INCOME TAX PLANNING IMPORTING AND EXPORTING IN THE PEOPLES REPUBLIC OF CHINA

Transcription

1 INCOME TAX PLANNING IN IMPORTING AND EXPORTING IN THE PEOPLES REPUBLIC OF CHINA By Ogden Murphy Wallace, P.L.L.C Fifth Avenue, Suite 2100 Seattle, WA Telephone (206) Facsimile (206)

2 ABOUT THE SPEAKER John O Donnell, a Member and the chair of the firm s Tax practice area, handles tax-related business and estate planning. During his 30 years of practice, Mr. O Donnell has represented clients in start-up matters, such as formation of new entities; expansion matters, such as mergers, acquisitions and joint ventures; divestiture matters, such as spin-offs and redemptions; and business termination matters, such as sales of assets and entities, liquidations and dissolutions. His estate planning practice emphasizes the inter-relationship between estate tax-reducing transactions and resulting income tax consequences, particularly for closely held and familyowned businesses. Mr. O Donnell also chairs his firm s participation in the International Lawyers Network (ILN). This ILN participation enables Mr. O Donnell and his firm to provide clients with effective legal representation at 70 locations in over 50 countries throughout the world. As both a CPA and an attorney, Mr. O Donnell maintains memberships in the state, local and national associations of both professions. He has served as past chair of the Washington CPA Society Taxation Committee and the Washington State Bar Association Taxation CLE Committee. He currently serves as an Adjunct Professor at the University of Washington Law School Graduate Tax Program, and an Adjunct Professor at Golden Gate University, Seattle Branch, Graduate Tax Program. Mr. O Donnell was born in 1946 in White Plains, New York. He received a B.B.A. in Accountancy from the University of Notre Dame in 1968, a J.D. from New York University Law School in 1971, and an L.L.M. in Taxation from Boston University Law School in 1979.

3 INCOME TAX PLANNING IN IMPORTING AND EXPORTING IN THE PEOPLES REPUBLIC OF CHINA Circular 230-IRS Standards of Practice requires disclosure that any federal tax advice contained herein was intentionally written without the requisite formality and scope needed for use as protection against federal accuracy related tax reporting penalties, and therefore cannot be used for that purpose. Furthermore, these materials were written to support the dissemination of the matters addressed herein, and the readers are advised to seek advice from independent tax advisors based on the readers particular circumstances. I. Everyone is Out to Tax You Whenever you do business internationally, multiple jurisdictions seek to tax you. As a general rule, each jurisdiction seeks to tax you to the maximum amount allowable under its applicable tax law. This tax maximization is done without regard for the fact that other jurisdictions are seeking the maximum tax as well. Each country s view of the broad scope of its taxing authority further compounds this problem. For example: The U.S. Point of View All US citizens, residents, and entities formed under US law are subject to US taxation on their worldwide income regardless of source of that income. The income tax rate for both individuals and corporations is 35% above a graduated rate bracket system. PRC View Foreign Investment Enterprises (FIEs) are Chinese/foreign equity joint ventures, and wholly foreign owned Chinese entities. Foreign Enterprises are foreign (e.g., non- Chinese) companies engaged in business in China or have income from sources in China. FIEs that have their head offices in the PRC pay tax on their worldwide income regardless of source of that income. Foreign Enterprises and FIEs with head offices outside the PRC pay tax on only 1

4 PRC source income. The applicable tax rate is a flat 33% for corporations and a graduated rate for individuals up to a maximum of 45%. A 15% corporate rate is sometimes possible for activities in special economic zones and under certain tax holiday arrangements (Nee, Goldstein and Sussman, 957-2nd T.M., Business Operations in the People s Republic of China, at A-37). Individuals either domiciled in the PRC or residents for more than one year are taxed on their worldwide income. Individuals neither residents nor domiciliaries are taxed only on their PRC source income. (957 2nd T.M. supra at A-61) II. Get Wise Counsel in Each Jurisdiction Don t get Chinese tax advice from a US lawyer or vice versa. Nobody knows it all. (e.g., PCR has special 5-year phase in of worldwide taxation for expatriates acquiring residency, opportunities for planned temporary absences to prolong 5-year period, etc.) III. The Three Possible Outcomes Beneath all the complexities of international taxation are only the following three basic outcomes: Situation A Double Taxation or Worse In this situation the income is fully taxed by at least two different countries and possibly additional jurisdictions as well. Situation B Effective Single Level of Taxation In this situation sometimes the income is subject to taxation by only one country. Other times, part of the income is taxed by different countries or each country imposes only a partial net tax so that the aggregate total tax on the income approximately equals the tax imposed by only one country, usually the country with the highest tax rate. 2

5 Situation C Less than Single Taxation This is the Holy Grail of international tax planning where transactions are structured so that the point of taxable income recognition occurs in situations where less than the normal taxes of one country are imposed. CAUTION: This Holy Grail tends to be illusory because the apparent tax avoidance is merely a tax deferral. If your ultimate goal is to return the profits to the United States, you will ultimately pay a full US tax on these profits. The contortions sometimes required to create Situation C transactions often appear not worth the risks or effort when analyzed as a mere tax deferral rather than a permanent tax savings. A. The Foreign Tax Credit System. B. The Tax Treaty. C. Repatriation of Taxable Income. IV. The Three Major Tax Planning Tools A. Foreign Tax Credits (FTC) Generally speaking, the US allows a direct credit (e.g. a dollar for dollar set off) against US income tax liability for foreign income taxes actually paid (IRC 901). This foreign tax credit is designed to minimize the potential double taxation of income from international transactions. The amount of foreign tax credit allowed is limited to the lesser of total US tax, or the amount of US tax on the portion of income subject to the foreign income tax. (IRC 904(a)). This limitation can be expressed by the following formula: FTC Limit = US Income Tax (Pre-Credit) X Foreign Source Taxable Income Worldwide Taxable Income 1. Normally this limitation mechanism converts a double tax situation into a single tax situation. EXAMPLE 1: 3

6 USCO has $100 of income in PCR and pays $33 PCR income tax. USCO has $300 of worldwide income and incurs $105 of US income tax. Total taxes before credits are $138. FTC Limit = 105 X 100 = US Net Tax = (FTC) = 72 Total Tax = 33 (PCR) + 72 (US) = The FTC calculation mechanism insures that the total tax on the potentially double taxed income equals the tax of the higher tax country. Thus the US will tax the foreign source income to the extent the foreign tax rate is less than the US tax rate. EXAMPLE 2: Same as EXAMPLE 1 except that the PRC tax is at only 15%, or $15 of tax. Total taxes before credits are $120. EXAMPLE 3: FTC Limit = 105 X 100 = US Net Tax = (FTC) = 90 Total Tax = 15 (PRC) + 90 (US) = 105 The US net tax rose from 72 to 90 to compensate for the reduced PRC tax. If the PRC tax is the greater tax, the foreign source income bears the greater tax. Same as EXAMPLE 1 except that USCO incurs a $50 loss from US operations so that total worldwide income is only $50 and total US tax is at a 20% rate, or $10 ($50 X 20%). Because foreign source income ($100) exceeds worldwide income ($50) the FTC limit is total US tax of $20. US Net Tax = (FTC) = 0 4

7 Total Tax = 33 (PRC) + 0 (US) = FTC is Sometimes Mismatched. What happens to the $13 excess of PRC tax ($33) over FTC ($20)? It becomes an FTC carryover and can be carried back two years and carried forward five years (IRC 904(c)). FTC carryovers are subject to the FTC limitation for the year to which carried. Therefore FTC carryovers can be only used in years where the foreign tax for the year is less than the US tax on the same income. The loss from US operations in EXAMPLE 3 illustrates one of the many ways foreign taxes and US taxes can be mismatched, leading to creation of FTC carryovers rather than current US tax reduction benefits. Similar mismatching problems occur for cash basis taxpayers that may actually pay foreign taxes in different years than the years foreign income is earned. Even accrual basis taxpayers may experience some mismatching because of different income and expense recognition rules under the tax laws of the different countries. The biggest cause of complexity and mismatching of FTC results from the basket rules. Since 1987, IRC 904(d) requires that FTC calculations be performed separately on the following nine different types of income: Passive income High withholding tax interest Financial services income Shipping income Dividends for non-controlled subsidiaries Dividends from a DISC or former DISC Foreign trade income 5

8 Distribution from a FSC or former FSC Residual income Thus even if overall income and expense recognition and tax payments are in sync, mismatching and resulting carryovers can occur within the basket calculations. Fortunately, the 2004 American Job Creation Act (P.L , 404) reduces the number of baskets to two, passive income and general income, for taxable years beginning after Hopefully, the practical application of FTC at that time will become more manageable. B. The Tax Treaty There is a treaty concerning income taxes between the PRC and the US known as the 1984 Peoples Republic of China United States Income Tax Agreement. The stated purpose of the treaty is to avoid double taxation and prevent tax evasion with respect to taxes on income. A copy of the treaty is attached to the back of this outline. Of particular interest is Article 5 of the treaty dealing with the concept of permanent establishment, use of agents and the status of subsidiaries. Permanent Establishment. Article 7 of the treaty provides that profits from the operation of a business of a US entity will be taxed in the PRC only to the extent that the US entity carries on that business through a permanent establishment situated in the PRC. Article 5 of the treaty defines a permanent establishment as a fixed place of business through which the business of an enterprise is wholly or partially carried on, including a place of management, a branch, an office, a factory, a workshop or a place of extraction of natural resources. The furnishing of services, including consultancy services, if done for periods aggregating more than six months within any twelve month period also constitutes a permanent establishment. What these definitions mean is 6

9 that a considerable amount of business and arranging for business transactions can be actually done on the ground in the PRC by a US entity without being subject to income taxation in the PRC as long as the business is conducted by itinerants not operating out of a fixed location. Paragraph 4 of Article 5 exempts from the definition of permanent establishment activities involving the use in the PRC of a stock of goods or merchandise belonging to the US entity. Use of any facility for the purpose of storage, display or delivery of such goods, for the purpose of processing such goods by another enterprise, or for the purpose of purchasing such goods or merchandise are all exempt from the definition of permanent establishment, and hence are exempt from PRC income tax if conducted by a US entity. The maintenance of a fixed place of business solely for the purpose of collecting information for the enterprise or for any other activity of a preparatory or auxiliary character or for any combination of otherwise exempt activities is also excluded from the definition of permanent establishment and likewise exempt from PRC income tax if conducted by a US entity. Thus a considerable amount of import/export type activity including permanent physical presence on the ground can take place in the PRC and be exempt from PRC income taxation as long as it is conducted by a US entity. Use of Agents. The time may come when business considerations require activities in the PRC beyond activities exempt from permanent establishment classification and hence subject to PRC income tax. Paragraph 6 of Article 5 of the treaty allows the US entity to preserve its tax exempt status by conducting these permanent establishment type activities through a broker, general commission agent or any other agent of an independent status. Such agents, however, must be acting in the ordinary course of their business. Moreover, if the activities of such an agent are devoted wholly or almost wholly on behalf of the otherwise tax exempt US entity, then 7

10 the agent will not be considered as having an independent status unless the transactions between the agent and the otherwise tax exempt US entity are made under arms length conditions. In other words, a captive agent will be considered a tax exemption disqualifying permanent establishment of the US entity if transactions between the US entity and the agent are not conducted on a fair market value basis. Use of Subsidiaries. Paragraph 7 of Article 5 provides that a controlled subsidiary of the otherwise tax exempt US entity will not in and of itself constitute the permanent establishment of the otherwise tax exempt US entity regardless of whether the subsidiary is itself a US or PRC entity, and regardless of whether or not the controlled subsidiary itself carries on a business through a permanent establishment or otherwise in the PRC. Note, however, that such a subsidiary could be considered a captive agent if not dealt with under arms length conditions, thereby constituting a tax exemption disqualifying permanent establishment of the parent US entity. C. Repatriation of Taxable Earnings Choice of Subsidiary. For various considerations of liability limitation, most enterprises will form a separate subsidiary for any long term involvement with activities in the PRC. There are many non-tax considerations beyond the scope of this outline for deciding whether to use a US entity subsidiary or a PRC entity as a subsidiary. If a US entity subsidiary is used, taxable income repatriation is automatic. The income earned by the US subsidiary is subject to US income taxation and would be included in the consolidated US income tax return if the subsidiary is part of a US consolidated group of companies. Using a US subsidiary to operate a permanent establishment in the PRC is questionable for tax purposes, because the entity will be 8

11 subject to both US and PRC income taxes at the same time. Such an arrangement might make sense, however, if there is substantial certainty that the FTCs for PRC tax will be in sync with the corresponding US income tax liability. Then the FTC mechanism will work as theoretically planned to produce a net tax cost equal to the higher of the two countries taxes. Such an arrangement might also make sense if the subsidiary is projecting continuing losses that would create no PRC income tax but would be of a benefit in reducing overall US income tax on the consolidated income tax return with the US parent. Otherwise, using either a controlled or noncontrolled PRC entity (and hence an FIE) to operate the permanent establishment in the PRC makes more tax sense. The entity will be subject to PRC income tax, but will not be subject to US income tax. However, the question then arises of how to ultimately repatriate these taxable earnings to the US for tax purposes. To Dividend or not to Dividend. The payment of a dividend by an FIE is a taxable event in both the PRC and the US. Article 9 of the tax treaty, however, limits PRC taxation to 10% of the gross amount of the dividend if the dividend recipient is a US person or entity. The PRC tax on the dividend is eligible for the US FTC. Thus a dividend usually produces net additional taxes. The FTC mechanism determines how much of this net additional tax goes to each country. If the dividend recipient is a US corporation owning 10% or more of the voting stock of the FIE, then not only the 10% PRC tax on the dividend, but also a pro rata share of the underlying PRC tax on the income earned by the FIE itself, is eligible for the FTC (IRC 902). Thus if all of the FTC calculation mechanism variables are in sync, the payment of dividend by 9

12 the FIE to its US corporate parent should produce no net US income taxes and possibly create a small FTC carryover as well. What if the FIE paid only 15% PRC tax on its underlying taxable income? Then in most corporate situations even for a greater than 10% US corporate parent, the FTCs from the PRC dividend tax and underlying tax on FIE income will be less than the additional US income tax created by payment of the dividend. Thus the dividend will create an increase in net US tax. In such a situation one might be tempted to forego the dividend in order to keep the income tax rate on the income earned by the FIE at a desirable 15% rate. This situation is a form of situation C described in III above at page 2 Because of the combination of tiered subsidiaries and special PRC tax holidays, the taxes on the income earned by the FIE are smaller than the taxes that would normally be imposed by either the PRC or the US. Avoiding the additional tax by not paying the dividend makes sense as long as the FIE has other attractive uses for the earnings, such as by reinvestment in the PRC, or paying off third party debt. Otherwise, the tax savings from dividends avoidance is merely a tax deferral. At some point business needs and risk reduction will compel the payment of the dividend at which point the additional taxes of income repatriation will be incurred. Thus the tax savings from dividend avoidance are merely a tax deferral in the meantime. Interest Expense. The payment of interest by an FIE is a taxable event in both the PRC and the US. Article 10 of the tax treaty, however, limits PRC taxation to 10% of the gross amount of the interest if the interest recipient is a US person or entity. The PRC tax on the interest is eligible for the US FTC. Therefore in most cases the additional 10% PRC tax is absorbed by the IRS rather than the US entity because of a corresponding reduction in US tax on 10

13 account of the FTC. Because the interest expense is usually deductible by the FIE in calculating PRC tax and because of the parity of corporate tax rates in the two countries (33-35%), payment of interest by an FIE subsidiary to a US parent is essentially a tax neutral form of income repatriation. The PRC tax savings to the FIE from the interest expense will approximately equal the combined net PRC and US income taxes to the US parent upon the receipt of the interest. In addition to current tax neutrality, there may be a longer term tax benefit from using a fairly high percentage of debt in capitalizing an FIE subsidiary. A normal business expectation is to recover initial capital investment in the FIE subsidiary from the accumulated earnings of the FIE and then continue the ownership and operations of the FIE with little or no ongoing capital investment. Unfortunately, under US tax law as long as the FIE has accumulated earnings, any withdrawals from the FIE will be considered as taxable dividends rather than a tax free recovery of initial capital. (IRC 316(a)). On the other hand, repayments of principal amount of indebtedness are tax free events in both the PRC and the US. Therefore initially capitalizing the FIE with as much debt as possible opens the door for future tax free recovery of a significant amount of initial investment. Paragraph 3 of Article 10 of the treaty exempts from the 10% PRC income tax interest payments to governments and entities sponsored by the government, such as the US import/export bank. Thus structuring the financing of the FIE through the import/export bank offers an opportunity to avoid this 10% PRC tax on the interest income. As noted above, however, in most cases it is the IRS rather than the US parent that incurs the economic cost of this PRC tax through the FTC mechanism, so that in many cases avoiding the 10% PRC tax is an illusory advantage probably not worth the effort. 11

14 Royalties. The payment of a royalty on intellectual property by an FIE is a taxable event in both the PRC and the US. Article 11 of the tax treaty, however, limits PRC taxation to 10% of the gross amount of the royalty if the royalty recipient is a US person or entity. Thus just as discussed under the interest expense section, in most situations the payment of royalties will be a tax neutral method of repatriating income. Management Fees. The payment of management fees by the FIE to the US parent is normally a tax free event in the PRC if the US parent does not have a permanent establishment in the PRC. The management fees, however, will be taxable income in the US to the US parent. Once again, because of the general parity of tax rates the transaction will be tax neutral if the FIE receives a corresponding expense deduction in calculating its own PRC tax. There is some question, however, whether the PRC will allow such a deduction to the FIE with respect to any management fees other than a strict reimbursement of actual costs incurred. (967 2nd T.M. supra at A-48). Sale of Interest in FIE. Sale of an interest in an FIE is a taxable event in both countries. Article 12 of the treaty exempts from PRC tax sales of less than 25% interest in an FIE. Sales of larger percentages are usually taxed at 20% of the gain on sale. (967 2nd T.M. supra at A-47). The US tax rate on such gain is approximately 35% for corporations and 15% for individuals. Thus in situations where the US rate exceeds the PRC rate, the net tax rate is the US rate with the FTC mechanism apportioning tax payments between the two countries. In situations where the PRC rate is higher, the result is payment of the PRC tax and a resulting FTC carryover for US tax purposes. In practically all situations, however, repatriation by sale of interest produces net additional taxes. 12

15 V. Conclusion Importing and exporting with the PRC, like any international transaction, has the danger of potential double taxation because of taxation by each country involved. The US foreign tax credit mechanism provides a theoretical method for minimizing or eliminating this double taxation. In practice, however, the foreign tax credit mechanism is complicated to apply, and often gives inconsistent and undesirable results. A simpler and more effective method for avoiding double taxation is to take advantage of the tax treaty between the US and the PRC to avoid or minimize PRC taxes to the extent possible. Even when PRC taxation is unavoidable, careful structuring of your business entities to maximize the tax savings available under both the tax treaty and the foreign tax credit mechanism enables repatriation of income earned and taxed in the PRC at close to a tax neutral situation. John O Donnell is a Member of Ogden Murphy Wallace, P.L.L.C. in Seattle, Washington. His practice emphasizes complex business, estate planning and tax issues. Specific legal problems need specific solutions. These materials provide a broad, general outline, and are not intended to provide legal advice. 13