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LEGAL:Chinese Taxation Recent Updates PART I
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Chinese Taxation Recent Updates  PART I

By Diego D'Alma (Principal Associate), Guanyu Shen (Associate) and Manuel Torres (Partner and Shanghai & Beijing Office Director).


1. Stricter Rules on Overseas Remittance to Affiliates: Circular 16

It has been the usual topic in China - how foreign investors cash out from their existing subsidiaries there. The most usual channels have been the following:


BT 201512 140 02 Legal 0021.1 Dividend distribution
When the subsidiaries in China have generated profits, dividend distribution can be resolved after the compensation of previous losses and the accrual of relevant statutory reserves, according to Chinese corporate rules.


Normally, the distribution of dividend would be subject to the Chinese withholding tax (enterprise income tax) amounting to 10 percent of the distributed. Some double tax treaty ("DTT"), entered into by China, grants preferential treatment on the withholding tax rate, i.e. five percent upon the meeting of relevant conditions.


There is no indirect tax to be levied on dividend payment.


1.2 Royalty payment
Where foreign affiliates provide usage rights for relevant intellectual property (IP) to Chinese subsidiaries, the foreign affiliates could charge royalties from the latter. Normally, the IP could be trademarks, technologies or just know-how.


Payment of royalties would be normally subject to the Chinese withholding tax amounting to 10 percent of the payment. Some DTT entered into by China provides a lower withholding tax rate, i.e. seven percent upon the meeting of relevant conditions.


The payment of royalties would be also subject to Chinese VAT at a standard rate of six percent, which shall also be withheld by the Chinese payer during remittance. The six percent VAT can create input VAT for the Chinese payer, if s/he is a general VAT payer (GVP) in China. Royalty for the usage of relevant technology might be entitled to a VAT exemption if the import of the technology can be recognized by the relevant provincial-level technology department in China.


1.3 Service fee
Where foreign affiliates provide certain services to Chinese subsidiaries, normally the former would charge service fees from the latter.


Whether the payment of service fees is subject to Chinese enterprise income tax (EIT) would depend on the foreign provider having a permanent establishment (PE) in China by virtue of relevant DTTs and Chinese domestic EIT laws. Normally, in general terms and depending on each DTT, a PE could be any of the following:


- A fixed place in China by the foreign provider, e.g. office, factory
- A dependent agent of the foreign provider, which can conclude contracts in China on behalf of the foreign provider
- Assignment of personnel to China by the foreign provider for the provision of services, who stayed in China for more than six months (183 days) out of any consecutive 12-month period


If there is a PE, the service fees would be subject to Chinese EIT at a standard rate of 25 percent by a deemed profits rate of no less than 15 percent. If there is no PE, the service fees would be free from Chinese EIT.


By virtue of Chinese VAT reform, many modern services -- e.g. consultancy services -- become subject to VAT at a standard rate of six percent, instead of original business tax (BT). The six-percent rate can create VAT input for the Chinese payer if s/he is a GVP in China.


BT 201512 140 03 Legal 001It may be noticed that the amount of dividend can be ascertained by actual book figures, whilst the pricing for services and royalties between affiliates might be a more discretional pursuant to business considerations within same group companies. In addition, service fees may be cashed out without any Chinese tax cost -- i.e. when all the services are provided offshore from China, there would be no EIT charged, and the six percent VAT would not be an expense for the parties since it can be used to offset the VAT payable for the Chinese payer.


Chinese tax authorities have noticed such potential discrepancies in their taxation administration, and therefore issued Circular 16.


Circular 16 re-emphasizes both the application of the arm's-length principle for affiliated transactions and the business substance of the transactions, notably:


- General controlling, supervision, and management services that foreign affiliates provide to Chinese subsidiaries in order to maintain the good status of its Chinese investment may not constitute business substance of the services

- Services which can be performed by the Chinese subsidiaries themselves cannot constitute business substance if foreign affiliates provide them

- Royalties paid to the mere owner of certain IPs (which actually have no contribution to the value its usage) may not constitute business substance of the royalty payment

- For IPO purposes, royalties paid to overseas established holding companies or financing companies may not constitute business substance.BT 201512 140 01 Legal 001


The aforementioned affiliated payments -- among others -- without a business substance do not constitute expenditure for the Chinese subsidiaries and, thus, cannot be deducted before the calculation of the EIT payable. This effect is based on the original regulation within Chinese EIT Law (2008), that any expenses irrelevant to the business operation of an enterprise may not be deductible for EIT.


Garrigues' comments:
Multi-national companies (MNC) are recommended to observe their existing agreements for cross-border charges from Chinese subsidiaries, especially considering that general consultancy services for general control of the subsidiaries (e.g., shareholders' activities, including the plan, management and supervision of the operation; human resources and financial matters of the Chinese subsidiary) may no longer represent qualified business substance. It's suggested that engineers or specialists from other departments be involved in the initiation of relevant service agreements, subject to underlying business, in order to input professional terminologies and areas to qualify for business substance.


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