This hesitation to recognize differences among types of foreign entities is presumably justified on the following grounds. First, classifying foreign entities requires the analysis of foreign laws, which can be a difficult exercise in terms both of the quantity and intricacy of details involved. Second, it is administratively complex to verify claims by the nominal recipients of income that the “real” recipients of the relevant income are someone else, especially given that such claims are more likely to be made when disclosing the “real” recipient brings tax benefits. Third, if foreign partnerships and partnership-like entities are to be recognized, special tax rules may have to be designed for them. But the proper tax rules for partnership-like entities are intrinsically complex, as demonstrated for example by subchapter K of the US Internal Revenue Code. This level of complexity is unsuited to the current state of development of China’s income tax, and is better postponed to the indefinite future.

Against this background, it is notable that China has recently begun to draw distinctions between types of foreign entities in the context of outbound transactions. China taxes its resident enterprises on their worldwide income and allows them to claim foreign tax credits (FTC). [1] In a recent piece of guidance issued by the Ministry of Finance (MOF) and State Administration of Taxation (SAT) on FTC issues (referred to below as “Circular 125”), [2] the tax authorities affirmed, as could be expected, that Chinese enterprises must include the income of foreign branches on a current basis. The same circular, however, also expands the scope of the current inclusion requirement to foreign entities or persons beyond branches, i.e. partnerships and trusts. Although the way it does this is circuitous, close textual analysis as well as understanding of the process by which Circular 125 was issued point unambiguously to the conclusion.

The sections in Circular 125 most relevant to the issue of entity classification read as follows: [3]  

 “In the case of a foreign branch entity that a resident enterprise has established and invested in and that does not have independent taxpayer status, of the foreign source income that it derives, the taxable income shall be the net amount after the deduction of various reasonable expenses related to foreign income from total foreign income[…]

The various items of foreign income derived by a foreign branch entity that is established by a resident enterprise and that does not have independent taxpayer status should be included as Foreign Taxable Income in the applicable taxable year of the enterprise, regardless of whether such income is remitted to China[…] [4]

For purposes of this Notice, not possessing an “independent taxpayer status” means either not possessing independent legal personality according to the law of the jurisdiction in which the [branch entity] is established by an enterprise or not being recognized as a tax resident of a treaty partner under the provisions of a tax treaty.” [5]

Four comments are worth making in connection with these sections. First, the second paragraph of the language quoted above (from Section 3(1) of Circular 125) states the explicit requirement for current inclusion of certain types of foreign income. Although this statement takes place in a section that overall is concerned with the application of the FTC limitation, [6] the current inclusion requirement should be understood as applicable in not just the FTC context. That is, even if a taxpayer is not claiming FTC or even if the FTC limitation is not applicable, [7] it would still be required to currently include income of a “foreign branch entity”. This directly follows from the idea that a taxpayer cannot take into account an item of income in the FTC limitation computation if the income is not treated as accruing to the taxpayer in the first place; otherwise the computation would be incoherent. [8]

Second, “branch entity” (“fenzhi jigou”) is not defined, and it may not be immediately clear that the term would encompass entities such as partnerships and trusts. Indeed, nor does any other provision of Circular 125 refer to partnerships and similar entities. [9] However, the phrase “branch entity” is used throughout Circular 125 together with the phrase “without independent taxpayer status”, so that “branch entity without independent taxpayer status” should be understood as a single term. The elaboration of the meaning of “independent taxpayer status” in section 13 (the third paragraph in the language quoted above), then, makes it clear that “branch entity” indeed refers to organizations, or to what would be characterized as “persons” under tax treaties. Only for “persons” does the question whether they are “residents” arise under tax treaties, and partnerships, trusts, etc. are clearly persons. [10] Thus a partnership or trust would be regarded as a “branch entity without independent taxpayer status” if it satisfies the test for not having “independent taxpayer status” under section 13.

Third, the term “independent legal personality” is used in China to denote the feature of having complete limited liability. Thus a Chinese statutory partnership, like statutory or even common law partnerships in the United States, could have various powers of a legal person (such as entering into contracts, suing and being sued, and having independent ownership of property), [11] yet still not be regarded as possessing legal personality under Chinese law. If this Chinese conception of “legal personality” is applied to foreign entities, then entities which would be recognized as legal persons under the legal doctrines of their jurisdictions of formation (e.g. a Delaware limited partnership) may still be regarded as not possessing “independent legal personality”. Under this interpretation, it is whether the entity has complete limited liability, not whether it has independent “legal personality”, that should be interpreted under the law of the jurisdiction of establishment pursuant to section 13. While this is the most natural interpretation of that section, further clarification would certainly be beneficial.

Fourth, because Circular 125 applies the “independent taxpayer status” test only in the context of determining when a Chinese enterprise should currently include income received by a foreign “branch entity”, it does not have classification implications for all foreign entities. Not only does it create no new rule for inbound transactions, even for outbound transactions, it does not address all relevant foreign entities. For example, a foreign partnership that is only indirectly owned by a Chinese enterprise—for example through a foreign corporation—would still have an unclear classification. How to treat such entities in the context of indirect FTC rules is still an open question. [12]

Overall, then, Circular 125 has staked out, in a circumscribed fashion, the position that foreign partnerships, trusts and similar entities may be treated differently from other foreign entities, in that their Chinese enterprise owners would have to currently include income received by the entities regardless of actual distributions. Even this limited position can be more clearly stated, but the government should have ample incentive to provide such clarification: after all, the requirement of current inclusion pre-empts deferral of income on the part of Chinese taxpayers by parking income in offshore partnerships, trusts, etc, and does so automatically, without resorting to the various tests in controlled foreign corporation (CFC) rules. [13] The position in Circular 125, in other words, is the position one would expect the Chinese government to take from a tax policy point of view. In addition, this position potentially helps Chinese enterprises with their tax treatment in certain foreign jurisdictions. For example, the United States takes the view that whether a non-US person can claim the benefit of a tax treaty that the US has entered into depends, among other things, on whether the relevant US-source income is treated as derived by the foreign person under the tax law of the foreign person’s resident country. [14] For example, if a Chinese enterprise invests in the US via a Cayman partnership, for the Chinese investor to access the benefits of the US-China treaty, it is not sufficient that US tax law treats the Cayman partnership as transparent and the Chinese partner as the beneficial owner of the income received by the partnership. Instead, Chinese tax law must treat the Cayman partnership as fiscally transparent, i.e. the Chinese enterprise must be required to include income received by the partnership on a current basis. [15] The initial steps taken by Circular 125 to treat foreign partnerships as transparent will certainly make it easier for Chinese enterprises to satisfy this requirement.

[1] Enterprise Income Tax Law (effective Jan. 1, 2008) [hereinafter EIT Law], Articles 3, 23 and 24.

[3] Translation provided by the author.

[5] Circular 125, Section 13.

[6] The lead paragraph of Section 3 makes reference to the Enterprise Income Tax Law Implementation Regulations (effective Jan. 1, 2008) [hereinafter EIT Law IR] and states: “An enterprise shall apply the following provisions to determine, from its foreign-source income (foreign before-tax income) as defined under Article 7 of the Implementing Regulations, the amount of its Foreign Taxable Income, as that term is used in Article 78 of the Implementing Regulations.”. EIT Law IR, Art. 7 provides source of income rules for the EIT Law. Art. 78 of the EIT Law IR contains the basic formula for China’s per country FTC limitation regime.

[7] Section 10 of Circular 125, for example, provides for simplified approaches to claiming FTC without requiring taxpayers to go through the FTC limitation formula of EIT Law IR Art. 78.

[8] Earlier drafts of the FTC regulation that was finally issued in the form of Circular 125 contained language requiring the current inclusion of income of “foreign branch entities” as a general matter, and not just in the context of FTC limitation computation. The rather terse Circular 125 omits this part of the draft rules.

[9] In some of the earlier drafts of the FTC regulation, the term “branch entity” was explained as referring to “company branches, entity, contractual project, sites for providing labor service, and so on” (italics added). 

[11] By contrast, for example, partnerships are not regarded as independent legal persons in various English law jurisdictions, including the Cayman Islands.

[12] Because indirect FTCs are generally claimed only when distributions are made to the home country taxpayer, the distinction between transparent and non-transparent entities may be less important for indirectly owned entities because there would be no mismatch between distribution and inclusion in income.

[13] Chinese CFC rules require a resident enterprise to currently include the income of a foreign enterprise only if the foreign enterprise is  established in a low-tax jurisdiction, is controlled by Chinese residents,  and fails to distribute all of its profits for reasons other than reasonable operational needs. See EIT Law Art. 45.

[15] See United States Treasury Regulations Section 1.894-1(d).