Permanent Establishment (PE) is widely used in the tax and finance professions but until recently was not used very often by HR and mobility practitioners. However, in recent months, there have been heated discussions concerning the automatic creation of a PE of the overseas sending employer in China on secondment of overseas employees to China and thereby exposed the overseas sending employer to controversial challenges by the Chinese tax authorities.
As HR and mobility practitioners play an important role in the employees’ secondment process, they should be more mindful in the secondment arrangement in order not to cause adverse Chinese tax and related regulatory implications to the enterprises and secondees. The purpose of this article is to provide HR and mobility practitioners with a better understanding of certain key concepts surrounding this controversial topic.
What is a PE?
In a nutshell, a PE is a fixed place at or through which an enterprise wholly or partly carries on business activities in another tax jurisdiction. It is however not limited to a fixed place (i.e., “Basic PE”) but can also be extended to business activities carried out through a dependent agent (i.e., “Agency PE”) or through employees (i.e., “Service PE”). The PE concept is important as the profits derived by an enterprise carrying on business through a PE created in another country can be taxable in that country. For the purpose of this article, we would only cover Service PE as the current secondment and PE controversy in China is largely caused by secondment of overseas employees from overseas enterprises into Chinese enterprises.
Taking the China / Hong Kong Avoidance of Double Tax Arrangement as an example, Article 5(3)(2) provides that:- “the term ‘permanent establishment’ also encompasses…the furnishing of services, including consultancy services, by an enterprise of One Side directly or through employees or other personnel engaged by the enterprise for such purpose, but only if activities of that nature continue (for the same or a connected project) in the Other Side for a period or periods aggregating more than [183 days][1] within any 12-month period.”
Based on the above, a Service PE can be constituted if all of the following three elements are present:-
1. furnishing of services;
2. through employees or other personnel engaged by the enterprise; and
3. project(s) lasting for period(s) aggregating more than 183 days within any 12-month period.
On the first point, the term “services” includes consultancy services but often excludes those activities that are purely of a preparatory or auxiliary character (e.g. advertising of goods or services). On the second point, the critical issue is whether the individuals act under the control and supervision of the overseas employing enterprises while working in China and more will be covered in the later part of this article.
On the third point, the days of physical presence method (i.e. any part of a day is counted as one day) is adopted in counting the 183 days time threshold. It is also worth noting that where the income tax treaty / arrangement entered by a foreign jurisdiction with China uses a time threshold of 6 months, instead of 183 days as in the China / HK income tax arrangement, according to Guoshuihan 国税函 [2007] No. 403, one month would be counted if there is an employee present in China for one day in a particular month. But, if there are no employees working in China for any period of 30 consecutive days, a month can be excluded from the counting.
If a PE is constituted in China in respect of the overseas enterprises, the business profits that are attributable to the PE would be subject to Chinese corporate income tax (“CIT”) at the rate of 25%. In practice, Chinese tax authorities tend to adopt a deemed profit method to determine the China sourced profits and, subject to negotiation and agreement with the local tax authorities, the deemed profit rate varies from 10% to 40%. In addition, business tax at the rate of 5% will also be imposed. Furthermore, there may also be Chinese individual income tax (“IIT”) exposures to those overseas employees who would otherwise be exempt from Chinese IIT had a PE not been constituted. Hence, the Chinese tax exposures of having a Service PE can be significant.
what is a secondment?
In a typical secondment arrangement, the overseas sending enterprise “loans” its employees to the receiving enterprise in China. The sending enterprise and the receiving enterprise would normally enter into an inter-company agreement in which the terms and conditions of the secondment would be documented therein. The loan employee (“secondee”) would also enter into a secondment agreement with the sending and / or receiving enterprise(s). Also, during the secondment period, the secondee would report to and work under the supervision and control of the receiving enterprise. This can be illustrated in the diagram below.
Sending enterprise
Receiving enterprise
Inter-company agreement
Control
Services
Secondment agreement
Employment contract
As to the payroll arrangement, in many cases, the sending enterprise would continue to pay the secondees (including home country’s pension and social security) outside of China and seek reimbursement from the receiving enterprise in China. In other cases, the receiving enterprise would pay the secondee directly in China. If the former is adopted, there could also be outward remittance issues when the overseas sending enterprise seeks to recover the secondees’ costs from the receiving enterprise in China.
Does secondment contstitue a service PE?
According to international practice, a proper secondment arrangement should not in itself constitute a Service PE. This is because despite the secondees render services in China for over the 183 days threshold (conditions 1 and 3 as mentioned above are met), they do not render services in China in their capacity as the employees of the sending enterprise (i.e. the legal employer). The sending enterprise merely loans/provides its employees (not services through its employees) to the receiving enterprise which solely controls and supervises the work of the employees during the secondment period. Hence, condition 2 is not met and an economic employment relationship has indeed established between the secondees and the receiving enterprises.
Other factors that are relevant in considering whether an economic employment relationship is in place include:-
Which enterprise receives the benefits arising from the secondee’s work?
Which enterprise gives day-to-day instructions or has authority over the secondee’s work?
Which enterprise bears the risks, costs, and responsibilities of the secondee’s work?
Which enterprise reviews and appraises the secondee’s work performance?
Whether the secondee’s work constitutes an inseparable part of the receiving enterprise?
Does the sending enterprise recover only the actual secondee’s costs or is a profit mark-up also charged?
Which party has the right to determine the remuneration of the secondee?
what are the hr’s roles in this secondment and pe controversy?
Despite Chinese tax authorities in different locations have taken various steps in attacking the PE exposures arising from secondment of overseas employees into China over the past few months, it is believed that they would eventually recognise the concept of economic employer as explained above and would place more emphasis to the form and substance in each individual case when considering the secondment and PE issues.
Given this, HR and mobility practitioners should be more cautious than ever when structuring the secondment arrangement into China so that exposures to Chinese CIT, IIT and other related issues (e.g. payroll and remittance, pension and social security etc.) to the enterprises and secondees can be properly managed. They should also review the existing secondment arrangement into China along the directions set out above in order to withstand potential challenges by the Chinese tax authorities.
[1] The time threshold under the China / HK income tax arrangement has been changed from “6 months” to “183 days” effective 11 June 2009.
Paul Arkwright
Publisher
