what we think

One of the first vehicles available to expand into China, the representative office (RO) has over the years been used by countless foreign companies to establish a first foothold in the country. The RO offers these companies a presence without demanding a big financial commitment. However, with the introduction of new rules, the rep office has just lost some more of its attractiveness. Principally, new tax stipulations could impose considerable additional financial burdens on ROs.

When choosing an RO structure, foreign companies accept two main limitations. First, the representative office can normally only engage in non-operational activities such as liaison and marketing, providing business information and engaging in preparatory and auxiliary activities. It is not permitted to directly engage in commercial activities (except in certain specific industries such as law). Second, despite having no direct income from commercial activities, an RO must still pay taxes, usually on a deemed-income basis.

According to some reports, however, an increasing number of ROs are engaging in activities beyond their legal scope of business. To strengthen the supervision of rep offices, two sets of regulations were issued earlier this year that may have a negative impact not only on the establishment of new ROs, but also on the operations of existing ROs. Foreign companies should take note of the rule changes, and take them into consideration when devising their investment plans for China.

Rules on Registering Rep Offices

The Notice Regarding Further Strengthening of the Administration of Registration of Representative Offices (the Notice) issued by the State Administration for Industry and Commerce (SAIC) and the Ministry of Public Security (MPS) on 4 January 2010 aims to strengthen the administration of representative offices with the following provisions:

• When establishing the RO, the foreign parent company must have been in operation for at least two years. Thus, it is no longer possible to structure an RO under a recently-established special purpose vehicle.
• Among the key documents to be provided when establishing an RO are the parent company’s incorporation certificate and a bank reference letter. In the past, this letter could be provided in its original form, but now foreign companies (with the possible exception of companies from Hong Kong, Macau, and Taiwan) must arrange the same authentication as for the incorporation certificate. This means it must first be notarized by a public notary, and then legalized by the Chinese consulate or embassy in the foreign company’s home country. This additional task can be a considerable hurdle – foreign banks may be reluctant to go through the whole process of signing the letter in front of a public notary.
• Previously, most jurisdictions allowed the rep office a term of up to three years (Guangzhou was a notable exception, requiring renewal every year). The Notice reduces this term to one year. In addition, among the documents now required for such renewal is a certificate to prove the continued existence of the foreign parent company. Some observers have suggested that each year, the parent company’s notarized or legalized incorporation certificate will be required. But according to a verbal response from the SAIC, any recent, original certification issued by local governmental authorities may be accepted. In any case, local departments of the SAIC will have the right to set their own requirements.
• An RO must hire Chinese employees through an employment agent, but foreign employees can directly work for the rep office. In the latter case, however, they must be appointed as either the chief representative or as an ordinary epresentative. In the past, the law set no limitations on the number of representatives that one rep office could have, but the Notice changes this. Now the number of representatives (including the chief representative) at an RO may not exceed four, which means that no rep office can have more than four expatriate employees. The only exception is made for existing ROs with more than four representatives, which do not need to implement a reduction but cannot hire additional representatives.

While the Notice has already taken legal effect, many cities are not yet implementing the new rules. In the recent establishment of a representative office in Qingdao for example, the handling officers continued to apply the old rules. Local authorities should be consulted on a case-bycase basis on whether the Notice applies, and if so, whether the local interpretations have been adopted in a supplement.

Major Stipulations Relating to Tax

Until recently, most ROs were taxed on a deemed-profit basis with reference to their total expenses. But on 20 February 2010, the State Administration of Taxation (SAT released the Interim Rules on the Implementation Regarding Tax Management on Representative Offices of Foreign Enterprises (Guoshuifa [2010] No.18; the Rules which prescribe a reform of the system to tax rep offices. The Rules will retrospectively take effect on 1 January 2010. According to the new tax rules:

• ROs should keep accounting books and records and accurately calculate taxable income according to the functions that the RO has undertaken, and the related risks that it has assumed. Enterprise income tax (EIT) on profits and business tax (BT) on certain service-related turnover shall continue to be due at the usual rates of 25 per cent and five per cent, respectively. The Rules also refer to value-added tax (VAT) that may be due, though so far it is not yet clear how a rep office that is not permitted to engage in the trade of goods can be liable for VAT.
• If an RO cannot accurately calculate income, costs, and expenses, and is therefore unable to report due taxes on an actual basis, the competent tax authorities are entitled to assess the taxable income by way of one of
  the following methods:

1. An expense-plus method for those ROs that can calculate expenses accurately but not their income or cost. The calculation formula is as follows:

A. Total Income = total expenses for the current period / (1 – deemed profit rate – BT tax rate)

B. EIT payable = total income x deemed profit rate x EIT tax rate

C. BT payable = rateBT payable =total income x deemed profit rate x BT tax rate

2. A deemed-profit method on the basis of income, for those ROs that can calculate their income accurately but not their expenses or costs. The calculation formula is as follows:

A. EIT payable = Actual total income x deemed profit rate x EIT tax rate

In the past, a 10 per cent deemed-profit rate was generally accepted. Under the Rules, the deemed-profit rate is established at 15 per cent or more;local authorities could even decide to refer to another rule (Guoshuifa [2010] No. 19) for non-residents, which allows the rate to be as high as 50 per cent. In all, this means a considerable additional financial burden for ROs that are taxed on a deemed-profit basis, and therefore this rule may encourage many to move towards a system of calculations based on actual profits.

Under old circulars, some rep offices were able to negotiate an EIT or BT exemption based on the activities for their foreign parent company. The Rules order tax authorities to review all existing EIT exemptions, and in the future EIT exemptions may be granted only where they are available under international tax treaties. The Rules do not specify how to deal with BT exemptions and existing provisions may continue to apply. In any case, ROs that are currently enjoying EIT exemptions should prepare to file for continuance in accordance with the Administrative Rules on the Application for Preferential Treatment of Non-residents under Tax Treaties.

The Rules also empower local authorities to issue more specific regulations to arrange a smooth implementation. So far, few local rules have been adopted, but rep offices are advised to stay informed and be prepared.

Intention and Effect

The reported intention of these new regulations is to address specific problems encountered in the supervision of rep offices in China, such as amendments of registered information without approval, false documents submitted to complete registration formalities, engagement in business activities, and failure to report tax. As a result, however, ROs will become more difficult to establish, and more expensive to operate. In short, the representative office may lose some of its shine in the eyes of foreign companies that want to expand in China.

On the other hand, it remains to be seen how the new rules will be enforced. So far, the response has varied from jurisdiction to jurisdiction, and a number of key issues have been left to local interpretation. The advised approach is for existing rep offices to initiate a dialogue with their supervising authorities, not only to ensure compliance but also to learn how to minimize the additional burdens and, perhaps, even benefit from some of the new rules.