Chinese companies that do business in the United States often find it most efficient to send some of their existing employees to the U.S. to jumpstart projects, set up new plants, and lend their expertise when their skills and knowledge of company operations can make a critical difference in a situation. While this can be a sound business practice, both the Chinese companies and their employees should understand their U.S. income tax obligations to ensure they don’t incur civil or criminal penalties.
What is a permanent establishment (PE) under the Chinese and U.S. tax treaty?
Permanent establishment or “PE” is the term used in international income tax treaties to describe when a business has made a significant enough connection with a jurisdiction that would allow that jurisdiction to impose an income tax on business profits. Income tax treaty provisions are generally more favorable than the domestic rules and are available to tax treaty partners on an elective basis. The Chinese and U.S. income tax treaty was set up to help individuals and entities avoid double income taxation and prevent the evasion of income tax in either or both countries. PE is defined within article 5 of the treaty and describes the conditions or activities that would cause a Chinese business to create a PE allowing the U.S. to assess a federal income tax. The treaty describes a couple of ways a PE can be created. One way is through a fixed place of business in the U.S. (a site PE) and the other is based on the type of work performed (a service PE). The treaty also mentions activities that will not create a PE.
Site PEs include any:
- Place of management
- Branch
- Office
- Factory
- Workshop
- Mine, oil or gas well, quarry, or other place where natural resources are extracted
Site PEs may also be a construction site, project, drilling rig, or ship when work is performed for specific durations as defined in the treaty.
Service PEs are created when services are performed by a business through employees or other personnel, and the activities continue for a period or periods aggregating more than six months in any twelve months in the U.S. For the same or connected project, the six-month calculation period begins on the date the first employee enters the US and ends when the last employee(s) leave(s) the country. Additionally, a PE will be created when a person has the authority and regularly exercises the authority to conclude contracts in the U.S.
What are the U.S. tax filing requirements once the PE is established?
After a PE is established, the foreign company and its foreign employee working in the US will both have US tax obligations. The foreign company is obligated to pay corporate income tax to the federal government (through Form 1120-F for the company) and file the associated return timely. It is also subject to employment tax (including social security and Medicare taxes) and has the obligation of withholding its employees’ payroll and individual income taxes.
The foreign employee who works in the US must also file and remit income tax returns and payments when the company that they’re working for has a PE in the US even if the foreign employee is in the US for less than 183 days.
What is the tax planning opportunity?
To avoid the complexities of having permanent establishment exposure, Chinese companies can set up a separate U.S. company and employ all employees working in the U.S. under the U.S. entity and properly report the payroll through U.S. company. In this scenario, the U.S. company would have the standard tax obligations of other U.S. companies instead of the foreign company.
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Tax treaties are generally not binding for state nexus purposes; a foreign company may be subject to state taxes even though it does not have a PE for federal income tax purposes. Both federal and state tax obligations should be considered and researched. If your foreign company needs help setting up or performing the tax and accounting work of a U.S. company, please contact us for assistance.
