The taxation treatment of income arising from the provision of consulting services by foreign companies in China has been a controversial area.
First, when non-resident companies provide consulting services to their clients in China, the services invariably contain both onshore and offshore elements. For example, a non-resident consulting company could either send its employees to China to provide services or it could engage a related company or its representative office in China to provide services jointly. It is generally not easy for non-resident companies to quantify and prove to the satisfaction of the Chinese tax authorities the due portions that should be treated as onshore and offshore services.
In an effort to clarify this grey area, the State Administration of Taxation issued tax circular 82 on May 12, 2000 to prescribe in clearer terms the tax treatment of income earned by foreign investment enterprises (FIEs), foreign representative offices of foreign companies (ROs) and overseas consulting firms (OCFs) engaged in the provision of consulting services in China. Circular 82 also attempts to standardise the assessing practice of various local tax bureaux when applying the current foreign enterprise income tax law and business tax law in this connection. The circular was effective from June 1, 2000.
Where FIEs or ROs sign contracts with clients to provide consulting services, the income earned is considered as earned entirely by them. As a result, the FIEs or ROs should file business tax (BT) and foreign enterprise income tax (FEIT) returns at their locations.
Where OCFs sign contracts with clients for provision of consulting services, all income earned should be subject to BT and FEIT if the services are performed entirely inside China. If the services are provided both inside and outside China, the income earned should be divided according to where the services are rendered – in accordance with the `general source' principle. Generally, if the client is located in China, the portion of services income that is considered to be China-sourced should not be less than 60 percent of the contract sum.
Where the consulting service activities are wholly conducted outside China by over-seas consulting firms, the income earned is exempt from taxation in China.
Where an OCF with an FIE or its ROs jointly sign contracts with clients for the provision of consulting services, the income earned should be allocated to each service provider based on reasonable ratios, such as work sharing or job sums as provided by contracts. The OCFs, FIEs and ROs should file their BT and FEIT returns with respect to their share of income.
Where OCFs and their related FIEs or ROs jointly provide services to a client located in China, the portion of income allocated to the FIEs or ROs should not be less than 60 percent of the total contract sum.
However, if the OCF assigns personnel to China to provide such services, at least 50 percent of the income that is allocated to the OCF should be deemed as earned inside China according to the source principle. Here, BT and FEIT returns should be filed with respect to the China-sourced income.
Circular 82 prescribes that if an OCF works jointly on a project with its RO in China, the taxable income of the OCF should be combined with that of the RO and reported in the RO's tax return. However, if an OCF does not have a RO in China working on the project, the OCF should report its taxable income through its China taxable establishment and its client should observe the relevant with-holding tax provisions applicable to payment to non-residents.
Circular 82 also acknowledges that where an OCF is resident in a tax treaty jurisdiction or in Hong Kong, the respective treaties and agreements regarding `permanent establishment' should be considered to determine if the OCF has a taxable establishment in China for FEIT purpose. If an OCF is deemed to have a `permanent establishment' in China under the treaties or agreements, it shall be liable to Chinese taxation based on Circular 82.
Under Circular 82, the tax obligations of OCFs from China consulting assignments have become more definitive. However, the prescribed minimum taxable percentages could be onerous to many OCFs where their participation in onshore work is minimal or less than 60 percent.
Prior to Circular 82, a 50-50 split was often considered acceptable to tax authorities. In future, it is anticipated that tax planning through appropriate contracts structuring will gain popularity as OCFs have more incentive to minimise their Chinese tax exposure.