There has been a noticeable increase in tax enforcement activity in specific 'high revenue risk' areas by the Chinese tax authorities over the last two or three years, leading up to and immediately following the country's formal admission into the WTO. Apart from specific attacks on clearly illegal activities such as customs smuggling and VAT invoice fraud, the major area of scrutiny in the commercial arena has been international transfer pricing arrangements, with world-class benchmarking and sophisticated revenue/cost screening techniques being applied in key tax jurisdictions to reduce avoidance of tax by multinationals.
More recently, an increased focus has been given to evasion by individuals of China's Individual Income Tax (IIT) regulations. The close attention paid by the authorities to Forbes magazine's 'China's Richest List' and other high-profile individuals – including sportspeople, entertainers, entrepreneurs and investors – has received much attention in the mass media.
The most publicised example has been that of Liu Xiaoqing, former popular movie star and entrepreneur/investor. Reputed to have been the 45th richest person in China, she was arrested in June 2002 on charges of tax avoidance. Other high profile cases include last year's second highest earner according to Forbes, Yang Bin, who has since been placed under house arrest. 'The person with higher status will fall down more heavily…' commented the Shanghai-based International Finance News.
Individuals lacking a high public profile should not be complacent either. There is an increasing scrutiny of IIT avoidance across the board, particularly after Premier Zhu Rongji's widely reported castigation last year of senior tax officials, over the apparent low level of IIT collection from high net-worth and high-income individuals.
As a direct result of this, tax authorities in major cities throughout China have introduced practices and procedures to monitor the level of IIT collection from individuals working in key areas, including: high-tech enterprises; electrical power, telecoms, banking, insurance, securities, petroleum, petrochemicals, tobacco, aviation, railway, real estate, water supply and gas supply enterprises; foreign-invested enterprises, foreign enterprises and representative offices generally.
While clamping down on tax avoidance (either intentional or inadvertent) at an individual employee level does not produce the substantial collections of underpaid tax that a high-profile transfer pricing audit might achieve, the cumulative effect of scrutiny of IIT, particularly on a targeted industry basis, can be significant. A successful tax recovery operation was carried out last year in the high-technology sector, for instance, where senior employees of several household-name corporations were subjected to scrutiny in relation to alleged under-declaration of offshore stock option benefits, prior to the dotcom implosion.
The consequence of such scrutiny is in most cases not simply a personal matter for the employee concerned – more often than not, the party most affected is the corporate employer. In the first place, the public disclosure of tax avoidance by its employees is likely to damage a company's goodwill and reputation. In addition, under many employment contracts an employee's China IIT burden will effectively be assumed by the employer, with the employee being responsible only for home-country actual or hypothetical tax. In these cases, the effective cost to the employer of underpaid IIT (ignoring penalties and late payment surcharges) is compounded due to the gross-up tax rates applied to 'net of tax' employment contracts.
Even if the employee remains personally liable for underpaid China taxes (where the employer does not offer a net of tax employment contract), the burden of underpaid IIT may in practice still fall on the employer, particularly where the employee has left China by the time any tax shortfall is actually detected. In such cases, through specific withholding agent provisions in the tax laws, the employer may be pursued for recovery of underpaid IIT, together with penalties and late payment surcharges. This can give rise to a potentially very costly burden, particularly where back-taxes have remained unpaid over a number of years.
Prior to May 1, 2001, the late payment surcharge rate applied to unpaid IIT was stipulated at a daily rate of 0.2 percent – approximately 73 percent a year. From that date the surcharge rate was lowered to 0.05 percent per day – about 18.25 percent a year, but still very high by international standards.
The clear and simple message for employers is that a potential problem should not be ignored. Underpayment of IIT is not simply a personal problem for their employees, many of whom may have a more cavalier attitude to complying with their IIT payment obligations if left to their own devices (particularly if they anticipate working in China only for a few years).
Many employers who know that they have a problem with their employees' past IIT compliance are troubled by the growing certainty that those employees will become the subject of IIT audit or inspection. This is particularly the case where aggressive compensation packaging may have been applied over a number of years.
Split employment contracts
Such techniques may involve 'split employment contracts', under which only part of an employee's total compensation is paid and declared in China, with the balance being paid offshore and not declared. Others may include deferred bonus or other compensation arrangements that have as their primary aim the total elimination or at the very least the substantial deferral and reduction of China IIT liabilities.
Employers who continue to adopt these arrangements need to realise that sooner, rather than later, the situation will be discovered by the Chinese tax authorities. Sophisticated benchmarking techniques now applied by many local tax bureaux mean there is an ever-increasing likelihood that declared compensation levels that appear out of line with regional industry group parameters will be queried. This is not to say that properly structured split employment contracts or deferred compensation arrangements will not always stand up to scrutiny, but employers need to understand and accept their risk exposure in this area.
The attitude of tax officials to genuine voluntary disclosures of under-payment of employees' IIT liabilities at the current time is often a reasonable and pragmatic one. Agreement may often be reached by negotiation to submit back-filings limited to only two or three years, with penalties and late payment surcharges also being contained to an acceptable commercial level. Of course there can be no guarantee that such a pragmatic attitude will continue to apply in the future, and it would therefore generally be wise to take full advantage of the current window of opportunity to correct past filing errors, while this still remains possible.
Going forward, an employer may be able to make substantial cost savings by fully exploring all legitimate techniques to minimise employee IIT liabilities. Spilt contracts and deferred compensation are only two of the alternatives to be considered.
Income from outside
China It is crucial that specialist advice is sought to minimise risk exposure and maximise potential tax savings. It is very unsafe to assume that accepted tax planning techniques in other tax jurisdictions can simply be applied in China to achieve similar results. Many tax minimisation arrangements hinge on the application of fundamental concepts governing the source of income or the timing of its derivation. Income which is either not sourced in China or which may be accrued in favour of an employee but not yet vested might legitimately remain outside China's tax net.
Often, however, different tax law concepts of source or derivation of income are applied in China, where internationally understood interpretations of these key concepts may be ignored by tax officials, simply due to a lack of awareness or understanding. In a similar manner, internationally accepted practices may simply be overridden by tax bureau interpretations that might not always be soundly based.
Although the situation continues to improve following China's admission to the WTO, the tax dispute and appeals process is still evolving. The current reality is that, in practice, it is unlikely that any tax dispute could be pursued through an independent appeals tribunal or through the courts. The lack of such avenues means that all taxpayers (whether individual employee or corporate employer) must determine their tax strategy according to their chosen risk profile, whether aggressive, moderate or conservative.
This article was written by David Cullen, partner and Victoria Bao, senior manager, PricewaterhouseCoopers, Shanghai. Both provide specialist advice on all aspects of China IIT and related matters.