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Senior Executive's IIT Management in MNCs By Peter Ni, Mark Gao, Sakura Ji 2017-12-13

 

 

 

While this has become less common compared with five to ten years ago, many multinational corporations (“MNCs”), when investing in China, would still second foreign senior executives (i.e., executives holding non-PRC passports) to China.  The Chinese subsidiaries of such MNCs, as the PRC employers of these executives legally, would have an individual income tax (“IIT”) withholding obligation to withhold the applicable IIT on their employment income, such as salaries and wages, bonuses, and equity incentive income.  Failure to withhold would result in a fine in the amount of 0.5 to 3 times the underpaid tax.  Moreover, under the PRC IIT laws, foreign citizens are not treated exactly the same as Chinese citizens and there are some tax incentives exclusively available to foreign citizens.  Overall, the PRC tax rules on foreign senior executives are not easy to fully understand.  As a result, this is an area where MNCs could easily make mistakes and thus expose themselves to significant risks.

 

The purpose of this article is to (1) sum up certain common issues regarding MNCs’ dealing with their foreign senior executives’ IIT, and (2) share with our readers Zhong Lun’s relevant insights.

 
 
 
 

Issue No. 1:

 Failure to declare and pay IIT on the employment income paid offshore

 
 

This is the most common mistake made by MNCs when dealing with IIT for their foreign executives in China.  As a very popular arrangement, a foreign executive may hold positions concurrently in both a Chinese subsidiary and an overseas affiliate within a MNC group and work for both at the same time.  Also, the salary of the senior executive may be split into two parts and the Chinese subsidiary and the overseas company would share the senior executive’s salary cost.  In a case like that, many MNCs would only declare the onshore part and withhold PRC IIT correspondingly, but fail to declare and withhold the IIT on the offshore part. The correct answer is that, regardless of whether a foreign executive is working as a full-time or a part-time employee of the Chinese subsidiary, all the salary paid by both the Chinese subsidiary and the overseas company should be declared to the Chinese tax authority.  Also, the IIT payable by the foreign executive shall be calculated by reference to both the employment arrangement with the Chinese subsidiary (full time vs. part time) and the actual number of days that the foreign executive spends in China in each month and in each calendar year respectively.

 

Specifically, pursuant to the PRC IIT laws, a PRC tax resident is subject to PRC IIT on worldwide income, while a non-PRC tax resident is only subject to PRC IIT on PRC sourced income.  A foreign senior executive may or may not be a PRC tax resident, mainly dependent on the days spent in China in each calendar year.  Many of them would try not to be PRC tax residents by managing their days spent in China each year.  However, even if they are non-PRC tax residents, it is important to note that PRC sourced income is not limited to the employment income paid by Chinese companies, but also includes employment income paid by overseas companies and attributable to the individual’s actual working period within China.  In the meantime, for the employment income attributable to the foreign individual’s actual working period outside China, it would be considered as non-PRC sourced income, regardless of it is paid by a Chinese company or an overseas company.  For easy reference, we would like to use an example to illustrate how a dually employed foreign individual shall determine IIT on employment income.

Example

Assuming that (1) a foreign senior executive (not a director) holds positions in both a Chinese company and an overseas company which is the tax resident of a country that has a tax treaty with China where the director fee clause of the tax treaty does not expressly apply to senior executives, (2) the Chinese company pays RMB 60,000 and the overseas company pays RMB equivalent of USD 10,000 (i.e. RMB 65,000) to the foreign individual as his monthly salary, (3) the foreign individual accumulatively stays in China for more than 183 days (say 200 days) in 2017, and (4) in December 2017, the foreign individual actually stays in China for 15 days and outside China for 16 days, the foreign individual’s PRC IIT for December shall be calculated as follows:

[(60,000 + 65,000 - 4,800) * 0.45 - 13505] * (15 / 31) = RMB 19,637.90

 

With the same assumptions above except that the foreign individual accumulatively stays in China for less than 183 days in 2017, his individual income tax for December shall be calculated as follows:

[(60,000 + 65,000 - 4,800) * 0.45 - 13505] * [60,000 / (60,000 + 65,000)] * (15 / 31) = RMB 9,426.19

 

As illustrated above, because the entire amount of the foreign senior executive’s salary paid by both the Chinese company and the overseas company should be declared to the Chinese tax authorities and the applicable IIT should be determined based on the actual number of days the foreign individual has stayed in China in each month and in each year respectively, it is not correct to declare and pay IIT on the salary paid by the Chinese company only.  

 

Zhong Lun’s Insights

 

In short, the IIT payable of foreign senior executives would depend on the following factors:

 

Whether the foreign individual is a PRC tax resident;

 

Whether there is a tax treaty between China and the resident country of the foreign individual;

 

The foreign individual’s actual working period within China

 

Whether the foreign individual works full-time or part-time in China; and

 

The ratio of the employment income paid in China to the entire employment income.

With that, in the case of dual employment, the only way to lower the PRC IIT for the foreign senior executive would be to reduce the days spent by the foreign senior executive within China and where applicable, properly lower the employment income paid in China.  However, in Zhong Lun’s experience, reducing working days in China may not be practical from a business perspective. 

 

One related issue is the potential corporate income tax on employment income paid offshore but charged back to China for reimbursement. The issue arises where some foreign senior executives work full-time in China but choose to be paid fully or partially offshore mainly due to foreign social security considerations.  Since these foreign executives typically work full-time for Chinese subsidiaries of MNCs, as a general corporate policy, their employment income would need to be charged back to the Chinese subsidiaries for reimbursement. The reimbursement process would have to go through a difficult foreign exchange control review process.  In addition, if the terms are not structured properly, the reimbursement might be treated as a service fee payment made to the overseas company, resulting in the overseas company being viewed as having permanent establishment in China and subject to PRC taxes.  

 

In short, MNCs should be fully aware of all the tax risks regarding seconding foreign senior executives to China and structure the terms of the arrangement carefully. 

 
 

Issue No. 2: 

Failure to correctly apply the rules regarding non-taxable allowances granted to foreign employees.

 
 

From Zhong Lun’s experience in conducting health check on IIT compliance for MNCs, we have noticed that many MNCs have incorrectly applied the rules regarding non-taxable allowances granted to foreign employees, which may result in significant tax risks to MNCs.  The non-taxable allowances mainly include housing allowance, meal allowance, relocation expense, laundry expense, home-visit expense, language training expense, and children education expense.  In our experience, the most common mistakes include:

 

 

Grant of allowances to Chinese employee and falsely treating them as non-taxable allowances;

 

 

Failure to verify the reasonableness and authenticity of non-taxable allowances; and

 

 

Failure to collect and preserve required supporting documents.

There are several important points to note here. First of all, the preferential tax treatment for allowances under PRC IIT laws applies to employees with foreign passports exclusively and thus, Chinese employees are not eligible for such treatment.  As to the overseas Chinese (such as US “green-card” holders who still hold PRC passports), there are no clear rules on if they can be treated as foreign employees for this purpose. So their eligibility would largely depend on local tax authorities’ practice.

 

Second, the PRC IIT laws require the amount of non-taxable allowances should be reasonable and such allowances should be actually spent on the prescribed items and evidenced by valid receipts/invoices. Because PRC IIT laws do not define the word “reasonable”, MNCs would have to exercise their good judgment to determine the amount.  Also, MNCs would need to verify the authenticity of the covered expenses. Zhong Lun has come cross several non-compliance situations where a foreign employee either “rent” a self-owned apartment or did not actually rent an apartment at all, but managed to obtain rental invoices from third parties as evidence.  Such a practice is a clear violation of the relevant rules.

 

Lastly, the PRC laws also require the Chinese employers of foreign employees to collect and retain necessary supporting documents related to the non-taxable allowances, including employment contracts detailing the type and amount of each allowance, valid receipts/invoices, and relevant underlying contracts (e.g., rental contracts), etc.

 

Zhong Lun’s Insights

 

In our experience, to correctly apply the rules on non-taxable allowances paid to foreign employees and avoid tax risks, MNCs should strengthen their internal management on the following aspects:

 

Ensuring that the allowances granted to foreign employees fall into the scope of the qualified types under the PRC IIT laws;

 

Ensuring that the type and amount of each allowance has been clearly stated in the employment contracts;

 

Ensuring that foreign employees regularly provide relevant contracts as well as valid receipts/invoices and verifying the authenticity of such contracts and invoices;

 

Ensuring that the amount of non-taxable allowances is reasonable by reference to the best practice in each location;

 

Ensuring that except for the permitted types of non-taxable allowance, all other allowance granted to the foreign employees shall be included in their monthly salaries/wages for IIT payable calculation; and

 

Providing necessary education and training to HR personnel and foreign employees in this respect.

 

 
 

Issue No. 3: 

Failure to apply the rules on equity incentives correctly.

 
 

Many listed MNCs choose to extend the grant of equity incentives to PRC based executives.  Such incentives include mainly stock options, restricted stock, and stock appreciation rights.

 

Equity incentives are treated as employment income under Chinese IIT laws and taxed in the same manner as salaries and wages.  As such, failure to withhold applicable IIT would result in significant tax risks to MNCs.  Especially, if the failure to withhold is discovered after an employee has left the company, the company may have to bear the cost of the applicable tax (as opposed to chasing the former employee for such tax) in order to reach a speedy settlement with the tax authorities. 

 

Pursuant to the PRC IIT laws, equity incentive income received by Chinese executives would be subject to PRC IIT at the progressive rate ranging from 3% to 45% (i.e., taxed as salaries/wages).  In addition, Chinese executives would be subject to PRC IIT at the rate of 20% on the capital gains derived from their subsequent sale of the relevant shares.  The 20% tax on capital gains is however not subject to the same withholding as applicable to equity incentive income.

 

As to foreign executives, because the equity incentives are presumably awarded for their PRC employment, such equity incentives would also be viewed as PRC sourced income and be subject to PRC IIT at the progressive rate ranging from 3% to 45%.  Whether the capital gains derived from sale of the shares would be subject to the 20% PRC IIT would however be based on the foreign executives’ tax residency status.  If the foreign executive is not a tax resident of the PRC, the foreign senior executive would not be subject to PRC IIT on such capital gains.

 

For foreign executives, there are some additional rules which may provide some tax relief. For example, if equity incentives are granted for not only their PRC employment but also non-PRC employment prior to and/or after the secondment to China, the equity incentives can be split into PRC sourced and non-PRC sourced based on the foreign executive’s working period within and outside China.  For example, if the foreign executive has worked for a MNC for five years and of which two years are in China and if the equity incentive granted to the foreign executive covers the entire five years, theoretically only the equity incentive in connection with the foreign executive’s actual working period in China, i.e., 2 years, would be considered sourced from China and subject to PRC IIT.

 

Zhong Lun’s Insights

 

Because equity incentive income would be taxed as salaries/wages in China, usually the tax burden would be quite huge.  Therefore, many MNCs and senior executives are eager to know whether there is any legitimate tax planning method available to them.  Based on our experience, there is one idea that is worth considering.

 

Specifically, the PRC has a special preferential rule on the equity incentive income received by a non-PRC domiciled individual (a foreign executive is generally considered as a non-PRC domiciled individual), under which, if the equity incentive award income is “received” by a non-PRC domiciled individual after he or she terminates the PRC employment and physically leaves the PRC, such income shall be exempt from the PRC IIT, provided that no PRC company takes a corresponding corporate income tax deduction. 

This special rule is stipulated in tax circular Guo Shui Han [2000] No.190.  As the tax circular is very generally-worded, in practice, if a foreign executive would like to take advantage of this rule, the following points should be well taken:

 

Such equity incentive income shall be “received” after the foreign executive terminates the PRC employment and physically leaves the PRC.  The term “receive income” is not defined by the tax circular but it generally means that the unrestricted ownership is transferred to the executive and there is no substantial risk of forfeiture.  For example, with respect to restricted stock (such as Restricted Stock Units or Restricted Stock), the income is considered “received” by an foreign executive when the restricted stocks are vested and transferrable by the foreign executive and the foreign executive doesn’t have a substantial risk of forfeiture.  If the restricted stock is vested and transferrable by the foreign senior executive before he or she physically leaves China, this special preferential rule cannot be applied;

 

The cost of equity incentive shall not be borne by any Chinese company and no Chinese company shall take a corresponding corporate income tax deduction; and

 

It is also suggested to communicate with the Chinese employer of the foreign executive in advance to ensure that it will not withhold the PRC IIT.

特别声明:

以上所刊登的文章仅代表作者本人观点,不代表北京市中伦律师事务所或其律师出具的任何形式之法律意见或建议。

 

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