When a foreign company operates in China they are taxed differently if they are considered to have set up a permanent establishment (PE). Construction projects are very likely to create a PE and foreign companies risk substantial and unexpected tax costs for construction projects if they do not manage this proactively and efficiently.
The general definition of PE under most of China’s double tax treaties is similar, namely "a fixed place of business through which the business of an enterprise is wholly or partly carried on".
However, for construction related projects China more commonly assesses the PE status of a foreign service provider using these criteria:
- whether the foreign company provides services in China, and
- how long the service lasts.
Subject to terms in different double tax treaties, China determines the PE status of a foreign company engaged in a construction related project based on whether the project lasts for an aggregate of at least 6 months for construction supervisory activities and providing services in China. If the foreign company's activities in China exceed that threshold, it will be likely to trigger a PE under a tax treaty.
By nature, a construction project and its design, project management and supervision, is lengthy and requires a local office or staff near or at the project site for daily management of the project. Such a project is likely to trigger a PE under a tax treaty.
What are the consequences of a PE?
If a foreign company triggers a PE in China, there are different tax implications for the PE and individuals working for it.
Corporate income tax (CIT)
Under domestic law China taxes PE's profits at 25%. To determine the attributable profit of the PE there are usually two methods: the actual profit and the deemed profit.
The actual profit method means the PE is taxed according to its actual profit. This method, though in principle the recommended approach under both the double tax treaty and Chinese tax law, is not used very often in practice due to the difficulty and complexity of assessing the reasonable profit of a PE. The tax authorities have insufficient resources to verify if a PE understates profit by comparing it with similar projects.
The deemed method is more easily accepted by the Chinese tax authorities because of the relatively simple calculations involved in it.
Under the deemed method the PE's profit is worked out according to its income or expense by applying a deemed profit rate. The applicable deemed profit rate for construction, design, and consulting services ranges from 15% to 30%. Taking the deemed profit rate into account, the effective CIT rate of the PE can be between 3.75% and 7.5%, which is lower than if the general 10% withholding tax is applied on the gross service fees. The exact deemed profit rate can be negotiated with the tax authority within the range provided by law.
A foreign service provider is subject to turnover tax such as business tax (BT) or VAT. In the past, 5% BT was generally levied on the service fee of the foreign service provider.
Starting from 1 January 2012 several cities in China including Shanghai, Beijing and Guangzho are gradually being enrolled in the pilot program of VAT reform, in which 6% VAT replaces 5% BT on certain covered services including design and consulting services.
If the service is subject to VAT and is provided by a foreign company to a Chinese service recipient, the VAT is withheld by the service recipient (assuming that the taxation of the PE is on a withholding basis, as in most cases) when it remits the payment to the foreign service provider. The service recipient can deduct the VAT from its output VAT on sales provided that the service recipient has a general VAT taxpayer status. In this case, it is preferable for the foreign service provider to agree with the service recipient in the service agreement that the service fee is exclusive of VAT. Otherwise, the VAT cost withheld by the service recipient from its payment will become the cost of the foreign service provider.
Individuals dispatched to work for the onshore project are subject to Chinese individual income tax (IIT) on income for work they perform in China.
In this case the 183-day exemption rule under the applicable double tax treaty does not apply and the individuals are taxed in China for their China sourced income (i.e. income in relation to their work during their stay in China) from the first day of working for the PE until the day that they leave China. In practice some local tax authorities apportion the individual's tax liabilities according to the actual number of days spent in China in a certain month to the total number of days in that month.
How to file taxes in China as a PE
The PE can choose to file its tax return voluntarily or on a withholding basis.
If the PE voluntarily files its tax return it is treated as if it were a Chinese company in terms of tax compliance. Specifically, the PE should have complete and accurate accounting records and should carry out regular tax filings and annual tax settlements. But in most cases PEs in China do not have the resources to carry out voluntary tax filings and cannot meet the compliance requirements on book keeping.
Alternatively, a PE can choose to be taxed on a withholding basis. In other words, the tax authority requires the Chinese service recipient to withhold the tax from its payment to the foreign service provider.
This method is more popular because the withholding method does not place a heavy compliance burden on the foreign service provider, and because it is easier for the tax authority to collect the tax payments from the foreign service provider.
If the PE is taxed on a voluntary basis the PE must conduct a temporary tax registration with the tax authority. If the PE chooses to be taxed on a withholding basis the local tax authority does not usually require any tax registration.
Applying for the tax exemption treatment if no PE is triggered
Under China’s domestic tax law, tax exemption under the tax treaty is not granted automatically. The taxpayer must apply for it by providing supporting documents to the Chinese tax authority to prove it is entitled to the tax benefits under a tax treaty.
Preventing double taxation of a PE
If a PE is taxed by the Chinese tax authority the foreign service provider may claim tax exemption or tax credits in its country of residence for the tax paid by the PE in China. The detailed method and procedures for claiming the tax exemption or credit can be found in the domestic tax law of the payer’s country of residence and the applicable double tax treaty.
Optimising the tax position of a construction project
The tax position of a construction related project can be optimised by:
- specifying the tax clause in the agreement and including the assistance obligation of the service recipient in case the service provider needs assistance from the service recipient to deal with the Chinese tax authority;
- splitting the amount in the agreement between onshore and offshore activities and prepare supporting documentation for the split;
- monitoring the length of the onshore project so as not to trigger the PE position in China;
- if the onshore service does not trigger a PE, applying for tax exemption on service fees based on the applicable double tax treaty;
- comparing the potential tax liabilities under the actual profit method and the deemed profit method and determine which is preferred if a PE cannot be avoided;
- contacting the Chinese tax authorities and negotiating for an optimised tax treatment for the PE within the scope of the law;
- for future projects considering whether establishing a legal presence such as a representative office in China to better manage the tax risk, based on the nature and type of the services provided.
For more information contact
T + 86 21 6138 1120
Dr. Bernd-Uwe Stucken
T + 86 21 6138 2521