By：Daisy Duan, Wang Yan, Chen Yijing and Sun Huanyu, this article was initially published by China Law & Practice on August 7, 2020
On January 17, 2020, the PRC Ministry of Finance and State Administration of Taxation jointly issued the Announcement on Individual Income Tax Policies Relating to Foreign Income (关于境外所得有关个人所得税政策的公告) (Announcement No.3), which further clarifies Chinese individual income tax (IIT) policies with respect to foreign income including the scope of foreign income, calculation of foreign tax credit, procedures on tax filing of foreign income and compliance requirements under cross-border secondment arrangement.
Article 1 of the PRC Individual Income Tax Law (IIT Law) (中华人民共和国个人所得税法) provides that an individual who is domiciled in China, or who is not domiciled in China but has resided in China for 183 days or more cumulatively within a calendar year, is a tax-resident taxpayer. A tax-resident taxpayer is subject to IIT in China on his or her income sourced from both within and outside China; an individual who is not domiciled in China and has resided in China for less than 183 days cumulatively within a calendar year, is a non-resident taxpayer. A non-tax-resident taxpayer is subject to IIT in China only on his or her income sourced from within China.
The principle that Chinese tax-resident individuals must pay IIT on their worldwide income, including income sourced within territory of China (domestic income) and income sourced outside China (foreign income) is immutable. At the same time, China allows foreign tax credits for qualified taxes paid outside China regarding foreign income to eliminate double taxation.
Many Chinese people now work abroad with the development and acceleration of outbound businesses. Following the newly amended IIT Law that came into force as of January 1, 2019, Chinese tax-resident individuals must report worldwide taxable income in their IIT annual filing between March 1 and June 30 following the end of the respective year. Announcement No.3 provides detailed guidance on taxation and tax administration on foreign income of Chinese tax-resident individuals, especially in relation to foreign tax credits, in the context of the newly amended IIT Law.
I. Clarification on the Scope of Foreign income
According to Announcement No.3, the following items are categorized under foreign income, unless otherwise provided:
1. income derived from labor services rendered outside China in the exercise of tenure of an office, employment, performance of a contract, etc.;
2. author’s remuneration paid and borne by foreign entities;
3. royalties from licensing the right to use patents, know-how, copyright, etc. outside China;
4. business operation income derived from production and business activities outside China;
5. interest, dividends and bonuses derived from foreign entities and non-tax-resident individuals;
6. income from the lease of property to a lessee for use outside China;
7. income from the transfer of immovable property situated outside China, or stocks, equity rights or other equity assets in foreign entities (Foreign Equity Assets) , or income from the transfer of property other than immovable property or equity assets where the transfer takes place outside China; and
8. incidental income paid and borne by foreign entities and non-tax-resident individuals.
Where there is transfer of Foreign Equity Assets in item 7 above, Announcement No.3 provides an exception that if more than 50% of the value of the invested entity’s assets is derived directly or indirectly from immovable property situated in China at any time within 36 consecutive calendar months immediately preceding the transfer, the income from such transfer must be regarded as domestic income rather than foreign income.
II. Foreign Tax Credit (FTC)
When the amount of applicable types of foreign income is determined, the FTC is calculated. Overall, there are major four steps in calculating the FTC: (1) calculation of IIT payable on a tax-resident individual’s domestic income and foreign income; (2) calculation of FTC limits on a country (region) basis; (3) identification of qualified foreign tax that can be used to credit; and (4) determination of the FTC, that is, whichever is the lower amount derived in step (2) and step (3). A detailed analysis of each step is set out below.
A. Step 1. Calculation of IIT payable
Following the combination of comprehensive income and classified income under the IIT Law, a tax-resident individual must calculate IIT payable on his or her different categories of domestic income and foreign income where applicable. In particular:
a tax-resident individual must consolidate his or her foreign comprehensive income (including income from wages and salaries; labor remuneration; author’s remuneration; and royalties) with his or her domestic comprehensive income for calculating the IIT payable;
a tax-resident individual must consolidate his or her foreign business operation income with his or her domestic business operation income for calculating the IIT payable; and
for other types of income (including foreign income derived from interest, dividends and bonuses, foreign income from lease of property, foreign income from transfer of property and incidental foreign income), the IIT payable on these foreign income must be calculated separately and must not consolidate with the tax-resident individual’s domestic income.
B. Step 2. Calculation of FTC limits
For the purposes of eliminating double taxation, qualified foreign tax (explained further in Section C below) can be credited against the amount of IIT payable for a tax-resident individual’s foreign income, subject to limits calculated as follows:
The total FTC limits from a country (region) is the sum of the FTC limits of comprehensive income, business income, and other types of income sourced from the country (region). Specifically,
FTC limit of comprehensive income sourced from a country (region) = IIT payable on comprehensive income sourced from inside and outside China × comprehensive income sourced from the country (region) ÷ aggregate comprehensive income sourced from inside and outside China;
FTC limit of business operation income sourced from a country (region) = IIT payable on business operation income sourced from inside and outside China × business operation income sourced from the country (region) ÷ aggregate business operation income sourced from inside and outside China; and
FTC limit of other types of income sourced from a country (region) = IIT payable for other types of income sourced from the country (region)
C. Step 3. Identification of qualified foreign tax
It is important to note that not all foreign tax can be used to credit against the amount of IIT payable. Announcement No. 3 makes it clear that the qualified foreign tax allowed for credit is the foreign tax that has actually been paid by the tax-resident individual on the foreign income in accordance with the tax laws and rules of the country (region) where the income is sourced.
Announcement No. 3 specifies that the following cannot be used for FTC claims:
foreign tax that should not have been paid or imposed in accordance with the tax laws and rules of the country (region) where the income is sourced;
foreign tax which should not have been levied under the tax treaty or tax arrangement between China and the country (region) where the income is sourced;
late payment interest and/or penalties imposed by overseas tax authorities for underpayment or late payment of foreign income tax;
foreign income tax paid but then refunded or compensated to the individual or its interested parties by the overseas tax authorities; and
foreign income tax on foreign income which is exempted from IIT in China.
In addition, Announcement No.3 also clarifies the treatment of tax sparing credit. If a tax-resident individual is entitled to tax sparing under an applicable tax treaty or tax arrangement, the amount of tax exemption or reduction by the counterparty tax authorities must be regarded as tax actually paid for FTC purposes.
D. Step 4. Determination of FTC amount
If the amount of qualified foreign tax is below the FTC limit, the qualified foreign tax can be fully used to credit the PRC IIT payable of the tax-resident individual. If the amount of qualified foreign tax exceeds the FTC limit, the tax credit amount will be the amount of FTC limit, and the excess amount of foreign tax can be carried forward for five years.
III. Tax filing for foreign income
A. Timeline for filing tax return
Where a tax-resident individual obtains any foreign income, the individual must file a tax return from March 1 to June 30 following the end of respective the year. If the foreign tax year when a tax-resident individual obtains foreign income is in the Gregorian calendar year, the Gregorian calendar year to which the last day of the foreign tax year belongs must be the Chinese tax year corresponding to foreign income. For example the tax year of Country A is from April 1 to March 31 of the next year. A tax-resident individual has obtained labor remuneration and paid income tax locally from May 2018 to December 2018. Although the Gregorian year of income is 2018, the last day of the tax year of this country is March 31, 2019, corresponding to the tax year of China in 2019, so the above income should be filed a tax return in China from March 1 to June 30, 2020.
Taxpayers or their withholding agents must keep the tax-related materials submitted for a period of five years from the end of the reporting period. When a tax-resident individual applies for FTC, unless otherwise provided, he or she must provide tax payment certificates, tax payment notices, tax payment records or other certificates issued by the foreign tax authority, or tax returns/tax payment notices plus corresponding bank payment vouchers as an alternative. A credit will not be allowed if the tax-resident individual fails to provide the aforementioned documents.
Where a tax-resident individual has declared foreign income but has yet to use the tax credit, and has obtained tax payment certificates and declared FTC in subsequent tax years, the tax credit may be carried forward to the tax year in which the foreign income falls, with a retrospective period of five years.
Where, within five years following the obtaining of such foreign income, there is any change in the amount of tax actually paid as stated in the tax payment certificate, the amount of tax actually paid will be recalculated and a supplementary tax refund will be made, with no late tax payment penalty imposed or interest refunded.
B. Location for filing tax return
A tax-resident individual who derives foreign income must a file tax return with the tax authorities in charge at the location of his or her employer in China.
Where there is no employer in China, the tax-resident individual must a file tax return with the tax authorities in charge at the location of his or her household residence or the place of his or her habitual residence in China.
If a tax-resident individual has no household residence in China, he or she must file a tax return with the tax authorities in charge at the place of his or her habitual residence in China.
IV. Guidelines for Cross-Border Secondment
For group companies with cross-border secondment arrangements, compliance with tax withholding obligations is one of the main concerns in practice. In response, Announcement No.3 stipulates the withholding and declaration issues under two types of cross-border secondment arrangements as follows:
1. Remuneration paid or borne by a domestic entity
If a tax-resident individual is seconded by a domestic enterprise, entity or any other organization (Seconding Entity) to work abroad, and the income obtained from wages and salaries or remuneration for labor services (Remuneration) is paid or borne by the Seconding Entity or other domestic entity, such a domestic entity must withhold and pre-pay tax for the tax-resident individual.
2. Remuneration paid or borne by a foreign entity
If the Remuneration is paid or borne by a foreign entity that is a Chinese institution (which includes overseas branches, subsidiaries, embassies (consulates), representative offices, etc. of enterprises, institutions, other economic organizations and state agencies in China, as well as Chinese embassies (consulates) stationed abroad) where the individual holds office or is employed abroad (by a Chinese institution), such a Chinese institution may withhold tax and entrust the Seconding Entity to file tax return to the tax authorities in charge.
Where a Chinese institution does not withhold tax or where the overseas entity is not a Chinese one, the Seconding Entity must report information of the personnel seconded abroad to the tax authorities in charge before February 28 of the following year.
1. Far earlier than the release of Announcement No.3, China had already established the principle that China’s tax-resident individuals are subject to IIT on their worldwide income, including both domestic and foreign income. It should be noted that Announcement No.3 is not the first guidance on the tax filing of foreign income of tax-resident individuals, and it is a revision and upgrade of the policies on foreign income that have been consistently implemented; however, it may be a new “alert” for taxpayers who may have previously ignored the relevant rules.
2. Chinese tax-resident individuals (including expats whose staying periods exceed 183 days and thus are regarded as Chinese tax-resident individuals) should fully consider their obligations and legal responsibilities under the IIT Law. In addition to filing and reporting foreign income and applying for an FTC in compliance, Chinese tax-resident individuals also need to pay special attention to the impact of tax-related information of financial accounts exchanged back to China on the tax supervision of their foreign income. The tax-related information is becoming increasingly transparent. A great number of countries have cooperated and strengthened the global exchange of income and tax information in recent years, primarily to screen the flow of money to combat against tax base erosion. The introduction of a Common Reporting Standard (CRS) in China has largely blocked loopholes previously caused by information asymmetry in the collection and administration of foreign income. Radical tax planning schemes will inevitably attract more attention and challenges from tax authorities, especially for high-net-worth individuals or senior management personnel with diversified income.
3. China’s IIT Law has introduced anti-tax avoidance rules. Chinese tax authorities may focus more on tax avoidance arrangements and make corresponding adjustments as per the anti-avoidance rules. In this regard, individual taxpayers are urged to carefully evaluate their tax risk under the scheme design when setting up their cross-border trading framework or allocating overseas investment assets, so as to avoid or reduce compliance risks triggered by improper application of relevant individual tax policies on foreign income as much as possible.
4. Announcement No.3 imposes additional withholding and reporting obligations on enterprises with cross-border secondment arrangements as well. According to the requirements of the administration of tax collection, if withholding agents fail to perform their withholding obligations, fail to pay taxes or to submit materials within the prescribed time limit, or fail to keep accounting vouchers and other data in accordance with the regulations, tax authorities may not only adjust the tax credit rating of enterprises, but also impose additional fines and late payment interests, or even criminal liability on responsible persons for tax evasion. In this regard, it is suggested that enterprises re-examine the impact of the new regulation on their internal compliance system, and implement effective risk control measures via clarifying the obligations of withholding, declaring and submitting, and keeping records for future reference.
（This article was originally published by China Law & Practice on August 7, 2020）