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New development on enforcement of permanent establishment in China
In a tax case ruling in late 2006 in Guo Shui Han [2006] 970 and Jing Guo Shui Han [2006] 616 (collectively called the "Rulings"), the Chinese tax authorities affirm that a Hong Kong Special Administrative Region company ("HKSAR Company") has created a permanent establishment ("PE") in Mainland China and that all its profit attributable to the PE should be taxable in the Mainland for foreign enterprise income tax ("FEIT") purpose.
Key facts of the case
The Rulings present the key facts as follows:
- The HKSAR Company was engaged in the business of sales of equipment and the provision of technical engineering services. However, it maintained no staff and conducted no business in Hong Kong.
- Its sales contracts were entered into by the staff and shareholders of a Beijing Company. Most technical engineering services were also performed by the Beijing Company.
- The HKSAR and Beijing companies are owned by the same group of shareholders who also worked in the Beijing Company.
Technical basis of the Rulings
- By virtue of Article 6 of the Implementation Rules of the FEIT law, the HKSAR Company has created a "China establishment" and the income derived inside and outside China related to the "China establishment" should be regarded as China sourced income and subject to FEIT in China.
- The Rulings emphasize that under Article 1, Sub-section 6 of the "Agreement between Mainland-China and HKSAR for the Avoidance of Double Taxation on Income" ("DTA") enacted in 1998 (similar clause provided in the updated version effective 2007), the "China establishment" of the HKSAR Company should be regarded as a PE in China due to the fact that the Beijing Company had general authority to conclude contracts habitually on behalf of the HKSAR Company.
- As such, all the profits of the HKSAR Company derived inside and outside in association with the PE should be subject to FEIT in the Mainland.
PwC observations
Despite the limited fact pattern given, it is worthwhile considering the profound impacts arising from the Rulings:
- The PE concept is not new to most foreign businesses. However, until now most attention has been focused on the provision of services by foreign contractors in China since the Chinese tax authorities have established over years effective rules and procedures to collect FEIT from foreign contractors. The PE risk arising from conclusion of contracts in China and the consequent FEIT exposures seem to be overlooked, probably due to the fact that the Chinese tax authorities have not enforced it in their assessing practice. The current tax case in the Rulings may signify that the Chinese tax authorities would gear up their enforcement in this respect;
- The fact pattern given in the Rulings appears to be straight forward, namely the HKSAR Company did not have staff and business in Hong Kong, its sales contracts were concluded by the Beijing Company, and thus all its profits should be attributable to the PE and taxable in China. However, this case may not be representative of all real-life situations. With the Rulings in place, it is imperative for foreign businesses to review their actual operations or business arrangements to ensure that they do not fall into the PE definitions under the FEIT law or that they are protected by the respective DTAs. Where necessary, there may be need to revisit and restructure their current business models for China in order to mitigate the PE risk. The practical risk of such PE exposure may first be drawn to the attention of those foreign company representative offices or trading agents in China that may be carrying on similar business arrangements with their foreign affiliates;
- Although the target of the current tax case is a Hong Kong company, it could generally apply to foreign enterprises of all jurisdictions; and
- Theoretically, the sales and services within China territory may also trigger turnover tax consequences. However, this issue is not covered in the Rulings. It is imperative to note that treaty protection is not available to turnover taxes under DTAs in general.
In short, the practical risk of PE exposures arising from the exercise of general authority to conclude contracts in China on behalf of foreign enterprises would no longer be considered as "remote". |
