Individual Income Tax – Part One

In this series of two articles we would like to share some information about a topic we deal with in our consulting work on a daily basis: Individual income tax. This affects every expat living and working in China on a very personal level. 

IIT DECLARATION DEADLINE: 31 MARCH, 2016

Our aim is to provide you with detailed information of current Individual Income Tax (IIT) laws in China. Most importantly, we want to point out a few tips for avoiding costly taxation. The first part will provide information about the Expat IIT Liability. The second part refers to the relationship between the tax burden on an expat and their length of stay in China.

MAIN FACTORS FOR IIT LIABILITY

There are several key factors to understanding when foreigners working in China will be liable to pay IIT in China. If and how much IIT needs to be paid depends on:

• How much the expat earns
• How long he/she stays in China
• Who pays his/her income
• What kind of position he/she is holding in his host country

LEVEL OF INCOME

First of all, it needs to be clear which parts of the salary an expat receives are deemed to be taxable income by the Chinese authorities. This includes the base salary, incentive compensations like commissions and bonuses, cash allowances and contributions to an overseas insurance scheme.

The tax rate levied on that taxable income then depends on its accumulated amount. China adopts a progressive taxation system where the tax rate for freelancer’s incomes progresses in three levels from 20% to 40% and the tax rate for regular employees in seven levels from 3% to 45%. A tax exemption of 4800 RMB per month for expats and of 3500 RMB per month for locals is granted. Furthermore, for each individual taxation grade there is a quick deduction amount which will be exempted additionally.

A quick formula to calculate the IIT burden is:

[(Gross Monthly Taxable Income– 4800) * Tax Rate] – Quick deduction

DURATION OF STAY AND PAYMENT SOURCE

Furthermore, it has to be determined which part of the worldwide income the expat might receive for various assignments from various sources is deemed taxable in China. The second important factor in determining an expat’s IIT liability is therefore the duration of his/her stay in China. The relevant thresholds for IIT liability are 1 day, 90 (respectively 183) days, 1 year and 5 years. The third factor is the source of payment for the expats income. By combining these three factors, we can evaluate on which part of his worldwide income the foreign employee needs to pay IIT in China.

Taxation of income received in China

If a Chinese company is paying the expat for his assignment in China – i.e. his income is borne by a Chinese legal entity – then he/she will be liable to pay IIT from the first day onwards. In contrast, if the China source income is borne by a Company outside of China – an overseas entity – then he/she will not be liable to pay IIT in China, unless he/she stays in China for more than 90 days. If there is a tax treaty between China and the foreign employee’s home country, this threshold is usually extended to 183 days.

Furthermore an expat might not only have to pay IIT in China on his/her income derived from activities in China, but possibly also on additional income derived from outside of China. Again, IIT liability on worldwide income depends on duration of stay and source of payment for that income.

Out-of-China income

If the out-of-China income derived is borne by a Chinese legal entity and the expat stays in China for more than one year, he will have to pay IIT on this income as well. If he stays in China less than a year, he will not have to pay IIT on the income derived outside of China.

However, there is one exemption to this. In some cases the expat holds a dual senior management role in China and another country. The payment for his work outside of China was borne by a Chinese entity. In this case he will have to pay IIT on the income derived from outside China from the first day.

Taxation of worldwide income

In the final and most tax-intensive case there will be a liability to pay Chinese IIT on the worldwide income. This case is referred to as the “Five-Year-Rule”. It applies when the expat has been staying in China continuously for a period of more than five years. In this case, the expat has been a tax resident in China for more than five years. Then, all income derived from overseas and borne by overseas entities will also fall under the Chinese IIT regime.

The following table gives an overview over the discussed scenarios.

As we have seen IIT liability for expats in China depends on a sometimes very complex combination of factors. An expat planning to keep his/her personal tax burden at a reasonable level should plan accordingly. We advise to carefully assess the structure of the taxable income, income-generating activities in and out of China, the sources of income and the duration of stay in China. The next part of our mini-series covers tips regarding the 5-year-rule and the structure of the salary/employment contract. These can help to keep the expat’s IIT burden at a reasonable level.