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Chinese representative offices: A trap for the unwary

Chinese representative offices: A trap for the unwary
As the simplest legal vehicle for foreign companies to enter China, a Representative Office (RO) is popular for its zero capital requirement, lower maintenance costs, and minimal establishment formalities. Because of its simplicity, many US entities consider entering the Chinese market through an RO with the intention of switching it over to a Wholly Foreign Owned Enterprise (WFOE) in the future. However, restrictions on the permissible business activities of an RO are often difficult to comply with and the conversion to a WFOE is a difficult process under Chinese law. Taxand China and Taxand US discuss the importance of RO governance and compliance for businesses.

The Chinese government is aware of the non-compliance of many ROs and has issued a series of policies in recent years to strengthen their administration. ROs that are found to be operating outside of their permissible business activities may find themselves exposed to unexpected tax consequences in China and abroad, such as being treated as a permanent establishment in China and being subject to tax on its deemed profits.

An RO is legally allowed to engage in marketing or other liaison activities without paying tax in China. However, if an RO illegally performs other activities, such as hiring employees, entering into contracts, or collecting revenue, it may create a permanent establishment in China for its owner and become a taxable entity. To rectify this potential issue, a WOFE may be utilised as the majority of the activities that cannot be performed by an RO can be performed by a WFOE. Accordingly, although a direct conversion of an RO into a WFOE is not permitted by law, foreign corporations with ROs engaged in activities beyond their permitted scope of work tend to establish a WFOE and close the RO.

Therefore, from a US tax point of view, a US company operating an RO through a foreign branch should be aware of the potential unintended US tax implications discussed below. 
Loss recapture rules
An RO that has generated losses that offset US taxable income and subsequently either transfers its assets to a WFOE or is “deemed” to incorporate into a WFOE, may become subject to certain loss recapture rules. 

In particular, there are ‘Overall Foreign Loss’ recapture provisions that may both recharacterise the source of certain income and potentially cause gain to be recognised on an otherwise non-taxable disposition. Additionally, the ‘Branch Loss Recapture’ rules provide for gain recognition to the extent of previously deducted losses on a transfer of assets (that would otherwise be non-taxable). Both of these provisions may have unexpected implications to a US company’s taxable income and foreign tax credit position. 

Foreign currency gain or loss
An RO of a US taxpayer that maintains separate books and records to record its activities, assets, and liabilities generally generates taxable gains and losses for its US owner during the course of its existence. The currency gains and losses that are created by the operations of such RO immediately flow through to the owner, with any gains or losses created by changes in the value of assets or liabilities of the branch potentially being recognised when there are transfers between the branch and its owner. In addition, the dissolution of an RO to create a WFOE triggers the taxation of any currency gains and losses inherent in the assets and liabilities of the RO.  

Dual consolidated loss (DCL) rules
The DCL rules prevent an entity from using a loss to offset income in the US while also using the same loss to offset income in a foreign country. The DCL rules normally apply to a US entity and its fiscally transparent foreign affiliates, such as a foreign branch (eg an RO). If a DCL exists, the loss cannot be used in the US unless certain reporting and certification requirements are met. Thus, if the RO exceeds its permissible business activities and becomes taxable in China, the DCL rules may apply to further complicate any US tax calculations.

Your Taxand contacts for further queries are:
Frank Tao
T. +8621 6447 7878 -517

John Valencia
T. +1 212-763-1968

Janine Burman
T. +1 212-763-9872

Nicole Mahoney
T. +1 312-601-9047

Taxand's Take

When entering into the Chinese market, businesses should consider both the Chinese and US legal and tax implications. US owners of an RO should review and limit the RO’s business activities to those that are within the legally permissible business scope of an RO. This will limit the US owner’s tax exposure in China. The US owner should also consider its foreign currency exposure and treatment of losses under US tax law.

If the US investor believes it may exceed its business scope limitations in China, the US owner should consider establishing a WFOE or realigning its activities to stay in compliance with the Chinese legal restrictions. If establishing a WOFE is the answer, the US owner should also begin planning how to effectively manage the US tax consequences of transitioning from an RO to a WFOE.

Taxand's Take Author

Dennis Xu

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