The New Rules of Tax Residency: A Potential Trap for Foreigners?

US and other foreign businesses now face higher income taxes in mainland China following new rules issued in March by China’s tax administration. The new law and implementing rules impose tax filing obligations on the worldwide income of foreigners (which includes Hong Kong, Macau, and Taiwan residents for tax purposes) if their physical presence in mainland China reaches or exceeds 183 days in a calendar year—a much lower threshold for tax residency than before—for six consecutive years. This revision is probably the biggest tax reform since the 1980s and furthers the objective of the Chinese government to enhance “law-based governance” in the hopes of achieving a more equitable distribution of wealth, and bringing China’s individual tax law closer to international standard practices.

While generally seen as a positive development, the new rules also create traps for the unwary.

It is critical for foreign individuals and companies to identify the opportunities and risks, and to adapt swiftly to the changes associated with this tax reform.

Development of China’s income tax reform

Timeline of reforms:

• August 31, 2018: China’s National People’s Congress publishes the Amendment to the China Individual Income Tax Law, which went into effect on January 1, 2019.
• December 22, 2018: The Ministry of Finance State Administration of Taxation (MOF SAT) publishes the Final Implementation Rules of the China Individual Income Tax Law Reform and the Practice Guidance of Additional Special Deduction.
• March 14, 2019: MOF SAT publishes its Announcement on the Criteria for Determining the Residence Time of Individuals Without Residence in China.
• March 16, 2019: The MOF SAT issues its Response to Reporters’ Questions Over the 183-day Criteria Over the Tax Resident Determination for Individual Income Tax.

These changes in the Income Tax Law offer certain benefits to tax residents like a rise in the threshold for taxation, as well as increases in personal tax deductions for things like elderly care, education expenses, and child support.

On the other hand, the tax reform shifted the responsibility of income tax reporting from employers to individual employees. Most problematic for foreign businesses is the change in tax residency rules, ostensibly designed to bring China’s individual tax law closer to international standard practices.

Who is a tax resident?

The prior Individual Income Tax Law never explicitly defined the concept of a “tax resident.” The new amendment defines both “resident” and “non-resident.” Individuals who are domiciled in mainland China, or non-domiciled but have resided in mainland China for 183 days or more within a calendar year, are considered tax residents. After six years of holding tax resident status, tax residents will be subject to paying individual income tax on their worldwide income.

Prior to this reform, foreigners were considered tax residents only if they resided in mainland China for one year or more. All non-China sourced income (e.g., dividends derived from overseas entities and income from transferring overseas property) of foreigners residing in China for less than five consecutive full years was specifically exempted from taxation under the “Five-Year Rule.” An individual that resided in China, but left for more than 30 days in a single trip, or more than 90 cumulative days in one of five calendar years, would also be exempt. There was, and still is, an exception—income paid by any Chinese enterprise, public institution, and other applicable economic organizations to foreigners and Hong Kong, Macau, and Taiwan residents is subject to Chinese income tax, regardless of whether the individual receiving such payment is a tax resident or not.

China ups duration of the tax residency requirement, sort of

The recent tax reform, however, changed many of these rules. Replacing the “Five-Year Rule,” the new “Six-Year Rule,” stipulates all non-China-sourced income of foreigners residing in China for less than six consecutive full years are exempted from income tax. Furthermore, foreigners who qualify as tax residents will be held to that distinction for the entire six years. The six-year measuring period begins from 2019, and a single day is counted only if the individual is in mainland China for the full 24 hours of that day. The same Chinese-sourced income exception still applies. Under these new rules, assumedly more foreigners, and more of their income, will be subject to Chinese income tax.

If foreigners are in China for more than 183 days in any one calendar year, but during other years are in China for less than 183 days or spent more than 30 days outside mainland China for any single trip, the clock on the six-year calculation will restart, therefore exempting them from the recent tax reform.

Avoiding the potentially adverse impact on foreign businesspeople

While the extension of the measuring period for tax residency from five to six years indicates an effort by the Chinese government to retain foreign talent in China, the 183-day rule for defining any one year may create a serious problem for many foreign businesses that require key employees to spend more than six months every year on the mainland. Affected individuals should carefully evaluate their options and perhaps restructure their employment arrangements in China. For example, to avoid becoming subject to Chinese income tax, foreigners residing in China should plan to travel outside of China for a period of more than 30 consecutive days in a calendar year at least once every successive sixth year period. They also need to be careful not to straddle their 30-plus-day absence over two calendar years (for example, December 2 through January 29), as it will still be considered two separate absences of less than 30 days each under the new tax regime.

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Employers unwilling to make adjustments for tax equalization of their employees affected by the reforms risk losing valuable foreign talent. Notably, the tax reform has also provided tax authorities with greater capabilities to enforce rules and expand tax collection. While it remains unclear how the new tax rules will be made compatible with the existing practice of companies themselves report employees’ individual taxes, businesses should pay close attention to any upcoming implementation regulations or rules on this issue and strategically plan their tax position and employment arrangements in mainland China to mitigate their tax exposure.

Yuanyou “Sunny” Yang’s practice includes negotiating and structuring business transactions and overseeing the legal operations for Chinese companies doing business in the United States, as well as assisting US companies in pursuing investment opportunities in China. She is admitted to practice in the United States (Pennsylvania and New York) and the People’s Republic of China. Read her full bio here.