A foreign company that sells to Chinese customers without a Chinese subsidiary may think it has no Chinese tax obligations. That assumption is wrong if the company’s activities in China create a permanent establishment — a PE — under Chinese tax law or under the applicable tax treaty. A PE exposes the foreign company to Chinese corporate income tax on the profits attributable to the PE, and it exposes the foreign company’s employees to Chinese individual income tax.
The PE risk is real, and it’s increasing. The Chinese tax authorities have become more aggressive in asserting PE, particularly for foreign companies whose employees spend extended periods in China or whose sales activities in China go beyond what’s permitted for a non-PE presence. Here’s what creates a PE and how to manage the risk.
What Creates a PE
A permanent establishment is a fixed place of business through which the business of a foreign enterprise is carried on in China. The definition comes from Chinese domestic tax law and from the PE article in the applicable tax treaty, and the two definitions are broadly consistent. A PE includes a place of management, a branch, an office, a factory, a workshop, a construction site of more than six months in China, and a service arrangement where employees of the foreign enterprise provide services in China for more than 183 days in a twelve-month period.
The office is the most common form of PE for foreign companies that are testing the China market. A foreign company that rents an office in China — even a serviced office, even a co-working space, even a desk in a shared office — has a fixed place of business in China and is at risk of creating a PE. The tax authorities treat any physical space that the foreign company uses regularly for its business activities as meeting the fixed place of business test.
The employee is the second most common form of PE. A foreign company whose employees work in China for extended periods — managing sales relationships, supervising manufacturing, providing technical support, negotiating contracts — may create a PE even if the company has no office in China. The employee’s home, a hotel room, or a customer’s office can constitute a fixed place of business if the employee conducts the company’s business from that location regularly.
The service PE is a specific category that applies when the foreign company provides services in China through its employees for more than 183 days in a twelve-month period. A foreign company that sends engineers to China to install equipment, train customers, or supervise a project may trigger a service PE if the cumulative days of service in China exceed 183 days in any twelve-month period. The 183-day test applies to the aggregate days of all employees, not to each employee individually.
The construction PE applies to construction, installation, or assembly projects in China that last for more than six months — or nine months or twelve months under certain treaties. A foreign company that undertakes a construction project in China that extends beyond the time threshold creates a construction PE, and the profits attributable to the construction project are taxable in China.
The dependent agent PE arises when a person in China acts on behalf of the foreign company and habitually exercises authority to conclude contracts in the name of the foreign company. A Chinese sales agent who has the authority to negotiate and sign contracts for the foreign company — even if the contracts are formally approved and signed by the foreign company’s management abroad — may create a dependent agent PE. An independent agent — an agent who acts for multiple principals and who is economically independent of the foreign company — does not create a PE.
The preparatory and auxiliary activities exception exempts activities that are preparatory or auxiliary in character — activities that support the core business but are not the core business itself. A warehouse used solely for storage, a purchasing office that only collects information, or a representative office that only conducts market research may qualify for the exception. But the exception is narrow, and the tax authorities construe it strictly. An activity that generates revenue or that involves customer interaction is unlikely to qualify as preparatory or auxiliary.
The Profit Attribution Problem
If a PE exists, the profits attributable to the PE are taxable in China at the standard corporate income tax rate — currently 25%. The profit attribution is determined by treating the PE as a separate and independent enterprise dealing at arm’s length with the foreign company of which it is a part.
The problem is that profit attribution is inherently uncertain. The PE is not a separate legal entity with its own accounts, its own transactions, and its own profit and loss statement. The tax authorities must reconstruct what the PE’s profit would have been if it had been a separate enterprise, and the reconstruction is based on assumptions and allocations that the foreign company and the tax authorities may not agree on.
The practical approach to profit attribution is to determine the functions performed, assets used, and risks assumed by the PE — the FAR analysis — and to allocate profit to the PE on the basis of those functions, assets, and risks. A PE that performs significant sales and service functions should be attributed a higher profit than a PE that only provides administrative support.
The foreign company should prepare contemporaneous documentation of the PE’s functions, assets, and risks to support its profit attribution position. The documentation should be prepared before the tax authorities raise a PE question, not after.
The Employee Tax Exposure
A PE creates Chinese individual income tax obligations for the foreign company’s employees who work in China. An employee of a foreign company who performs services in China — even if the employee is paid abroad, even if the employee is in China for less than 183 days — may be subject to Chinese individual income tax on the income attributable to the China workdays.
The tax treaty relief for short-term employees — the 183-day rule that exempts an employee from Chinese tax if the employee is in China for less than 183 days and the salary is paid by and borne by an employer outside China — doesn’t apply if the foreign employer has a PE in China. If there’s a PE, the employee’s salary is treated as borne by the PE — even if the payroll is processed abroad — and the treaty exemption doesn’t apply.
The foreign company that has a PE is required to withhold Chinese individual income tax on the salaries of employees working in China and to file withholding tax returns. Failure to withhold and report exposes the foreign company to penalties and interest, and it exposes the employees to personal liability for unpaid tax.
The Registration and Filing Obligations
A foreign company that has a PE is required to register with the Chinese tax authorities and to file Chinese corporate income tax returns. The registration is not the same as establishing a WFOE — a PE is a tax presence, not a legal entity — but the registration requirement is mandatory, and the failure to register is a violation of Chinese tax law.
The filing requirement includes annual corporate income tax returns, quarterly provisional tax returns, and withholding tax returns for employee salaries. The foreign company must maintain books and records in China — in Chinese or with Chinese translations — that support the PE’s profit calculation.
A foreign company that has been operating in China without a PE registration and without filing Chinese tax returns — because it didn’t realize it had a PE — faces a retroactive tax exposure. The tax authorities can assess tax for the open years — generally five years, extended to ten years in certain cases — plus interest and penalties. The retroactive exposure can be significant, particularly if the PE has been operating for several years with significant China-source revenue.
Managing the PE Risk
A foreign company that wants to test the China market without establishing a PE should structure its activities to stay within the boundaries that don’t create a PE. The key boundaries are: don’t have a fixed place of business in China, don’t have employees working in China for extended periods, don’t have an agent in China with the authority to conclude contracts, and don’t provide services in China for more than 183 days in a twelve-month period.
The activities that can be conducted without creating a PE include market research, attending trade shows, visiting customers for introductory meetings — as long as the employees don’t negotiate or conclude contracts — and managing the China business remotely from abroad. The scope of permissible activities is narrow, and the company should obtain professional advice before undertaking any activity in China.
A foreign company that has crossed the PE threshold — whether intentionally or unintentionally — has options. The first option is to establish a WFOE and transfer the PE’s activities to the WFOE, which is a Chinese legal entity that’s fully compliant with Chinese tax law. The WFOE is taxed on its actual profits, not on a reconstructed profit attributable to a PE, and the tax compliance is straightforward.
The second option is to regularize the PE — register with the tax authorities, file returns for the open years, and pay the tax, interest, and penalties. The voluntary disclosure approach is generally more favorable than waiting for the tax authorities to discover the PE, because the tax authorities may reduce penalties for voluntary disclosure.
The third option is to terminate the PE-creating activities and wind down the PE. The wind-down should be documented to demonstrate that the activities have ceased and that there’s no ongoing PE exposure.
