The current Chinese Individual Income Tax Law, which came into effect on January 1, 1994, is applicable to foreign individuals, local residents and entrepreneurs. Since its promulgation, the law has been supplemented by various administrative rulings issued by the Ministry of Finance and the State Administration of Taxation (SAT) which, although not codified, have the force of law.
The rule which has attracted most attention is the clarification of the five-year residence rule. According to the IIT Law, individuals who do not have a domicile in China but have resided there for more than five years will be subject to IIT on all income, including that derived from outside China. This means that worldwide income, including royalties, interest income, capital gains and non-China sourced salary income, will be subject to IIT starting from the sixth year of residence.
The Ministry of Finance and SAT have clarified that the residency rule refers to individuals who have resided in China for five consecutive years and in each of those years have resided in China for a full tax year. A full tax year refers to the case where an individual has resided in, and not departed from, China for more than 30 consecutive days or a total of more than 90 days during the year. The counting of the five-year residency period starts from January 1, 1994, or the year in which the individual started to reside in China, whichever is later.
In order to avoid being taxed on worldwide income, the following steps could be taken to break the exposure:
-simply leave China for a consecutive 31 days or a total of 91 days in the fifth year
-have an employment outside China and do not reside in China for more than 183 days (or 90 days for non-treaty residents) during the sixth year
-simply leave China for a consecutive 31 days or a total of 91 days during the sixth year and each year thereafter, so that only the income sourced in the Mainland for those years will be taxable.
As the Chinese tax authorities become more sophisticated, they are starting to focus on areas which they ignored in the past. The SAT issued a circular in January 1998 concerning the levy of IIT on individuals who receive a discount or subsidy from their employers when they exercise stock options.
Under the circular, individuals (whether or not domiciled in China) will be taxed on the discount or subsidy received from their employers as a result of their services or employment at the time they exercise the stock options. The discount or subsidy will be regarded as salaries or wages from employment and taxed in accordance with China's IIT Law. The gain on the subsequent disposal of stock by the individuals will be regarded as income from the transfer of marketable securities, and not as income from employment.
However, the circular is not able to clarify all the uncertainties on stock options. It does not provide any guideline on the IIT treatment of stock options if they are awarded as the result of employment in both China and overseas.
Employers' contributions to overseas insurance funds is another area the tax authorities did not address until covering in detail in the May 1999 issue. In summary, a circular was issued in June 1998 requiring an employer's contributions to overseas insurance funds to be brought to tax in China and employees working in China are not allowed to deduct the contributions made by them-selves to overseas social insurance for the purposes of IIT.
Tax treatment of directors
In the past, directors of a foreign parent company would assume the management role in the foreign investment enterprise in China. Directors may receive compensation from the foreign investment enterprise even though they may not have any position there which entitles them to such compensation. Therefore the compensation received by directors of foreign companies was reported as directors' fees or dividends, which resulted in more favourable tax treatment.
In order to mitigate this shortfall, the SAT issued a circular in May 1999 clarifying the tax treatment of such payments to directors. The circular provides that as this compensation is received by the directors for the pro-vision of services in China, it should be subject to tax in China as China-sourced employment income.
Since Hong Kong returned to China in July 1997, an increasing number of Hong Kong SAR residents have been working in the Mainland. An arrangement has been put in place between China and the SAR to ensure that Hong Kong residents are not paying income tax twice.
The arrangement provides that salaries and wages derived by an SAR resident for services rendered in the Mainland in respect of an employment are not taxable in China if all the following conditions are met:
-the individual stays in China for a period or periods not exceeding the aggregate 183 days in the calendar year concerned
-the individual's remuneration is paid by, or on behalf of, an employer who is not a resident of China
-the individual's remuneration is not borne by a permanent establishment in China.
While there have been several measures which tighten the control of IIT, there have also been recent developments which have resulted in IIT relief.
For example, the Shanghai Finance Bureau and Local Tax Bureau issued a circular in August 1998 clarifying the IIT incentive for acquiring residential properties. The incentive will apply to both local individuals and expatriates (including residents of Hong Kong, Macau and Taiwan) who file IIT returns in Shanghai and who acquire residential properties in Shanghai between June 1, 1998 and May 31, 2003. This incentive is to allow payments of principal and interest on mortgage loans by individuals for acquiring residential properties to be deducted for IIT purposes over this period upon approval from the tax bureau. The incentive will be applied on the ‘pay first, refund later' basis.
In the past, lump sum bonuses (excluding monthly bonuses) received by individuals who do not have their domicile in China should be treated as salaries and wages for a separate month, with no deduction and time apportionment allowed to be applied against the bonuses. With a new circular issued in May 1999, individuals are permitted to exclude completely the portion of bonus attributable to the months they do not work in China at all. This is provided they are not employed by a foreign investment enterprise and do not travel frequently into China to perform their duties.
In view of the rapid changes in China's tax laws and regulations, it is important to keep abreast of developments in the IIT Law. Employers are the withholding agent and need to ensure that their employees are remitting an accurate amount of IIT and are liable for any unpaid or underpaid employees' IIT. These may result in hefty interest and penalties if non-compliance persists for a long period of time.
Currently, the major target of the tax audit is expatriates' IIT. Therefore, we would recommend companies perform a review of IIT compliance and that all problems are rectified before the taxman knocks at the door.
Written by Ms. Doris Yang, tax partner, and Mr. Vincent Pang, tax manager, PricewaterhouseCoopers in Beijing. The above information is not intended to be comprehensive or final. Professional advice is strongly recommended before entering into any planning arrangements based on the announced regulations.