The fact that China's accession to the World Trade Organisation (WTO) will soon become a reality has made foreign insurers excited about the promising future of its insurance market. However, international insurers seeking business opportunities need to face the rapid changes in Chinese tax rules and increasingly aggressive tax authorities.
Foreign insurers establish a presence in China by setting up representative offices. Before 1996, the Chinese tax authorities did not impose corporate taxes on representative offices of foreign insurers on the grounds that these offices were not allowed to conduct profit-making activities.
However, in 1996 and 1997 various tax circulars were introduced that imposed income tax and business tax on representative offices of foreign financial institutions engaged in providing consulting activities in China. Since then, tax bureau across the country have sought to challenge the tax-free position of foreign insurers' representative offices.
Under these existing regulations, where a representative office is deemed by the tax authorities to be a taxable entity in China, its overall corporate tax burden would likely be about 10 per cent of its operating costs.
A foreign insurer may avoid its tax exposure by carefully drafting the business scope for its representative office while setting up the office. Preferably, an advance ruling of the tax-exempt position should be obtained from the local tax authorities once the office has duly registered.
In structuring direct investment in China, foreign insurers must observe their home country tax issues in order to identify a tax effective holding structure. Foreign insurers from places with a territorial tax system, such as Hong Kong, generally do not face home country taxation of profits earned by their joint ventures in China before actual distribution of such profit to their home countries. Insurers from the US, Canada, the UK, Japan or Australia would need to check their home countries' `controlled foreign company' tax rules that may, in some cases, deem profits earned by their joint ventures in China to be subject to immediate home-country taxation even though such profits have not been repatriated back to the parent.
One common holding structure adopted by foreign insurers is the use of an offshore special purpose vehicle to hold their equity interest in joint ventures in China. This structure may offer the following benefits or protection to foreign insurers in dealing with their direct investment in China:
-flexible structure for future divestment or restructuring tax treaty protection of the capital gain on disposal of the equity interest in the joint venture through the treaty network of the special purpose vehicle tax treaty reduction on withholding tax arising from repatriation of dividends, interest or royalties from the joint venture greater legal protection for the ultimate parent company.
Corporate income tax issues
Once a proper holding structure has been selected, foreign insurers need to deal with the income tax issues in connection with the operations of their joint ventures or branches in China.
A key question is whether their joint ventures or branches can secure tax holidays or other tax incentives. The Chinese tax authorities currently take the view that the tax holiday and preferential tax rates enjoyed by foreign banks would not be extended to foreign insurers as domestic insurers are not granted these incentives. With China's accession to the WTO, these super national tax incentives are unlikely to be continued.
Securing a tax deduction for head office charges is another critical tax issue faced by the Chinese branches of foreign insurers. These branches generally rely on the back-office support services from their overseas head office in relation to areas such as human resources and accounting. Head office charges to the Chinese branch would likely be scrutinised by the tax authorities. To obtain a tax deduction for these head office charges, foreign insurers need to prepare detailed documentation in order to justify the head office cost allocation basis.
Tax deductibility of the various reserves and provisions made in the insurance accounts is another hot topic. Foreign insurers should be prepared to put significant effort toward explaining the nature and accuracy of these reserves and provisions to the tax officials, as well as the basis for their tax deductibility.
Foreign insurers operating in a loss position in China may not face immediate income tax issues. However, they are still subject to a heavy indirect tax burden – business tax (BT), a turnover tax levied at 8 per cent on the gross revenue from insurance business in China. Life insurers are in a particularly advantageous position here, as a range of products for life, old age and health insurance are currently exempt from BT. Foreign insurers preparing to launch life products in China should carefully observe this BT exempt product list.
Currently, foreign life insurers in China are not allowed to underwrite group life policies, health policies or pension products. However, the WTO agreement would permit them to phase in these products. In preparing for diversification, foreign life insurers may also need to evaluate the possibility of securing a BT exemption on these new product offerings as the tax costs involved are substantial.
The withholding tax consequence of cross-border reinsurance payments may become another hot tax topic in the future as China would, upon accession, permit foreign reinsurers to participate in the market through cross-border provision of reinsurance.
The tax-filing obligation of insurance sales agents is also a crucial indirect tax management issue for foreign insurers in China, especially for life insurers with a large sales force. Insurers should be aware that they are the statutory withholding agent for the taxes on commission payments made to their agents. The withholding taxes involved cover not only individual income tax but also BT.
With the above pitfalls in mind, foreign insurers in China should pay greater attention to manage their tax affairs. China's imminent entry into the WTO will not only impact the foreign insurance sector, but also reshape the country's tax and regulatory environment.
This article was written by Matthew Wong, tax partner, and Johnny Foun, tax manager, of PricewaterhouseCoopers in Shanghai. The above information is not intended to be comprehensive or final. Professional tax advice is strongly recommended before entering into any tax planning arrangements based on these notes.