Did you ever think your business would be subject to a tax in China even though you had no legal entity and no employees on the ground in China? If you did have a company registered in China, did you ever think you would need to pay tax on the profits you take out of the country, even after you paid taxes locally already?

Welcome to the China withholding tax. By default, it is a 10% charge on gross amounts being sent out of China (and in some cases subject to additional VAT taxes as well). It acts like a tax on “passive” income, for example, on IP royalties from a licensor outside of China to a customer licensee in China. Even for services provided by a foreign company to a customer in China. This type of income is considered “China-sourced.” 

Since the company earning such income does not have a taxable entity in China (i.e., it does not have a taxable “presence” in China) that the local tax authorities can easily assess and collect taxes on, the authorities require that instead the customer “withhold” the tax on the foreign companies behalf and pay that tax to the local tax authorities.  

In addition to IP royalties and service fees, the withholding tax applies to dividend payments to a mother company outside of China, interest payments for debt and rent payment to a company outside of China, and other similar payments deemed to be passive income.

Withholding tax has been on the books in China for over 30 years, and your local customers will most certainly be looking to withhold the tax from you to comply with local regulations. It’s similar to an employer withholding personal income tax from an employee’s paycheck and remitting it to the tax authorities. The tax obligation is on the income-earner; the payment obligation is on the company making the payment (generally to be made within 7 days).

Foreign companies with negotiating leverage will look to explicitly pass this tax burden back on to their customers, with gross-up clauses in their contracts stating that fees payable are net of taxes, including withholding tax. Chinese customers will look to resist, arguing that these are taxes fundamentally owed on the “deemed” income of the foreign company. The customer is merely acting as the foreign companies agent because the foreign company cannot technically make the payment itself. At the end of the day, it’s a matter for discussion and all essentially built into the final “price.”

The standard withholding tax rate is generally 10%, but some treaties can reduce this rate. Singapore and Hong Kong companies are the most well-known for having a lower 5% withholding tax rate for some categories of payments. However, companies from all other jurisdictions without any special tax treaty will default instead to the 10% withholding tax rate. Note whereas in the past, many businesses set up de facto holding companies in Hong Kong to reduce withholding tax payments for passive income coming out of China, such as dividends, there has been an increase in scrutiny requiring the company to have actual operations to legally enjoy the lower withholding tax treaty benefits.

Withholding tax in China is real, and it is not insubstantial at all. Remember, even a mother company charging inter-group services fees to its child (subsidiary) company in China will be subject to a withholding tax. Be prepared and consult a tax advisor on how to go about handling withholding tax for your customer and inter-group transactions with China.

Engage a legal advisor to help you efficiently review your business contracts with distributor, suppliers, and other partners to make sure you are legally protected.

Contact us at inquiries@ChinaLawSolutions.com for more information.