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Right now there is a study conducted by the OACD which concludes that a lot of multinational companies are not paying their fair share in the source country and the Chinese tax authorities are finding the same line of thinking. So they plan to strengthen their transfer pricing regulations to allocate more profits into the Chinese tax net. But sometimes the transfer pricing regulation can only do so much so they also want to focus on permanent establishment in that area as a supplement to transfer pricing.
So there are different kinds of permanent establishment, so called PEs. There are service PEs and agency PEs, construction PEs, etcetera. So for China, historically they have done a good job of service PE because in the past in order to make any service fee remittance out of China you’ve got to first get a tax clearance certificate. That is a foreign exchange control requirement. But to the tax and post on those transactions is usually based on profit that is computed using a cost plus model. So usually the tax rate for exposure is not that significant. But going forward, China may actually learn from other jurisdictions. Instead of using cost plus to attribute profits, they can actually use some kind of formal allocation method to allocate more foreign profits into Chinese tax net. So that is one potential area of development.
The other situation is that China plans to enforce the agency PE rules more rigorously. So where especially in situations where a foreign luxury brand, all the expensive bags that are manufactured outside of China and so the manufacturing profits are out of the touch from the Chinese tax authorities. But those products are sold in China and there is a local agent helping the foreign manufacturer to liaise with the customers, negotiate contract terms, to help fulfill the orders. So these type of activities that could be interpreted by the Chinese tax authority as constituting agency PE and if that’s the case then they would have a reason to tax some of those offshore profits that were formally inaccessible to them. So that’s the agency PE risk.
Companies should definitely be more aware of those PE exposures from the service PE and also from the agency PE area and the tax team should develop a detailed internal working guidelines or protocols and communicate that with the business people. So if the company does not even know that they send people to China doing business on a regular basis or they have suppliers or distributors in China doing this type of contract negotiation work for them in China, then they should follow those PE protocols carefully to mitigate the service PE and also the agency PE risks.
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