It’s a common situation.
Mr. Lin, a U.S. citizen and chief representative of ForCo’s representative office in Shanghai receives his salary from abroad. So does Mr. Schmidt, an entrepreneur, who has built a thriving business making laser products in China and selling them to the U.S. His Hong Kong sales company pays him a large salary. Ms. Zhou, an Australian citizen living in Beijing and working on contract for ForCo has her salary remitted to an account in Hong Kong. All three have resided in China for more than a year. Mr. Lin and Mr. Schmidt arrange for nominal salary payments in China, on which they pay Chinese individual income tax (“IIT”). Ms. Zhou does not report income for her contracting work or pay IIT on it in China.
All three are foreign nationals and are substantially reducing their Chinese tax bills by not reporting income paid outside China. Are Mr. Lin, Mr. Schmidt and Ms. Zhou liable to pay IIT on that income? Are their employers liable to withhold IIT on their income and pay it to the Chinese treasury?
Income from wages and salaries is subject to rates ranging up to 45% in China, and income derived by individuals from labor services, dividends, interest and royalties is subject to a flat rate of 20%. Article 2 of the Individual Income Tax Law of the People’s Republic of China (“IIT Law”) lists income on which IIT is levied; in short it is levied on all kinds of income, including remuneration, capital gains and passive income. Chinese citizens and domiciliaries of more than 5 years pay IIT on their worldwide income of all kinds. Taxpayers with income from outside China (including from Hong Kong) are required to submit a tax return and remit the IIT payable to the State treasury within 30 days of the end of the year.
An individual who is not domiciled in China but has resided in China for more than 1 year and less than 5 years is subject to IIT on his/her remuneration from services performed in China (“China-Sourced Income”) and that part of his/her non-China Sourced Income that is borne by an establishment in China (“China-Borne Income”). Article 2 of the Implementing Rules of the IIT Law states that ”resided in China” means habitually residing in China because of economic involvement or certain other reasons. Temporary leave for business trips, vacation or home leave are still counted as days an individual resides in China. Article 5 of the same rules makes clear that all remuneration derived from employment or labor contract services performed in China is China-Sourced Income and therefore subject to IIT, even if payment is made and received outside China.
In other words, unless some exemption applies, Mr. Lin, Mr. Schmidt and Ms. Zhou are all required to pay IIT on income from work performed while in China, without regard to who benefits from the work or where their remuneration is paid. In addition, the employer or contracting party that pays each of them may be obligated under Article 8 of the IIT Law to withhold IIT and pay it to the Chinese treasury. Failure to comply with obligations to pay and/or withhold can result in interest and substantial penalties for both the taxpayer and withholding agent. Tax evasion or refusal to comply with directives of the tax bureau regarding unpaid taxes can result in criminal sanctions.
Some individuals are paid the majority of their remuneration outside China, often while receiving a nominal salary in China on which they pay IIT. Some continue this arrangement for years, but it can come to the attention of the Chinese tax authorities in one of several ways:
- Sale of the employer in China or its parent company abroad: Individual taxpayers may not realize they are liable to pay IIT on money received outside China, or they may know they should pay but are willing to accept the risk of discovery to realize tax savings. Large companies many not be aware of arrangements made by local management. In any case, the payments outside China are often disclosed or discovered during the due diligence review prior to closing of the sale and the buyer may refuse to accept the risk of IIT underpayment or demand a substantial discount to accept it.
- Listing: Failure to pay IIT on remuneration received outside China must be rectified or disclosed when the employer or its parent company complies with listing and ongoing disclosure requirements.
- Parent company has a low tolerance for risk: Arrangements made by local management are discovered during an internal review, and the parent company demands they be reported to the tax authority and rectified.
- Disgruntled employee: Underpayment of salary is disclosed by a fellow employee (or former fellow employee) to the tax bureau.
- New job at higher salary: The individual taxpayer moves to a position with another company in China requiring substantially the same skills but at much higher salary, and the new employer insists on reporting the full amount to the tax bureau each month.
- Audit: The arrangement is disclosed in an audit or inspection.
If the under-reporting of IIT has continued for any length of time (it may have been in place for many years), the costs to rectify it can be substantial. Further, taxpayers and their employers as withholding agents should consider that the tax bureaus can impose penalties in any case of non-payment, but they will often waive penalties and require only interest if the taxpayer or his/her employer voluntarily comes forward before being reported or discovered.
The best approach, however, is to plan for minimizing underpayment risk at the outset of an employment or services arrangement. Taxpayers and their employers/contractors should be aware of the following:
- Less than 90/183 days: If the employee or contractor taxpayer does not need to be in China more than 90 days (183 days for most treaty countries) in a calendar year, he or she should not be required to pay IIT, unless it is China Borne Income.
- 1 to 5 years: If the taxpayer is working in China longer than such period, he/she will be considered to be working in China for 1 year but less than 5 years, and will be liable to pay IIT on China Borne Income (i.e., paid or borne by an establishment in China) and on China-Sourced Income (i.e., for work performed in China), even if the party benefitting from the work is located outside China. His/her foreign-sourced income (i.e. non-China Borne Income derived from services performed outside China) remains exempt from PRC IIT, but paying his/her salary outside China does not avoid or reduce exposure to IIT on China-Sourced Income.
- Dual contracts: If the taxpayer will be working outside China for remuneration paid by an employer outside China (i.e., non-China Borne and non-China Sourced Income), he/she can reduce IIT liability by working under dual contracts. He/she has the burden of proving that no establishment in China bears the cost of the work outside China, and work inside and outside China should be clearly documented under separate contracts. IIT will generally be imposed on a days-in/days-out basis. Payments must be suitable to the work – income cannot be shifted out of China by paying a much higher rate for work abroad without proof that the skills required are different and warrant the higher rate. Note that passive income like capital gains realized outside China is not subject to IIT.
- 5 years or more: If the taxpayer employee remains in China for 5 years or more, he/she becomes liable to IIT on his/her worldwide income of all kinds, including passive income. If the taxpayer, for example, owns the parent company of his/her employer in China and plans to sell it, the proceeds from the sale will now be subject to IIT in China. To avoid this outcome, the taxpayer must leave China prior to the end of the 5-year period for more than 30 consecutive days or 90 days in total within a calendar year.
- Breaking 5+ year domiciliary status: If the taxpayer is a domiciliary for tax purposes because he/she has not left China for more than 30 consecutive days or 90 days in total before the end of the 5-year period, he/she will become subject to IIT on worldwide income, including passive income from outside China. He/she can then only break the status by:
- Leaving China for more than 30 consecutive days or 90 days in total within a calendar year; his/her status will revert to a 1 to 5 year resident status for that year only (i.e., IIT applies only to China-Sourced and China-Borne Income for that year); or
- Spend less than 90 days (183 days for most treaty countries) in China during a year and his/her status will revert to that of a newcomer to China (i.e., IIT applies to China-Borne Income only).
Special thanks to Sylvia Zhang of Jaguar Business Consultancy Ltd., Beijing for her research and comments.