Although representative offices ("RO") are legally only allowed to conduct limited activities in China eg. liaison, research and marketing for their foreign holding companies, it has been a popular form of business entity for foreign companies to set up due to its simple registration requirements and no registered capital payment is needed.  Recent changes to the tax rules for ROs may however affect this trend.

The tax rules relating to ROs have been recently amended by the "Tentative Measures for the Tax Administration of Resident Representative Offices of Foreign Enterprises" (Guoshuifa [2010] Number 18) issued on 20 February 2010 (the "Circular"). The new Circular was effective retrospectively from 1 January 2010 and revoked any other circulars and regulations which are inconsistent with it. 

Significance of the New Circular

The following are the key features of the Circular :-

(a)     ROs are required to file tax on an actual basis according to their books and records and the income reported by ROs should commensurate with the functions and risks undertaken by it (Article 6). Profits deeming methods, which were in the past commonly adopted by ROs (in particular ROs conducting trading and agency services), may now only be used upon examination by and agreement of the tax authorities in certain circumstances;

(b)     The deemed profits rate has been changed to "no less than 15%" pursuant to Article 8 (compared with 10% under the old tax rules); and

(c)     Applications for exemption from enterprise income tax will no longer be acceptable unless there is a relevant tax treaty or arrangement.  The tax authorities will conduct a "clean-up" on all tax exemptions granted to existing ROs (Article 11).

Tax on Actual Basis as the Primary Method

In connection with the new requirements for ROs to file tax on an actual basis, Article 6 specifically provides that ROs shall keep their accounting books and records in accordance with the relevant laws and shall carry out its audit based on lawful and valid documents.
 
In case the RO fails to maintain sound accounting books and records or fails to make accurate tax filings, the tax authorities are authorized to determine the taxable income of the RO pursuant to the methods set out in Article 7, namely, the "expense plus method" or the "actual revenue deemed profits method" as explained below.

(a)  Expense plus method

Pursuant to Article 7(1), for ROs which are able to accurately ascertain its expenditures but not its revenue or costs and expenses, the tax authorities will use the "expense plus method" to ascertain the RO¡¦s taxable income. The formula to be used is as follows :-

Revenue = expenditures for the period / (1 - deemed profits rate - business tax rate)

Taxable income = Revenue x deemed profits rate x enterprise income tax rate

(b)  Actual revenue deemed profits method

Pursuant to Article 7(2), for ROs that are able to accurately ascertain its revenue but not its costs and expenses, the tax authorities will use the "actual revenue deemed profits method" to ascertain the RO's taxable income. The formula to be used is as follows :-

Taxable income = Total revenue x deemed profits rate x enterprise income tax rate

In both methods, Article 8 expressly provides that that the deemed profits rate applicable to ROs shall not be less than 15%.  

Moreover, if a RO engages in activities making it liable for Value Added Tax ("VAT") and Business Tax ("BT"), it shall be required to calculate and pay tax in accordance with the relevant VAT or BT regulations (Article 9).

Impact

Following the Circular, all existing ROs should now properly maintain their accounting books and records so as to ensure that they accurately reflect their revenue and profits.

It remains to be clarified as to why ROs should be subjected to VAT since ROs are not permitted to carry out processing services and the goods imported by ROs are only supposed to be used for the purpose of display.

Also, the Circular requires the profits reported by ROs to "commensurate with the functions and risks undertaken" by them.  The concept is vague and further detailed rules will be needed to avoid any uncertainties.

With the huge increase of the deemed profits tax rate from 10% to "at least 15%", the tax burden of ROs will increase significantly. Together with the recent regulations tightening control over the management of ROs by the State Administration of Foreign Exchange, foreign investors may now need to consider alternative forms of business entities for their investments/businesses in the PRC.  For foreign investors in industries that are subject to preferential enterprise income tax with a profits tax rate lower than 15%, ROs may no longer be a good option.

If you have any questions about the Circular or other issues on foreign direct investments, joint ventures, mergers and acquisitions in Mainland China, experienced lawyers in our China Business Department will be happy to assist you.