, timing of tax filing and payments, withholding requirements, etc.
  
As far as dependent personal service income (or virtually, employment remuneration) earned by foreign employees is concerned, the Chinese domestic IIT law and regulations exempt this income from IIT if the foreign employee's physical presence in China does not exceed 90 days within a tax year (i.e. a calendar year) and none of the employment remuneration cost is paid nor borne by a Chinese entity or the permanent establishment ("PE") that their overseas employer has in China.  This IIT exemption applies whether the foreign employees are considered treaty residents or not.  For those who are residents of a treaty state, the relevant DTAs would extend the threshold for IIT exemption from 90 days to 183 days.  Once such extended threshold is exceeded, the foreign employees (despite being treaty residents of another treaty state) would be subject to IIT according to the domestic IIT law and regulations.  In other words, the typical DTA provides a longer grace period for tax residents of a treaty state to stay in China without exposing them to Chinese IIT.
  
New administrative measures applicable to personal income
  
Regarding passive income (such as dividends, interest, royalties and capital gain income) covered in the typical DTA, Circular 124 requires treaty resident individuals (and also treaty resident enterprises) to observe the procedure of "Application-approval" in order to enjoy the respective treaty benefits.  Whereas, for other personal income covered in the typical DTA, treaty resident individuals (and also treaty resident enterprises) would need to undergo a "Recordfiling" procedure pursuant to Circular 124.
  
Under the Approval-application procedure, treaty resident individuals should lodge their applications with the Authorized-approval Tax Bureaus, which are to be designated by the provincial-level tax bureaus (or equivalent), and could be different from the in-charge tax bureaus.  Also, treaty resident individuals are not required to repeat the application if it is for the same type of income within three years upon the first approval, where the prescribed conditions are fulfilled.
  
Under the Record-filing procedure, treaty resident individuals (or their withholding agents where relevant) are required to file the prescribed documents (see below) with the in-charge tax bureaus for record-filing purposes.  The Circular is silent on whether there are any examination and approval procedures by the tax bureaus.
  
Circular 124 provides that, for the various situations, where there was non-compliance to the Circular or the treaty benefits were approved based on false information, the Chinese tax bureaus may impose penalties, surcharges and/or interest in accordance with the China Tax Collection Administration Law.
  
PwC observations

• Key messages behind Circular 124
  
  In the past, the Chinese tax authorities did not enforce any administrative procedure for foreign employees claiming the treaty benefits pursuant to the relevant article of DTAs on China-sourced employment remuneration.  This was partly due to the fact that DTAs (which despite providing criteria and requirements on which treaty resident individuals could qualify for the treaty benefits) contain no reference on the administrative procedures required or imposed by the respective treaty states.  As a result, foreign employees might only be requested by the local-level tax bureaus to provide information/documents in conjunction with claiming the treaty benefits on a case-by-case basis.  In some cases, the local-level tax bureaus may not even be aware of the presence of foreign employees who might "mistakenly" believe that they qualified for the treaty benefits and hence failed to pay IIT.  In the past, these foreign employees simply took the position that they "deserved" the treaty benefits on the basis of their citizenships or nationalities and of their physical presence in China for not exceeding 183 days within the specified base period as provided in the respective DTAs.
    
  However, Circular 124 now makes it clear that foreign employees should take positive steps to secure the entitlement of the treaty benefits when the 90-day threshold under the domestic IIT law and regulations is exceeded.  Foreign individuals should no longer take it for granted that they are automatically entitled to enjoy the treaty benefits, instead, they should undergo the Record-filing procedure with the in-charge local tax bureaus in the locations where they derive their employment remuneration.  Failure to comply with this Record-filing procedure would "disqualify" these individuals from claiming the treaty benefits.
    
  After illustrating the above principles, Circular 124 goes on to provide a set of unified administrative procedures to enable the foreign employees deriving China-sourced employment remuneration or their statutory withholding agents to file the required declaration and supporting documents to local-level tax bureaus for Record-filing purpose.
    
  

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• What remains uncertain?
  
  As mentioned above, Circular 124 only requires the Record-filing procedure for claiming the treaty benefits in respect of, among others, dependent personal service income without mentioning whether an explicit approval from the tax authorities is required.  Hence, it might be interpreted that the treaty benefits could be automatically available to treaty resident employees after the Record-filing procedure is completed.  However, treaty resident employees (and their foreign employers or withholding agents) should note that, where outward remittance of services fee payment to overseas recipients is required, it would be necessary to apply for a Tax Exemption Certificate with the in-charge local tax bureaus.  It remains to be seen as to how the local-level tax bureaus would review the Record-filing package when considering the application for the Tax Exemption Certificate and whether they would subsequently reject the treaty benefits claim if the entitlement to the treaty benefits is in doubt.  In any event, Circular 124 has provided a full set of follow-up monitoring administrative procedures and measures to identify and disallow any unwarranted treaty benefits.

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• Interaction with DTA treatment for foreign company employers
  
  Typically, foreign employees rendering services in China would fall within one of the following categories:
    
  

  • Short-term business travelers visiting China for temporary business purposes on an as-needed basis, e.g. attending meetings; and
  • Foreign employees of a foreign company being assigned to China to work on a project or for a period of time.

  
  For project-based foreign employees, due care should be exercised not only to ensure the conditions pursuant to the Article for "Dependent Personal Services" in DTAs are satisfied, but also to assess the PE exposures in China with respect to their foreign employers because they would fail to enjoy the treaty benefits should their foreign employers constitute a PE in China.  For service-type PEs, as the foreign employers would actually constitute the PE by virtue of the presence of their foreign employees in China, it would be important both from corporate income tax and IIT perspectives if the presence of the foreign employees and the length of the project in China can be restricted to the respective grace periods allowed under the relevant Articles in the DTA.
    
  In addition, it is imperative to note that there will be essentially two "tests" for a foreign employee, being a treaty resident, to enjoy the treaty benefits:
    
  

  • First test: The foreign employer does not constitute a PE in China by virtue of the DTA which China has entered into with the state where the foreign employer is a tax resident; and
  • Second test: The foreign employee has not stayed in China for more than the 183-day threshold within the specific base period as stipulated in the DTA which China has entered into with the state where the employee is a tax resident.

  
  In some cases, the tax residence of the employer and the tax residence of the employee could be different because the foreign employee is not necessarily a tax resident of the same tax jurisdiction of the employer.  In some other cases, either the state where the employer is a tax resident or the state where the employee is a tax resident may not have concluded a DTA with China.  Such situations have not been addressed by Circular 124 or other Chinese domestic tax rules so far.  Until further clarifications are provided by the SAT, it is believed that the foreign employee should have reasonable ground to follow the international practice to handle such situations.

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• Documents / Information to be disclosed in the Record-filing procedure
  
  In undergoing the Record-filing procedures, the treaty resident individual shall submit the following documents and information:
    
  

  • "Form of non-tax resident's claim for treatment under DTAs (for Record-filing)" ("the Record-filing form");
  • Certificate of Treaty Resident issued by the treaty partner's competent authority in and after the preceding calendar year; and
  • Other relevant documents as required by the Chinese tax authority.

  
  Where there is a statutory withholding agent, the treaty resident individual shall also provide the same documents and information to the local withholding agent which would in turn submit them as appendices to the withholding filing package to the local in-charge tax bureau for Record-filing purposes.
    
  We note that the documents and information that need to be disclosed in the Record-filing procedure not only cover the particulars of the treaty resident individual and his payer / withholding agent, but also include the amount of gross or taxable income and the IIT deduction or exemption under the treaty benefits.  Further, explanations of the grounds or basis for enjoying the DTA benefits should also be provided in the Record-filing form.  This is the first time such a tax-reporting form in which China requires the taxpayer to justify the basis of their entitlement / eligibility to a tax claim.
    
  Proof of tax resident status of the other treaty state is required in the Record-filing procedure.  However, such a seemingly simple and reasonable request may turn out to be a practical hurdle for the treaty resident individuals.  Alerts should be given to the level of practical complexity and difficulty and the amount of efforts consumed in obtaining such an official proof from the tax authorities of the treaty state.  Normally the tax authorities of the treaty state will need to take necessary reviews to verify whether the applicant qualifies as its tax resident.  For instance, the US-China DTA provides in Article 4 that "… the term 'resident of a Contracting State' means any person who, under the laws of that Contracting State, is liable to tax therein by reason of his domicile, residence, place of head office, place of incorporation or any other criterion of a similar nature. … Where by reason of the provisions of paragraph 1 an individual is a resident of both Contracting States, then the competent authorities of the Contracting States shall determine through consultations the Contracting State of which that individual shall be deemed to be a resident for the purposes of this Agreement."
    
  It may not attract too much concern of those who just take it for granted that they are the tax residents of a treaty state, but when it comes to an official application, they should not under-estimate the level of scrutiny down the road in the application review and assessment by the tax authorities of the treaty state.
    
  As exemplified above, given the extensive scope and depth of information required by the Record-filing procedure, it will certainly demand a careful review of all relevant facts and circumstances in the process of observing full compliance with Circular 124 requirements.

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• Re-opening of the claim of treaty benefits prior to Circular 124
  
  If a treaty resident individual already paid the IIT on income that should have been eligible for the DTA's treaty benefits, they could apply to the in-charge local tax bureaus (within three years from the date of the IIT settlement) for refund of IIT overpaid by complying with the requirements as imposed by Circular 124.  Hence, in theory, the re-opening could be made to the period as early as back to 1 October 2006, as the effective date of Circular 124 will be on 1 October 2009.

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• What should foreign employees do?
  
  As analyzed above, foreign employees of a treaty state should not take it for granted that they qualify for treaty benefits automatically by mere reference to the relevant articles of DTAs.  It now very much depends on whether the Record-filing procedure as provided by Circular 124 is timely and properly completed.  To meet this procedural requirement, foreign employees will require a considerable level of preparation and collection of relevant information as well as careful review of relevant facts and assessment.  Individuals should handle this matter jointly with their foreign company employers (and local withholding agent where applicable), with the focus to address the following corporate and individual income tax exposures and compliance requirements in both planning and implementation stages:
    
  

  • Time spent / to be spent by the foreign employees in China;
  • PE exposure of the foreign employer in China by virtue of all the foreign employees staying in China for the same project;
  • Assessment and collection of the tax residence certificate or other evidence of the tax resident status in the treaty state where the foreign employee claims to be tax resident;
  • Sufficient documents and information to be provided to the Chinese tax authorities in the course of the tax compliance process in China;
  • Collaboration of the withholding agent in the tax compliance process in China; and
  • The tax consequences back in the treaty state after enjoying the DTA's treaty benefits in China.

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