Common Tax Pitfalls for Foreigners in China

By Rebecca Lai, Tax Partner, and Hao Dong, Tax Manager, PwC International Assignment Services

People often feel individual income tax ("IIT") in China is not a very complicated matter. The reality is that it is not as easy as you think. As a matter of fact, many people misunderstand IIT principles and end up paying "unexpected" tax liabilities plus severe non- compliance penalties and late payment surcharges. From experience, all of these can be avoided - or at least mitigated - if these potential "pitfalls" are understood from the outset. In this article, our global mobility experts from PricewaterhouseCoopers will share some of these common pitfalls and help you avoid such exposure.

Business travellers

Pitfall #1: Foreigners travelling to China are asked to keep track of their days to 183 days and below. This 183- day threshold is a tax treaty concept, whereby a foreign tax resident covered by a tax treaty entering China can be exempt from IIT when certain factors are met. However, the 183- day threshold is only one of the factors that we need to consider; the other two are often overlooked and lead to this pitfall. For the sake of completeness, these three factors are:

(i) the recipient is present in the other Contracting State for a period or periods not exceeding the aggregate 183 days in the calendar year concerned / in any consecutive period of 12 months;

(ii) the remuneration is paid by, or on behalf of, an employer who is not a resident of that other State; and

(iii) the remuneration is not borne by a permanent establishment (or simply "PE") or a fixed base which the employer has in that other State.

In counting the number of days for the purpose of the first factor, any part of a day in China is counted. So if one arrived in China on January 1st and left on January 3rd, it would be counted as three days. Also, the 183 days can be counted on a calendar year or any 12- month basis. If it is the latter, any days spent in China during the calendar year before (or after) you start (or finish) your China employment or assignment, can also lead to IIT exposure, as the counting of the 12- month period can span over two calendar years.

The second and third factors relate to the entity which bears (or "deemed" to bear) the remuneration costs. The challenge is that it is in most cases beyond the employee's control and not known to HR. The case will become even more complicated when the China tax authorities consider the overseas employer has created a PE in China. Many companies and HRs have now become more cautious and have taken a more proactive approach in mitigating the exposures arising from the second and third factors.

The following are tips to mitigate this pitfall:

- Use an effective way or technology to monitor the days of the business travellers and the project(s) they are involved in.

- Have a clear communication channel with the business travellers, project managers, finance, tax and HR departments.

- Understand the compliance and withholding requirements, and take prompt action when the tax liability arises. The monthly IIT filing deadline is the 15th of the following month and failure to comply can lead to interest and penalties.

- Have a mobility policy or guideline to deal with the tax and compliance matters. For example, a dos and don'ts list for business travellers to mitigate the PE exposures, tax arrangement when the IIT is triggered, etc.

Hence, managing business travellers is difficult and would require the cooperation of various parties in the organisation, HR, finance, project management team, etc. Professional advice and support should also be obtained.

Non - taxable Benefits

Pitfall #2: Foreign employees are eligible for certain non- taxable benefits when certain conditions are met. These include:

- Housing;
- Children's education;
- Home leave (incurred by the employee up twice a year);
- Meals and laundry services;
- Language training; and
- Relocation.

Given that the tax burden in China is heavy - with the top marginal tax rate being 45% - it is common for companies to incorporate the above benefits into the remuneration package so that it helps to reduce the tax burden of the foreign employees concerned. However, we have seen many of the arrangements fail because of poor documentation, weak internal controls and a lack of support.

The success of the program requires proper implementation and administration. If not, it will end up costing you more than you have saved. Below are some of the problems being challenged by the tax authorities:

- The contract or secondment letter for the foreign employees only indicates a gross salary while the provision of benefits is not mentioned. Apparently, this does not withstand the challenge as the entire gross salary would be regarded as taxable income.

- No or weak internal control over the day- to- day administration and reimbursement process, especially in the absence of a proper policy. As a result, non- qualified expenses are not picked up as taxable income.

- Payment is made before fapiao is presented for reimbursement. This is not in line with the tax regulations whereby the qualified benefits shall be provided either directly by the employer or as a reimbursement of actual expenses incurred.

- Failure to attend to certain formalities when implementing the arrangement. Tax authorities in some locations - - e.g. Tianjin, Guangzhou and Chengdu - - now request the implementation of these non- taxable benefits to be disclosed through a record filing. Failure to comply with this requirement may lead to underpayment of tax as well as penalties and surcharges.

Apart from the above, the law requires that the amount be deemed "reasonable", but the question often asked is how to define this. Other questions include how to deal with reimbursements when the expenses are prepaid for a period of time; how to verify the fapiao; how to handle the claim if the fapiao is lost. As most of the answers are not available in the regulations, different tax authorities may have different interpretations and approach, so it is important to understand the local requirements and practices before implementation.

Contract and payroll

Pitfall #3: Many foreign employees are paid partly in and outside China and thought they could declare the China payroll for IIT purposes without including the offshore payroll.

According to the China tax regulations, full employment income has to be reported and the China employer has the withholding obligation. Reporting only the China payroll is not in compliance with the regulations. China tax authorities can use their database for detailed analysis and benchmarking and this helps them to easily identify audit targets (especially those with reportable income below the industry average).

Where the individuals have roles and responsibilities outside of China, relief exists in that the monthly tax liabilities can be prorated based on the days spent in China. It is essential to keep a good record of travel days for correct monthly tax withholding purposes and retain the travel document - i.e. passport - for inspection in case details are requested during a tax audit.

Meanwhile, there are many companies sending their employees to China without a proper secondment letter and merely indicating in their employment contracts that they will work in China. Or, even if they have a secondment letter, the roles and responsibilities, reporting line and performance evaluation are not properly addressed or are very ambiguous. These can lead to challenges from the tax authorities on IIT, corporate income tax or PE.

As a final word of caution, the above three pitfalls are not exhaustive and, from our day- to- day practices, we have seen many more pitfalls leading to unnecessary tax exposures and challenges. From our experience, many of them could have been avoided or mitigated if there was proper and careful planning in place. Also, with the use of effective technology, it will certainly help you to better manage your risk and exposure arising from sending or hiring foreigners to work in China.

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