International taxation  How to minimize permanent establishment risk in China

Recently, we were increasingly asked by clients whether a German parent company that sends employees to China to provide services would set up a permanent establishment (PE) right away. But, in general, how can one reduce the tax risk through a PE from both a Chinese and a German perspective?

The following article introduces and overviews PE tax issues for German companies investing in China. We hope this gives you a clearer understanding of the issue and helps you plan ahead to reduce the tax risks associated with establishing a PE when doing business in China.

The term "permanent establishment"

"Permanent establishment" (PE) is an important term in international taxation. It is primarily used to determine a party's right under a tax treaty to tax the profits of an entity of the other party. For example, according to the general opinion, China may only tax the profits of a German company if the German company conducts its business through a PE in China.

A PE can be either a physical branch (a branch of a foreign company in China) or a virtual branch (e.g., when a foreign company sends employees for more than a certain period of time to provide services in China). Business premises are usually stationary, continuous, and operational facilities. A Chinese subsidiary founded by the German parent company in China does not constitute a PE.

Types of PEs and criteria for the existence of a PE

Art. 5 of the German-Chinese Double Taxation Agreement (DTA) states that PEs primarily include assembly, service, and representative PEs. For space reasons, this article only deals with the usual "service PE".

Time criterion for the establishment of a service PE: If a German company in China provides services, including consulting services, through its own employees or employs other persons who carry out activities of this type (for the same or a related project) within any period of twelve months, longer than 183 days consecutively or cumulatively, then a PE is deemed to be justified.

Case Studies

We present three typical examples below and hope they can shed more light on the subject.

Case study 1

A German company concluded five sales contracts with a Chinese company and sent a total of seven people from Germany to China ten times over a period of three years. The five contracts appeared to be separate, and the number of days the personnel was in China for each project did not exceed 183 days. But the contracts were all related to the provision of services within the technical installation, commissioning, and technical advice for a production line of the same customer.

However, the Tax Authority considered the five contracts to be for "the same project or a related project" whose employees were in China for more than 183 days in any given 12-month period. Therefore, in this case, the Tax Authority believed the German company had established a PE in China for the services provided.

Case study 2

A German company sent fifteen people from Germany to China six times between 2017 and 2019 to provide advice and technical support for installing systems for a Chinese customer. However, to avoid establishing a PE, this German company did not stay in China for more than 183 days per year, which is below the period specified in the German-Chinese DTA for the establishment of a "service PE" through the provision of services: „no more than 183 consecutive or cumulative days in any twelve-month period“.

The Tax Authority considered that "the activities of the sent personnel were business-related and therefore the time spent in China by the personnel working on the corresponding projects must be aggregated." Since the total number of these days exceeded 183 days in 12 months, it was determined that the German company had established a PE in China. In addition, although the income of the German employees in the PE was paid in Germany, it was considered Chinese income, so the German employees were personally liable for Individual Income Tax (IIT) in China.

Case study 3

A German parent company founded a WFOE, a Wholly Foreign-Owned Enterprise, a manufacturing company, in Tianjin, China, in 2017. The subsidiary asked the German parent company for production support. Therefore, the parent company sent eight employees from Germany to the Chinese subsidiary from 2017 to 2019 to support production management. The eight German employees were paid by the parent company and their social security continued to be paid in Germany. The wages and salaries for these eight German workers in China and the travel expenses between Germany and China were not passed on from the parent company to the subsidiary.

During an audit of the German company in 2020, the German Tax Authority encountered several ambiguities:

• The eight German employees traveled to China and back 50 times between 2017 and 2019;
• Most proof of work related to services performed for the Chinese subsidiary;
• The eight German employees did not bring any financial income for the parent company from 2017 to 2019;
• The parent company was unable to provide additional documentation to demonstrate that the work of the eight German employees was related to the parent company and brought economic benefit to the parent company.

The German Tax Authority believed that the eight German employees' wages, salaries, and travel expenses were not deductible for Corporate Income Tax (CIT) purposes. The reason for this was that the eight German employees did not generate any income for the parent company during their employment at the parent company, and their actual work (2017 to 2019) was not related to the parent company. Therefore, these eight German employees' wages, salaries, and travel expenses were not tax deductible from 2017 to 2019.

In the above cases, the cross-border tax risk resulted from the German companies' lack of understanding of the Chinese-German DTA. It led to the non-recognition of Corporate Income Tax (CIT deductions due to the sending of employees within the company to provide services to affiliated companies. German companies should be aware of involuntarily established PEs in China and not simply assume that "sending employees to China for fewer than 183 consecutive or cumulative days in any 12-month period" is exempt from this tax risk.

Characteristics of a service PE

• Working in China or providing services in China;
• Services/deliverables relate to professional service activities such as engineering, technical, management, design, training, and consulting (excluding specific construction and operational activities);
• Employees or other workers are employees of the German company, employed by the German company, and under it’s control to carry out work services for the contractual partner at it’s direction.
• Any period greater than 183 consecutive or cumulative days within any twelve-months period means:
• The period from the date of first arrival in China to the date of completion and handover of the service project shall be taken as the calculation period for the number of days the person stays in China.
• The length of continuous or cumulative stay of all employees in China for different periods related to the provision of services for the same project is counted. Still, the days for each person of the same group of people in the same period are not calculated separately (The period is crucial, not the number of people).
• Throughout the course of the project, if the German company provides services in China for more than 183 days in any of the "twelve-month periods", then the German company establishes a PE in China. In addition, if a project continues for several years, where a German company sends employees within only one twelve-month period to provide services in China for more than 183 days and during following periods for less than 183 days, the company shall still be deemed to have a PE in China. A PE concerns all services provided by the company for the entire project in China instead of services provided within a twelve-month period.

Note: "Same or related project" means that a company's multiple business-related or related projects should be combined to calculate the number of days in China. When determining whether multiple projects are related, the Tax Authority considers the following factors:

• Is a framework project contract divided into several project contracts?
• Are the projects similar, identical or same in nature?
• Are the projects being carried out by the same employees sent to China?
• If they are separate and independent projects, are they for the same client or an affiliate? Was the completion of the first project a necessary condition for the completion of the second project?

In practice, it is common for German companies (from now on referred to as "home companies") to send personnel to China (in particular to domestic subsidiaries) to provide services or perform related tasks. Due to the different models of sending employees to China, the associated tax issues are complex, and the tax risks are high. Thus, different models of sending employees to China are treated differently for tax purposes and are associated with different risks. Home companies are at risk of establishing a PE in China, while the sent employee is faced with the question of how Individual Income Tax (IIT) is paid in China. We have listed four standard models for sending employees to China below:

1. The standard non-profit model

At the request of a Chinese company, the home company will temporarily send technical or managerial personnel to China to solve temporary problems. In this case, the home company assumes all or part of the responsibility and risk for the results of the employee’s work in China and usually evaluates the employee's performance in China. The Chinese company does not pay the home company any other costs apart from wages.

In this model, the job is usually temporary and does not require permanent work in China. Even if the employees are sent to China for more than 183 days, no Chinese Withholding Tax is levied on the home company since the payment of wages is not a PE profit.

2. The project profit model

At the request of a Chinese company, the home company temporarily sends specialists or managers to carry out a project in China. In this case, the home company takes all or part of the responsibility and risk for the results of the employee's work in China and usually evaluates the employee’s performance in China. Due to the long duration of the entire project, this is expected to exceed 183 days. In addition, the Chinese company has to pay the service fees to the home company.

In this model, the service fees paid by the Chinese company to the home company are usually higher than the wages and therefore represent the profit of a PE. These service fees are subject to Withholding Tax in China.

3. Employment model in China

At the request of a Chinese company, the home company sends specialists or managers who accept a position and work permanently in the company in China (secondment). After completing their tenure in China, the employees will return to Germany to continue their work in Germany. The Chinese company concludes Chinese employment contracts with these employees in China, in which the Chinese company assumes full responsibility and risk for the work results of the employees and assesses and evaluates the performance of these employees. The Chinese company does not pay the home company any other costs apart from wages.

Under this model, although the total tenure is generally longer than one year, the seconded staff does not constitute a PE associated with the home company in Germany since the work is entirely done in China. Thus, no Chinese Withholding Tax is levied on the home company; domestic/Chinese employment has been converted.

4. The Board Members and Executives model

A German shareholder who sends employees to China only to exercise his shareholder rights and to protect his legitimate shareholder rights and interests in the invested Chinese subsidiary usually does not establish a PE.

In this model, the German company keeps the German employment contract with the employee while the employee is on the Board of the Chinese subsidiary. As a result, the Chinese company does not have to pay service fees to the home company but pays a board member's salary payment to the seconded employee.

Based on the above standard models, there are the following six key elements* as criteria for whether the home company establishes a PE when sending employees to China to provide services:

1) Does the receiving company (Chinese company) pay any management fee or service fee to the home company (German company)?

2) Does the amount paid by the receiving company to the home company exceed the wages, salaries, social security contributions, and other expenses paid by the home company to the employees sent to China?

3) Will the home company pay the fees in full to the employee sent to China, or will a certain amount be withheld?

4) Is Chinese Individual Income Tax (IIT) paid in full on the wages and salaries of the employees sent to China, which the home company bears?

5) Does the home company decide on the number of the employees sent to China, their qualifications, remuneration rates, and place of work in China?

6) Does the home company take partial or complete responsibility and risk for the work results of the employees sent to China, and does it evaluate their work performance?

*Legal Base: Notice on Issues of Corporate Income Tax Collection on the Provision of Services in China by Posted Personnel of Foreign Enterprises (SAT Notice No. 19 of 2013)

Tax implications for German companies when sending employees to China to provide services

These are primarily Withholding Tax, VAT, and Individual Income Tax. There are two types of situations: those that create a PE and those that do not. If a PE is established, Withholding Tax, VAT, and Individual Income Tax are due. If there is no PE, Withholding Tax (tax exemption possible after applying for a treaty benefit within the DTA), VAT, and Individual Income Tax apply.

1. A PE is established in China

Suppose a German company sends its employees to China to provide services, and the Chinese customer or its own Chinese subsidiary pays the German company for the services, and the employees are more than 183 consecutive or cumulative days within a twelve-month period in China. In that case, a PE is established in China. The German company is subject to a 25% Corporate Income Tax (Withholding Tax) in China based on the profit ratios set by the Chinese tax authorities. See model 2 above.

Profit rate determined by tax authorities related to the service contract

With the above profit ratios, the Chinese tax authorities can determine the profit ratios for non-resident enterprises (PEs) based on the following criteria:

Chinese Withholding Tax = Service Fees x (Profit Win rate determined by tax authorities x 25%)

2. A PE is not established in China

Suppose a German company sends its employees to China to provide services, and the Chinese customer or its own Chinese subsidiary pays the German company for the services, and the employees are less than 183 consecutive or cumulative days within a twelve-month period in China. In that case, no PE will be established in China. If German companies apply for a tax exemption within the DTA, then the provision of services is not subject to Chinese Withholding Tax.

Note: The services mentioned here do not include services related to royalties.

VAT on service contracts

As shown in the table below, VAT is payable in China on service fees received by a German company for sending employees to a subsidiary or a Chinese customer:

Individual Income Tax (IIT) on service contracts

Since the home company sends employees to China to provide services, the individual income of these employees during their stay in China is subject to Individual Income Tax in China (according to the German-Chinese DTA and the Chinese Individual Income Tax laws). Therefore, here we will only use the wages and salaries of employees sent to China (not self-employed workers) as an example.

According to the German-Chinese DTA (Art. 15 Para. 3), the tax exemption of Individual Income Tax on wages (employee work) is regulated. The requirements for applying for the DTA between Germany and China are that the following three conditions are met at the same time.

• The recipient does not reside in the other jurisdiction for longer than 183 consecutive or cumulative days in total in any twelve-month period commencing or ending in the relevant tax year and;
• The remuneration is paid by or on behalf of an employer who is not a resident of the other state, and;
• The remuneration is not borne by a PE or a fixed facility that the employer has in the other state.

In other words, the remuneration received by a German person who is employed in China is taxable in China if the remuneration derives from one of the following circumstances:

• Stay in China is more than 183 consecutive or cumulative days within any 12-month period;
• The remuneration is paid/borne by or on behalf of a Chinese employer;

Compensation is borne by the employer's PE or fixed base in China.

In general, Individual Income Tax calculated according to the DTA is more favorable than Individual Income Tax calculated according to the rules of Chinese law. In practice, however, it is rare that these employees sent to China can claim a tax exemption. The reason for this is:

• These workers stay in China for a short period of time, and even if they pay Individual Income Tax in China, the amount of tax is so small that it does not match the cost of preparing the documents for a tax exemption application. Therefore, it is better to calculate Withholding Tax according to Chinese legislation.
• Chinese customers and German companies do not believe or are unaware that these employees are subject to Individual Income Tax in China and therefore do not apply for tax exemption or pay Individual Income Tax.
• If Chinese companies pay the service fees abroad/in Germany, the banks do not ask for documents on the withholding and payment of Individual Income Taxes.

If the Individual Income Tax is calculated and paid according to Chinese law, then the table below applies to the taxation of the wages of the employees sent to China:

Employees

Executives**

Remark:

• *Non-resident taxpayers are defined as individuals who are not residents of China and do not live in China or individuals who are not residents of China but have cumulative stays in China of less than 183 days in any one tax year.
• Wages and salaries from China or abroad/Germany: Income from the provision of services in China due to employment, contract, etc., is income generated in China, regardless of the location of the payment within China. In other words, during the period in which the employee is providing services in China, the salary paid by the German company is the employee's income from China, although it is paid abroad/from Germany.
• **Executives include directors, supervisors, and those in senior positions. Executive positions include general manager, deputy general manager, department heads, chief engineers and directors of various departments, and other positions comparable to senior management.

Tax filing and registration

According to Chinese tax law, a German company providing engineering or labor services in China must register for tax purposes with the relevant local Tax Authority where the project is located within 30 days of signing the project or service contract. Furthermore, the Chinese company, as the withholding agent, shall register the Withholding Tax with the local Tax Authority within 30 days from the date of Withholding Tax liability.

Our recommendations

1. German parent companies and their Chinese subsidiaries should know the tax risks associated with claiming tax exemptions for their employees sent to China and withholding and remitting Individual Income Tax. Therefore, it is advisable to seek advice from a professional Sino-German tax team before sending employees to China to understand the tax implications and reduce the tax risks of both the parent company and the subsidiary from German and Chinese perspectives.

2. In practice, most employees would like to keep their jobs in Germany and continue to have their salaries and social security contributions paid in Germany. In this model, the German company and the employees sent to China usually conclude "posting contracts" “secondment arrangements” as supplementary agreements. The German company no longer accepts the responsibility and risks arising from the work of the employees sent to China and does not evaluate their performance. At the same time, the Chinese subsidiary concludes Chinese employment contracts with the seconded employees and applies for their work permit and their residence permit in China. The seconded employees are paid in full from Germany, and the German parent company does not pass on any German wages to the Chinese subsidiary. These seconded employees work for the Chinese subsidiary and are under the direction of the Chinese subsidiary. The Chinese subsidiary takes full responsibility and risk for the results of the employees work and evaluates their performance.

However, if the seconded employees are paid in full by the German parent company without having the wages charged to the Chinese subsidiary, then the wages, salaries, and travel expenses between China and Germany of these employees do not constitute Corporate Income Tax-deductible expenses for the German parent company. The reason for this is that the seconded employees do not generate any income for the parent company, and their actual work content has no connection with the parent company. It is recommended that the German parent company pass on the wages to the Chinese subsidiary. Since the cost burden of the wages does not represent a profit for the PE, no Chinese Withholding Tax is levied on the German parent company. Furthermore, we would suggest that the expenses (e.g., Hotel fee, taxi fee, mobile phone fee, business traveling fee etc.) occurred for the project in China, after the German employees signed the labor contracts with the Chinese subsidiaries are claimed from the Chinese subsidiaries according to Chinese tax laws. Seconded employees should be trained to ask for the compliant Fapiaos and Bills when they are making payments. Otherwise, the German company will have tax issues after claiming the expenses occurred for the China project (Income is booked in the Chinese subsidiary, expenses are booked in the German parent company, and expenses not related to the operating activities of the German parent company are not deductible before tax for the German parent company) and the recharge towards the Chinese company will take a long time.

3. In some secondment arrangements, the German parent company and the Chinese subsidiary share the wages and salaries of the seconded employees. The employees work for both the German parent company and the Chinese subsidiary. Both the German parent company and the Chinese subsidiary assume the responsibilities and risks arising from the seconded employees' work while evaluating their performance. In this model, the German parent company does not charge the Chinese subsidiary for its services, and the Chinese subsidiary does not pay wages and salaries to the German parent company.

It is recommended that seconded employees keep records of their work for the German parent company. I.e., records of e-mails, meeting minutes, reports on project results, orders received, etc., so that you can present evidence to the German Tax Authority in the event of future tax audits and the risk of non-deductible business expenses before Corporate Income Tax for the German parent company is reduced. At the same time, German companies should be aware of the PE risk when a Chinese subsidiary pays service fees to the German parent company, and the employees stay in China for more than 183 days.

4. If the German company can get the newly hired employees to sign an employment contract directly with the Chinese affiliate without having a German employment contract, and the employee is fully paid by the Chinese affiliate, the employee will work for the Chinese affiliate Subsidiary, and the contract belongs to the Chinese employment relationship. This means that the requirements for a secondment are no longer met, so there is no risk that the German parent company could set-up a PE in China.

5. Since the German parent company and the Chinese subsidiary are related companies, the German parent company should charge the Chinese subsidiary for its services based on the arm's length principle for independent companies. The service fee price should be fair and reasonable.

6. If the Tax Authority has any doubts about charging the service fees, they can ask the German and Chinese companies to provide authentic and valid documents. Thus, it is recommended that the client collects and retains relevant documentation in advance, e.g., entry and exit stamps in their passports, work records, email records, meeting minutes, reports on project results, etc. These documents are the basis for the Tax Authority to verify the usefulness's authenticity and assess the adequacy and compliance with the principle of independence of these services. Without sufficient supporting documents, there is a risk that the Tax Authorities will require the Chinese company not to deduct all or part of these expenses as "deductible expenses" before Corporate Income Tax and to pay the Corporate Income Tax and tax penalty in future tax audits.

7. It is recommended that the Chinese company bears the VAT on service charges since it can offset the input tax with the output tax. In addition, the German-Chinese DTA does not include VAT. Therefore, if the German company bears the VAT, it cannot offset this Chinese VAT in Germany.

If you have any tax questions, please get in touch with china.desk@bdp-team.de or book a free initial consultation with us via: https://www.terminland.eu/bdp-team/. Our bdp China Desk Team will be happy to advise and support you.