A little known rule for China expats could add to your tax burden unless you plan a long overseas trip
The “five-year rule” is a term with which expatriates should be familiar prior to taking up employment or secondment in China. Not knowing its implications can lead to unnecessary confusion and tax exposure for both employers and expatriates. From our experience, however, many expatriates and even their companies’ human resources personnel misunderstand or are unfamiliar with this important tax rule.
In this piece, global mobility experts from PricewaterhouseCoopers outline the workings of the rule and its implications, and share insights on how to manage the confusion and, more importantly, possible tax exposure.
Unlike Chinese nationals who are liable for China Individual Income tax (“IIT”) on their worldwide income, foreign nationals (i.e. individuals not domiciled in China) only become liable for China IIT on their worldwide income if they have lived in China for a full year after having lived in China for five consecutive full years.
In order to fully understand this rule, we first need to understand the meaning of one full year. It means, during a tax year (January 1 to December 31), the expatriates do not leave China for 31 days or more in a single trip or for a total of 91 days or more cumulatively.
To give a simple example, let’s consider fictional hypothetical case of Mr Smith. He came to China on January 1, 2014 for a two-year secondment but took the following trips during the year:
In the above example, Mr Smith would be regarded as having stayed in China for one full year despite spending 45 days overseas. This is because each trip was less than 31 days and together they totaled less than 91 days.
The question that people often ask is whether the overseas trip must be for business purposes. The answer is no as all overseas trips (business or personal) are counted. Another common question is whether days spent in the Hong Kong and Macao Special Administration Regions are regarded as days spent outside of China for this day count purpose. The answer is yes.
Now we move on to the more complicated concept of five consecutive full years.
In Example 1, above, if the expatriate spent full years in China from 2010 to 2014, he has stayed in China for five consecutive full years. The expatriate will become liable to China IIT on his worldwide income in each subsequent full year spent in China from year 2015 onwards.
Whereas, in Example 2, he spent a full year in China from years 2010 to 2013 and was away from China for 31 days or more (in a single trip) or for 91 days or more (in multiple trips) in the year 2014. Therefore, there were only four consecutive full years (2010-2013). Despite spending a full year in China in 2015, this qualifies as the first year of a new five-year cycle.
To help clarify further, if an individual arrived in China on January 2, 2010 to begin a work assignment, he was away from China for 1 day (January 1. In order to break the full year, the individual needed to take the 31/91 days break over the rest of the year.
But if an individual arrived in China on June 1, 2010 to begin an assignment, he would already have been away from China for more than 31/91 days from the period from 1 January to 31 May.
The above scenario has been a typical planning strategy for expatriates wishing to manage their China IIT exposure. On a cautionary note, however, we are aware that some local tax bureaus have taken a relatively aggressive stance against expatriates who have tried breaking their five-year cycle to avoid their worldwide tax exposure obligations. Therefore, companies and expatriates should revisit their current arrangements and understand the position taken by the tax bureaus under whose jurisdiction they are governed.
If an expatriate is subject to China IIT on his worldwide income, it means all his employment, investment and other personal income can be subject to China IIT. Any foreign tax paid may be creditable against the China IIT payable, but the process and reporting can be complicated and onerous as it involves two or more countries. If it is not planned carefully, it can lead to serious cash flow problems or double tax exposures.
It is good practice for companies with expatriates working in China to have a proper policy or protocol in place to help them to monitor and minimize such exposures and to deal with the potential complex situations when worldwide tax exposure occurs.
While it is still possible to avoid the worldwide tax exposures after the five full years of residence is established, it is much harder and difficult to implement in many cases. As such, it is always good and comparatively easier to take necessary preventive measures to avoid this from happening in the first place.
While many expatriates and human resources personnel are aware of the five-year rule, from our experience, many companies do not have a plan or system in place to manage and deal with the potential exposures. To name a few examples:
- There is no proper system (or electronic travel tracker) in place to monitor the expatriate’s travel history. In many cases, they learn too late that the five consecutive full years of residence has already been established.
- There is no prior agreement or communication about the tax subsidy or support (if any) offered by the companies to the expatriates who become liable to worldwide tax in China and this often leads to unnecessary disputes and unhappy endings.
- As explained at the start, in addition to the five-year rule, an individual who is regarded as having domiciled in China can also be subject to China IIT on his worldwide income. Although this usually only applies to Chinese nationals without any foreign permanent residence, technically speaking, any individual who habitually resides in China due to his household registration, family or economic ties can also be exposed to the worldwide tax in China. As such, companies and expatriates should understand the relevant law and local practice and assess their tax position on a case by case basis.
Jacky Chu is the Partner leading the Global Mobility practice in PwC China and he is based in Shanghai. Gertie Chen is a Director in the Global Mobility practice in PwC China Shanghai office specializing in mobility, personal tax and HR services.