By Victor Tu

More than six years ago, many foreign investors choose setting up a Representative office (RO) in China rather than an official legal entities like Joint Venture (JV) or Whole-Foreign-owned Enterprise (WFOE), the main reason is that avoiding Corporate Income tax (CIT) since it’s only a branch of the company (not a legal entity) and in meanwhile, the startup losses could be offset against the profits in their headquarters’. However, with the convenience of setting up a WFOE and cancellation of tax exemption of CIT on Representative office in China, there are fewer new ROs established in China. Even like this, some investors prefer to RO compared to other business structure (Sometimes RO is called Permanent Establishment (PE) on tax terms as well). So today, we will walk through this briefly and analyze its CIT implications.  

Why setting up a RO?  

l  In most situations, the function of RO is to liaise with the customers or suppliers in mainland China, actually according to the rules of Market Supervision Bureau, RO could not conduct the active business, it could not purchase products and resell or providing consulting services to third party customers. In some cases, i.e. legal industry, the foreign law firm are not allowed to setup an official entity in China. They have to choose to setup a RO.

l  Prior to February, 2010, The RO, as a non-tax-resident Company in China, it has no tax implications on CIT, because it is not a legal entity, it is only a branch and in most cases, there are no revenues for them, there are only expenses.

l  Since ROs only produce losses (if there is no revenue), from the tax’s perspective, the headquarters from their investing countries could take advantage of it and reduce their tax burden in their own countries.

Why the rules changed?

On February 20, 2010, The National Tax bureau issued the new rules, after that date, all ROs must pay the CIT in China by a flat rate. The most reasons claimed are that many ROs are doing the active business, keep running the operation by revenues rather than receiving the grants from the parent entity, in meanwhile, they don’t pay any taxes in China. At the same time, due to the unprofessional bookkeeping for most ROs, the tax bureau decided to choose a flat rate calculation on the CIT.

How Does CIT work for RO?

For example, in year 2015, A RO totally expensed RMB1 million for its operation (Five employees), and no active revenue other than receiving financial fund from headquarter in Germany. The expenses mainly Comprising：

Payrolls                       RMB  400,000

Furnishing                   RMB  150,000

Internet and phones     RMB   60,000

Travel costs                 RMB  300,000

Office Rentals               RMB   90,000    

Since there are no revenue, the expenses will be converted into deemed revenue under the rule. For different industries, the tax bureau will set a specific net profit margin rate for a RO, the scope is set out below:

l  Construction ,Designing and Consulting             15%-30%

l  Management service(i.e. Hotel)                          30%-50%

l  Other Service                              no less than             15%

In this case, it is only a RO for a bolts and nuts manufacturing company in Germany, which is helping the headquarter to follow up the customers and suppliers in China. So, it is set by 15% for the assessed net profit margin rate.

Calculation:

Formula: CIT Tax payable = Expenses/ (1-Net Profit Margin rate set by tax authority-Business tax rate)* Net Profit Margin rate set by tax authority*Corporate Income Tax rate

Expenses other than CIT     RMB 1,000,000

Net Profit Margin rate                             15%

Business Tax rate*                                   5%

Corporate Income tax rate                      25%

The CIT payable= 1,000,000/ (1-15%-5%)*15%*25%=RMB 46,875

* After May 1st, 2016, the Business Tax has been phased out across the country, VAT applies to the construction and service industry instead.

Summary

If you are considering to develop your business in China and Choose to set up a Representative Office, you’d better off understanding the tax burden as a matter of the decision making.