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FINANCE: The latest IIT trends and challenges affecting foreign employees and their employers
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The latest IIT trends and challenges affecting foreign employees and their employers

By Kelvin Lee, PwC Tianjin

In brief
BT 201608 140 01 Finance 234bfd 438d5f33c8a04392a1f8a8964afc3787Over the past few months, we have seen tax bureaus in major cities across China taking strict action to tighten the tax compliance requirements and tax collection on China Individual Income Tax (IIT). These efforts include implementation of new measures over the administration of non-taxable fringe benefits and new tactics against those who failed to report their offshore payroll. The new measures and tactics target foreign employees working in China and have been successful in recovering some tax revenue loss - it is likely that they will be adopted widely in other cities across China in the near future.

In this article, we will share with you our observations on these new measures and tactics as well as recommendations for companies and foreign employees on how to manage their tax exposures, such as ensuring they have the proper contractual and supporting documentation and complying with additional registration requirements.

In detail
New measures over non-taxable fringe benefits

In China, all employment related income received by an individual (whether it is in the form of cash, kind, marketable security or any form of economic benefits) is taxable for IIT purposes, except for the provision of certain fringe benefits to foreign employees which can be exempt from IIT. These benefits include:

- housing
- meal and laundry
- home leave
- children's education
- language training
- relocation

BT 201608 140 04 Finance hlHowever, there are certain requirements and local practices that must be met for these fringe benefits to remain exempted from IIT. Based on our observation, many companies and foreign employees fail to understand and comply with these requirements and practices. As a consequence, when they are audited by in-charge tax bureaus, their arrangements (including tax exemption status) are successfully challenged and they need to pay back the underpaid taxes together with late payment surcharge and non-compliance penalty.

In Shanghai, after having been introduced in early 2016, a detailed breakdown and disclosure of the non-taxable fringe benefits is now required to be reported in the monthly IIT return. By doing so, tax authorities have a more complete picture of the compensation level and income components of foreign employees concerned. In addition, in recent months, an increasing number of local tax bureaus in Shanghai have required companies to register their non-taxable fringe benefit arrangements with the in-charge tax bureau in order to secure IIT exemption. Some companies, in our view, appear not to have a proper structure and arrangement in place and can be easily caught by the in-charge tax bureaus when they perform registration.

In Beijing, a special tax inspection is being conducted specifically on non-taxable fringe benefits. During the inspection process, the in-charge tax officials will review relevant documentation including employment contract/secondment letter, company reimbursement policy/guideline, original tax receipts ('fapiao') etc. The tax officials will also pay particular attention to the following areas:

- supporting documents - whether there is any fapiao to support expenses and tax exemption claim and whether the fapiao is genuine or not;
- non-qualified expenses - whether the amount is spent on non-qualified expenses (e.g., home leave expenses for family members) which would be re-classified as taxable income; and
- reasonable nature of expenses - whether the amount involved is within a reasonable range.

Therefore, companies and foreign employees should review their current arrangements and make sure they are in compliance with the law and changing local practice.

New tactics against offshore payroll
BT 201608 140 02 Finance Income TaxDual contract arrangements have been (and are still) used by companies and foreign employees in IIT planning. Under a typical dual contract arrangement, foreign employees will enter into two employment contracts - one with the Chinese employer and the other with an overseas employer. The salary will be split between the two contracts and partly paid inside and outside of China. However, for the IIT reporting, they will usually report only the portion of the employment income that is allocated to the Chinese contract when they should have reported the combined employment income from both contracts. There are usually historical and commercial reasons for using dual contract arrangements but we have seen an increasing number of companies reviewing these arrangements and making necessary changes.

The tax position and reporting requirements of a dual contract arrangement may be different and on a case-by-case basis. In general, some companies and foreign employees would try to argue that the portion of salary allocated to the overseas contract and paid outside of China should not be subject to IIT because (i) the income is derived from overseas; (ii) they are only liable to IIT on China sourced income (as opposed to worldwide income); and (iii) the Chinese employer has no statutory withholding obligation on the payment made by the overseas employer outside China.

There is a Guangzhou Middle People Court's judgment on a dual contract arrangement case that was recently published. In the case, the taxpayer (a UK national) has entered into two independent employment contracts separately with a China employer and a US employer - they are affiliated companies. The Court upheld the decision made by Guangzhou local tax bureau that the taxpayer's employer in Guangzhou China has a statutory withholding obligation on the salary paid by his 'other employer' in the US. The Court is also of the view that even if the employment income from US contract was already subject to tax in the US, it does not mean that income would be exempt from IIT in China.

BT 201608 140 05 Finance hl2The tax principles set out in this judgment are not new (nor unclear in the past) and, in fact, they have always been positions taken by the Chinese tax bureaus in dealing with dual contract arrangements. It may be more interesting to know how the Guangzhou tax bureau discovered this dual contract arrangement in the first place; however, this is not mentioned in the judgment. From our experience, tax bureaus will become suspicious of existence of dual contract arrangements where the offshore payroll is excluded from the IIT reporting and the reported income is far below the norm.

As more and more tax bureaus now use electronic/online tax filing systems, they have built up (or in some cases even 'purchased' from the market) a valuable benchmarking database for identifying potential audit targets. Hence, companies and foreign employees having dual contract arrangements should review their situations and take necessary action immediately.

The takeaway
The tax enforcement effort on foreign employees has been (and will continue to be) tightened. Companies having implemented non-taxable fringe benefit arrangements for their expatriate employees should make sure they have proper contractual and supporting documentation in place and have complied with any additional registration requirements imposed by the in-charge local tax bureau in order to secure IIT exemption.

BT 201608 140 03 Finance Individual Income TaxesCompanies having dual contract arrangement or failing to report the offshore payroll for their foreign employees will be subject to closer scrutiny by the in-charge tax bureaus because of information exchange with other tax jurisdictions under the tax treaty provision; income benchmarking against salary data in the tax system; or information sharing among other authorities within China. Companies and foreign employees should be aware that their risk exposure for failure to report the offshore payroll is much higher than before. They should review their current arrangements and discuss immediately with their tax consultants for any necessary action.

Companies need to manage the above carefully because the in-charge tax bureaus can downgrade their tax credit ratings. Should this happen, it will unavoidably have impact on the companies and their day to day operations. For example, companies with lower tax credit ratings may have their tax incentive applications denied and may also be subject to more frequent and more extensive tax audits. Their names can also be published and it will pose reputational risk to the company.


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