Daniel Hui and Kate Lai examine the key changes behind implementation rules
Almost four months since the release of the new Individual Income Tax (IIT) laws (the first draft was published on 29 June for public consultation and the updated draft passed into law on 31 August), the State Administration of Taxation (SAT) of the People’s Republic of China (PRC) finally issued the long-awaited implementation rules for the new PRC IIT laws on 20 October. The SAT has also issued a paper on interim measures for additional itemized deductions under the new laws. Both the implementation rules and the interim measures paper (the papers) are open for public consultation until 4 November.
The papers addressed some of the concerns under the new IIT laws. This article looks at some key themes that generated a lot of public discussions, namely, changes to tax residence rule, new itemized deductions, and extension of anti-avoidance measures to individuals.
Highlights of the implementation rules
The rationale behind the implementation rules is to facilitate the smooth implementation of the new laws, streamline the tax administration and management process, and increase enforcement while also making the system easy for taxpayers to comply with. The implementation rules also provide clarification of the anti-avoidance rules and measures to strengthen the exchange of information for tax enforcement purposes.
For those who are not domiciled in Mainland China, the new tax residence rules define individuals as tax residents if they are present in Mainland China for 183 days or more in a calendar year. A tax resident is subject to PRC tax on worldwide income. The current implementation rules (valid until 31 December 2018) see taxpayer only becomes subject to tax on worldwide income after they have been resident in Mainland China for five full years. This five-year period can be broken, and the clock restarted, by taking a single trip of more than 30 days or multiple trips that, in total, amount to more than 90 days outside of Mainland China (known as “tax break”). Under the new implementation rules, while the five-year rule is retained, a tax break is completed by taking a single trip of more than 30 consecutive days outside Mainland China. For individuals who have become tax residents for five consecutive years, from the sixth year onwards, they are subject to worldwide taxation unless they are considered non-residents for that year (i.e., spending less than 183 days in Mainland China for that year). See Figure 1 for illustration.
The new implementation rules mean that for individuals who have been relying on a cumulative 90-day tax break to avoid worldwide taxation need to plan ahead to ensure that they can arrange a tax break of more than 30 days during the relevant period once the new IIT laws become effective. If an individual becomes a resident for five consecutive years without taking a tax break, in order to escape worldwide taxation the individual will need to be considered a non-PRC resident or able to demonstrate that they are dual resident (e.g. Hong Kong and Mainland) under tax treaty arrangement and tie-break to the other jurisdiction (e.g. Hong Kong).
For example, under the tax treaty between Hong Kong and Mainland China, where an individual is considered a resident of both sides, his status is determined by looking at factors in the order of (1) where he has a permanent home available to him; (2) where his personal and economic relations are closer; (3) where he has a habitual abode. If his residence status cannot be determined by the above, a mutual agreement process between the tax authorities of both jurisdictions can be initiated.
However, for individuals who habitually live with their family in Mainland China and have established sufficient economic ties there, they may be regarded as being domiciled there and subject to worldwide taxation regardless of whether they have taken a tax break, as this is only applicable to non-PRC domicile individuals.
For employers, the consequences of their employees becoming tax residents could be far-reaching. In particular, where companies have implemented tax subsidy arrangements (e.g., tax equalization), it is important to review the existing policy, consider how the policy is administered, and address any gaps as soon as possible.
The new IIT laws allow deductions, for all employees, in respect of childrens’ education, continued education, medical expense for serious illness, mortgage interest or rent, and elderly support. The withholding agents’ (e.g. employers) concerns regarding verification of expenses have subsided as in the papers, the SAT adopted an approach to impose standard deduction amounts for most deduction categories rather than based on actual expenses (see Table 1 for details).
Another piece of good news is that the expatriate concession on non-taxable benefits are to be retained – expatriates can continue to enjoy non-tax concessions on childrens’ education, language training, and housing allowance etc. or if they choose to, they can claim the standard deductions (but the same type of expenses can only be deducted once). This policy is most welcomed as the current standard deduction thresholds do not appear to have taken into account the much higher costs of living by expatriates.
Although the public consultation paper states that the taxpayers are responsible for providing true and correct information, under the implementation guidelines, if the withholding agent is made aware of any discrepancies or false claims, they should request the taxpayer to clarify and correct the information or report to the tax bureau for handling.
Taxpayers are also entitled to request the withholding agents to, where appropriate, correct the tax withholding and, if the agent refuses to correct, the case should be reported to the tax bureaus for handling. To mitigate disputes among employers and employees, companies should set up clear policy and guidelines on the reporting, deduction and withholding process.
The new IIT laws introduced anti-avoidance rules on individuals which empowers the tax bureaus to make tax adjustment tax under the following circumstances:
- Transactions between individuals and related parties are not independent and not at arm’s length.
- Profits are not allocated properly to resident individuals by an offshore corporation which is set up in a low tax jurisdiction without reasonable operational needs and the corporation is controlled by resident individuals or jointly controlled by resident enterprises.
- Inappropriate tax benefits derived through arrangements without reasonable commercial reason.
Under the implementation rules, the individual anti-avoidance rules are, predominately, consistent with the anti-avoidance rules for corporations. With respect to related parties transactions, the implementation rules added to the definition of related parties to include husband and wife, immediate family, brothers and sisters, and anyone maintained or supported by the individual.
The controlled foreign corporation regime follows the corporate income tax rules under which an offshore company is a controlled foreign corporation (CFC) if it is majority owned (more than 50 percent) by PRC tax residents. Putting the anti-avoidance rule into context, if a CFC is set up in a jurisdiction where the resulting tax is less than 50 percent of that calculated under the PRC Corporate Income Tax Law and does not distribute its earnings without reasonable commercial reason – defined as not distributing for the predominant purpose of achieving a reduction, avoidance or deferral of tax – any shareholder with at least a 10 percent interest can have their share of those undistributed profits attributed to them personally. The implementation rules also provides that a CFC can exist, even if the over 50 percent shareholding threshold is not met. A company is deemed to be a CFC if the PRC resident has effective control over the company in terms of shareholding, capital, operation, sales and purchase decisions etc.
While not specifically related to the anti-avoidance laws, it is worth noting that the implementation rules set out that non-cash transfer of assets by way of gift, debt repayment, sponsorship and investment purpose are deemed disposal of the asset and subject to individual income tax accordingly. This will further close the existing loophole that may have been used by individuals to “dispose” of their assets without attracting tax.
The anti-avoidance laws, coupled with the information collected through enhanced information sharing between departments and the automatic exchange of financial asset information under the Organization for Economic Cooperation and Development’s (OECD) Common Reporting Standard (CRS) will give the tax bureaus the tools necessary to target aggressive tax planning and tax avoidance acts. The new laws will likely have a significant impact on offshore investments. PRC residents should reevaluate common holding structures for offshore investments that have historically been relying on gaps in the current IIT rules to avoid tax.
Roadmap for improving tax compliance
Looking at the new PRC IIT laws and the implementation rules in conjunction with recent events in the tax arena leaves a clear impression – a future of tighter rules and greater enforcement of tax obligations in Mainland China. There are also other indications that tax is becoming a topic of official and public scrutiny in the Mainland as it has around the world in recent years. For example, to clamp down on CRS avoidance, the OECD has recently published the result of its analysis of over 100 residence and citizenship by investment schemes offered by CRS-committed jurisdictions, identifying those schemes that potentially pose a high-risk to the integrity of CRS. The OECD has also made it clear that it will continue to work with CRS-committed jurisdictions, as well as financial institutions, to ensure that the OECD measures remain effective in ensuring that foreign income is reported to the actual jurisdiction of residence.
In the past few years, the world has made great progress in improving tax transparency, and it is important to strengthen law enforcement to ensure that taxpayers are law-abiding. The compliance model promoted by the OECD and adopted by countries like Australia and New Zealand seek to understand the taxpayer’s compliance behaviour and apply the most appropriate compliance strategy. The model recognizes there is a spectrum of compliance behaviour and discover what influences the taxpayers’ behaviours. Because most taxpayers have an ideal attitude of “willing to do the right thing,” the tax authority aims to make compliance easier or to assist them in complying. At the other end of the spectrum, regarding taxpayers who decide not to comply, strong law enforcement helps maintain taxpayers’ overall confidence in the tax system.
Take for example the recent high profile case of the famous actress evading tax through the use “yin-yang” contracts. The heavy monetary sanction serves as a warning to others who choose not to comply; while the amnesty programme encourages compliance by making it easier and clearer for those who want to comply but do not always succeed.
The way forward
The implementation rules provide helpful guidance to the application of the new PRC IIT laws. Taxpayers are encouraged to continue to review their tax arrangements and ensure they understand their compliance obligations. Businesses should also consider the implications of the new rules and devise appropriate talent and mobility policies that are fit for purposes.
Daniel Hui is Partner of China Tax and Kate Lai is Director of People Services of KPMG China.