Individual Income Tax in China. Part II: Practical Advice
By Richard Hoffmann, ECOVIS Beijing China
This is the second part of our two-part article series on individual income tax (IIT) in China. In the first part we have given an overview on how individual income tax liability is determined for individuals in China. In this part we will now point out several tips about IIT optimization for expats.
5-year-rule for individual income tax
Five years is an important threshold for determining expat IIT liability: an expat who is a tax resident in China for a consecutive five years will have to pay PRC IIT on all of his income, no matter where it was derived and no matter by whom it is borne. That is, after five years of tax residency an expat will be taxed in China on his/her worldwide income. This rule should always be kept in mind, since going over the 5 years can significantly increase an expat’s tax burden.
However, the 5-year-rule does not necessarily apply to every expat who would like to live in China for a prolonged period of more than 5 years. There are two possible scenarios in which IIT liability on the expat’s world income could be avoided.
Scenario 1: Before the fifth year
The first scenario is that the expat leaves China, be it for business purposes or for visiting his home country, for more than 90 days cumulatively or more than 30 consecutive days for a single trip within any given year before he/she has been a tax resident for 5 years. By doing this the expat has broken tax residency and the “clock” for the 5-year-rule will be reset. For example, the expat can arrange to leave China for the necessary time period in the fifth year of his tax residency. Upon his return, tax residency will then be calculated from year one again.
Scenario 2: After the fifth year
In the second scenario the expat might have missed the deadline for leaving China for an appropriate amount of days and has already been a tax resident for more than 5 years. Now there are two possibilities for the expat:
(1) For the sixth year, the expat could arrange to spend more than 90 days cumulatively or more than 30 consecutive days in a single trip outside of China. This would mean that the expat has broken tax residency in this year. All of his China source income will be subject to IIT, but his world income will not be. However, this measure will not “reset the clock” of the 5-year-rule and has to be repeated in the seventh and all following years.
(2) If in the sixth year the expat stays in China for less than 183/90 days (depending on the tax treaty between his home country and China) then tax residency is also broken. Only his/her China source income borne by a China entity will be subject to IIT. Furthermore, the “clock” of the five year rule will also be reset and this measure thus does not need to be repeated every year. In other words, if the expat manages to travel out of China for more than half/three quarters of the sixth year the five-year-rule will not be applicable and upon his return tax residency will be calculated from year one again.
Apart from considerations of basic IIT liability on different part of the expat’s income, there are also tips on IIT keeping the IIT that the expat already needs to pay at a reasonable level. A very effective method of reducing the IIT burden is to structure the salary the expat is being paid in China in the right way. When designing the expat’s labor contract, employer and employee can cooperate to achieve a higher net salary for the expat while keeping the gross salary low at the same time – an arrangement both sides will benefit from. There are two possibilities for doing this: the introduction of fringe benefits into the labor contract and the introduction of an annual bonus.
Tax Exemption for Fringe Benefits
For foreign nationals working in China the Chinese regulations allow for certain benefits provided by the employer to be exempt from IIT, i.e. those benefits will not be part of the expat’s taxable income. This includes the China social security insurances, allowances for meals, laundry, relocation and housing, home-leave of the expat for up to 2 round-trips per year, fees for Chinese language training and tuition fees for the education of the expat’s children.
For such benefits to be tax-exempt, certain conditions need to be met. Otherwise they will be treated as normal taxable income. First of all, the overall amount of benefits provided has to be reasonable, which means it generally should not exceed about 30-40% of the gross base salary. Furthermore, the benefits cannot be provided on a cash basis, but rather need to be paid to the employee on a non-cash or reimbursement basis, for which an official tax receipt (Fapiao) is mandatory. For example, a housing allowance can only be tax-exempt if (a) either the employer pays rent to the landlord directly or if (b) the employee pays the rent on his own and then provides the Fapiao for his/her payment to the employer, who reimburses the amount.
All in all this means that for the benefits provided, supporting documentation has to be kept, including for example lease agreements, Fapiao and of course the employment contract, which needs to contain a detailed and correct account of all applied benefits. This should always be kept in mind when implementing this type of salary structure in practice.
Structure of Annual Bonus
Another way of structuring a salary to reduce the IIT burden for (foreign and Chinese) employees is the implementation of an annual bonus. Such a bonus will receive preferential tax treatment: it will be divided by twelve to determine the corresponding monthly amount and will be taxed according to the respective tax bracket of this monthly amount. This leads to lower taxation than the same amount being paid together with the monthly salary. However, this preferential treatment will only be applied to one bonus payment per year, other bonus payments will be taxed with the regular rates. An example serves to illustrate this:
Scenario 1: Quarterly bonus
Assume an employee with a base salary of RMB 85,000 per month and a quarterly bonus of RMB 50,000. The tax rate for the base salary is 45% and the IIT burden on it will be RMB 22,585 (see the formula for IIT calculation in part one of the article series: [(85,000 – 4,800) * 0.45] – 13,505 = 22,585).
Three of the four bonus payments will be treated as being part of the base salary: the amount of those bonus payments will be divided by twelve and added to the monthly base salary, in order to determine the tax rate. Note that in some cases, when the base salary is lower than in this example, this might also lead to the base salary itself being taxed with a higher rate, since adding the bonus payments could push the salary in to a higher tax bracket.
In our case however, the base salary with the bonus payments will still be taxed with a rate of 45%. The IIT burden on this part of the bonus is therefore 3* RMB 50,000 * 0.45 = RMB 67,500. The fourth bonus payment however will receive preferential treatment and be taxed with a rate of 10%, since this corresponds to the tax rate that one twelfth (50,000/12 = RMB 4,167) of the bonus would be taxed with. The IIT burden on this part is therefore (RMB 50,000 * 0.1) – 105 = RMB 4,895. The total IIT burden on the bonus is now RMB 72,395.
Scenario 2: Annual bonus
Consider now an employee with the same base salary of RMB 85,000 and the same total annual bonus amount of RMB 200,000, but paid only once per year instead of quarterly. The tax burden on the base salary is of course still RMB 22,585. The tax burden on the bonus is lower though, since the whole bonus now receives preferential treatment. It will be taxed with a rate of 25%, as the amount of one twelfth of the bonus (200,000/12 = RMB 16,667) falls into this tax bracket. The IIT burden on the bonus is therefore (RMB 200,000 * 0.25) – 1,005 = RMB 48,995. As opposed to the first scenario a total of RMB 72,395 – RMB 48,995 = RMB 23,400 per year can be saved on IIT.
In a nutshell
As can be seen from the practical advice laid out above, expats should take good care in planning their stay in China to keep their individual income tax burden from becoming too high. In dealing with the 5-year-rule they should watch the time they have already spent in China and arrange for appropriate travel abroad. In dealing with their salary they should cooperate with their employer to realize a tax-efficient salary structure which includes benefits and an annual bonus.