OVERVIEW OF THE US-CHINA INCOME TAX TREATY
US-CHINA INCOME TAX TREATY PLANNING
The US-China Income Tax Treaty (the “Treaty”) was signed in Beijing on April 30, 1984 and became effective on January 1, 1987.[1] For an increasing number of companies and individuals involved with US-China commerce, the Treaty offers numerous tax planning opportunities that are sometimes overlooked. Treaty tax planning is critical not only for purposes of maximizing available tax benefits, but also to avoid the tax traps and associated legal costs that can be prevented or mitigated through advance planning.
1. Taxpayers & Tax Laws Within Scope of Treaty
Article 1 of the Treaty states that it applies to taxpayers on the basis of their legal residence, not their citizenship. However, there is a notable exception known as a “Saving Clause” in which the U.S. preserves the right to tax its citizens on their worldwide income.[2] This exception is intended to “save” the right of the U.S. to tax former citizens whose loss of citizenship is deemed to have had as one of its principal purposes the avoidance of U.S. tax.
Article 2 sets forth the tax laws within the scope of the Treaty. In the U.S., the Treaty only applies to federal income taxes, not state or local taxes. In China, the Treaty applies to the Individual Income Tax, the Enterprise Income Tax Law[3] and the Local Income Tax.
2. Characterization of Income
Income is taxed on either a gross or net basis, depending upon its character. Under the Treaty, the characterization of income can be divided into three broad categories: business income, investment income and employment income. Characterization is a critical planning consideration because a taxpayer’s ultimate international tax consequences can vary significantly depending upon how income is characterized.
A. BUSINESS INCOME
Under Article 7 of the Treaty, net business profits are taxable only in the country of the taxpayer’s residence unless the profits are attributable to a “Permanent Establishment.” Furthermore, Article 8 of the Treaty empowers the U.S. and Chinese taxing authorities to recalculate business profits allocated among related enterprises (an issue known as “Transfer Pricing”). These related but separate concepts are discussed in more detail below.
Permanent Establishment
Article 5 of the Treaty defines a Permanent Establishment as “a fixed place of business through which the business of an enterprise is wholly or partly carried on.” A U.S. or Chinese company with a branch, office or factory in the other country would clearly have a Permanent Establishment subjecting the company to income taxation by both the U.S. and Chinese governments.
However, in other situations, reasonable minds could differ on the question of whether a Permanent Establishment exists. Fortunately, the Treaty defines parameters to facilitate meaningful tax planning. For example, the Treaty states that consultancy services would not constitute a Permanent Establishment unless the activities continue for more than six months in any twelve month period. Similarly, a building or construction site would not constitute a Permanent Establishment unless the activity exceeds six months.
As another example, business activities (such as sales and marketing) conducted through an independent agent do not constitute a Permanent Establishment. However, engaging an agent who habitually concludes contracts does constitute a Permanent Establishment. Therefore, exporters who are engaging in sales and marketing activities abroad through agents in either the U.S. or China may want to ensure that the process of finalizing sales contracts is handled by employees or agents in the home country.
Foreign persons or entities claiming an exemption from U.S. tax because their activities in the U.S. do not constitute a Permanent Establishment must disclose this position on IRS Form 8833 (Treaty-Based Return Position Disclosure). The IRS has been reviewing Form 8833 Permanent Establishment disclosures very closely in recent years.
Transfer Pricing
The issue of Transfer Pricing arises when a U.S. or Chinese company conducts operations in the other country through a subsidiary or other related enterprise. Article 8 of the Treaty states that when there is sufficient indicia of relatedness through participation in management, control or capital of the related enterprises, then the taxing authority has the power to re-allocate income, deductions and credits in accordance with an “arm’s length” standard. Because the tax risks are so high, Transfer Pricing is a very hot issue for multinationals operating abroad.
There are several options available to minimize the tax risks associated with Transfer Pricing. By far, the most effective way to manage this risk is though the negotiation of a bilateral Advanced Pricing Agreement (“APA”) between the taxpayer, the IRS and China’s State Administration of Taxation (“SAT”). The first bilateral APA involving the U.S. and China was concluded in January of 2007 between Walmart, the IRS and the SAT.[4] Several other bilateral APA applications are pending. U.S. and Chinese taxpayers can also enter into unilateral APAs with the IRS and SAT respectively, negotiate or pursue post-audit remedies such as administrative appeals, Competent Authority assistance (discussed later in this article) or judicial action.
B. INVESTMENT INCOME
Both the U.S. and China impose taxes upon nonresidents who earn passive investment income from sources within their respective borders. Investment income earned by nonresidents in the U.S. is taxed at a flat 30% of the gross amount without any deductions or allowances for costs.[5] However, U.S. and Chinese taxpayers may be able to limit the amount of the tax imposed on investment income by using the Treaty. In the U.S., a foreign taxpayer must present a completed Form W-8BEN to the withholding agent in order to claim the Treaty benefit reducing the amount of the 30% withholding on investment income.
The Treaty defines five categories of investment income, as follows: interest, dividends, royalties, gains and income from real property. As a general rule, withholding of interest, dividend and royalty income is limited to 10% of the gross payment. By contrast, there are generally no limits on the withholding of gains[6] (such as capital gains from the sale of property or stock) or rental income from real property.[7]
An unfavorable decision by the taxing authorities concerning characterization of income can be disastrous. For example, in a case ruled upon by the Beijing High Court in 2002,[8] income paid by China’s CCTV to a U.S. satellite company (for providing video distribution services) was ultimately characterized by China as passive royalty income for the use of scientific equipment subject to 7% withholding by the withholding agent, CCTV.[9] The U.S. satellite company had argued, unsuccessfully, that the payments constituted business income which was not taxable in China because the U.S. company lacked a Permanent Establishment. The amount of the tax that had to be paid as a result of this decision was over 1.5 million dollars.
C. EMPLOYMENT INCOME
Article 14 of the Treaty addresses employment income under the heading “Dependent Personal Services.” Several other Treaty articles address employment related categories including: Independent Personal Services (Article 13), Director’s Fees (Article 15), Artists & Athletes (Article 16), Pensions & Annuities (Article 17), Government Employees & Pensions (Article 18), Teacher, Professors & Researchers (Article 19) and Students & Trainees (Article 20).
Article 14 states that employment income (defined as salary, wages and similar remuneration derived from employment) is generally taxable in the employee’s country of residence and the country where the services are performed. Thus, a U.S. employee working in China is potentially subject to withholding, return filing and payment of income tax obligations in both China and the United States.
However, Article 14 defines an important exception which should be considered as part of advance tax planning by the employer, employee and their respective tax advisors. Under this exception, employment income is taxable only in the taxpayer’s country of residence when all three of the following conditions are satisfied: (1) the taxpayer is in the country where the services are performed for 183 days or less in a calendar year and (2) the income is paid by an employer which is not a resident of the country where the services are performed and (3) the income is not related to an employer’s Permanent Establishment.
3. Tax Credit
Article 22 of the Treaty addresses the core issue of all international tax planning: the Tax Credit. The stated purpose of Article 22 is to “eliminate” double taxation. In theory, if a taxpayer of one country pays income tax in the other country, then the amount of the tax paid is available as a credit to offset the income taxes imposed by the taxpayer’s country of residence. While this is a simple and straightforward concept, the actual implementation of this goal (at least for U.S. taxpayers) is often complicated and requires planning and proactive behavior.
Article 22 states that U.S. residents are entitled to a credit against the U.S. tax on income for income tax paid to China “in accordance with the provisions of the law of the United States.” Translation: U.S. residents are subject to the complicated rules governing the Foreign Tax Credit.[10] Two of the most prominent restrictions to be aware of are: (1) the credit only applies to foreign source income (as opposed to U.S. source income) and (2) the amount of the credit is subject to certain “limitations” within two[11] specifically defined income categories.[12]
One of the biggest tax risks for U.S. companies engaging in trade with or doing business in China is the threat of double taxation. If the SAT determines that certain income has a China source, but the IRS determines that the same income is U.S. source, then the Foreign Tax Credit is unavailable and double taxation will result. Tax Credit planning which takes into account the source of income rules can reduce this risk. For example, under the source rules, income from the sale of purchased goods is sourced where the sale takes place (where title passes).[13] Thus, an exporter wishing to generate foreign source income could contract to have title of the goods pass in the importing country.
4. Treaty Dispute Resolution
Taxpayers who believe that they have been denied relief available under the Treaty may utilize Article 24, which defines what is known as the Mutual Agreement Procedure (commonly referred to as “MAP”). Under MAP, the “Competent Authority” of each country is supposed to communicate, exchange information[14] and then hopefully resolve the dispute via mutual agreement.
The Treaty defines the U.S. Competent Authority as the Secretary of the Treasury. This duty has been delegated to the IRS Deputy Commissioner, Large and Mid-Size Business Division (International). The procedures for requesting U.S. Competent Authority assistance are set forth at IRS Rev. Proc. 2006-54 (hereinafter the “CA Procedures”).
The CA Procedures provide a blueprint for U.S. taxpayers to seek relief from adverse international tax consequences. The topics addressed include: (1) applying for advance rulings before submitting a formal Competent Authority application, (2) requirements for applying for formal Competent Authority assistance (including standard, accelerated and small case procedures), (3) filing Protective Claims to preserve alternative remedies in the event that the Competent Authority process is unable to provide the desired relief[15], (4) coordination of Competent Authority assistance with other IRS administrative and judicial proceedings[16] and (5) requests for foreign initiated adjustments without formal Competent Authority involvement.
The decision about whether or not to request formal Competent Authority assistance, the steps to take and the order in which to take them depends upon the specific facts of each taxpayer’s situation. At a minimum, taxpayers and their advisors should engage in a cost/benefit analysis to assess the expected time and cost of seeking Competent Authority assistance (and filing appropriate Protective Claims) in relation to the dollar amount at issue and the “best case” tax relief outcome.
In China, the Competent Authority is the SAT. China’s entire tax system has been maturing rapidly, including the aspects of the system governing MAP. In 2005, the SAT issued Guoshuifa 115 titled “Provisional Regulations on the Application of Mutual Agreement Procedure by Chinese Residents and Nationals.” The procedural remedies set forth are available to Chinese residents and nationals and are analogous to the CA Procedures available to U.S. taxpayers.
Copyright 2008 Joel S. Todd. All rights reserved.
This article is intended to provide accurate and authoritative information but does not constitute legal, accounting or other professional advice. If expert advice is required, the services of a competent professional should be sought.
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[1] A complete copy of the US-China Income Tax Treaty and the Treasury Department’s Technical Explanation can be found at the IRS website at
[2] Treaty Protocol 1, Article 2.
[3] This law became effective on January 1, 2008 and replaced the Foreign Enterprise Income Tax, which in 1991 had replaced the prior Chinese laws governing income taxes on joint ventures and foreign enterprises which are identified at Article 2 of the Treaty.
[4] See First China-US Bilateral APA Concluded (KPMG China Alert January 2007, Issue 1).
[5] In the U.S., this category is defined by I.R.C. 871 (individuals) and 881 (corporations) as Fixed or Determinable Annual or Periodical gains, profits and income and is commonly known as “FDAP.”
[6] Pursuant to Article 12 of the Treaty, only the country of residence can tax ship and aircraft related gains, as well as gains from the sale of less than 25% of the shares of a company (the assets of which are not principally real property).
[7] Pursuant to Article 6, only the country of the taxpayer’s residence can tax income from the use of ships and aircraft.
[8] See Ge Tan, Tax Treaties’ Interpretation and Application under the Challenges of the Digital Economy – Issues Raised by PANAMSAT v. Beijing State Tax Bureau (Volume 16, Issue 1 2006, Revenue Law Journal).
[9] Under Article 11 of the Treaty, the normal limit of withholding on royalty income is 10%; however, there is a special 7% limit for royalty income from the rental of industrial, commercial or scientific equipment under Paragraph 6, Protocol 1 of the Treaty.
[10] I.R.C. Sections 901 et seq
[11] Under The American Jobs Creation Act of 2004, the number of such income categories for tax years after 2006 was reduced from seven to two.
[12] This rule is intended to prevent ”cross-crediting” between relatively low taxes on foreign investment income and typically higher taxes on foreign business income.
[13] See I.R.C. Sections 861 and 865.
[14] Article 25 provides for the confidential exchange of information between the U.S. and Chinese Competent Authorities.
[15] Including measures to preserve the taxpayer’s right to claim a refund or credit, extend the period of limitation on assessment or refund, avoid lapse or termination of taxpayer’s right to appeal any tax determination, or the right to contest any adjustment or seek a correlative adjustment.
[16] Including simultaneous Competent Authority action and IRS appeals, coordination with ADR and Pre-Filing Procedures and coordination with tax litigation.
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