By Chris Devonshire-Ellis
July 18 – Most SME’s have established operations in mainland China with a company in Hong Kong to support their China operations. These companies have done so to direct billing for China work through their Hong Kong company to take advantage of lower corporate income tax base of 16.5 percent in Hong Kong (from 2008/09) compared to 25 percent in China. Is it still worth it?
The tax differential is only 9 percent. Many people may not realize it is also criminal tax evasion to bill work conducted in China from another jurisdiction, and the Chinese government is increasingly looking at businesses with overseas presence to start coming clean.
The Hong Kong tax authorities are now actively sharing data with their mainland counterparts. That means that the practice of billing a client partly in China, and partly in Hong Kong – or elsewhere – to minimize the tax burden is going to start to end. According to our contacts at the State Administration of Taxation, foreign businessmen using such tactics to evade the higher payment of tax in China “are being actively pursued.”
We hear of closer ties between the governments of Singapore and China, as they also seek to strengthen relations and share data on international business activities between the two nations.
The issue will also affect services businesses in the China market as well. Several prominent law firms promote themselves as China specialists, yet have no offices in the country and subcontract their domestic client’s China work to local Chinese firms while taking a large cut undeclared to the Chinese authorities. The payment goes from the client in the U.S. to the U.S. firm this bypassing the Chinese tax authorities completely. Yet that work should be declared in the country as China derived income.
Failure to do so constitutes evasion. The U.S. government is under pressure to clamp down on this practice and bring U.S. businesses in China back into line. As part of several agreements to strengthen U.S.-China tax ties, the Internal Revenue Service is setting up an office in Beijing within the next few months.
U.S. firms are going to have to face questions over the nature of their China activities, and whether their China derived income has been declared in the country. This is required under both Chinese and U.S. GAAP law. If not, penalties could be severe from both sides. Evasion of tax in China carries a fine of up to five times the amount due, plus the original amount.
The authorities may also request information, sometimes even from another country’s tax bureau, for records of audited accounts including the China billing in the past seven years. With the increase of Chinese foreign direct investment into the United States, authorities want to ensure Chinese usage of offshore or avoidance of state and federal taxes are minimized. To do so, China wants U.S. companies with quasi operations here to pay tax in full.
It means that companies or firms overseas, that have been issuing invoices for work conducted in China, are likely to face tax demands from the Chinese government to pay up. Businesses that have been high-profile in their provision for China work will likely be the obvious target for the Chinese tax bureau.
The implications are huge. Foreign businesses that have been engaging in less than compliant activities may start facing real problems. In the past 12 months, China has been demonstrating that it wants only serious businesses in the country that can afford the cost of the tax burden. To be fair to authorities, it shouldn’t really be a problem for foreign businesses to pay tax on China-derived income; the corporate tax rate is 25 percent, which by international standards is competitive.
Businesses that cannot afford such a rate are not in fact capable of making ends meet in China and are best closed. No one wants to see failures or untoward practices due to an inherent lack of business financial strength. Our view is that China will start to clamp down, and investigate such businesses from this Autumn onwards, as the fiscal year end approaches.
For companies then that are not in compliance with China’s tax laws, which means declaring China derived income in full, regardless of whether you have an office here or not. This is especially true if you are issuing split invoices; now would be a good time to assess the financial impact of reporting those earnings in China or face the consequences.
To get into compliance, restructuring is relatively straightforward if you are already a WFOE in the country. Just moving your billing back to China and increasing your tax exposure should assist and answer to any possible investigations.
For businesses operating and selling services to China without a legal China presence, the situation requires more serious investment. It is time to set up a legitimate entity to bill for China services in accordance with the law. Those who do not may face the unfortunate position of being questioned over the nature of the work from Chinese tax authorities as well as their own domestic tax authority.
Professional advice on these areas is recommended and compliance measures should be put in place before the end of the Chinese fiscal year on December 31.