The Chinese government is gradually tightening the rules regarding imposition of withholding tax on interest, royalty and other payments made by resident enterprises to non-residents. The latest move in this direction by China's highest national tax authority, the State Administration of Taxation (SAT), was the release in 1998 of an interpretation circular No. 757 clarifying when the liability to pay withholding tax arises in respect of payments made to non-resident corporations.
Under Chinese corporate tax law, payments of interest, royalty, rental and other income by residents to non-residents are subject to withholding tax at a rate of 20 per cent – a lower rate may apply depending on tax resident status of recipients and/or location of payers. Prior to the release of this interpretation circular, it was generally under-stood that the liability to pay withholding tax arises only when actual payment is remitted by a resident to a non-resident. This is because the tax law does not contain any pro-visions which would deem amounts accrued to a non-resident corporation but unpaid as liable to withholding tax.
Generous treatment
Admittedly, the old law was generous compared with the treatment of non-resident corporations in countries such as Singapore, Canada and the US. These jurisdictions generally tax such amounts on both `accrued' and `paid' basis when they are payable to related corporations or allow tax deduction for accrued amounts only when withholding tax has been paid.
Such a tax policy has an anti-avoidance effect as non-resident investors would not be able to defer withholding tax in the host country if they want their host country subsidiaries to have the benefit of a tax deduction of the accrued expenses. However in China, prior to Circular 757, many foreign companies were able to derive such a tax benefit by deferring Chinese withholding tax on, for example, interest charges to their subsidiaries in China as these subsidiaries book and claim interest payable to foreign parent/ sister companies as tax deductible expense.
With the release of Circular 757 on December 9, 1998, the position has changed dramatically. SAT now takes the view that withholding tax arises in the period during which the relevant amounts have been accrued by the payer corporation in its books of account. Accordingly, the relevant amounts shall be deemed to have been accrued when it has been accounted for as ‘cost or expense' by the resident payer regardless of whether actual payment has been made. The resident payer shall withhold and remit tax to the local tax authorities at that time according to law.
Significant ramifications
Circular 757 could have significant tax ramifications for subsidiaries of foreign companies that have accrued considerable interest, royalties or rental in their accounts but have not actually made payments as: (1) with-holding tax is now immediately due and payable on the accrued amount, and (2) late payment surcharge and penalty may arise on such an amount.
Another notable move by the Chinese SAT in this direction was the release of an interpretation Circular No. 4 in January 1998 which imposes business tax on royalty payments made by Chinese residents to non-resident foreign companies. Such business tax is imposed at the rate of five per cent on the gross royalty amount. Prior to Circular 4, royalty payments made by residents to non-resident foreign companies were only subject to withholding tax as discussed above. Business tax was not considered applicable to such payments since the business tax law did not make it clear whether non-residents who did not conduct business in Chinese territory but derived passive income from there were liable to such tax.
Foreign investors were relieved by the release of interpretation Circular 35 in March 1997 by SAT which clarified that business tax was not applicable to interest and rental income of movable property derived in China by non-resident foreign corporations. However, such relief was ended abruptly when SAT expressed a more aggressive stance in Circular 4 in relation to the position of royalty payments. Regardless of the underlying reasons for Circular 4, it was the beginning of a less friendly assessing attitude about taxation of passive income payments made by Chinese residents to non-residents foreign corporations.
Another example of a similar move by the Chinese tax authorities is apparent in a report about the Beijing State Tax Bureau's recent attempt to levy withholding tax on the value of software components bundled in the sale of telecoms equipment by foreign suppliers. Here, the Beijing State Tax Bureau's approach clearly deviates from international norms and the trend in China is towards a more aggressive withholding tax regime for non-resident foreign corporations deriving passive income from China.
Written by Edward Shum, China Tax Partner, PricewaterhouseCoopers in Hong Kong. The above information is not intended to be comprehensive or final. Profession-al advice is strongly recommended before entering into any tax planning arrangements based on the announced regulations.
