Rep office clampdown

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 activities of an RO are generally limited to non-direct profit-making activities such as conducting 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:

? its immediate head office was a principal manufacturer or a principal trader, and
? it only conducted market research or provided commercial information, liaison and other services of an auxiliary or preparatory nature to its immediate head office.

Based on the old tax circulars, 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 business 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 obtaining sufficient supporting documents to confirm 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 percent of its operation cost.

Tax exemption is still possible but limited to ROs of principal manufacturers and, subject 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, taxation, 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 This method is no longer applicable.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 better 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 authorities 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 Administration 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 routine, tax audit risks in respect of any noncompliance by ROs will increase. In addition, 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 opening 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 structures and consider alternatives that may better serve their long-term business objectives.