Rep office clampdown

Since it is becoming much
harder for representative offices to obtain tax exemption approval, it may be time for FIEs to
consider alternatives.

Since China opened its door to foreign investment
back in the early 1980s, the
resident representative office (RO) has been one of the
most popular market entry structures adopted by foreign investors due to its simple
operation and relatively low start-up costs. The legally permitted activi-ties of an RO are
generally limited to non-direct profit-making activities such as con-ducting business
liaison, market research and assisting in head office trade visits. However, it is still subject
to Chinese taxes unless granted exemption by the mainland tax authorities.
Until a
new tax circular was implemented on July 1 this year, an RO would be qualified for tax
exemption if:
ï‚· its immediate head office was a principal manufacturer or a
principal trader', and
ï‚· it only conducted market research or pro-vided
commercial information, liaison and other services of an auxiliary or preparatory nature to
its immediate head office.
Based on the old tax cireulars, principal traders are
defined as companies engaged in trading business on their own account and bearing
inventory risks. The RO of such a principal trader could be exempt from busi-ness tax and
corporate income tax in China. However, in practice the tax authorities have been reluctant
to grant them tax exemption approval because of the difficulty in obtainmg sufficient
supporting documents to con-firm whether the head office acts as a pond-pal trader or a
commission agent.
Possibly because of this difficulty, the new circular states that
the RO of a trading company (including both principal traders and commission agents)
should be taxed on a cost-plus basis, calculated at about 10 per cent of its operation
cost.
Tax exemption is still possible but limited to ROs of principal manufacturers
and, sub-ject to approval by the State Administration of Taxation, government organisations
and non-profit-making organisations. In addition, the ROs would be required to provide a
certification issued by the home country's tax authorities to confirm the nature of their
operations.
Previously, ROs engaged in consulting services in the areas of
business, law, taxa-tion, accounting and auditing could apply to
use the cost-plus
method for calculating China tax liabilities. This method is no longer applicable. Under the
new circular, such ROs are required to keep a complete set of books and records in order
to ascertain the taxable amount and file their tax returns on an actual income
basis.
In addition, the exempted RO is required to submit an annual report on its
activities within one month after the year-end. This would enable the local tax authorities to
bet-ter monitor the activities of tax-exempt ROs so as to confirm their eligibility for tax
exemption. A more stringent tax exemption approval process is likely after this circular
became effective on July I.

Strengthening controls
Over the last
two years. local tax autharities have adopted stricter procedures on the tax administration
and audit inspection of ROs. This new circular puts greater pressure on local tax
authorities to exert these controls. For example. they are required to strengthen their
communications with other relevant local authorities, such as the State Adminis-tration of
Industry and Commerce and the Ministry of Commerce. with the objective to improve tax
administration control on RO tax registration and tax filings.
As the tax
administration on ROs tightens and tax audit inspections become more rou-tine, tax audit
risks in respect of any noncompliance by ROs will increase. In addi-tion, with the tightening
up of approval review on tax exemption applications, it is becoming more and more difficult
for ROs to obtain such tax exemption approval.
After its accession to the World
Trade organisation, China has been gradually open-ing up its domestic markets – for
example. foreign investment entities will soon be allowed to set up trading companies in
China to conduct domestic trading. Therefore, some of the traditional rules of the RO will
diminish. It may also be time for foreign Investors to review their existing RO struc-tures
and consider alternatives that may bet-ter serve their long-term business
objectives.

Written by Charles Leung, partner, and Janet Xu, senior manager of the Guangzhou office of PricewaterhouseCoopers.