IIT reform: Paving the future of personal income tax compliance in China
In 2019, the major individual income tax (IIT) reform initiated in 2018 was reinforced with a string of clarifications. Chinese tax residents and foreigners with exposure to Chinese IIT are coming up to speed with the changes. Michelle Zhou explores the issues.
Following six months of public consultation and discussion between representatives of the National Peoples' Congress (China's parliament), in late 2018 China's IIT Law was amended for the seventh time since its inception. This major overhaul led to an overall reduction in the personal income tax burden for low and middle-income earners, while also instituting new safeguards on the integrity of the national tax base.
The revenue impact was immediate. According to statistics from the State Taxation Administration (STA), IIT collection between January and May 2019 was down by CNY 259.4 billion ($36.8 billion) compared with the same period in 2018. Approximately 109 million taxpayers were treated as IIT exempt, as their salary and wages income fell under the annual personal exemption threshold of CNY 60,000.
While taxpayers and their advisors are still digesting the implications of the IIT rules, further innovations have been made. For example, IIT and Chinese corporate income tax (CIT) incentive policies are being rolled out in the Greater Bay Area (GBA – the cluster of cities in South China including Guangzhou, Shenzhen, Hong Kong SAR and others) to attract talented staff and investment into the area. Other local government authorities, such as the Lingang free trade zone in Shanghai have also followed suit with equivalent incentives.
The counterweight to reductions in the tax burden for low and middle-income taxpayers is the strengthening of enforcement efforts by the STA. Beginning in June 2019, tax authorities across the country launched enhanced IIT audit activities, with a view to applying the anti-avoidance rules contained in the new IIT regime.
Prior to 2019, solely the CIT law contained a robust and comprehensive set of anti-avoidance rules, while the IIT law lacked comprehensive provisions of this sort. Furthermore, since the inception of the IIT law in the 1980s, the Chinese tax authorities have always relied heavily on tax withholding mechanisms; this has meant that the focus has been on collecting personal income tax revenue from wage earners for whom the employer could act as the withholding agent. By contrast, the collection of IIT on other non-wage income, lacking straightforward withholding mechanisms, was relatively weak.
The introduction of the new IIT anti-avoidance rules is expected to close some of the loopholes which existed under the old system and strengthen the administration of IIT. In view of the progressive rollout of a 'social credit rating' system in China, the IIT changes should prompt individual taxpayers to place paramount importance on their personal tax compliance in order to maintain their personal credit rating and minimise potential negative effects on their future business dealings.
During 2019, China activated social security totalisation agreements (SSTAs) with Luxembourg and Japan – in May and June 2019, respectively – and concluded a new SSTA with France, in September 2019. China has now extended its SSTA network to cover 11 countries including: Germany, Korea, Denmark, Finland, Canada, Switzerland, the Netherlands, Spain, Luxembourg, Japan and France. The SSTA eliminates duplicate contributions to the social security systems for international workers in both China and their home countries. It also improves the competitiveness of treaty countries with foreign operations by reducing their cost of doing business in China. The development will be largely welcomed by foreign companies as a stimulus to invest in China.
Alignment with international conventions
With the 2018 IIT reform, the STA sought to align certain Chinese rules and practices with those typical internationally, as well as bringing in new innovations, including:
International standard '183-day' test adopted for determination of tax residency;
Taxpayer identification number formally introduced to facilitate IIT administration for individual taxpayers and enable the sharing of personal information among various government authorities; and
Individual taxpayer's tax compliance status, which will be a factor in the assessment of an individual's personal credit rating.
The new IIT anti-avoidance rules encompass the arm's-length principle for the pricing of related-party transactions, a controlled foreign companies (CFC) rule, and a general anti-avoidance rule. These rules are not new in the context of China CIT but are very relevant to IIT as observed in recent personal income tax evasion cases.
As China and its nationals continue to expand their footprint around the globe, we envisage that the following areas are likely to be scrutinised by the STA in coming years to safeguard the integrity of the national tax base.
One is the determination of tax domicile. Over the past decade, wealthy Chinese entrepreneurs have been targeted by foreign countries with favourable migration policies. For many Chinese nationals, acquiring a foreign passport means a reduction in their personal tax burden, as some of these destination countries adopt lower personal income tax rates. Even if these individuals remain in China after acquiring a foreign passport, they could still benefit from China's preferential tax policies for foreign nationals.
However, such individuals are often unaware that acquiring a foreign passport does not automatically shield them from Chinese taxation. Article 10 of the new IIT law puts the onus on individuals to perform tax clearance procedures, prior to cancelling their China household registrations when emigrating overseas. At this juncture, it is unclear whether the tax clearance procedures under the new IIT regime will be the first step to introducing an 'exit tax' for individuals relinquishing Chinese citizenship. However, the introduction of the new clearance requirements has inevitably drawn the attention of those who have retained their household registration, after obtaining a foreign passport, when they seek to assess their personal tax planning options and go-forward tax compliance status.
Pending further STA guidance on the disclosure details demanded under the tax clearance procedures, individuals who have changed their citizenship, or intend to do so, should review their tax domicile and tax residence status on a regular basis (annually at the very least). This is a key step for them to assess their compliance with the tax laws in China and relevant tax jurisdictions.
A second area will be that of special purpose vehicles (SPVs) in offshore jurisdictions. Indirect transfers of equity in Chinese companies by Chinese tax resident individuals has been more closely monitored by local Chinese tax authorities in recent years. These are cases where, say, a Chinese resident holds equity in a Chinese company through two layers of companies in the British Virgin Islands (BVI). The upper tier BVI company disposes of the lower tier BVI company, thereby indirectly transferring the Chinese investment but leaving the proceeds overseas. Cases have been reported in Shenzhen, Beijing and Jiangsu where China IIT was assessed on indirect transfers prior to the introduction of the new IIT rules. With the IIT anti-avoidance rules being implemented progressively, there will be firm legal basis for Chinese tax authorities to dissect indirect transfers and assess IIT where inappropriate tax benefits are suspected to be derived.
Under the new IIT CFC rules, Chinese tax authorities can assess Chinese IIT on an offshore company share transfer where they determine that income has been pushed up into a controlled company overseas (for example, the upper tier BVI company described above), and there are no reasonable operational needs for retaining it there over repatriating it to China. The introduction of these rules, together with the new economic substance requirements being rolled out in several offshore jurisdictions, are prompting wealthy Chinese individuals to reassess their existing investment arrangements. See Offshore economic substance laws: Implications for Hong Kong SAR's funds sector for more on the latter rules.
Only the beginning
The recent introduction of anti-avoidance rules into the Chinese IIT law may be viewed as the first step on a longer journey. Chinese tax policymakers are looking closely at other measures used internationally, which they may later consider for adoption into domestic law.
Mechanisms such as voluntary disclosures or amnesty programmes are important features of some countries' tax systems. These mechanisms allow for taxpayers to report and settle outstanding taxes with a reduction in, or even an exemption from, fines and interest, rather than having to carry the risk of much greater tax and penalty exposure if the tax authorities detect non-compliance.
In China, tax compliance in the entertainment sector has been a key focus in recent times, with cooperation on historic non-compliance advisable for mitigation of penalties, though more formalised systems would be a worthwhile policy innovation going forward.
Information transparency and exchange
In 2010, the US Congress passed the Foreign Account Tax Compliance Act, which stipulated that all US citizens living in the US but holding overseas assets worth more than $50,000, or US citizens and green card holders who reside outside the US and have $200,000 or more in overseas assets, must declare and file tax returns to the US government. Any refusal to do so is considered as intentional tax evasion and exposed to fines of up to $50,000. All non-US financial institutions must identify and disclose the account details of their US clients to the US tax authorities and undertake withholding obligations, if any.
On the international front, automatic exchange of information (AEOI) on financial accounts is improving tax compliance. It is delivering concrete results for governments worldwide and is proven to be effective at improving transparency. By mid-June 2019, more than 90 jurisdictions participating in the OECD's common reporting standard (CRS) since 2018 have exchanged information on 47 million offshore accounts, with a total value of around €4.9 trillion ($5.4 trillion). The AEOI initiative, implemented through 4,500 bilateral agreements to date, represents the largest exchange of tax information in history and the largest collective international effort to counter tax evasion in over more than two decades.
In order to maintain the integrity of the CRS, the OECD continuously analyses actual and perceived loopholes that have been brought to their attention and tried to determine appropriate actions to close these loopholes. Moreover, the OECD has analysed more than 100 residence and citizenship by investment schemes, known as golden passports or visas, offered by CRS-committed jurisdictions, and identified schemes that potentially pose a high-risk to the integrity of the CRS.
As of May 2019, mainland China has activated 67 exchange relationships with respect to more than 100 jurisdictions committed to the CRS; the STA's first exchange with Hong Kong SAR occurred in 2018. As the economy becomes increasingly globalised and cross-border activities become more prevalent, relying solely on domestically collected information on taxpayers will not suffice to ensure taxpayer compliance. China's recent IIT reform, its active participation in the CRS to date and its investment into the Golden Tax System will establish the appropriate legal, administrative and technological framework to verify taxpayer compliance, and bring national tax administration in line with the globalised economy.
Paving the way for the future
The 2018 China IIT reform is only the beginning of a long journey to a much more sophisticated Chinese tax system for individuals in future. The full effect of the recent changes will only become fully evident once full substantive and procedural guidance is rolled out and implemented.
The author would like to thank Lina Hu, KPMG China senior manager, for her contribution to this article.
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Michelle Zhou leads the KPMG people services practice in the eastern and central China region, and has more than 10 years of experience in assisting multinational clients across a broad spectrum of industries on personal income tax compliance and advisory needs. In particular, she has experience in Australian, Chinese and US expatriation taxation, and has served on accounts of various sizes during her career with KPMG.
Over the years, she has undertaken speaking engagements at events held by the American Chamber of Commerce, Australian Chamber of Commerce, Canada Business Council and EU Chamber of Commerce to update their members on the latest regulatory developments and trends in Chinese individual income tax, as well as topics on remuneration packaging, equity based compensation structuring, and others. Michelle has also delivered lectures to students in the finance discipline of Fudan University on expatriation taxation. In recent years, Michelle and her team have successfully assisted clients in the tax and foreign exchange registration of equity-based plans in China since the introduction of the relevant regulations in China. She has also actively participated in various projects relating to the design, implementation and roll-out of employee incentive plans, including equity-based compensation plans.
Michelle has a master's degree in commerce (advanced finance) from the University of New South Wales, and is an associate member of the Taxation Institute of Australia.