Meaning
Definition of a fixed place of business within bilateral tax treaties determines whether a foreign entity is subject to full corporate income tax in China. Under the concept of permanent establishment risk article 5, a foreign company can be taxed on its global profits attributed to its Chinese activities if it maintains a physical presence or a dependent agent in the country for a certain period. This risk is particularly high for companies that send engineers or consultants to work on projects at a client’s site for more than six months in a year.
If a permanent establishment is deemed to exist, the company must register with the local tax bureau, keep detailed accounts, and pay the standard twenty five percent corporate income tax on its local earnings. This is much more burdensome than the ten percent withholding tax applied to royalties or service fees. Article 5 of the typical tax treaty provides the specific criteria for what constitutes a fixed place, including offices, branches, factories, and construction sites.
It also defines the activities that are considered preparatory or auxiliary and therefore do not create a tax liability.
Fixed Place
Physical presence of a company’s operations is the most direct indicator of a tax exposure. When evaluating permanent establishment risk article 5, the authorities look for a place of business that has a certain degree of permanence. This could be a small rented office or a dedicated desk in a shared workspace that is available to the foreign company’s employees.
The duration of the presence is a key factor, with most treaties setting a threshold of six months or one hundred and eighty three days. If the foreign company’s staff are present for longer than this, the tax bureau may claim that a permanent establishment has been formed. This applies even if the company does not have a formal legal entity in China.
The burden of proof is on the company to show that its presence was temporary and did not constitute a core business operation.
Agency Threshold
Activities of individuals who have the authority to conclude contracts on behalf of a foreign company can also trigger a tax liability. Under permanent establishment risk article 5, a dependent agent is someone who habitually exercises the power to negotiate and sign agreements in the name of the foreign principal. This includes sales representatives who spend most of their time in China meeting with clients and closing deals.
If an agent is seen as acting exclusively for one foreign company, the tax authorities will likely argue that the company has an indirect presence in the country. This rule is designed to prevent companies from avoiding tax by using individual contractors instead of setting up a branch. The treaty usually excludes independent agents who act in the ordinary course of their own business.
Profit Allocation
Determination of how much income is attributable to a local presence is the final challenge in managing this exposure. Once a permanent establishment risk article 5 event occurs, the foreign company must perform a complex calculation to separate its Chinese profits from its global revenue. This involves looking at the functions performed, the assets used, and the risks assumed by the local team.
The tax bureau may use a deemed profit method if the company’s records are insufficient. This method often results in a higher tax bill than a calculation based on actual costs and revenue. Companies often use internal time tracking and cost centers to limit the amount of profit that is taxed in China.
A final settlement with the tax office requires a formal audit of the local activities and a comparison with the company’s global transfer pricing policy.
