On 19 June, Liu Kun, the Minister of Finance of the People’s Republic of China, outlined draft legislation to reform the PRC’s individual income tax (PRC IIT). The full text was released on 29 June. These changes have the potential to be far reaching – impacting foreigners living or working in Mainland China, employers’ tax obligations, and holding structures for businesses and investments.
This article looks at the implications that the proposed measures may have on Hong Kong businesses and entrepreneurs operating in Mainland China.
Highlights of the reforms
The most significant elements of the PRC IIT reforms are changes to tax residence, new itemized deductions for all employees, and the extension of anti-avoidance measures to individuals.
The legislation introduces the broad concepts with the main changes taking effect from 1 January. Implementation guidance is expected to follow, but businesses need to consider the implications of the law changes and to start planning their responses now.
Without detailed implementation rules, it is necessary to make some informed speculation about how the rules may be implemented. However, the guiding principles for the reforms include the stated intention of bringing the PRC IIT rules in line with “international norms.” This and the existing corporate income tax rules offer a reasonable road map for what to expect.
New tax residence rules will impact foreigners (including individuals from Hong Kong, Macao and Taiwan) based in Mainland China, and very frequent travelers and commuters. Currently it is common for foreigners based in Mainland China to limit their exposure to PRC IIT to income sourced from the Mainland – keeping foreign assets outside of the PRC tax net. This is possible because a non-PRC domiciled taxpayer only becomes subject to tax on worldwide income after they have been resident in PRC for five full years. This five-year period can be broken, and the clock restarted, by taking a 30-day “tax break” outside of Mainland China.
From 1 January, a new tax residence test will take effect. This makes an individual tax resident in PRC if they are present in Mainland China for 183 days or more in a calendar year. It is not clear at this stage whether the five-year concession will continue.
Looking at what the “international norm” might be, it is possible to make a case either way. Most jurisdictions have a days-count test for tax residence; many rely solely on this, others relax the position allowing concessions that exclude foreign investment income for taxation for a period of time.
Regardless of whether PRC IIT retains a five-year concession, it is unlikely that any such period will be able to be refreshed as easily. The 183-day residence test would mean that resetting the concession period would require 183 days out of Mainland China to break the period of continuous residence.
So foreigners based in Mainland China and business owners operating there need to prepare for the likely future state where they become taxable on worldwide income – including PRC IIT being imposed on investment income and business holdings outside of Mainland China.
Becoming a tax resident of PRC means that the new controlled foreign corporation (CFC) rule for individuals will also apply. Assuming that the CFC rule for individuals will be consistent with the current corporate income tax rules, an offshore company is a CFC if it is majority owned (more than 50%) by PRC tax residents. If a CFC does not distribute its earnings without reasonable commercial reason, any shareholder with at least a 10% interest can have their share of those undistributed profits attributed to them personally.
The corporate tax implementation of the CFC rule also provides that a CFC can exist, even if the over 50% shareholding threshold is not met. A company is deemed to be a CFC if the PRC resident has effective control over the company in terms of shareholding, capital, operation, sales and purchase decisions, etc.
There are not rules to address the personal aspects, such as whether non-resident relatives’ shareholdings should be considered. The stated desire to align with international norms may give an indication of how the rules might be implemented. In other locations, CFC rules typically include provision for individuals’ shareholding to be aggregated if they are closely related, for example parents and siblings. It can be expected that a similar approach will be taken to prevent shareholding being fragmented between relatives.
Looking at a practical example, consider a business established in Hong Kong with significant operations in Mainland China. The majority shareholder lives with his family in Hong Kong, and also owns a separate business with operations in Vietnam and Malaysia, and property interests in Hong Kong, the U.K. and U.S. The business plan for the PRC business is to expand operations, so the owner needs to commute to factories in Shenzhen and travel to Shanghai frequently. In total, he spends more than 183 days in Mainland China.
As a consequence, the owner becomes tax resident in PRC, subject to tax on worldwide income and subject to the CFC rule. This means that not only are the profits derived from the PRC operations taxable in PRC but potentially the income and gains derived from the Vietnam and Malaysia businesses, and the Hong Kong, U.S. and U.K. property interests. All could become exposed to PRC IIT, unless relief is available under a double tax agreement.
For people living in Hong Kong and travelling to work in the Mainland, it will be important to determine how the double tax agreement will apply. In particular, people in this situation need to plan ahead and determine whether they will be able to demonstrate that they are dual resident (Hong Kong and Mainland China) and that the tiebreaker rules should resolve this dual residence in favour of residence in Hong Kong.
Increased compliance in the future
Looking at these reforms in conjunction with recent events in the tax arena leaves a clear impression of a future of tighter rules and greater enforcement of tax obligations in Mainland China. Most significantly, the PRC IIT reforms introduce rules that put new tools into the tax authorities’ tool kits to impose worldwide tax on Chinese nationals and non-Chinese nationals living in Mainland China. Also, the automatic exchange of financial asset information under the OECD’s common reporting standard will provide the information to support audit and enquiry activities.
There are also other indications that tax is becoming a topic of official and public scrutiny in PRC as it has in other jurisdictions in recent years. For example, the U.K. recently introduced legislation that increases the penalties for people who have not properly declared tax on their offshore income.
Chinese nationals’ offshore investments
For Chinese nationals, these reforms will also likely have a significant impact on offshore investments. Common holding structures for offshore investments rely on the gaps in the current PRC IIT rules that allow assets to be held without PRC tax being imposed because of the absence of anti-avoidance rules. With the introduction of CFC rules and a general anti-avoidance provision, it is necessary to reevaluate those positions.
Many structures that have been compliant with the letter of the law in the past will no longer have that shield. Combine the broadening of the tax laws with increased transparency through CRS, and greater scrutiny can be expected.
Between now and January, investment holdings should be reviewed for compliance with these expanded rules. Structures that are not compliant will need to be revisited and, if they cannot be restructured to be compliant, the financial implications of the law changes determined.
Every business with foreign nationals working in Mainland China needs to consider the implications of the changes to residence rules and potential loss of expatriate concessions for allowances. Although the cost technically falls to the employee, employers need to consider the implications on HR and mobility policies, and the ability to attract and retain foreign talent.
Business owners and investors with a personal presence in Mainland China need to consider the implications for themselves, their investments and their business interests if they are or become tax resident in Mainland China.
Although the details of the rules remain unclear, time is short if any changes are needed. It is necessary to make plans now, albeit with imperfect information.