The month-long public consultation of the Draft Amendments to the Individual Income Tax Law of the People’s Republic of China ended on 28 July 2018. According to the website of the National People’s Congress (“NPC”, www.npc.gov.cn), more than 67,000 people have submitted over 130,000 comments on the Draft Amendments. Through the increase of standard deduction, widening the lower tax bands and introducing specific deductible items, the Individual Income Tax (“IIT”) burden on individuals is expected to reduce. The NPC website reported that the IIT payable by an individual making RMB10,000 a month drop by 74%.
However, if the Draft Amendments are passed as they are, starting next year, when a foreign individual resides in China for 183 days or more in a year, his foreign earnings may be subject to IIT. This is particularly worrying for Hong Kong individuals, many of them work for Multinational Enterprises based in Hong Kong, who travel to the Mainland frequently to carry out their employment duties.
The last issue of Tax Tips was about tax residency of companies. Thanks to the timely introduction of tax residency into the IIT Law, this issue of Tax Tips discusses tax residency of individuals, which will have a profound impact on Hong Kong businesses and individuals.
The Current Rules
Article 1 of the current IIT Law reads as follows:
“Individual income tax shall be levied in accordance with the provisions of this Law by individuals who have a domicile in China, or though without domicile but have resided for one year in China on their income derived from sources within and outside China.
Individuals who are neither domiciled nor resident in China, or who are not domiciled and reside for less than one year in China, shall pay individual income tax in accordance with this Law on income derived from sources within China.”
What is domicile, not domicile, reside for one year or less than one year? According to the Detailed Implementation Rules of the IIT Law (“DIR”, which is also subject to corresponding amendments to be announced), the term “individuals who have domicile in China” means individuals who by reason of their permanent registered address (HuJi), family or economic interests, habitually reside in China. The DIR did not define what is “not domiciled in China” but generally it refers to individuals who do not fall into the definition of domicile in China. In practice, as long as the individual does not possess HuJi in China, that person would be a Foreigner and regarded as not domiciled in China.
The term “resided for one year in China” means to have resided within China for 365 days in a tax year. That does not mean that only those who live in China every day in a tax year would become what is commonly referred to as “One Year Taxpayer”. According to the DIR, no deduction of days would be considered for “temporary departure”, which is defined as absence from China for not more than 30 days in a single trip, or not more than a cumulative total of 90 days over a number of trips, within the same tax year. In other words, in order to avoid being considered a One Year Taxpayer and pay IIT on income sourced in and outside China (i.e. worldwide income), the individual shall either travel outside of China for more than 30 days in a single trip, or more than 90 days cumulatively, in a tax year. As long as the individual is not domiciled in China and is not a One Year Taxpayer, only income sourced in China is subject to IIT.
Having said the above, many Foreigners who station in China with temporary departures are not paying IIT on their worldwide income. This is because Article 6 of the DIR provides that: for individual not domiciled in China and resides in China for more than one year and less than five years, subject to the approval of the tax authorities-in-charge, IIT may be paid on only that part of income which was paid by companies, enterprises or other economic organisations or individuals in China. Individuals who reside for more than five years shall, commencing from the sixth year, pay IIT on the whole amount of income derived from sources outside China.
The effect of this Article is that Foreigners would only be subject to IIT on worldwide income on the sixth year if they become One Year Taxpayer for five consecutive years. Therefore, many Foreigners who have stationed in China for four years would, on the fifth year, make a single trip out of China for more than 30 days, or spend more than 90 days cumulatively outside of China, in order to restart the five-year-count. As such, it should be very rare that any Foreigners would be paying IIT on their worldwide income.
The Draft Amendments
The concept of tax resident has been introduced by the Draft Amendments to replace One Year Taxpayer. Article 1 of the IIT Law will be replaced by:
“Individuals who have a domicile in China, or though without domicile but have resided in China for 183 days or more in a tax year, shall be a resident individual and subject to individual income tax in accordance with the provisions of this Law on their income derived from sources within and outside China.
Individuals who are neither domiciled nor resident in China, or who are not domiciled and reside in China for less than 183 days in a tax year, shall be regarded as a non-resident person, and pay individual income tax in accordance with this Law on income derived from sources within China.”
If the above is passed into law, assuming that the definition of “domicile in China” is unchanged, Foreigners (including Hong Kong individuals) would be regarded as Chinese tax residents by residing in China for 183 days in a tax year, and their worldwide income would be subject to IIT. As a result, Foreigners may easily become dual-residents – resident of both their home jurisdiction and China. Unless the to-be-amended DIR contains provisions relaxing the requirements (similar to the provision in Article 6 discussed above), the period of stay required for IIT to be imposed on worldwide income shall be reduced from five years to 183 days!
It is understood that the Draft Amendments will be passed in August this year, and the revised IIT Law will be effective 1 January 2019. From 1 October 2018 to 31 December 2018, IIT on salaries and wages may be calculated by applying the new monthly standard deduction of RMB5,000 and the new tax rates (for consolidated income), without deducting the additional deduction (previously available to Foreigners).
What kind of Foreign Income is subject to IIT?
All income items covered under the IIT Law shall be subject to IIT at the applicable new rates, as follow:
- Consolidated income (salaries and wages, labour services, author’s remuneration, royalties) at progressive rates from 3% to 45%;
- Business income at progressive rates from 5% to 35%;
- Interest, dividend, gains, property leasing income, property transfer income, occasional income and other income at a rate of 20%.
That is to say, if a Hong Kong individual becomes a Mainland tax resident, the above kinds of income earned in Hong Kong, including the potentially substantial amount of income from property transfer, could be subject to IIT. The Mainland tax authorities would have the taxing right even on income that is subject to Hong Kong tax, such as property rental income.
OMG, what should I do?
Before knowing how the DIR is to be amended, taking action now would seem immature. Notwithstanding, there is no harm in thinking possible solutions.
The simplest solution is to avoid staying in China for 183 days or more. That would not be easy for Hong Kong people who need to daily commute to nearby Chinese cities, and it may be harder in the future under the Greater Bay Area Initiative being promoted by the Hong Kong and Mainland governments.
A more complex and troublesome way is to re-allocate foreign assets and earnings so that the income generated would not be considered the income of the Foreigner. This is a somewhat palliative measure that should be considered only as the last resort.
A better solution is to dig deeper into the tax rules to find the way out.
Definition of “Resident” in Double Tax Agreement
Whenever tax issues between two tax jurisdictions arise, the Double Tax Agreement/Arrangement (“DTA”), if available, should be consulted. For Hong Kong individuals, the DTA between Hong Kong and the Mainland (“HK-CN DTA”) would be relevant. According to Article 4 – Resident of the HK-CN DTA, the term “resident of One Side” (for the part relating to individuals) means:
“(1) in the case of the Mainland of China, any person who, under the laws of the Mainland of China, is liable to tax therein by reason of his domicile, residence … or any other criterion of a similar nature. This term, however, does not include any person who is liable to tax in the Mainland of China in respect only of income from sources in the Mainland of China;
(2) in the case of the Hong Kong Special Administrative Region:
(i)an individual who ordinarily resides in the Hong Kong Special Administrative Region;
(ii)an individual who stays in the Hong Kong Special Administrative Region for more than 180 days during a year of assessment or for more than 300 days in 2 consecutive years of assessment one of which is the relevant year of assessment…”
In case an individual who ordinarily resides in Hong Kong becomes a Mainland tax resident under the new IIT Law, he would be regarded as a resident by both Sides. Not a situation that anyone would like to be in.
How to Decide Which Side the Individual a Resident of
It is not uncommon for a tax jurisdiction to treat a Foreigner a tax resident if he resides 183 days or more in that jurisdiction. The proposed amendment to Article 1 of the IIT Law is an alignment with the international norm. From the perspective of China, such an amendment is reasonable and perhaps long overdue. Since such a change practically has no impact to local Chinese nationals, it is likely that very few of the 130,000+ comments on the Draft Amendments would argue against the change. Therefore, it is expected that Article 1 will be amended as proposed.
As it is the international norm, it should be common for two Sides to dispute on the tax residency of an individual from one Side residing in the other Side. One of the main purposes of the DTA is to prevent double taxation and thus such disputes can be resolved by the DTA. Most, if not all, of the DTAs would contain rules to settle residency issue, which can be a direct negotiation between the competent authorities of the two Sides, or they go through the tie-breaker rules contained in the DTA first and only resolve by mutual agreement when the case goes into a deadlock. According to Article 4(2) of the HK-CN DTA, when an individual is a resident of both Sides, his status shall be determined by these tie-breaker rules:
(1) he shall be deemed to be a resident only of the Side in which he has a permanent home available to him; if he has a permanent home available to him in both Sides, he shall be deemed to be a resident only of the Side with which his personal and economic relations are closer (“centre of vital interests”);
(2) if the Side in which he has his centre of vital interests cannot be determined, or if he does not have a permanent home available to him in either Side, he shall be deemed to be a resident only of the Side in which he has an habitual abode;
(3) if he has an habitual abode in both Sides or in neither of them, the competent authorities of both Sides shall resolve by mutual agreement.
There are three technical terms here: “Permanent Home”, “Centre of Vital Interests” and “Habitual Abode”. Returning readers of Tax Tips would know that elaboration of these terms may be found in the Commentaries to the OECD Model Tax Convention on Income and on Capital: Condensed Version 2017 (“the 2017 Model Tax Convention”), as extracted below:
The residence is that place where the individual owns or possesses a permanent home, meaning that the individual must have arranged and retained it for his permanent use as opposed to staying at a particular place that is intended to be of short duration (travel for pleasure, business travel etc).
Home can be a house or apartment belonging to or rented by the individual, but the permanence of the home is essential; this means the individual has arranged to have the dwelling available to him at all times continuously. A house owned by an individual cannot be considered to be available to that individual during a period when the house has been rented out and effectively handed over to an unrelated party so that the individual no longer has the possession of the house and the possibility to stay there.
Centre of Vital Interests
If the individual has a permanent home in both Sides, it is necessary to look at the facts in order to ascertain with which of the two Sides his personal and economic relations are closer. Regards will be had to his family and social relations, his occupations, his political, cultural or other activities, his place of business, the place from which he administers his property etc. The circumstances must be examined as a whole, but it is nevertheless obvious that considerations based on the person acts of the individual must receive special attention. If a person who has a home in one Side sets up a second in the other Side while retaining the first, the fact that he retains the first in the environment where he has always lived, where he has worked, and where he has his family and possessions, can, together with other elements, go to demonstrate that he has retained his centre of vital interests in the first Side.
It requires a determination of whether the individual lived habitually, in the sense of being customarily or usually present, in one of the two Sides but not in the other during a given period. It is a notion that refers to the frequency, duration and regularity of stays that are part of the settled routine of an individual’s life and are therefore more than transient. The length of time to look at in determining where an individual habitually abodes should be sufficiently long, and the relevant period of time will not always correspond to the period of dual-residence.
Other than the 2017 Model Tax Convention Commentaries, readers may also refer to the “Interpretation of the DTA between the People’s Republic of China and Singapore and the Protocol” issued by the State Administration of Taxation of China under Circular GuoShuiHan (2010) 75. The interpretation contained therein would also be applicable to other DTAs signed by China and other jurisdictions where the provisions are identical. The interpretations adopted are basically a simplified version of the 2017 Model Tax Convention Commentaries.
It is good to have rules set out in the DTA to help determine which Side the tax residency of an individual belongs to. However, what happens in practice? This is the key problem. The current IIT Law does not determine the chargeability to IIT based on residency, and a Foreigner would only be subject to IIT on worldwide income when he resides in China for five consecutive years which is a position that can be easily avoided. Therefore, it is likely that the Chinese tax offices have handled very few cases of resident determination. When such cases begin to surface next year, numerous Foreigners would face a substantial increase in IIT if the tax officers do not have a good understanding of how to determine tax residency. As employers are unlikely willing to bear the additional IIT exposure, many employees especially Hong Kong people may refuse to work in the Mainland.
IIT affects the well-being of every individual and deserves high attention. The above discussions should be helpful to readers in planning ahead of the changes. Companies are recommended to closely follow the development of the Draft Amendments and the upcoming changes to the DIR in order to ensure that human resources issues are managed well and the employees’ concerns are addressed. For Hong Kong individuals who ordinarily reside in Hong Kong, they should consider applying for the Certificate of Resident Status with the Hong Kong Inland Revenue Department as supporting of tax residency. Affected individual and companies should talk to knowledgeable tax consultants, such as us, as soon as possible for advice on managing the tax exposure.Contact Us
(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 8 August 2018: https://manageyourtax.com/HKEJ Forum 14)
IIT Amendment Bill:
OECD Model Tax Convention: https://read.oecd-ilibrary.org/taxation/model-tax-convention-on-income-and-on-capital-condensed-version-2017_mtc_cond-2017-en#.WmNWKqiWYdU#page32
Guo Shui Fa (2010) 75:
HK Tax Resident Certificate – Individual – Mainland: