Beijing Strengthens Tax Audit on Employer Granted Fringe Benefits

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Abe Zhao

Abe Zhao Baker McKenzie FenXun (FTZ) Joint Operation, China

Abe Zhao is International Tax Director at Baker McKenzie FenXun (FTZ) Joint Operation, China

Subsidy-related relief measures described in this article play an important role in alleviating the tax burden for foreign expatriates working in China. Chinese employers should take advantage of these measures and develop a tax compliant program to administer qualified fringe benefits to its expatriate employees.

For many years, the most important individual income tax (“IIT”) relief for foreign expatriates working in China has been the IIT exemption on qualified employer fringe benefits. Under tax regulations issued in the 1990s ( Caishuizi 1994-20; Guoshuifa 1997-54), foreign expatriates (non-Chinese citizens) working in China may be exempt from IIT for qualified subsidies that are received in association with their employment in China, to the extent that the amounts of the benefits are reasonable as determined by the Chinese tax authorities. The prescribed categories of qualified expatriate subsidies are generally apartment and house rental, meals, relocation, laundry, home visit travels, linguistic training, and children's education. To qualify for IIT exemption, the regulations provide two mechanisms for granting the benefits. One is for the employers to directly incur expenses on behalf of the expatriates in the qualified categories aforementioned and hence benefits are provided to the expatriates in non-cash form. Direct cash subsidies to the foreign expatriates would not qualify. The other is for the expatriates to incur expenses in the prescribed categories first, gather and submit the supporting documents such as tax invoices and contracts as evidence, and seek reimbursements from the employers based on actual amounts incurred.

Although the national rules on IIT exemption are relatively simple, the devil lies in the detail. Issues such as whether a particular type of expense falls within the qualified categories, what amounts are considered reasonable, and what supporting documents are needed, are subject to the interpretation of the tax authorities in each location. The qualification standards and enforcement practices often vary across the country.

As IIT withholding agents of the expatriates, Chinese employers will be held responsible if they fail to withhold IIT on subsidies that do not qualify for exemption. It is important for employers to understand the exact local requirements and implement them internally with consistency. Some recent IIT audit cases, as represented by the one described in the next section, indicate a significantly stepped-up effort by the Chinese local tax authorities to scrutinize subsidy-related IIT exemption for foreign expatriates. These cases illustrate the necessity for Chinese employers to review and refine their internal control procedures to mitigate tax risks.

Beijing IIT Audit Case

It was reported in the media that a Chinese subsidiary of a Fortune 500 company was recently audited by the Local Tax Investigation Bureau (“LTIB”) in Beijing. Besides distribution functions, the Chinese entity serves as a regional headquarters for the Southeast Asia operation of the multinational group and therefore employs about 100 foreign expatriates in Beijing. During the audit the Chinese tax officials discovered that some foreign expatriates of the Chinese company derived more than 50 percent of their employment compensation in the form of IIT exempt subsidies. Internal benchmarking data of the LTIB suggested that the normal percentages for similar foreign invested enterprises in Beijing were around 20 percent. Therefore the tax officials expanded their audit efforts and examined more than 90 boxes of supporting documents. The following issues were discovered:

  •   The Chinese company reimbursed some foreign expatriates for tuition expenses, meal expenses, and school shuttle expenses related to their children's overseas education and treated such reimbursement as IIT exempt income in China. According to Circular 54, in order for subsidies related to linguistic training and children's education to be exempt from Chinese IIT, the training and education activities must take place in China. As a result, the Beijing tax investigation Bureau denied IIT exemption for such subsidies.
  •   The Chinese company reimbursed some foreign expatriates for expenses related to piano training and gym classes, and took the position that such reimbursement for training expenses were entitled to IIT exemption. The tax officials indicated that the main regulatory purpose behind Circular 54 was to provide IIT relief to foreign expatriates who do not speak the Chinese language and therefore need to incur extra expenses to acquire such linguistic skills in order to function effectively in China. Treating reimbursement for piano training classes and fitness classes as IIT exempt income runs contrary to this regulatory intent and therefore is not a tenable tax position.
  •   The Chinese company reimbursed airplane expenses incurred by the relatives of some foreign expatriates when they traveled between their home countries and China and treated such reimbursement as IIT exempt. According to Chinese regulations ( Guoshuihan 2001-336), qualified reimbursement should only cover travel expenses incurred by the foreign expatriates themselves when they take up to two personal trips per year between the employment locations in China and their family locations (e.g. where an expatriate's spouse or parents live). Therefore, the LTIB ruled that reimbursements for travel expenses incurred by the expatriates' relatives do not qualify for IIT exemption.
  •   When granting rental subsidies to foreign expatriates, the Chinese subsidiary classified ancillary expenses such as utility costs, real estate management expenses, and apartment cleaning expenses of the expatriates as components of rental expenses and treated their reimbursements as IIT exempt income of the expatriates. Apparently these expenses were listed separately from the rents in the lease agreements. The Beijing tax officials maintained that expenses ancillary to rental such as real estate management, utility, broadband internet access, cleaning fees, safe box rental, etc. are not rental expenses themselves. Therefore the LTIB determined that such reimbursements by Chinese employer were not qualified subsidies and should be subject to IIT.
  •   When determining whether a reimbursement by a Chinese company to a foreign expatriate employee is a qualified subsidy, a critical supporting document is the Chinese official tax invoice or “fapiao” that the foreign expatriate collects from the Chinese vendor. Such an invoice must be authentic in the sense that it should be issued by the Chinese vendor who actually rendered the services to the expatriate and it should be printed on government issued invoice paper with an official serial number. In this Beijing case, the tax officials, through sample checking, found a number of the fake tax invoices submitted by the foreign expatriates of the company. For example, the auditors discovered that a foreign expatriate employee provided to the employer multiple tax invoices coming from a Chinese consulting firm for language training classes as supporting evidence for reimbursement. However, after further investigation, the tax officials learned that the primary business of the Chinese consulting firm issuing the fapiaos was operating parking lots and had nothing to do with linguistic training. Therefore the associated reimbursements were denied IIT reimbursements because the fapiaos submitted as supporting documents were fake.

At the end of the tax audit, the Beijing tax investigation bureau issued an adjustment notice to the Chinese taxpayer, and collected an additional 16 million renminbi of underpaid IIT and 12 million renminbi of penalty.

Summary

The Chinese IIT system has a top marginal tax rate of 45 percent for salary income. The subsidy related relief measures described above play an important role in alleviating the tax burden for foreign expatriates working in China. Therefore, Chinese employers should take advantage of this tax relief measure and develop a tax compliant program to administer qualified fringe benefits to its expatriate employees.

However, the purpose of the incentives is to facilitate the foreign expatriates to acclimate into the working and living environment in China. Therefore, the regulations have very tight rules on the types of expenses that may qualify for this incentive as well as the procedures that must be followed to claim the incentive. When administering the program, it's important that Chinese employers follow the rules closely and do not adopt overly liberal interpretations that are not supported by the regulatory language.

As the withholding agent for the expatriate employees' salary income, the Chinese employer will bear the primary responsibility for management of its expatriate subsidy program according to the requirements of the Chinese regulations and will incur tax costs and penalties if it is discovered not to follow the government rules and procedures during audit. The heightened enforcement efforts on IIT exemption is not just witnessed in Beijing and has been seen in some other cities of China in recent months. Multinational companies with the pre-existing programs of the granting IIT exempt subsidies to expatriates are encouraged to review their internal procedures and rectify any areas that may create tax compliance risks.

For More Information

Abe Zhao is International Tax Director at Baker McKenzie FenXun (FTZ) Joint Operation, China. He can be contacted at Abe.Zhao@bakermckenziefenxun.com.Baker & McKenzie FenXun (FTZ) Joint Operation Office is a joint operation between Baker & McKenzie LLP, an Illinois limited liability partnership, and FenXun Partners, a Chinese law firm. The Joint Operation has been approved by the Shanghai Justice Bureau.

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