Our previous articles looked at some of major issues relevant to selecting an investment vehicle inChinaand how foreign investors are taxed under the enterprise income tax (EIT). The fourth article in our series focuses on two vehicles for foreign investments - representative offices (ROs) and foreign-invested partnerships (FIPs) - as well as other taxes on businesses inChina.

Income taxation of ROs

Foreign companies, particularly those in the trade agency and service industries, often choose an RO to carry on liaison and marketing activities inChina. As mentioned in our first article, an RO of a foreign company may only engage in non-profit making activities in China and must be relevant to the business of the head office, including: acting as a liaison with clients and the head office, introducing the products of the head office, conducting market research and collecting information. Thus, an RO of a foreign company may not sign and conclude contracts with Chinese customers.

Although an RO generally is not allowed to engage in profit-making activities inChina, this does not mean that ROs are EIT-exempt. On the contrary, most ROs are taxed at the same rate as domestic companies. The Chinese tax authorities generally take the position that most RO activities make meaningful contributions to the overall profit of their head offices and, therefore, the share of profits attributable to such activities should be taxed inChina. For a foreign company whose country of residence has concluded a tax treaty with China, should the activities of the company’s Chinese RO be auxiliary and preparatory in nature, the company can technically argue that those activities did not create a permanent establishment in China, therefor any business profits derived therefrom should be exempt from Chinese EIT according to the treaty. However, in practice, it is difficult to demonstrate to the satisfaction of the Chinese tax authorities that such activities are auxiliary and preparatory in nature and then obtain treaty relief.

There are two methods for ROs to calculate their taxable profits: the deemed profit method and the actual profit method. The deemed profit method is more commonly used under which an RO is taxed in accordance with its expenses or revenue. In practice, the actual profit method only applies to ROs of foreign law firms.

• Deemed profit method

         Where the profit is deemed based on the costs or expenses of an RO (i.e. cost-plus method), 

         Taxable income = Expenditure of the current period / (1 – Deemed profit rate – 5 percent Business Tax (BT) rate**)

         EIT payable = Taxable income × 25 percent EIT rate 

         Where the profit is deemed based on the revenue of an RO, 

         Taxable income = Revenue of the current period × Deemed profit rate

         EIT payable = Taxable income × 25 percent EIT rate 

         The deemed profit rate cannot be lower than 15 percent. 

•       Actual profit method

         Under this method, taxable income is the amount remaining from gross income after costs/expenses, losses, etc. are deducted. Like a normal foreign-invested enterprise, an RO must maintain accounting books and records and be able to accurately calculate its taxable income if the actual profit method is applied. 

** NoteIt is unclear whether the 5 percent Business Tax will shift to Value-Added Tax (VAT) after the VAT reform. Our experience has been that most tax authorities still consider an RO’s activities to be subject to Business Tax rather than VAT, although local practice may vary. 

(Our next article will discuss Income Taxation of Foreign-Invested Partnerships)