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Growing Markets i n East and South Asia Tax Planning International: Special Report
Growing Markets i n East and South Asia Tax Planning International: Special Report

Growing Markets in East and South Asia

Growing Markets i n East and South Asia Tax Planning International: Special Report

Tax Planning International: Special Report

Growing Markets i n East and South Asia Tax Planning International: Special Report

Growing Markets in East and South Asia

Six months ago the Asian economies were among the hardest hit in the world, as exports to the rich countries plunged. However, the doughty resilience of these economies should not be underestimated as they have already survived the Asian crisis of the late 1990s and are now rebounding more strongly than expected thanks to the biggest fiscal stimulus of any region of the world.

With the aversion of the economic crisis, whether temporary or permanent, certain Asia Pacific countries have nevertheless been established as being increasingly important business locations, generally offering low costs, incentives and long-term growth prospects.

In “Growing Markets in East and South Asia”, a number of KPMG experts and practitioners, attempt to discern the tax and legal landscape of each of the eight countries discussed, and beyond the obvious differences, whether there are certain features that are common to them all. The depth of this understanding and comparison is facilitated by the unique layout of this Report in that each section comprises four articles with much the same titles: The tax and legal framework; Tax treatment of cross-border service activities; Holding and financing strategies for investment; Investing in real property: Some tax aspects.

At the end of each section, readers will not only have a firm grasp of the corporate tax system and company law unique to each country, but will also understand how legal changes affect investment in real property; what the treatment of cross-border service activities means for foreign enterprises, as well as what financial planning considerations are associated with foreign investment strategies.

Commissioning Editor: Bronwyn Spicer

Growing Markets in East2009and South: Asia is published

by BNA International Inc., a subsidiary of The Bureau of National Affairs, Inc., Washington, D.C., U.S.A.

Administrative Headquarters: BNA International Inc., 1st Floor, 38 Threadneedle Street, London, EC2R 8AY, U.K.; tel. +44 (0)20 7847 5801; fax. +44 (0)20 7847 5840; e-mail:

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Copyright © 2009 The Bureau of National Affairs, Inc. Reproduction or distribution of this publication by any means, including mechanical or electronic, without express permission is prohibited. Subscribers who have registered with the Copyright Clearance Center and who pay the $1.00

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Permission to reproduce BNA International Inc. material may be requested by calling +44 (0)20 7559 4800; fax. +44 (0)20 7559 4880 or e-mail: customerservice@bnai.com

The information contained in this Report does not constitute legal advice and should not be interpreted as such. All efforts have been made to ensure that the information contained in this Report is accurate at the time of publication.

Growing Markets2009in East and

BNAI’s Tax Planning International: Special Reports, a series of

Reports focusing on key topics in international tax.

South:

Asia forms part of

The material contained in this Special Report is written by tax specialists who are experts in the laws of their own jurisdiction. Tax and legal matters are frequently subject to differing opinions and points of view, therefore signed articles within this report express the opinions of the authors and are not necessarily those of their firms, BNA International or the editor. While the authors and editor have tried to provide information current at the date of publication, tax laws around the world are subject to change and therefore readers should consult their tax adviser before taking any action related to the content of this Report.

Contents

Growing Markets in East and South Asia

Indonesia

The tax and legal framework

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Graham Garven and Jim Nichols

Tax treatment of cross-border service activities

 

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Michael Gordon and Jim Nichols

Holding and financing strategies for investment

 

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15

Graham Garven and Jim Nichols

Investing in real property: Some key tax aspects

 

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17

Michael Gordon and Jim Nichols

China

The tax and legal framework.

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Mario Petriccione and William Zhang

 

Tax treatment of cross-border service activities

 

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Mario Petriccione and William Zhang

 

Holding and financing strategies for investment

 

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Mario Petriccione and William Zhang

 

Investing in real property: Some key tax aspects

 

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31

Lewis Lu and Mario Petriccione

Vietnam

The tax and legal framework.

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Ninh Van Hien

Tax treatment of cross-border service activities

 

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Ninh Van Hien

Holding and financing strategies for investment

 

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Ninh Van Hien

Investing in real property: Some key tax aspects

 

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Ninh Van Hien

Korea

The tax and legal framework.

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Jae Won Lee and Na Rae Lee

Tax treatment of cross-border service activities

 

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45

Jae Won Lee and Deok Hyun Seo

Holding and financing strategies for investment

 

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47

Jae Won Lee and Deok Hyun Seo

Investing in real property: Key tax implications .

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49

Jae Won Lee and Chung Wha Suh

Contents

Malaysia

Outline of the corporate tax regime .

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51

Leanne Koh Li Ann

Tax treatment of cross-border service by non-residents

 

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55

Peggy Then

Holding and financing strategies for investment .

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59

Nicholas Crist

Tax planning for real estate investments

 

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63

Chew Theam Hock

The Philippines

The tax and legal framework.

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Jim Nichols, in consultation with KPMG Manila

 

Tax treatment of cross-border service activities

 

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71

Jim Nichols, in consultation with KPMG Manila

 

Holding and financing strategies for investment .

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73

Jim Nichols, in consultation with KPMG Manila

 

Investing in real property: Some key tax aspects .

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75

Jim Nichols, in consultation with KPMG Manila

 

Pakistan

The tax and legal framework.

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77

Shabbir Vejlani and Asif Ali Khan

 

Tax treatment of cross-border service activities

 

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Shabbir Vejlani and Asif Zia

Holding and financing strategies for investment .

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85

Shabbir Vejlani and Asif Zia

Investing in real estate: Some key tax aspects

 

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Shabbir Vejlani

India

The tax and legal system

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91

Amarjeet Singh

Taxation of cross-border services .

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95

Amarjeet Singh

Holding companies and financing

 

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97

Amarjeet Singh

Real estate investment: Key regulatory and tax aspects .

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101

Amarjeet Singh

Indonesia The tax and legal framework Graham Garven and Jim Nichols KPMG Hadibroto, Jakarta and

Indonesia

The tax and legal framework

Graham Garven and Jim Nichols KPMG Hadibroto, Jakarta and KPMG LLP, London

During colonial times, Indonesia was the hub of a vast Dutch trading empire stretching from South Africa to the Pacific. In more recent years, after four decades of authoritarian rule, in 1998 Indonesia transitioned to a democratic system of government.

Indonesia is the world’s largest archipelago and fourth most populous nation. This, combined with its strategic location, rich natural resources and growing economy make it an increasingly important business location.

I. Applicable company law

Indonesia has a civil law system, based on Dutch law. Indonesian company law is governed by Law 40/2007.

Law 40/2007 permits only one corporate form – the limited liability company (Perseroan Terbatas or “PT”). A PT is very broadly analogous to the Dutch BV corporate form. It requires a minimum of two shareholders and must have a minimum authorised capital of IDR50 million, of which at least 25 percent must be paid up.

II. The foreign direct investment framework

Although there is a general recognition that Indonesia needs the development capital and the technical and management skills of foreigners, there are a number of restrictions and procedures that must be addressed. The desire to control foreign investment is manifested in a variety of ways, for example, in general:

All foreign investment is approved and monitored through government bodies;

A domestic shareholding may be required in a foreign invested company;

Companies can employ only a limited number of expatriates and are required to demonstrate plans for replacement of those expatriates by Indonesians;

Foreign companies are required to work jointly with Indonesian companies in order to undertake government contracts;

Certain fields of business are closed or may be restricted to investment by foreigners;

Land holding and/or land rights are covered by a number of restrictions.

The Investment Law No. 25 of 2007 was introduced mainly to improve on the previous foreign investment legal framework and regulates both foreign and domestic investment. With regard to foreign investment, the law encourages foreign direct investment by granting the right of entry for foreign business through a government licensing procedure. The procedure is controlled principally by the Investment Coordinating Board (“BKPM”) which is responsible for the evaluation and approval of most foreign investment proposals and the coordination of licensing requirements. Similar procedures apply for wholly domestic investment, but with a broader range of permitted activities.

Initial investment proposals to BKPM need to be in fields that are not closed to foreigners, as do applications for expansion of existing facilities. Periodically, the government publishes a Negative Investment List which lists the business ventures restricted or closed to foreign investment. Sectors that are generally closed to foreign investment include healthcare, small scale retail and media.

In some cases where there are restrictions on participation by foreign companies, such as in construction, oil and gas and in government projects, participation may be possible in conjunction with an Indonesian company. Indirect involvement by means of technical assistance and management agreements is also common, particularly in sectors where direct investment has not been permitted. The Investment Law specifies that foreign investment must be in the form of a limited liability company, Perseroan Terbatas (“PT”), incorporated in Indonesia with the approval of BKPM and/or, potentially, requiring various approvals from other government ministries. In addition, for certain specified sectors such as banking, oil and gas, mining and construction, the set up of a registered branch by a foreign enterprise may also be permitted. There is an anomaly in that the Indonesian Tax Office

Indonesia: The tax and legal framework

will often allow the registration of a branch for tax purposes in the absence of a business license. This means that although the branch is operating unlawfully, it is still able to fulfil its tax obligations.

A PT company having an approved foreign shareholding is

known as a “PMA” company (Penanaman Modal Asing). The legal form and operation of a PMA company is otherwise the

same as that provided for in respect of entirely domestically owned companies. A “foreign investor” is usually a foreign company. However, foreign individual investors are also acceptable to BKPM. Foreign investors can initially hold in many cases up to 100 percent equity, except for in the case

of restricted industry sectors. Under Indonesian company law,

a minimum of two shareholders is required for every company.

The Investment law grants the foreign investor the freedom to manage a company including the right to appoint directors and, if necessary, foreign technicians and managers where skilled Indonesians are not available.

PMA manufacturing companies may not directly distribute domestically to end consumers. They may however establish

a separate company to distribute domestically (which can be

100 percent owned by the PMA company or another foreign entity). In addition, PMA companies are permitted to sell their products directly to:

Another PMA distribution company;

Manufacturers who use the products as raw materials or for plant and equipment;

Construction companies who use the products in their projects; or

Wholesale entities.

III. Exchange controls

BKPM, together with Bank Indonesia, the country’s central bank, will monitor the source and disbursement of funds approved for the establishment of a venture. For PMA companies, sources external to Indonesia in foreign currencies must be used to finance all loan capital and the foreign parent’s equity capital. Certain external borrowing requires official approval, but loans for wholly private sector projects are not subject to this approval. PMA companies may borrow from domestic non-state banks for working capital requirements.

The import and export of Indonesian currency (“IDR”) is subject to exchange controls and the lending of IDR to a foreign enterprise by an Indonesian bank is generally prohibited. However, it is possible to structure a loan to a PMA company from a foreign parent so that it may make remittances in foreign currency, such as USD, by reference to the prevailing USD-IRD exchange rate. The loan agreement would thus be economically in IDR, but will specify that the settlement currency was USD.

One further alternative that achieves much the same result would be to make a USD loan to the PMA company from its foreign parent combined with a USD-IDR swap agreement between the parties so as the loan plus the swap are economically equivalent to an IDR loan. Either of these two options should prevent taxable exchange differences from arising in the PMA company in respect of the loan.

IV. The corporate tax system

The Indonesian corporate income tax system is based on two main laws:

The Tax Administration Law (Law 28/2007);

The Income Tax Law (Law 36/2008).

These laws are the most recent amendments to tax laws originally issued in 1983.

In addition, there are tax laws covering VAT, taxation of Land

and Buildings (both a “rates” style annual tax and the taxation of sale and acquisition), a stamp duty law (stamp duty applies at a low nominal rate on most financial and legal documents) and various local and regional taxes which may not have significant impact. There is no separate capital gains tax, as gains are taxed as income.

At the outset, it should be noted that in Indonesia there is a fairly high degree of uncertainty regarding the interpretation and application of laws. This is very evident in respect of the tax laws and the conduct of the Indonesian Tax Office (“ITO”). The ITO conducts tax audits with a comparatively unfettered degree of power and the administrative provisions of the tax laws are often seen to be geared to favour the ITO rather than taxpayers.

A. Fundamental principles

Indonesian tax residents are taxable on worldwide income under a system described as “self assessment”. This is largely

a misnomer as the ITO follows a rigorous and extensive tax audit regime. Non-residents are taxable only on income derived from or received from Indonesia.

Under domestic law, a company is considered resident in Indonesia if it is incorporated there. Having a place of management in Indonesia can only result in creating an Indonesian permanent establishment, rather than having any wider implications for corporate residence under domestic law.

To eliminate double taxation, Indonesia allows a credit against income tax payable for taxes paid abroad subject to certain limitations. This relief can be availed of only by resident taxpayers in respect of the foreign tax paid or incurred. The foreign tax credit is limited to the same proportion of the tax against which such credit is taken.

B. Tax base

Taxable profits are based on accounting profits after adjustment for tax depreciation and non-deductible expenses. Expenses are generally deductible provided they are incurred to “earn, secure or collect profits.” Tax depreciation for both tangible and intangible assets connected with the enterprise’s business operations is generally provided for as a tax deduction, except in the case of internally generated goodwill. Provisions are not generally deductible, except in certain industries (notably banking and insurance). In addition the costs of providing benefits to employees are generally not deductible.

Losses may be carried forward to offset future profits. The losses are offset against the first profit to arise, and they can only be used in the five subsequent years after the year of loss. In remote areas and certain fields, a longer loss carry forward up to 10 years may be permitted.

Indonesia: The tax and legal framework

C. Tax rates

The corporate tax rate applies at a single flat rate of 28 percent

in 2009 and will be reduced to 25 percent in 2010, in contrast

to the progressive rates which applied up to 2008, with a

maximum rate of 30 percent.

The corporate tax rate for a public company is subject to

a discount of five percent if 40 percent of its paid-up

capital is publicly owned by at least 300 parties (individual

and/or corporation) and no single shareholder has more than five percent;

Companies with a gross annual turnover less than IDR4.8 billion are eligible for a 50 percent rate cut, resulting in a flat rate of 14 percent for fiscal year 2009 and 12.5 percent for fiscal year 2010 and thereafter. This applies to Indonesian companies, even if they are part of a far larger worldwide group;

Where gross annual turnover exceeds IDR4.8 billion but

is less than IDR50 billion, the 50 percent rate reduction

applies on the proportion of taxable income which results when IDR4.8 billion is divided by the gross annual turnover;

There is a branch profits tax levied at 20 percent on the post tax profits accruing in an Indonesian permanent establishment of a foreign enterprise.

D. Tax incentives

There are a limited range of tax incentives available in Indonesia. The incentive system includes both activity based and geographically based components. These incentives include accelerated tax depreciation and an extension of the maximum loss carry forward period to 10 years.

E. Withholding taxes

Except where preferential tax rates or exemptions are provided for under a tax treaty, payments to non-resident corporations without a registered Indonesian permanent establishment are subject to final withholding tax at a rate of 20 percent. This includes dividends, financing costs, royalties and payments for services (whether or not rendered in Indonesia).

Tax treaties to which Indonesia is party may provide for lower rates of withholding tax on dividends, interest and royalties of between 0 percent and 15 percent.

A final withholding tax is the amount of income tax withheld by

a withholding agent which constitutes as a full and final

payment of the income tax due from the payee on said income. The liability for payment of the tax rests primarily on the payor as a withholding agent.

On the other hand, a creditable withholding tax is tax withheld on certain income payments to domestic corporations or permanent establishments. This is intended to equal or at least approximate to the tax due of the payee on said income. The income recipient is still required to file an income tax return to report the income and/or pay the difference between the tax withheld and the tax due on the income. If the tax withheld turns out to be greater that the tax due on the income it is possible to obtain a refund, but only after a tax audit has been completed by the ITO.

As a general rule, withholding tax arises at the time when income is paid or payable to the non-resident or when it is accrued as an asset or an expense in the books, whichever comes earlier.

F. Anti-avoidance

Whilst there are no explicit anti-avoidance provisions in the tax law, the ITO makes extensive use of provisions allowing adjustment to related party transactions, which are its main anti-avoidance tool. Indeed, amendments to the related party

provisions, effective for the 2009 tax year, indicate a purpose to attempt to use such provisions in a manner akin to a “general anti-avoidance provision”. The approach to transfer pricing principles taken by the ITO is often markedly different and counter to TP principles in any established tax jurisdiction. Therefore, where there are related party (defined as where there

is a direct or indirect 25 percent shareholding) transactions,

particular care must be taken.

Generally, there are no specific provisions in respect of thin capitalisation. However, interest on excessive related party debt may be disallowed as a tax deductible expense under the rules allowing for adjustments to be made where there are related party transactions. Whilst there are no set limits for an acceptable debt/equity ratio, a 3:1 ratio (as used as a guide by BKPM) is often used by tax auditors as a benchmark.

Indonesia has rules on the taxation of controlled foreign companies (“CFCs”). Broadly these rules apply to deem a dividend to have been made from a company more that 50 percent directly owned by Indonesian resident shareholders.

Compliance requirements are rigorous and the penalties for non-compliance harsh. In addition, the need for taxpayers to settle an assessment prior to objecting or appealing has historically led to many adjustments being made on the basis of fiscal budgetary pressures rather than technical merit. Assessments of underpaid tax are subject to penalty interest and surcharges ranging from two percent per month to 100 percent of the unpaid tax, depending on the perceived transgression. Higher penalties apply if criminal acts have been committed.

Tax strategies require careful consideration. In this regard a strong focus should be placed on complete documentation which has a detailed focus on the facts and circumstances of the Indonesian operational circumstances. Rigorous adherence to processes and procedures (on an annual basis) is also required.

A clear understanding of the potential issues that could be

raised by the ITO and the detailed/practical operational aspects

of the business (and transactions) are all essentials to reduce

the risk of a lengthy and costly tussle with the ITO.

V. Conclusion

Whilst Indonesia has made some progress recently in the fields of foreign investment and tax law to provide clarity and encourage growth and investment, there remain a number of bureaucratic hurdles to investment and the application of laws and regulations is often inconsistent. In particular, transactions with related parties remain an area where there is significant uncertainty over tax outcomes.

Graham Garven is a Tax Partner with KPMG’s Indonesian firm.

Jim Nichols is a Tax Manager in KPMG London’s International Corporate Tax practice, specialising in Emerging Markets.

For further information, please contact the authors by email at:

graham.garven@kpmg.co.id and james.nichols@KPMG.co.uk

Tax treatment of cross-border service activities

Michael Gordon and Jim Nichols KPMG Hadibroto, Jakarta and KPMG LLP, London

This article addresses the tax treatment of non-Indonesian enterprises carrying out service work in Indonesia. This could be, for example, a consultancy business providing advice to clients in Indonesia and sending staff to work at the client’s premises, or a manufacturing business selling heavy machinery to Indonesia and sending personnel to supervise its installation. In either case the question will arise whether any part of the income is taxable in Indonesia under Indonesian domestic law, and whether any relevant double tax treaty provides protection.

I. Introduction

The licensing and regulatory rules in Indonesia can be quite complex. The applicable regulations will often depend on the type of project at issue. For example, there are specific regulations governing the power and telecommunications sectors. In addition to understanding the relevant rules, investors must also consider the most appropriate business structure for their role in the proposed project. Thus, it is important to seek professional advice at the beginning of a project in order to avoid unnecessary complications later.

II. Indonesian permanent establishment (“PE”)

A PE is defined in Indonesian domestic law as “running a

business or carrying out activities in Indonesia.” This definition

is further clarified by a non-exhaustive list of activities that

would result in a PE. Specifically, this includes the supply of services in any form by an employee or other person for more

that 60 days in any 12-month period. A construction, installation or assembly project is also included on the list, without specifying any minimum time period before a PE is created.

A registered branch of a foreign enterprise is included in the

definition of PE. However, Indonesian tax law also provides for

the registration of an “unlicensed” PE – i.e. activities of a foreign enterprise in Indonesia that are taking place without obtaining regulatory approval to set up a branch. Notwithstanding the fact that such activities are technically not allowed under the foreign investment laws, such a PE can register for income tax and VAT and file tax returns as for a registered branch.

The above definition of PE is fairly wide. As such, where cross-border services are being performed it is usually preferable if the service provider is resident in a country with a tax treaty with Indonesia that can provide some protection (see below).

Profits of a PE would generally be taxed as for a resident company and hence would be subject to 28 percent corporate income tax. In addition a 20 percent branch profits

tax is also levied on net profits of any PE, after deduction of corporate income tax or any final withholding taxes. The branch profits tax may be reduced subject to any lower rate specified in a relevant tax treaty.

III. Withholding tax on other Indonesian source income

In the absence of having a PE in Indonesia, a foreign enterprise may still be subject to Indonesian withholding tax on other income considered to be Indonesian source, which generally means that it is derived from property or activities in Indonesia. Such income is subject to final withholding tax of 20 percent in Indonesia. This includes income from dividends, interest, royalties, technical assistance and service fees (whether the services are rendered in Indonesia or otherwise), rental and leasing income.

Furthermore, withholding taxes may apply to payments made to an Indonesian PE of a foreign enterprise or local subsidiary. These include a creditable withholding tax (of 1.5 percent - 4.5 percent depending on the service) applicable to service fees paid to such a PE or subsidiary. Technical/management services and most other services including consulting and advisory fees are subject to a creditable withholding tax at two percent of gross income.

Apart from discussion of the technical and practical requirements in respect of management and technical service fees are the issues of:

Treatment of such expenses as “royalty” payments; and

Treatment of such payments as “deemed dividends” where they are paid to connected parties and deemed to be excessive and therefore non-deductible for the payor.

Royalties (which are widely defined under domestic law) are subject to a creditable withholding tax of 15 percent if paid to an Indonesian PE of a foreign enterprise or local subsidiary. A 20 percent final withholding tax applies to royalties paid to a foreign resident without a PE. Treatment of service fees as royalties may result if inadequate documentation is

Indonesia: Tax treatment of cross-border service activities

maintained. In Indonesia it is essential to have an agreement in place which formalises the arrangement, sets out the types of services to be provided, the basis of operation of the arrangement and the allocation basis of costs.

Other specific considerations 1. “Turnkey” contract model

Any turnkey type contract must be structured carefully to ensure that the offshore procurement activity and offshore services, if any, are not subject to tax in Indonesia. The Indonesian Tax Office (“ITO”) takes the position that turnkey contracts are subject to withholding tax on the whole contract value (including equipment and offshore services) unless there are provisions to the contrary in a relevant tax treaty.

2. Purchase of goods

Purchases of goods and equipment from Indonesian suppliers will be subject to VAT in almost all cases, but will not be subject to any withholding taxes.

Some types of projects are granted import facilities for equipment on a “Masterlist”. Purchases of “non-masterlist” goods and equipment from overseas suppliers will be subject to import taxes:

VAT at 10 percent;

Import duty and surcharges at variable rates;

Income tax prepayment at 2.5 percent.

Income tax prepayments on imports can be offset against the importer’s income tax liability for the same financial year. It can only be used for other purposes, or repaid, after tax audit verification. Exemption from prepayment may be requested annually during the period before the importer has commenced trade.

IV. The position under double tax treaties

Most of the tax treaties entered into by Indonesia use definitions of permanent establishment found in the OECD Model Conventions (to which there are some modifications drawn from the UN Model). Where such a treaty applies, this can therefore add significant protection for the service provider from creating a taxable presence in Indonesia or being subject to Indonesian withholding tax on services performed in Indonesia. In such a situation, a PE will generally only be created in Indonesia where:

The foreign enterprise has a fixed place of business in Indonesia through which the business of the enterprise is wholly or partly carried on;

The foreign enterprise has an agent in Indonesia with the power to conclude contracts in the name of the enterprise; or

The foreign enterprise furnishes services in Indonesia for a specified minimum period of time.

In common with many Asia Pacific jurisdictions, there is a specific “services PE” concept in most of the tax treaties to which Indonesia is party (which usually draws on the wording in the UN Model in this respect). Where the relevant treaty includes provisions based on the UN Model in relation to the furnishing of services, this would generally mean that a PE would be created in Indonesia if employees or other personnel of the foreign enterprise furnished services in Indonesia for

more than the minimum period specified. This minimum period generally varies from two months to six months (see table at the end of this article).

In the case of construction, installation or assembly projects, most of Indonesia’s tax treaties provide for a minimum period of six months before a PE is created, although some provide for only three months. The recently signed treaty with North Korea is the only exception, with a 12 month period.

Where a treaty applies and the service activities performed fall outside of the scope of the definition of a PE in the relevant treaty, then service fees can be paid without deduction of Indonesian withholding tax in accordance with the “business profits” article of the relevant treaty. However, under certain circumstances service fees may be characterised as royalties under Indonesian law. This could occur, for example, when the services included a transfer of knowledge or information when the service provider has the relevant intellectual property or “know how”.

There are cases where companies enter into “combined” agreements, e.g. covering royalty or “know-how” matters as well as “service” fees. Such combined type of agreements present practical problems in Indonesia. The ITO is quick to determine that all payments under the agreement should be treated as payments for “know-how” and, accordingly, subject to withholding tax – as a royalty. This will result in the imposition of a withholding tax assessment and penalties.

Where service fees fall to be treated as royalties, the payments will be subject to a final withholding tax of 20 percent under domestic law or to a lower rate to the extent permitted by the relevant treaty. Most tax treaties have a maximum royalty withholding tax rate of 10 percent-15 percent. However if procedures are not complied with in terms of a Certificate of Tax Domicile (“CoD”) of the recipient of the royalty, then the 20 percent domestic rate will apply. A CoD must be renewed annually. It is essential that a Certificate of Domicile of the supplier is on file with the Indonesian entity at the time payment is made.

When considering the treatment of such fees, the commentary to the OECD Model Convention provides guidance on the distinction between service fees and royalties that may be referred to in a treaty situation and may narrow the scope of what the ITO can argue to constitute royalties.

The Indonesian Tax Office may have regard to the “beneficial ownership” issues and the foreign lender would have to demonstrate that it was beneficially entitled to the income in order to benefit from the treaty. Unfortunately the circumstances in which the beneficial ownership concept would be applied are not well defined in Indonesian tax law and therefore this may be subject to significant uncertainty.

V. Other points to be considered

There are likely to be other considerations, besides those referred to above, in deciding how to structure the provision of services into Indonesia. For example, if the nature and extent of the services is such that a PE will definitely be created, then consideration may be given to setting up a local subsidiary to provide the services. A local subsidiary would not suffer the branch profits tax, but would be required to deduct dividend

Indonesia: Tax treatment of cross-border service activities

withholding tax of up to the maximum rate prescribed by a relevant tax treaty instead.

A PE generally offers more flexibility and fewer administrative

burdens in relation to its set up and operation. However, the choice will depend on the specific circumstances of the activities and where a PE is feasible care must be taken to ensure that only those profits attributable to the PE are subjected to Indonesian tax.

VI. Conclusion

Where services are being provided to an Indonesian taxpayer,

it is important to ensure that these are fully supported with

documentation evidencing active services and that activities

do not in themselves create a PE. Where the creation of a PE

is unavoidable, consideration should be given to the legality of

such an operation, given the complex licensing procedures, and ultimately to the attribution of taxable profits of the PE. In many cases it may be necessary to establish an Indonesian subsidiary to remain within the licensing regulations.

Table

Country/

Technical services

Construction

Services PE?

Territory

withholding tax?

project PE?

China

No

6 months

6 months

France

No

6 months

183 days

Germany

Yes – 7.5%

6 months

No

Japan

No

6 months

6 months

Luxembourg

Yes – 10%

5 months

No

Pakistan

Yes – 15%

3 months

No

Switzerland

Yes – 5%

183 days

No

UAE

No

6 months

6 months

UK

No

183 days

91 days

USA

No

120 days

120 days

Michael Gordon was formerly a Tax Partner with KPMG’s Indonesian firm.

Jim Nichols is a Tax Manager in KPMG London’s International Corporate Tax practice, specialising in Emerging Markets.

For further information, please contact Graham Garven of KPMG Indonesia and Jim Nichols by email at: graham.garven@ kpmg.co.id and james.nichols@KPMG.co.uk

Holding and financing strategies for investment

Graham Garven and Jim Nichols KPMG Hadibroto, Jakarta and KPMG LLP, London

A foreign direct investment into any country requires planning on how to hold the investment, whether directly from the

investing parent, or through one or more tiers of intermediate holding companies, how to finance it, whether wholly by equity or through a mixture of debt and equity, and in the latter case how to structure the debt.

We shall consider each of these aspects in turn below. As can be seen from the analysis of some of the other countries

in this report, some of these issues are common to other jurisdictions, whereas others are more peculiar to Indonesia.

I. Holding company strategies

In general, holding company strategies may be intended to achieve any or all of the following objectives:

To reduce withholding tax on dividends in the source country (Indonesia) or direct tax on dividends received in the residence country;

To mitigate any tax on capital gains either in the source country or the residence country on disposal of the shares to a third party or within the group.

The following analysis deals with the source country issues only, from the perspective of a foreign investor in Indonesia.

A. Indonesian domestic law position

Under the Indonesian Income Tax Law, dividends and interest paid to non-resident shareholders are subject to 20 percent withholding tax, whilst the sale of unlisted shares by non-residents is subject to a five percent final withholding tax on the gross sales proceeds or market value, if greater.

Foreign investors are subject to the same special tax rules on sale of listed shares as Indonesian investors, such that a tax of 0.1 percent applies on the gross value of the transaction.

Interest costs are generally deductible in Indonesia, subject to provisions denying a deduction on related party debt deemed to be excessive (see below).

B. Double tax treaties

Shareholders resident in a country with a double tax treaty with Indonesia may benefit from a reduced rate of dividend withholding tax of 10 percent or 15 percent (see table at the end of this article). Thus, for foreign shareholders, total Indonesian taxes on profits will range from 35.2 percent to 42.4 percent (28 percent income tax plus withholding tax on dividends) in 2009.

Furthermore, most tax treaties provide for an exemption from Indonesian tax on gains realised by a non-resident shareholder on shares in an Indonesian company. However some of these do not permit an exemption in cases where the assets of the company whose shares are transferred consist principally of Indonesian immovable property.

The tax treaties to which Indonesia is party typically provide for a reduced rate of interest withholding tax of 10-15 percent. The only major treaty with a provision for a rate lower than this is the treaty recently negotiated with the Netherlands. This provides for a 0 percent rate on interest on loans with a term of more than two years. However, a circular letter (SE-17/PJ/2005) issued by the Indonesian Director General of Taxation on June 1, 2005 states that the “Competent Authorities” of the Netherlands and Indonesia have not yet discussed the law to implement this, as required by the treaty. As such the Indonesian tax authorities have denied the use of the 0 percent rate and instead require tax to be withheld at 10 percent until such time as a procedure is adopted.

The Indonesian Tax Office may have regard to “beneficial ownership” issues and the foreign lender would have to demonstrate that it was beneficially entitled to the income in order to benefit from the treaty. Unfortunately the circumstances in which the beneficial ownership concept would be applied are not well defined in Indonesian tax law and therefore this may be subject to significant uncertainty. Export credit agencies or other foreign government provided loans are usually exempt from withholding tax pursuant to tax treaties.

In order to take advantage of reduced tax treaty rates or exemptions, a certificate of domicile must be obtained from the tax authority in the jurisdiction in which the foreign shareholder is a tax resident.

II. Financing strategies

As discussed above, for foreign lenders in treaty countries, a reduced interest withholding tax rate of 10 percent or 15 percent generally applies. As interest is generally a tax deductible expense, debt financing is usually preferable to equity financing from an Indonesian tax point of view, as it achieves a saving of both corporate income tax and dividend withholding tax, the combination of which would be greater than the interest withholding tax burden. Related party debt can also be used to finance an Indonesian PE of a foreign enterprise in a similar way to an Indonesian subsidiary, although it should be noted that loans from the head office or

Indonesia: Holding and financing strategies for investment

branches of the same enterprise will not generate tax deductible interest, except in the case of PEs of banks.

There are no specific thin capitalisation rules in the tax law. However, the loan to equity ratio is fixed by the BKPM approval. 25 percent equity is normal, but higher gearing may be permitted where this can be justified commercially. In addition interest on excessive related party debt may be disallowed as a tax deductible expense under the rules allowing for adjustments to be made where there are related party transactions. Whilst there are no set limits for an acceptable debt/equity ratio, a 3:1 ratio is often used by tax auditors as a starting point.

One further notable exception, where interest is not tax deductible, is where the loan has been taken out for the purpose of acquiring shares in an Indonesian company in circumstances where the dividends that may arise from those shares would be non-taxable in the hands of the shareholder. This generally applies where an Indonesian company holds at least 25 percent of the shares in another Indonesian company.

Interest expense is recognised on an accrual basis for tax and accounting purposes. Rolling-up unpaid interest does not alter the timing of deduction, or withholding tax obligations.

Foreign exchange differences on borrowings, whether realised or not, are taxable/deductible in the period they arise. However it is possible to structure a loan so that it is economically denominated in IDR. This could be achieved for example by having a loan agreement economically in IDR, but specifying that the settlement currency was USD at the prevailing USD-IDR exchange rate.

One further alternative, which achieves much the same result would be to make a USD, combined with a USD-IDR swap agreement between the parties, so as the loan plus the swap are economically equivalent to an IDR loan.

A. Bank financing

Interest and fees payable to an Indonesian bank and other financial institutions are not subject to withholding tax. Indonesian banks include banks established in Indonesia, as well as branches of foreign banks which have been granted operating licenses in Indonesia.

The overseas branches of Indonesian established banks should similarly be exempt from withholding tax, however this has not always been accepted by the Indonesian Tax Office.

In principle, a “back to back” arrangement could be entered into with an international bank whereby an IDR loan to the Indonesian subsidiary is granted by an Indonesian branch of the bank, with a corresponding deposit made by the foreign parent at a branch in its home country. This has the benefit of eliminating interest withholding taxes. However, either the bank or the foreign parent would need to bear the foreign exchange risk. This could be managed by either making a payment to the bank to bear this risk or entering into an appropriate instrument to ensure that the overseas deposit is economically in IDR. In either case there will be practical issues to address and the additional expenses incurred may not be justified by a potential interest withholding tax saving of 10 percent.

B. Deductibility of finance costs for an acquisition of shares

As noted above, interest on loans taken out by an Indonesian company to acquire a 25 percent or greater share in another Indonesian company is generally not tax deductible and so this strategy would not be effective in such circumstances. Additionally there is no group taxation modus available in Indonesia. Therefore, in order to be part of an effective tax planning strategy any interest expense will need to arise in the hands of a company which has sufficient taxable income against which to utilise it.

One strategy could be for the foreign investor to acquire the shares directly, with the Indonesian target subsequently borrowing funds to effect a share buy-back. However, this option is likely to run into difficulties in securing the necessary regulatory approval from BKPM in relation to granting approval for the foreign enterprise to invest into Indonesia.

As such leveraging a share acquisition of an Indonesian target in a way that will give rise to deductible interest expense is likely to be difficult to achieve.

III. Conclusion

Indonesia has a fairly extensive double tax treaty network and multinationals may find that they can obtain tax savings on an investment depending on the vehicle used. Leveraging may also be possible to increase tax deductions although there may be restrictions on the level of debt at initial approval stage and care must be taken to ensure that the debt is not seen as being utilised for the financing of equity or interest costs may be treated as non-deductible.

Below is a table setting out the key features of selected treaties.

Table

Country/

Capital gains

Maximum dividend withholding tax a

Interest

Territory

protection on

Withholding Tax

share disposal?

Australia

No

15

10

China

Yes b

10

10

Kuwait

Yes

10

5

Netherlands

Yes

10

10 c

Portugal

Yes

10

10

Switzerland

Yes

10

10

UAE

Yes

10

5

UK

Yes

10

10

USA

Yes

10

10

a Assuming a 25% or greater holding; UK shareholding requirement is only 15%.

b Except where assets of the Indonesian company comprise principally of immovable property located in Indonesia.

c 0% rate if on loan with a term of more than 2 years. However ITO deny this in practice.

Graham Garven is a Tax Partner with KPMG’s Indonesian firm.

Jim Nichols is a Tax Manager in KPMG London’s International Corporate Tax practice, specialising in Emerging Markets.

For further information, please contact the authors by email at:

graham.garven@ kpmg.co.id and james.nichols@KPMG.co.uk

Investing in real property:

Some key tax aspects

Michael Gordon and Jim Nichols KPMG Hadibroto, Jakarta and KPMG LLP, London

The law relating to real property in Indonesia can be complex. This article gives an introduction to some of the aspects that may be relevant to the tax structuring of Indonesian real property.

I. The legal framework

A foreign investor may invest in Indonesian real property

through a wholly foreign-owned company or in a joint venture company with a local partner. These are referred to as “PMA” companies, which is a category of limited liability company where some or all of the shares are owned by foreign shareholders. A foreign investor can either establish a new PMA company or it can acquire an existing PMA company; similar rules apply to both methods.

A PMA company may obtain the right to lease, build on or use

land for between 70 and 95 years, depending on which right is obtained and each of these is renewable simultaneously for between 45 and 60 years with a further shorter renewal period available on later application.

In some situations, where property is being developed, the

property developer does not own the land and there is a common practice of “BOT” (Build Operate Transfer) arrangements. In such arrangements, a property developer contracts with a landowner to construct a property on the owner’s land at the developer’s cost. The developer will manage the property and will receive the income generated by the property for a predetermined period. The landowner will receive a ground rent during the “operating” period and at the end of the period, the building will revert to the landowner.

Where a foreign company operates as a branch, no investment

in real estate would be permissible.

II. Outline of ongoing tax position of an Indonesian real estate company

A. Income

Rental income on real estate is subject to final withholding tax

at an effective rate of 10 percent from gross rental. This is

normally withheld by the lessee. However, if the lessee has not

been appointed as a tax withholder, the tax should be self-paid by the taxpayer who receives the income. There is then no further tax on the rental income.

Other income of a real estate company, for example from property management, may be subject to income tax at the general corporate rates as follows:

2009 fiscal year

28%

2010 fiscal year and thereafter

25%

A reduction in rates may apply if revenues are less than IDR50

billion (approximately USD4.5m). (Refer to the article Indonesia:

The tax and legal framework)

There is a 20 percent withholding tax on interest, dividends, royalties and other fees payable outside the country, which is generally reduced to 10-15 percent by tax treaties. The non-resident must provide the PMA company with a certificate of tax domicile from the competent tax authority in the country of residence in order to take advantage of the tax treaty.

B. Deductions

In respect of income to which a final withholding tax applies, expenses relating to rental income are not deductible, including interest, depreciation and other costs. In respect of other income, interest should be allowed as a deductible item, unless such charges are from a related party and are in excess of commercial rates.

Land is not depreciable, except for plantation and certain other industries. Depreciable assets other than building and construction are specified by tax regulation to fall into one of four asset categories according to the type of asset. Building and construction are divided into permanent and non-permanent structures. Buildings and other immovable property are depreciated based on the straight line method at five percent (permanent) or 10 percent (non-permanent).

Generally, tax losses in respect of income not subject to final withholding tax can be carried forward for five years beginning the first year after such loss occurs.

C. Other annual taxes

There is an annual tax on land and buildings. Tax is imposed at an effective rate of 0.1 percent for properties with an appraised value of less than IDR1 billion, and 0.2 percent for properties with an appraised value over IDR1 billion, or for certain businesses (e.g. plantations). The appraised value is fixed every three years in most cases. Although the owner is normally responsible for paying the tax due on rented property, the lease agreement can specify who is liable for this tax.

III. Outline of tax consequences of a disposal

Broadly, there are three options for structuring a disposal of the property, the tax consequences of each of which are outlined below.

A direct disposal of the property itself;

Indonesia: Investing in real property: Some key tax aspects

A disposal of the shares in the Indonesian company by the foreign shareholder;

A disposal of the shares in an offshore holding company above the Indonesian company.

A. Disposal of the property

Proceeds from the sale of land and building by a company are subject to a five percent withholding tax on the sale value, which is a final tax.

Additionally, there is a five percent transfer tax on the sale of land and buildings that is payable by the purchaser.

B. VAT

VAT at a rate of 10 percent applies to real estate transactions.

In addition to 10 percent VAT, there is a 20 percent sales tax on

apartments of more than 150 square meters or if the price is more

than IDR4 million/square meter. Care is therefore required in relation

to apartment properties in case the vendors have previously

engaged in dubious transactions aimed at avoiding this tax.

C. Conveyancing taxes/stamp duties

A

nominal stamp duty of either IDR3,000 or IDR6,000 applies

to

certain documents, such as receipts, agreements, and

notarial deeds.

D. Disposal of shares in an Indonesian real estate

company

There is a five percent tax on the disposal of shares in an unlisted Indonesian company. This is based on the sale price, irrespective of any actual gain or loss. Many treaties provide for an exemption from this tax, however some of Indonesia’s tax treaties deny this exemption if the assets of the Indonesian company are principally immovable property located in Indonesia. Therefore, the shareholders of the Indonesian subsidiaries ideally should be resident in a country with an advantageous treaty and an exemption from any gains realised on the shares in their home jurisdiction.

E. Disposal of shares in an offshore holding company

Indonesia does not generally seek to assert extra-territorial taxing rights in this situation. However, the income tax law now contains a provision which may allow Indonesia to tax the sale

of shares in an offshore special purpose vehicle holding

company as if the sale was of the shares of the Indonesian

subsidiary.

IV. Structuring the investment

There are several factors to consider when selecting the structure of the shareholding, in particular, the tax treaty provisions relating to dividends and disposal of shares by non-residents.

A. Profit repatriation

Foreign currency can be freely remitted into and out of Indonesia. For a foreign investment project the Foreign Investment Law further guarantees this position. There are certain restrictions on remittances of local currency and there are reporting requirements for foreign currency purchases exceeding USD100,000 per month.

Dividends to foreign shareholders are subject to a withholding tax

of 20 percent. This is generally reduced to 10-15 percent under

various tax treaties, for example, the Netherlands (10 percent), Australia (15 percent), Singapore and many others (15 percent, or 10 percent if 25 percent shareholding). If profits are retained in the company rather than distributed as dividends, withholding taxes are not imposed until the distributions are declared.

Although the company law permits a company to issue shares of different classes, preference shares and redeemable shares are extremely unusual. Investors have so far been reluctant to undergo the delays and uncertainty of seeking approval for such arrangements.

As a result, shareholder debt arrangements are a common means to enhance the return to investors relative to a pure equity holding.

Royalties and technical assistance/management fees can be paid where a foreign shareholder or other entity provides support services relating to the Indonesian project. An Indonesian withholding tax is imposed at the applicable tax treaty rate (generally 10-15 percent). Technical assistance fees are subject to withholding tax unless they represent active services under a relevant tax treaty. Passive services are treated as a form of royalty. Fees for travelling to Indonesia to undertake a specific property review for the Indonesian company could be treated as an active service. Note, however, that where a business is subject to final tax, such as property rental, these charges (royalties, technical assistance/management fees) are not tax deductible.

V. Leveraging the investment

The Investment Coordinating Board (“BKPM”) generally will consider that initial debt funding should normally not exceed 75 percent of total investment. The local entity should report the debt to Bank Indonesia.

There are no thin capitalisation restrictions for tax purposes. Where there is a special relationship between taxpayers, the tax office can re-determine the amount of income and/or deductions, and reclassify debt as equity in determining taxable income. Nevertheless, convertible debt and subordinated loans are commonly encountered and these are treated as debt for tax purposes.

However, where a final withholding tax applies to a particular income stream, there is no deduction for interest against the relevant income and therefore leveraging the investment may not be tax efficient.

VI. Conclusion

The new investment law has relaxed previous restrictions on real estate ownership and it would now seem that there is greater flexibility for foreign investors to obtain land on a long-term lease basis. Income earned from real estate investment is subject to a final tax and therefore care must be taken in structuring investments to avoid tax leakage from non-deductible costs, including interest.

Michael Gordon was formerly a Tax Partner with KPMG’s Indonesian firm.

Jim Nichols is a Tax Manager in KPMG London’s International Corporate Tax practice, specialising in Emerging Markets.

For further information, please contact Graham Garven of KPMG Indonesia and Jim Nichols by email at: graham.garven@ kpmg.co.id and james.nichols@KPMG.co.uk

China The tax and legal framework Mario Petriccione and William Zhang KPMG LLP, London and

China

The tax and legal framework

Mario Petriccione and William Zhang KPMG LLP, London and KPMG Huazhen, Shanghai

In this article on China we look at: applicable company law; the foreign direct investment framework; exchange control; and the corporate tax system.

I. Applicable company law

Chinese company law is based on the Company Law of the People’s Republic of China (the “CL”), promulgated on October 27, 2005. Essentially the CL allows two types of companies, namely the “joint stock company” (“JSC”, very broadly equivalent to the European plc/ SA/ AG legal form) and the limited liability company (“LLC”, broadly equivalent to the French Sarl or the German GmbH). Only the JSC is allowed to issue shares to the public.

In general, for both types of company, once share capital has been issued it cannot be repaid or redeemed. Dividends may be paid only out of after-tax profits, after making good past years’ losses and subject to any compulsory transfers to reserves. The general rule on such transfers is that 10 percent of after-tax profit must be transferred to a statutory reserve, until such reserve has reached 50 percent of the paid-in capital. However, in the special case of an Equity Joint Venture (“EJV”:

see below), the specific legislation referred to below prescribes that it is the Board of Directors that decides the proportion of after-tax profit to be transferred to the various reserves. Hence, the percentage stipulated in the CL is not applicable to EJVs.

II. The foreign direct investment framework

Foreign direct investment can take three main forms:

A Wholly Foreign Owned Enterprise (“WFOE”), governed by the law of October 31, 2000 and the related rules and regulations; this should generally take the legal form of an LLC;

An Equity Joint Venture, governed by the law of March 15, 2001 and the related rules and regulations; this must take the legal form of an LLC, and the Chinese shareholder must be a company rather than an individual; or

A Co-operative Joint Venture, governed by the law of October 31, 2000 and the related rules and regulations; this may take the form of an LLC or simply of a contractual relationship (which in China does not have separate legal personality), but it must prepare accounts.

Foreign companies in certain industries such as banking, insurance and shipping may set up branches in China, which are not separate legal entities in China.

In general, most foreign direct investment is subject to an approval process, which, depending on the size of the investment, is governed by the central or local authorities. The rules which provide guidance for foreign investment in China were overhauled in 2004 and distinguish four areas of the economy:

The prohibited sector, including projects regarded as endangering state security or the public interest, projects that cause pollution or endanger health, and projects that use large areas of agricultural land;

The restricted sector, including areas where there is a state monopoly and extraction of mineral resources;

The encouraged sector, for example certain high technology activities, activities relating to re-use of resources, activities relating to environmental protection, and investment in the central and Western regions of China; and

The permitted sector, which covers all other activities.

Investment in the restricted sector requires central government approval if the investment exceeds USD50 million, whereas in the permitted and encouraged sectors the local authorities can approve investments up to USD100 million. All investments in excess of USD100 million require approval of the National Development and Reform Commission (“NDRC”) in the central government.

III. Exchange control

China has a comprehensive exchange control system, which is administered largely by the State Administration of Foreign Exchange (“SAFE”). Some of the foreign investment into a WFOE or joint venture company can generally be made in the form of debt from other group companies outside China. When the company is first registered, the authorities will require a certain proportion of the total investment to be made in the form of equity rather than debt; the percentage of equity

China: The tax and legal framework

required depends on the amount of the investment, so for investments above USD36 million up to two-thirds of the investment can be made as debt, whereas for lower investment amounts higher equity percentages are required. In addition, more stringent requirements are imposed on the capitalisation of real estate foreign-invested enterprises (“FIEs”). For instance, under a notice issued by the SAFE in July 2007, foreign debts to real estate FIEs established on/after June 1, 2007 are no longer allowed.

IV. Corporate tax system

A. The tax reform

On March 16, 2007, the National People’s Congress promulgated the new Corporate Income Tax Law of the People’s Republic of China (“CITL”), which has taken effect from January 1, 2008. The new law replaces the old dual tax system, whereby domestic and foreign owned enterprises were subject to different sets of tax rules, with a single tax system applicable both to domestic enterprises and Foreign Investment Enterprises (i.e. enterprises with a foreign participation of at least 25 percent). As is usual with Chinese legislation, the actual law sets out only the broad framework of the new system. The Implementation Rules which were issued by the State Council in December 2007 provide more details, however, the rules are still silent on some key areas (e.g. tax treatment on various reorganisation transactions). Therefore, the CITL and its Implementation Rules are likely to leave ample discretion for the Ministry of Finance and/or the State Administration of Taxation which have been issuing circulars specifying further details on how the new rules are to be applied. However, it is still expected that there is likely to be continuing uncertainty on many of the detailed aspects of the new rules although the CITL has taken effect for more than a year.

As will be seen below, underlying the new law is a shift from the previous policy of subsidising the import of capital to a more neutral approach where imported capital is taxed on a level playing field with domestic capital.

B. Fundamental principles

The new law introduces a concept of residence based either on incorporation or effective management (whereas the old law

effectively bases residence – while not using that term – solely on incorporation). In common with the old law, the new law also has a concept of PE (“an establishment or place of business in the PRC”). Non-resident companies are taxable at the normal corporate tax rate (see below) on the profits attributable to such “establishment”. By contrast, the profits of

a non-resident enterprise that are not attributable to such

“establishment” will be subject only to the withholding tax

described further below under withholding taxes.

A Chinese resident company is taxed on its worldwide profits.

However, losses of foreign branches are not deductible in China.

Dividends paid by a Chinese resident company to another qualifying Chinese resident company are exempt from corporate taxation, whereas dividends received by Chinese resident individuals are taxed at 20 percent.

The corporate tax rate under the new law is 25 percent (down

from 30 percent plus three percent local tax). In principle this applies across the country, in contrast to the old system where

a tax rate of 15 percent applies in Special Economic Zones and

reduced rates applying in other special economic areas (e.g. 24

percent for FIEs in Coastal Open Economic Zones, 15 percent for manufacturing FIEs in Export Processing Zones, etc.).

The CITL and its Implementation Rules set out the following general principles related to tax depreciation:

Tax depreciation is generally available on fixed assets connected with the enterprise’s business operations, provided, in the case of assets other than buildings and structures, they are assets put into operational use;

Some more favourable tax depreciation treatments are provided under the CITL and its Implementation Rules, e.g. there is no restriction on the residual value of fixed assets under the CITL in contrast to the old regulations applicable to FIEs where the residual value of the fixed assets should be at least 10 percent of their costs; the minimum depreciation periods for transportation vehicles other than aircraft, trains, vessels and electronic equipment are reduced from five years (provided under the old regulations), to four and three years respectively;

Tax depreciation is also available on intangibles connected with the enterprise’s business operations, but not on self-generated goodwill or on intangibles in relation to which the development expenditure has been claimed as tax deductible;

Tax depreciation on fixed assets and intangibles should be calculated using the straight-line method.

Tax losses can be carried forward for a maximum period of five years. No carry-back of losses is allowed.

Unless specifically allowed by the State Council, enterprises are not allowed to file tax returns on a consolidated basis.

C. Tax incentives

By contrast with the old geographically based incentive system, under the new law, incentives are based on type of activity or size of business. Specifically, “high tech” enterprises will qualify for a 15 percent tax rate, and small-scale enterprises with “small profits” will be taxed at 20 percent.

Enterprises are required to obtain recognition of being “high-tech” enterprises in accordance with the new recognition criteria and procedures in order to enjoy preferential tax treatments.

Small-scale enterprises are defined as industrial enterprises of which the taxable income for the year should not exceed RMB300,000, total employees should not exceed 100, and total assets should not exceed RMB30 million; or as other enterprises of which taxable income for the year should not exceed RMB300,000, total employees should not exceed 80, and total assets should not exceed RMB10 million.

The State Council stipulates the grandfathering treatments for enterprises with business licences dated prior to March 16, 2007 that are entitled to preferential tax treatments under the old laws.

For CIT rates:

Transitional treatments for the reduced rate of 15 percent under the old laws will be as follows:

Table

2007

2008

2009

2010

2011

2012

15%

18%

20%

22%

24%

25%

The 24 percent reduced rate under the old tax laws will transit to the standard CIT rate of 25 percent immediately from 2008.

China: The tax and legal framework

D. Withholding taxes

The new law stipulates a 20 percent tax rate for Chinese sourced income of a non-resident who does not have an “establishment or place of business in China” (normally to be levied by withholding tax). Such tax rate is reduced by the State Council in the Implementation Rules to 10 percent. “Chinese sourced income” includes dividends, interests, rentals, royalties and gains from transfer of property derived by a non-resident enterprise.

Under the old Foreign Enterprise Income Tax Law (“FEITL”, Article 19), there is an exemption from dividend withholding tax for dividends paid by FIEs. The CITL and its Implementation Rules contain no such exemption. However, enterprises may seek double tax treaty protection under the relevant double tax treaties. It is also now clarified that any dividends paid out of pre-2008 retained earnings will still be exempted from the withholding tax even if paid in 2008 or a subsequent year.

E. Reinvestment relief

Under Article 10 of the FEITL, a refund of Chinese corporate income tax is made to foreign investors who reinvest their share of the profits of an FIE. The refund is generally 40 percent of the tax paid by the FIE on the corresponding profits. No similar mechanism is envisaged under the new law.

F. International aspects

As stated earlier, the new tax system, like the old one, is based on taxation of worldwide profits of Chinese companies, wherever arising. Subject to the Controlled Foreign Company (“CFC”) rules discussed below, it appears that under the new system the profits of foreign subsidiaries will be taxed only when distributed up to the Chinese parent. The new law provides unilateral double tax relief for withholding tax, and, subject to holding a controlling participation, underlying tax; the working of the legislation is unclear but suggests it is intended to give the relief regardless of the number of tiers of shareholdings involved. The relief is subject to a maximum equal to the Chinese tax liability on the income. Under the old system, the tax credit is computed on a country-by-country basis; this method is adopted under the new tax system. Unrelieved foreign tax credits can be carried forward up to five years.

G. Anti-avoidance

The CITL and its Implementation Rules contain CFC rules whereby, where a foreign enterprise controlled by China-resident enterprises (or individuals) is located in a jurisdiction that has a tax rate less than half of China’s (i.e. less than 12.5 percent), the portion of the enterprise’s profits attributable to Chinese shareholders will be taxed immediately in China, unless there are “reasonable business needs” for retaining the profits.

There is also the “thin capitalisation” rule whereby interest on related party borrowings in excess of a prescribed debt/equity ratio is disallowed. The debt-equity safe-harbour limits are 5:1 and 2:1 for financial institutions and other companies respectively.

Finally, the new law contains a general anti-avoidance rule whereby, where enterprises have entered into transactions that do not have reasonable business purpose, the tax authorities have the power to make reasonable adjustments to those enterprises’ taxable profits or revenue.

H. Transfer pricing

The State Administration of Taxation released key transfer pricing regulations in January 2009, which guide the implementation of special taxation adjustment matters covering transfer pricing, advance pricing arrangements, contemporaneous documentation, cost sharing agreements (“CSAs”), CFC, thin capitalisation and general anti-avoidance as formulated under the new law and its Implementation Rules.

The regulations are retroactively effective from January 1, 2008. For 2008 tax years onwards, taxpayers in China have to comply with the following requirements each year:

Annual filing consisting of nine forms detailing related parties and related-party transactions;

Contemporaneous documentation with detailed content requirements. However, the contemporaneous documentation is not required for companies meeting certain criteria;

Additional documentation for CSAs for taxpayers who have CSAs in place; and

Additional documentation regarding thin capitalisation financing for taxpayers whose lending exceeds the debt-equity safe-harbour limits.

The regulations come at a challenging time for many multinational corporations. In addition to having to adjust to the sudden decrease in demand caused by the current economic crisis, enterprises are now facing an increased risk of a transfer pricing audit.

V. Turnover taxes

In addition to the corporate income tax reform and the new transfer pricing rules, the State Council issued revised Value-added Tax (“VAT’), Business Tax (“BT”) and Consumption Tax (“CT”) regulations and their Implementation Rules in late 2008, which could have a significant impact on the operation of the enterprises which are liable to these types of taxes.

In view of the reforms of the VAT, BT and CT regimes, taxpayers are recommended to study these regulations and rules and to assess the impacts of these regulations and rules on their operation, based on which the taxpayers can take proper arrangements/plannings to reduce their tax costs or to minimise the tax risks.

VI. Conclusion

China is still a highly regulated environment and there are still many additional constraints compared with those faced in many western countries. However, the new corporate tax system as well as the reforms on VAT, BT and CT represent a major step towards a modern tax and legal framework where there is clarity on the rules for the taxation of business profits. The new tax system broadly creates a level playing field between imported and domestic capital and can be expected to favour the development of privately owned Chinese enterprises and their growth outside China.

Mario Pettricione is a Director of International Corporate Tax and may be contacted by email at:

mario.petriccione@kpmg.co.uk

William Zhang is a Senior Tax Manager and may be contacted by email at: william.zhang@kpmg.com.cn

© KPMG (UK) LLP 2008

Tax treatment of cross-border service activities

Mario Petriccione and William Zhang KPMG LLP, London and KPMG Huazhen, Shanghai

This article addresses the tax treatment of non-Chinese enterprises carrying out service work in China. This could be, for example, a consultancy business providing advice to clients in China and sending staff to work at the clients’ premises, or a manufacturing business selling heavy machinery to customers in China and sending personnel to supervise its installation. In either case the question will arise whether any part of the income is taxable in China under Chinese domestic law, and whether any relevant double tax treaty provides protection.

Under the new Corporate Income Tax Law (“CITL”) enacted on March 16, 2007 and which has entered into force on January 1, 2008, a foreign enterprise is taxable in China under two alternative scenarios:

If the enterprise has an “establishment or place of business” in China, then such enterprise is subject to the normal 25 percent corporate income tax rate on the Chinese-source income of the “establishment” and on non-Chinese source income effectively connected with such “establishment”;

In all other cases, Chinese source income of a non-resident enterprise is subject to a 20 percent tax rate under the CITL, normally by way of withholding tax, which is reduced to 10 percent under the Implementation Rules of the CITL issued by the State Council in December 2007.

I. “Establishment or place of business”

The concept of “establishment or place of business” is defined in the Implementation Rules of the CITL as an establishment or a place of business that is engaged in the production and business operations in the PRC, which is along the concept under the old law. Examples are “management organisations, business organisations, administrative organisations, and places for factories and the exploitation of natural resources, places for construction, installation, assembly, repair and exploration work, places for the provision of labor services and business agents”. It is obvious that this is a very wide definition. First, there is no requirement of permanence: an “establishment or place of business” can be a very short-lived presence. Secondly, the definition would seem automatically to catch any construction, installation or assembly project, as well as any business agent. Thirdly, the meaning of “places for the provision of labour services” is also potentially very wide; it would seem to cover many cases where the foreign enterprise sends personnel to the premises of the customer in China to execute or complete the work.

II. Withholding tax on other Chinese-source income

In the absence of an “establishment or place of business”, a foreign enterprise will be taxable in China on other income regarded as having a Chinese source. Again, the Implementation Rules of the CITL define this concept as follows:

Profits (dividends) earned by enterprises in China;

Interest derived within China (on deposits, loans, bonds, advance payments made provisionally on another person’s behalf, or on deferred payments);

Rentals on property leased to and used by lessees in China;

Royalties such as those received from the provision of patents, proprietary technology, trademarks and copyrights for use in China;

Gains from the transfer of property, such as houses, buildings, structures and attached facilities located in China and from the assignment of land-use rights within China;

Other income derived from China and stipulated by the Ministry of Finance or the State Administration of Taxation (“SAT”) to be subject to tax.

So, generally, where there is no “establishment or place of business” in China, fees for services are not subject to tax by way of withholding tax either.

III. The position under double tax treaties

In view of the wide definition of “establishment or place of business” in domestic law, it is usually desirable to ensure that the enterprise providing the services is protected by an appropriate double tax treaty. Most treaties, of course, have a narrower definition of “permanent establishment” (“PE”) than the above definition of “establishment or place of business”. In particular, as a general rule, treaties provide that a permanent establishment exists only if either:

The foreign enterprise has in China a fixed place of business through which the business of the enterprise is wholly or partly carried on; or

China: Tax treatment of cross-border service activities

The foreign enterprise has in China an agent with power to conclude contracts in the name of the enterprise.

In relation to services, many of China’s treaties provide for an additional category of PE, namely the “services PE” concept in the UN Model Treaty. This provides, broadly, that there is a PE of the foreign enterprise if the foreign enterprise furnishes services “through employees or other personnel engaged for that purpose”, if such activities continue for longer than a specified period (six months in the UN Model) within any 12-month period. As will be seen in the table, some of China’s treaties, namely the ones with Cyprus, Hungary and Mauritius, extend this six-month period to 12 months, of course so making it less likely that the service activities result in the existence of a PE under the relevant treaty. The treaties with the United Kingdom and Ireland are exceptions and do not provide for such a “services PE” concept.

In this regard, an interesting point is that, following revision of the commentary to the OECD Model in 2003, the OECD interprets the “fixed place of business” concept as potentially covering a situation where an enterprise carries out services work at a customer’s premises (see paragraph 4 of the commentary to Article 5, particularly the example in paragraph 4.5 of the painter who spends three days a week at a client’s premises over a two-year period). In this regard, it may be that treaties that follow the UN Model and contain a clear rule on when the provision of services gives rise to a PE provide better protection than treaties based on the OECD Model, where there is far more uncertainty on the circumstances where a service activity conducted at a client’s premises gives rise to a PE.

Another important difference among the PE Articles of China’s treaties is in the duration that a construction, installation or assembly project needs to have before it is regarded as a PE. Normally, this is six months, but, as shown in the table, the treaties with Cyprus, Hungary and Mauritius allow 12 months.

In determining the number of “months”, one may make reference to Guoshuihan 2007 No.403 (“Circular 403”) issued

by the SAT, with regards to the interpretation of “month” in the double tax arrangement between Mainland China and Hong Kong. According to Circular 403, the Mainland will take the period from the month in which an employee of a Hong Kong enterprise arrived in the Mainland for furnishing services, up until the month in which the project was completed and the employee left the Mainland, as the relevant period. Even if the employee is present in the Mainland for one day in a particular month, it will be treated as one month. If during this relevant period, no service was provided by the employee in the Mainland for a period of 30 consecutive days, one month can be deducted.

Although Circular 403 relates specifically to the double tax arrangement between Mainland China and Hong Kong, it may have an impact on the way the tax bureau interprets “month” for other tax treaties. The tax bureau may potentially adopt the restrictive interpretation of “month” as provided in Circular 403 for other tax treaties.

So, to what extent can a foreign enterprise choose which treaty to rely on for protection? The opportunity that many multinational enterprises take up is to set up a company in the jurisdiction chosen as having the appropriate protection in its treaty with China, and conclude and perform the contract for the services in question through that company. Careful thought needs to be given to the degree of substance required by the company; for example:

Does the company need to employ the staff performing the contract or is it enough for the staff to be seconded to it?

What level of substance does the company need in its chosen home country?

Who should be the directors of the company?

The above are all difficult questions that will require advice in each individual case. The Chinese tax authorities have not so far taken a great amount of interest in cases of treaty abuse,

Table