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China
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China is a strong player in the global market and wants to take the leading position. Europe and the USA are having a hard time with a lot of things when it comes to the thinking and direction of the Chinese government. But economic ties have become so close that European companies would do well to establish their own presence in this market. This guide is intended to provide assistance.

Table of Contents

General conditions in China

China has a civil code corresponding to the Civil Code, which is based on corporate law and tax law, including accounting based on the Western model. In terms of content, the ideas of the Chinese central government are of course anchored in these blueprints. The economy is also centrally controlled, but there is a high degree of privatization. The state exercises an omnipotence over its citizens that is unparalleled. But that hardly seems to bother the citizens. Because the Chinese people, especially the elderly, still know the reality of life 45 years ago.

You cannot deny or blame people for being hardworking and inquisitive. The drive for personal prestige is closely linked to professional advancement and money. If a Chinese young man today can only find a woman to marry if he owns a condominium, then it quickly becomes clear how closely personal, family concerns are linked to his professional and financial situation. Although China calls itself a communist state, in reality there is predatory capitalism at all levels.

Digital surveillance

Now that the elites have worked their way up to billionaires and know how to get there, a heavy hand is now being clamped down wherever corruption or other offenses against state interests are noticeable. Through maximum control through digital surveillance, the state not only protects itself against the emergence and spread of harmful ideas.

Through comprehensive digital monitoring of people's movements, spoken words, and access to companies' digital data, the state misses out on next to nothing. Any gaps are quickly identified and closed with determination. Anyone who doesn't follow the rules will feel it. Anyone who, as a person or as a company, violates the applicable law can be forced to leave the country.

One can easily imagine that successful companies will not be shut down in this context, but will simply be transferred to other hands. Companies are threatened with the total loss of their investment and years of development work. Not all companies have noticed this and have therefore not instructed their employees on how to deal with the new situation. Anyone who allows themselves to continue to travel in the old ways by doing nothing is risking a lot. Compliance is more important than ever.

The tax system in China

The Chinese state primarily levies taxes on income and sales. As in other countries, these two areas must be viewed separately. Therefore, this article only deals with the income tax of companies, while we discuss the income tax of private individuals, especially foreign employees working in China, and sales tax in China in separate articles.

The tax subjects with regard to income taxation are natural persons and companies. Foreign companies are no longer given preferential treatment over domestic companies. Regardless of the legal form chosen, you are subject to corporate income tax (CIT). This is also applied to the taxation of permanent establishments that foreign companies have in China. This can even have a positive effect if, for example, a German OHG or KG has set up a permanent establishment in China. The pro-rata result is then subject to the 25% CIT (although the amount of the profit may be negotiable). In Germany, the result is simultaneously exempt from trade tax and income tax.

Corporate Income Tax

After being founded, companies in China must first register for tax purposes. This should typically be done within 30 days of the business license being granted. Without tax registration, it is not possible for a company to open a bank account. All company accounts must be reported to the tax authorities; banks store the company's tax numbers in the account information.

The companies' income is determined based on the Chinese trade balance through additions and settlements. A linear tax rate of 25% applies to all companies. However, the tax rate for smaller companies is reduced to 20%. High-tech companies pay 15% CIT for corresponding investments. Further discounts are granted in certain special economic zones. Losses can be carried forward into the future and offset against future gains. There is no loss carryback.

A tax rate of 20% applies, for example, to “non-resident” enterprises that have no establishment in China or whose establishment in China cannot be attributed any income and to small companies with low profits. This includes industrial companies whose income does not exceed RMB 300.000, which do not have more than 100 employees and whose total assets do not exceed RMB 30 million. For all other companies, upper limits of income of RMB 300.000, 80 employees and a balance sheet total of RMB 10 million apply (Implementation Rules.

The tax rate of 15% applies to companies that qualify as new and high-tech companies worthy of support - possession of their own intellectual property is also a requirement).

Reduced tax rates

Companies operating in the following areas can be exempt from tax or benefit from reduced tax rates:

 

  1. Agriculture, forestry, livestock farming or fishing
  2. funded infrastructure projects
  3. Projects for environmental protection or saving water and energy
  4. Technology transfer (under certain conditions)
  5. “non-resident” enterprises that have no establishment in China or whose establishment in China cannot be assigned any income (for which a reduced tax rate of 4% already applies according to Article 20)

 

The governments of autonomous regions also have the option of granting tax advantages, which then have to be approved by the government.

Tax advantages for high-tech companies

Foreign companies with a Chinese subsidiary that operates in the high-end technology sector or in the area of ​​so-called “high value-added services” are subject to a tax rate reduced to 15%. Companies that operate in the following areas are eligible:

 

  • Computer and information services (e.g. “information system integration” and “data service”),
  • Research and Development
  • Industrial design, cross-border
  • Licensing and transfer of IP
  • cultural technological services (digital production of cultural products) and
  • traditional Chinese medical medicine and treatment services.

 

In addition to the reduced tax rate, these companies benefit from the fact that they can write off their research and development expenses not only immediately in full, but also multiplied by a factor of 175%.

Business expenses can be deducted to a limited extent

The law specifies which costs can be deducted from income and which cannot. A prerequisite for the deduction of costs is that these costs are “reasonable” and related to the generation of income. Another requirement is the presentation of a so-called Fapiao, a special form of invoice.

As is well known, digitalization in China is much more advanced than one could even imagine in Europe. With effect from January 1, 2019, the paper form of the Fapiao was abolished in a pilot phase and replaced by an electronic form. In several cities, including Shenzhen, the WeChat app, which is installed on practically every smartphone in China, has been functionally expanded. Additional provinces were added on September 1, 2020. The new system is expected to be introduced across the board by the end of 2020. The first fapiao of modern times was issued by a restaurant. WeChat can also be used to book free parking spaces and pay for the hairdresser or the bread roll at the kiosk. For this purpose, information from consumers' smartphones is automatically linked to that of entrepreneurs and the tax office based on blockchain technology.

Input tax

The old officially issued forms may continue to be used for the time being. Therein lies the danger of continuing as before. Not all companies have noticed this and have therefore not instructed their employees on how to deal with the new situation. Anyone who allows themselves to continue to travel in the old ways by doing nothing is risking a lot. Because input tax fraud is increasingly being punished harshly. Anyone who, as a person or as a company, violates the applicable law can be forced to leave the country. One can easily imagine that successful companies will not be shut down in this context, but will simply be transferred to other hands. Companies are threatened with the total loss of their investment and years of development work.

Business expenses

Under the conditions mentioned, regardless of their allocation to a value creation process, the following business expenses are partially fully deductible, but partially deductible only to a limited extent:

 

  • Compulsory insurance contributions for employees, up to 14% of wage costs (IR Art. 40)
  • Certain insurances (IR Art. 46)
  • Investments for environmental protection or saving energy and water, a maximum of 10% of the investment amount in the current year, the unclaimed amount can be carried forward to the next 5 years. (Art. 34; IR Art. 100)
  • Donations to charitable purposes, maximum 12% of profits (Art. 9; IR Art. 51)
  • Up to 70% of investments in small/medium unlisted high technology companies by Venutre Capital companies. The investment must be held for two years. (Art. 31; IR Art. 97)
  • 50% or 150% of the costs for qualified research and development activities (Art. 30; IR Art. 95)
  • Advertising costs amounting to a maximum of 15% of sales revenue; any excess amount can be carried forward into the next few years. (IR Art. 44)

 

Deduction bans are also formulated by the CIT (Article 10), for example:

  • Sponsoring
  • Costs not related to generating revenue. This also includes stolen goods!

 

Derivative goodwill acquired through an asset deal cannot be deducted until the company is sold or liquidated. (IR Art. 67).

Tax losses

A loss is defined as a negative amount resulting from the deduction of non-taxable income, tax-exempt income and various other permissible deductions from the total income for the respective year (IR Art. 10). The Loss carryforward However, this is only taken into account for the annual tax return, not for the quarterly tax returns. This will result in a higher tax burden in the current year, followed by a tax refund at the end of the year.

According to Art. 18 CIT, losses can be carried forward for a maximum of 5 years. The previous year's losses are only fully offset in the following year. If offsetting is not possible due to further losses, only 80% of the initial loss carryforward can be used in the second year, 60% in the third year, only 40% in the fourth year and only 20% in the fifth year. The rest expires.

Retroactively from 2018, so-called “High-and-New Technology Enterprises” (HNTE) and so-called “Technology-based Small and Medium-sized Enterprises” (TSME) will be granted an extended loss carryforward period of up to ten years in certain cases. Unused tax losses that a company incurred in the five years before qualifying as an HNTE or TSME can therefore be carried forward and used for up to five additional years.

Withholding tax

Taxed profits may also be distributed abroad. According to the DBA China-Germany, 5% capital gains tax can be levied on dividends. These can be taken into account in Germany if the recipient is a natural person or a partnership. If the recipient is a corporation, the dividend is tax-free, so that the tax levied in China is not offset. However, China has retroactively decided to suspend withholding tax if the distribution is directly reinvested in China.

Favored direct investments include capital increases in an existing equity investment, new participation or expansion of participation in previously unaffiliated Chinese companies, the establishment of a new Chinese company and other forms of investment permitted by the Chinese Ministry of Finance. However, the acquisition of listed shares is excluded, with the exception of certain permitted strategic investments, as well as the acquisition of interests in affiliated companies.

Dates and deadlines

  • The tax return must be submitted within 15 days of the end of a quarter. The tax should also be paid during the same period.
  • The annual corporation tax return must be submitted within 5 months of the end of the year

 

Failure to file the tax return on time will result in a warning and a maximum fine of RMB 2.000. In addition, points are deducted from scoring. You will be given a new deadline in which you can submit your tax return. If the tax return is not submitted again, a higher fine will be due. The company also has to expect severe sanctions. The electricity may simply be turned off or qualified employees may be encouraged to look for another job.

Effect of the DBA

Germany and China signed a new agreement to avoid double taxation in 2016. A company is still subject to tax in the country in which it is registered and therefore resident. Under the agreement, a company is tax resident in the country in which its general management is located. Pure domiciliary companies are permitted and can often be found in China, including in the form of the “office-in-office solution from AHK Shanghai or other providers. Although these companies are registered in China, they are managed from abroad and are therefore subject to tax there.

Under the treaty, a company's profits are taxed in the country in which it is resident unless the company has a permanent establishment in the other country. Then the profits attributed to this permanent establishment are taxed in the other country.

Plants in China

What exactly is meant by a permanent establishment is defined in Article 5. Accordingly, a permanent establishment is a “fixed business facility through which the activities of a company are carried out in whole or in part”, in particular the term also includes a “place of management”. This definition based on the location of management makes a small but subtle difference that has an impact on the qualification as a permanent establishment. Let's consider the following example:

A German company has an office in China with employees through which raw materials are to be sourced from the Chinese market. There are various suppliers to choose from. In the first case, all information is passed on to Germany. There it is decided from which supplier the raw materials should be purchased and this information is passed on to the Chinese office that sources the raw materials. The location of the management is in Germany, so it is not a permanent establishment. Taxation takes place in Germany.

In the second case, a person in the Chinese office has the authority to choose the supplier themselves. The location of management is now in China, which means that the conditions for a permanent establishment are met, which is now taxed under Chinese law.

Also the term “fixed place of business” requires a more precise definition. For example, if a service employee travels through China equipped with only a toolbox to carry out repairs here and there, the toolbox does not constitute a permanent business facility. A workplace in a co-working space is not considered a permanent establishment; a closed office only if there is appropriate infrastructure such as internet connection and furniture.

Service establishment

A special feature of the agreement with China is this Service establishmente. This occurs if a company provides services, including consulting services, with the help of its own employees or other personnel committed for this purpose and the project lasts a total of more than 183 days within a year-long period of twelve months.

Furthermore, this defines WBA also facilities that, due to their nature, represent permanent business establishments, but are nevertheless explicit not The following are considered permanent establishments:

a) Facilities used exclusively for the storage, display or delivery of the Company's goods or merchandise;

b) Inventories of the Company's goods or merchandise maintained solely for storage, display or delivery;

c) Stocks of the Company's goods or goods which are maintained solely for the purpose of being processed or processed by another company;

d) a fixed place of business maintained solely for the purpose of purchasing goods or merchandise or obtaining information for the company;

e) a fixed place of business maintained solely for the purpose of carrying out other preparatory or auxiliary activities for the company;

f) a fixed place of business maintained solely for the purpose of carrying out several of the activities referred to in points (a) to (e), provided that the resulting overall activity of the fixed place of business is of a preparatory nature or constitutes an ancillary activity.

Result of the permanent establishment

For a permanent establishment, separate accounting and not annual financial statements under commercial law must be prepared, but a tax balance sheet with a profit and loss statement in accordance with local law, in the local language and currency. Since permanent establishments are not legally independent companies, this means maintaining shadow accounting for purely tax purposes. The balance sheet allocation of assets, proportionate equity and liabilities must be carried out according to economic allocation is already a challenge in itself. The transition to Chinese law, management in the local language and currency conversion are further tasks that need to be mastered. This entails corresponding costs for the tax advisor, without whom this is hardly possible.

Whether the tax authorities of the countries involved have the same views on the distribution often only becomes clear years later during tax audits. The company would be more helped if it received early, reliable tax assessments.

Failure to prepare tax accounts in China

In China this is possible by openly declaring that you cannot prepare the required tax balance. In this case, China will estimate the permanent establishment's earnings and apply a national regulation to do so. After that, the profit is estimated at 15-45% of the income. It is therefore a question of negotiation as to what percentage you can agree on. Of course, this only makes sense if the actual profit is not significantly lower and an allocation of expenses and income can be clearly presented.

Regardless of the estimated or negotiated amount of the result taxed in China, the actual profit from the permanent establishment must be exempt from taxation in the country of residence of the company.

Jürgen Bächle
Jurgen Bachle

has been working as an independent tax consultant and expert in international tax law since 1989 and has been a member of the board of the German Association of Tax Consultants Baden-Württemberg, DSTVBW, for over 20 years.

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