The decision to award Beijing the 2008 Summer Olympic Games precipitated much media coverage of the business opportunities resulting from the city's need to clean up its environment and upgrade its basic infrastructure and sports venues. Foreign expertise will be needed in areas such as architecture, engineering, construction, project management and event marketing. In trying to win work, foreign companies will be faced with various regulatory, accounting and tax issues.
In bidding for project work, one of the biggest concerns is the structure under which to conclude and implement the contract. Most companies have their own preferences and internal policies in terms of what structure to use. Some prefer to execute and carry out contracts directly, using their own overseas entity. This structure generally involves selling goods to China directly from overseas and sending people there to provide the services. Some companies prefer a local subsidiary to carry out the work, or they subcontract work to unrelated third parties locally. The choice of structure depends on regulatory restrictions, award criteria and cost. Using a foreign entity works best when foreign-made goods are sold directly China, or in the provision of services where the work is performed outside China. This structure can also be used when services are rendered onshore in China or partly in China and partly offshore.
There is little restriction on using this structure, especially when all activities occur outside China. However, where services are to be provided within China, consideration needs to be given as to whether the activities can be undertaken by a foreign entity or whether they need a special license.
From a taxation perspective, stamp duty is applicable to the gross value of the contract. The direct sale of tangible goods China generally does not attract Chinese tax for the foreign seller. Unless otherwise agreed between the parties, the Chinese importer should be responsible for import duty and value added tax (VAT). For the provision of services, the offshore portion of work is not subject to any Chinese tax.
03-11-6However, onshore work is subject to business tax at either 3 per cent or 5 per cent, depending on the nature of service. Foreign enterprise income tax (FEIT) will also be applicable if the onshore activities give rise to a permanent establishment. FEIT in this respect is generally levied on a deemed profit basis, with the deemed profit rate ranging from 20 to 40 per cent and FEIT rate at 33 per cent, unless there is local concession. The presence of a permanent establishment will also trigger individual income tax for personnel assigned to work on the project.
The existence of a tax treaty is important when using offshore entities to carry out onshore services.
Tax treaties generally provide for a permanent establishment to be triggered only after activities in China have lasted for a certain period, which gives the foreign entity some protection from FEIT and individual income tax implications. However, business tax is still applicable.
Overseas payment for the supply of goods and services is subject to complex foreign exchange control administration. As part of the remittance process, tax settlement receipts or tax exemption certificates for the service portion (non-trade items) to be obtained from the local tax authorities will need to be submitted to the bank as supporting documentation. Remittance of payment is the area where most foreign companies have problems due to foreign exchange administration and tax issues.
In trying to undertake a project, the scope of the business should be given first consideration. Companies should ascertain whether or not the local entity has the appropriate scope to perform the work and whether any special licence is required to meet criteria set forth in the bid documents. With China's WTO accession, more industrial sectors are opening up to foreign investment.
FEIT represents the area with the greatest planning opportunity. Foreign enterprises, which are subject to FEIT for activities carried out in China, generally pay the tax on a deemed profit basis, which sometimes is higher than actual profit margin. However, for China-incorporated entities, FEIT is normally calculated on actual profits (revenues less relevant costs and expenses). Taking into account various tax incentives, the effective tax rate can be lower than that calculated on a deemed profit basis.
Local entities also have an advantage in terms of payment. They can invoice and receive payments in yuan, thereby bypassing foreign exchange and tax clearance complications. Under the present tax regime, after-tax profits of the local entities can be repatriated in foreign exchange without incurring additional withholding tax.
In certain cases, it is necessary to use both offshore and local entities for operational reasons and to achieve tax minimisation. This structure is applicable especially where one entity does not have the resources or is not allowed to undertake all the activities required by a project.
For example, in a contract that contains both sale of goods and provision of services in China, it may be desirable to segregate the transaction into two separate contracts or to execute a tripartite contract, provided that the buyer is agreeable to such an arrangement. As previously mentioned, a direct sale of goods into China generally does not attract any tax for the foreign seller. However, for provision of onshore services, if the duration of the service is long enough to trigger a permanent establishment, it may be more advantageous to use a local entity to undertake the service if FEIT imposed under the deemed profit method is higher than that calculated under the actual profit method.
Another alternative structure is to subcontract certain parts of the work to unrelated third parties. However, in adopting this structure, it is important to consider the business tax and FEIT consequences of the sub-contracted portion of the work. Technically speaking, sub-contract values can be excluded or deducted when calculating business tax and FEIT. Nevertheless, this arrangement has to be accepted by local tax authorities.
In deciding which structure to use, companies need to consider commercial and operational reality alongside tax and cost implications. Planning should be done as early as possible, preferably during the negotiation stages as parties need to consider whether or not a desired structure can be accepted and implemented. Notwithstanding this, structuring can still be done after contract execution, provided there is sufficient flexibility in the agreement terms.
This article was written by Matthew Mui, partner, and Howard Yu, senior manager, of PricewaterhouseCoopers Ltd Beijing office.