Implications of Draft Amendment to the Individual Income Tax Law

Overview


The Draft Amendment to the Individual Income Tax Law was officially released for public comments on June 29, 2018. The legislative body will review the Draft; date of effectiveness will be no earlier than January 1, 2019. This revision of the Individual Income Tax Law is a fundamental revision of China’s existing IIT system.

This China Law Alert includes contributions from Robbie H.R. Chen and Viola Shen from MWE China Law Offices.

In Depth


On June 29, 2018, the Draft Amendment to the Individual Income Tax Law (Draft) was officially released for public comments. According to the text, the Draft is intended to be reviewed by the legislative body and the earliest time it could become effective would be on January 1, 2019. Once effective, the Draft will become the seventh revision of the Individual Income Tax (IIT) Law since its original promulgation. The current version of the Draft will be a fundamental reform of China’s IIT system in a number of ways, including:

The Draft’s modifications to the IIT system will directly affect the tax liabilities of individuals in all income brackets and will create new challenges for employers and other withholding agents to comply with their withholding obligations. In the Appendix, we have provided a chart comparing the current tax laws and the changes in the Draft. It is recommended for both individuals and employers to become familiar with the Draft’s changes to prepare for smooth implementation of the new requirements.

The Reshaping of the Tax Resident Concept

In accordance with international tax practice, the Draft reintroduces the concept of resident and non-resident individuals for the purpose of calculating IIT. The tax treatment of residents and non-residents differ in a number of ways and, as a result, the tax liabilities of many foreign nationals working in China may change.

Under current tax law, an individual will become a tax resident in China after being domiciled for one year, but their global income could be exempt from IIT as long as they stay in China for less than five years. The Draft shortens this time frame to 183 days, which is more consistent with the definition of tax resident under many international tax policies. As a result, foreign nationals working in China would be deemed as a China tax resident after approximately six months of working in China, which could allow individuals from certain jurisdictions to file non-resident taxes in their home country. However, the Draft is silent on whether the previously five year threshold for global taxation would remain, which we think is likely to change to align with the double tax treaty treatments and international practice.

For deductions, the Draft provides unified IIT treatment under a standard deduction for both resident and non-resident individuals. Previously, non-residents would be able to take an additional deduction of RMB 1,300. Under the Draft, both residents and non-residents will take the standard deduction of RMB 5,000 from monthly income to determine IIT.

The Draft has not addressed whether changes will be made to other deductions specific to foreign nationals, such as meal and housing allowances, or the social insurance deduction. However, these are likely to change as the previous IIT amendments have been trying to treat equally Chinese nationals and expatriates.

We recommend that the foreign nationals in China review their compensation package to determine whether modifications are necessary based on the changes proposed by the Draft.

The New Classification of Earnings for IIT

The Draft adjusted the categories of earnings for the purpose of calculating IIT, including wages, salary, author’s remuneration and royalties (comprehensive income), as well as “income from production or business operation conducted by self-employed industrial and commercial households,” and “income from contracted or leased operation of enterprises or institutions” (business operation income). These categories of comprehensive income and business operation income will be subject to the progressive IIT rates applied on an annual basis.

In addition, the Draft increases the number of progressive tax levels for IIT on the comprehensive income. Under the existing regulations, the effective tax rates applied to service remuneration (based on the amount received) are 20 percent, 30 percent and 40 percent, with author’s remunerations and royalties taxed at 20 percent. The Draft applies seven rates (from 3 percent to 45 percent) under the progressive tax structure for all comprehensive income, as defined above. Therefore, the classification of comprehensive income as well as the changes in IIT calculations could lead to a change in the IIT liabilities of self-employed individuals.

Modification of Tax Rates and Increase of the Standard Deductions

Based on the Draft’s adjustment of the tax brackets for the application of IIT, middle- to low-income tax levels would be more evenly spread across different IIT rates and should limit the tax liabilities of many workers.

In addition, a standard deduction would now apply to all comprehensive income (salary, remunerations, royalties, etc., see definition above) and would be increased from RMB 3,500 per month to RMB 5,000 per month (i.e., RMB 60,000 per year). In the table below, we have compared the IIT liabilities to example monthly salaries under the old regulation and the Draft (all amounts in RMB):

Income (before taking itemized deductions)

Tax liabilities under current regulations

Tax liabilities under proposed regulations

Reduced liabilities

10,000

745

290

455 (61%)

20,000

3,120

1,590

1,530 (49%)

30,000

5,620

3,590

2,030 (36%)

50,000

11,195

9,090

2,105 (19%)

70,000

17,770

15,590

2,180 (12%)

100,000

29,920

27,590

2,330 (8%)

 

Additional Itemized Deductions for Certain Living Expenses

The draft permits the deduction of certain living expenses, including children’s education expenses, medical expenses for serious diseases, mortgage interest payments and rent. According to the Ministry of Finance, this provision is intended to adjust for the differences between individuals with different income levels to increase relative equality in tax treatment.

Detailed implementation rules have yet to be issued to clarify the application of these deductions. For example, it is unclear whether all education expenses (public or private school tuition) will be deductible; whether mortgage interest deductions will depend on the number of apartments/houses one owns; or whether the rental deduction will vary according to the location and size of the apartment. It could be reasonably expected that later clarification would provide caps on the amounts allowed for deductions of living expenses.

In addition, the Draft requires certain government authorities, such as education, health and the People’s Bank of China, to provide relevant information to the tax authorities. It is unclear whether the information will be used for ascertaining the deductibility of some expenses or for verification. Thus, it will be necessary to wait for further clarification on how to utilize these itemized deductions, how to comply with withholding rules, whether withholding agents have the obligation to provide personal information, and how to effectively protect information privacy.

Anti-Avoidance Rules

Under the current IIT Law, there is no anti-avoidance rule for IIT law (with a few exceptions in regulations1), which has hindered the investigation of some individual tax avoidance cases because the tax authorities do not have a statutory basis for imposing taxes. In this Draft, tax authorities are delegated the authority to impose and adjust tax liabilities when the individuals do not transfer property in accordance with the arm’s length principle, when they set up tax shelters overseas, or when they make unreasonable business arrangements for the purpose of tax avoidance.

While awaiting clarification of the application of the anti-avoidance rules for IIT, it would be useful to consult the anti-avoidance rules in the enterprise income tax regime. For example, State Administration of Taxation Bulletin No. 7 (2015) allows the taxation of indirect transfers of taxable property by non-resident enterprises. A similar concept could be applied to individual taxpayers, which would have a large impact on negotiating and drafting agreements for PE/VC, cross-border mergers and acquisitions. Likewise, there remains a possibility that establishing tax shelters overseas, for example, in BVI or Cayman, and leaving profits there to avoid distributions to shareholders, may result in taxation as controlled foreign corporations similar to the treatment under the enterprise income tax law. It may also impact other individuals who do not transfer property in accordance with the arm’s length principle, such as free transfer of real property to overseas trustees to set up trusts.

Moreover, the Draft established the taxpayer identification number system in accordance with the CRS. In addition to the requirements of the relevant agencies to provide information on itemized deductions, the Draft will promulgate regulations regarding transfers of real property and equity interests, which require the relevant authorities to ensure the individuals’ tax compliance at registration. Notably, similar provisions on the registration of equity transfers were repealed years ago because the equity transfer is usually registered before the individual receives the cash consideration; the Draft would reestablish the connection between registration and tax compliance, which will exert significant influence over the drafting of the transaction documents in equity transfers from individuals.

We suggest that individuals, especially high-net-worth individuals, be cautious about tax planning both at home and abroad, and seek professional advice on asset transfers and tax planning in order to minimize risks.

According to the Draft, the Amendment will take effect on January 1, 2019, but individuals can start utilizing the standard deduction of RMB 5,000 from October 1, 2018. We expect the Draft to be finalized before 2018 ends and the relevant regulations to be introduced accordingly. We will provide additional updates as information becomes available.

1 Administrative Measures for Individual Income Tax on Equity Transfer Incomes (for Trial Implementation) stipulates that the transfer of property must be in accordance with fair market value.

Appendix: Comparison of Key Provisions

Provision

Current Statutes

Draft Amendments

Tax Residents

Article I. Individual income tax shall be paid in accordance with the provisions of this Law by individuals who have domiciles in the People’s Republic of China, or who have no domicile in China but have resided in the country for one year or more on their income gained within or outside China.

Individuals who have no domiciles and do not reside in the People’s Republic of China or who have no domiciles but have resided in China for less than one year shall, in accordance with the provisions of this Law, pay individual income tax on their income gained within China.

Article I. Individual income tax shall be paid in accordance with the provisions of this Law by residents, defined as individuals who have domiciles in the People’s Republic of China, or who have no domicile in China but have resided in the country for 183 days or more on their income gained within or outside China.

Non-residents, defined as individuals who have no domiciles and do not reside in the People’s Republic of China or who have no domiciles but have resided in China for less than 183 days, shall, in accordance with the provisions of this Law, pay individual income tax on their income gained within China.

Integrated Income from Labor

Article 2 Individual income tax shall be paid on the following categories of individual income:
(1) Income from wages and salaries;
(2) Income from production or business operation conducted by self-employed industrial and commercial households;
(3) Income from contracted or leased operation of enterprises or institutions;
(4) Income from remuneration for personal services;
(5) Income from author’s remuneration;
(6) Income from royalties;
(7) Income from interest, dividends and bonuses;
(8) Income from the lease of property;
(9) Income from the transfer of property;
(10) Incidental income; and
(11) Income from other sources specified as taxable by the department of finance under the State Council.

Individual income tax shall be paid on the following categories of individual income:
(1) Income from wages and salaries;
(2) Income from remuneration for personal services;
(3) Income from author’s remuneration;
(4) Income from royalties;
(5) Income from production or business operation conducted by self-employed industrial and commercial households;
(6) Income from interest, dividends and bonuses;
(7) Income from the lease of property;
(8) Income from the transfer of property;
(9) Incidental income; and
(10) Income from other sources specified as taxable by the department of finance under the State Council.

Items (1) to (4) (integrated earned income) will be taxed on an annual basis for residents, and on monthly basis or per filing for non-resident. Items (5) to (10) will be taxed separately as under the current laws.

Earned Income Tax Parameter Table

Monthly Taxable Income

Marginal Rate

Income of RMB 1,500 or less

3

The part of income in excess of RMB 1,500 to 4,500

10

The part of income between RMB 4,500 and 9,000

20

The part of income between RMB 9,000 and 35,000

25

The part of income between RMB 35,000 and 55,000

30

The part of income between RMB 55,000 to 80,000

35

The part of income in excess of RMB 80,000

45

Monthly Taxable Income

Marginal Rate

Income of RMB 3000 or less

3

The part of income in excess of RMB 3000 to 12,000

10

The part of income between RMB 12,000 and 25,000

20

The part of income between RMB 25,000 and 35,000

25

The part of income between RMB 35,000 and 55,000

30

The part of income between RMB 55,000 to 80,000

35

The part of income in excess of RMB 80,000

45

Tax Parameter Table for Income from Production or Business Operation

Annual Taxable Income

Marginal Rate

Income of RMB 15,000 or less

5

The part of income between RMB 15,000 and 30,000

10

The part of income between RMB 30,000 and 60,000

20

The part of income between RMB 60,000 to 100,000

30

The part of income in excess of RMB 100,000

35

Annual Taxable Income

Marginal Rate

Income of RMB 30,000 or less

5

The part of income between RMB 30,000 and 90,000

10

The part of income between RMB 90,000 and 300,000

20

The part of income between RMB 300,000 to 500,000

30

The part of income in excess of RMB 500,000

35

Standard Deductions and Itemized Deductions

Article 6 The amount of taxable income shall be computed as follows:
(1) With respect to income from wages and salaries, the amount of taxable income shall be the part remaining after the deduction of RMB 3,500 for expenses from the monthly income.
(2) With respect to income from production or business operation gained by self-employed industrial and commercial households, the amount of taxable income shall be the part remaining after the deduction of the costs, expenses and losses from the gross income in a tax year.

The amount of taxable income shall be computed as follows:
(1) resident’s integrated earned income, calculated on an annual basis, less the RMB 60,000 standard deduction and other itemized deduction if applicable, will arrive at the taxable income. Itemized deductions include statutory pensions, medical insurance, unemployment insurance, social security and housing fund paid in accordance with laws and regulations. Additional itemized deductions include children’s education expenses, medical expenses for serious diseases, mortgage interest expenses, rent expenses, etc.

(2) non-resident’s earned income amount exceeding the standard deduction amount, RMB 5000, will be the taxable income. Service remunerations, author’s remunerations, royalties will be calculated based on each payment.

Anti-Avoidance Provisions

N/A

Article 8:Tax agencies have the authority to adjust tax payable if any of the following occurs:

“(1) the business dealings between individuals and their affiliated parties do not conform to the arm’s length principle and have no justifiable reasons;

“(2) enterprises that set up in countries (regions) with low tax rates, controlled by residents, or jointly controlled by residents and resident enterprises, and have no reasonable cause for such set-up, and do not distribute or reduce the distribution of the profits to shareholders

“(3) individuals who obtain improper tax benefits by making certain arrangements without reasonable business purpose.

“Relevant tax authorities may adjust the tax liabilities in accordance with the provisions of the preceding paragraph. Any underpayments need to be paid in full plus interests in accordance with the law.”