Navigating Chinese Taxation – Insights for German Companies Part I: Introduction of Service Permanent Establishment in China

published on 27 August 2023 | reading time approx. 3 minutes

The internationalization of German companies into the Chinese market is undoubtedly a promising step, but it comes with a multitude of complex tax and operational challenges. Especially for German companies looking to expand their business activities in China or those already established, complex issues arise in the areas of establishment of a permanent establishment, Chinese tax law, tax optimization possibilities, and the intricate nature of tax regulations leading to numerous tax pitfalls.

In this article series, we focus on these challenges and provide German companies operating in China with comprehensive insights, well-founded information, and expert advice. Our aim is to offer you a reliable guide and assist you in successfully navigating the complex tax and operational aspects of your business activities in China.

We will illuminate the tax framework and optimization opportunities available to German companies active in or seeking engagement in this dynamic market. Practical recommendations, the identification of potential pitfalls to be avoided, and the minimization of tax risks will be the central focus of our article series.

In our first part, we will delve into the concept of a permanent establishment and the associated tax challenges.

The Significance of Permanent Establishments in China

Many foreign enterprises may face Service Permanent Establishment (PE) issues in China when performing certain activities in China. According to the current tax regulation and practice, if the service recipient is domiciled in China and the service activities is assessed to be taxed in China, the service recipient usually acts as the withholding agent for the related taxes (Value Added Tax - VAT and/or Corporate Income Tax - CIT). That requires both service providers and recipients to have certain level of knowledge of Service PE compliance practice and risk assessment in China.

Defining Permanent Establishments in China: Spotlight on Service Permanent Establishments

The definition of PE in tax treaty signed between China and other countries is usually defined as regular PE, service PE, construction PE and agent PE. Hereinafter we only discuss the service PE which is commonly seen in China in company’s daily operation. Referring to the Sino-German Double Tax Agreement (DTA), service PE in China is defined as furnishing services, including consulting services, by a German enterprise through its employees or personnel, when the activities in China (for the same or connected project) continue for a period or periods aggregating more than 183 days within any 12 month period.

Criteria for Evaluating Service Permanent Establishments

To make self-assessment of whether a service PE is constituted, the following issues are quite crucial according to the explanation of tax treaty. The competent Chinese tax authority may also review these factors (but not limited) to determine the tax obligation of the service providers:

A. Days staying in China
B. Single or connected projects
C. Long-term projects over years

That is to say, to determine the length of project days is comprehensive, in particular for connected projects and aggregating days of a project over years. Simply to calculate the days staying in China within a calendar year might lead to wrong assessment result.

When a service PE is constituted, the personnel working for the service PE might be subject to Chinese individual income tax (IIT) which requires a comprehensive assessment as well.

Practical Challenges in Service Permanent Establishments in China

In practice, we have encountered that for such service PE projects, service providers may not have sufficient knowledge and experience to assess whether service PEs are constituted in China or not. For third party service PE, aforementioned factor A is usually fixed due to project needs, yet factor B and factor C might requires further assessment by reviewing the overall project arrangement; for intercompany service PE, sometimes factor A is more flexible to arrange, yet in many cases, it comes with a combined intercompany agreement to cover onshore, offshore services which makes the assessment not entirely straight forward and transparent.

Furthermore, as mentioned above, when tax is due in China, the service recipient usually acts as withholding tax agent for relevant VAT and CIT. While in some cases, the service recipient refuses to withhold and pay the taxes on behalf of the service provider. Under such a circumstance, the service provider might declare the relevant taxes on its own, which procedure is more complicated compare with withholding approach. The service providers may declare IIT of the personnels working for the PE projects by themselves or engaging a third-party agent.

Tax Implications and Recommendations for Your Company

Whether a service PE is constituted in China or not, it is sometimes quite complicated to make self-assessment in particular when the projects might be deemed connected or projects last for over years. In order to be tax compliant in China, it is recommended that both service providers and recipients shall set clear tax clause in the service agreement and also define clearly the onshore and offshore services separately when possible. The importance of IIT compliance is highly addressed when a service PE is constituted.

In next issue of China Newsletter, we will continue to discuss the tax practice on onshore service and offshore service in China.