Chinese tax authorities completed a busy December publishing finalized regulations addressing tax reform of individual income tax. For U.S. businesses with mainland China operations, it’s important to understand the immediate and future impact of the changes on their workforce. With the new regulations taking effect Jan. 1, 2019, there’s a short time frame for both businesses and employees to review, understand and implement required changes.
Overall the Chinese regulations can be seen as both giving and taking away benefits to individual taxpayers. Preferential tax treatment that lowers the tax burden on incentive compensation, such as bonuses and equity income, continues and has been expanded. Taxpayers can also benefit from the introduction of new deductions available against taxable income. But this change is short-lived, as preferential treatment will be phased out in a few years, with taxpayers facing potentially much higher income tax burdens in the future.
For employers, the changes will bring both administrative challenges in managing payroll deductions and elections. The phasing out of preferential tax treatment and the resulting increases in employee taxation of incentive compensation will likely create market pressure to mitigate this: Employees will be looking to see how their employers respond -- creating a new front in an already competitive talent battle.
International assignees and expatriates will also see their currently preferential tax treatment of benefits, from accommodation to children’s schooling costs and language tuition, move to being fully taxable in the future. Assignment tax costs for employers are set to increase and expatriate benefit packages become more costly on a net basis. For companies with tax-equalized assignees working in China, the combined impact of lower U.S. federal tax rates from 2017’s tax reform legislation and tax changes in China will see for some, significant increases in the tax cost to the company of the assignments.
There are five developments in the new regulations that U.S. business and individuals working in China should address to understand the impact on their budgets.
1. Tax residency for non-domiciled individuals:
Chinese income tax is limited to China-sourced income only for individuals who are not domiciled in China. For long-term residents of China, they can benefit from not being subject to tax on their worldwide income if they spend 30 consecutive days outside mainland China in a tax year. The period of absence was previously required in a five-year period and this has now been extended to six years.
2. Preferential tax treatment of bonuses and equity income:
- This provides some relief for expatriates working in China and particularly those individuals potentially impacted in 2018 who now have another year to meet the criteria. U.S. residents will benefit from not being taxed on worldwide income in two countries and the potentially complex implications this would create.
- For businesses with non-domiciled expatriate employees in China, if they are sent on assignment or extended business trips to the United States, they may not be able to benefit from U.S. tax relief under the double tax treaty as they do not meet the residency requirements to qualify. Companies should review and take advice so not to have unexpected U.S. tax consequences.
The ability to apply annual Chinese tax rates once a year to a bonus and equity income event has meant taxpayers could qualify for considerably lower taxation on this income than were it taxed alongside regular income. This benefit was extended but it will cease after 2022, meaning all employees potentially face significantly higher rates of tax on such income.
3. Preferential tax treatment of international expatriate benefits:
- Employees should review how the coming changes will impact them, potentially where tax rates could rise from 10% to 45% in 2022. U.S. individuals in China who are still subject to U.S. taxation on worldwide income may now pay tax in excess of U.S. federal rates, increasing their overall effective tax rate.
- Employers should consider how to address future changes that impact bonus and equity payments. Where they may in future be worth less on a net basis to employees, how much of the burden will transfer to employees and will the changes see competitors vie for talent with increased compensation packages.
Many international assignees benefit from limited tax, or none, on certain employer-provided benefits, including housing, children’s schooling fees and living costs, where a registered tax policy is in place. These benefits will no longer be available with such tax relief after 2022 potentially resulting in significant increases in tax cost for international assignees. For locally employed expatriates, the cost of providing such benefits will also increase requiring employers to consider how to address such changes.
4. Changes to deductible expenses:
- Where benefits are provided on a gross basis, employees will in future be subject to China tax, meaning potentially high tax burdens arising on non-cash income like accommodation. U.S. individuals may find their overall effective tax rate increases, too.
- Tax-efficient delivery of benefits will be phased out, so employers should review and update compensation packages for local employees to identify who will bear any future taxes. For tax-equalized employees in China, companies will see tax costs increased as they absorb the additional tax on the benefits. Employers will want to review the potential cost impact of this phase-out ahead of time.
A new list of deductible expenses with more relaxed substantiation rules has been enacted. These deductions are available to both international and domestic employees (the former must choose between the expatriate deductions and these once per year). The new list could make payroll administration more complex when employees choose to deduct costs, as the payroll administrators will need to review whether these costs are actually deductible and whether they fit within the maximum amount allowed. International assignees may continue to benefit from the exemptions in an international employee policy, so a business shouldn’t be required to change its policy approach if this policy already is in place. However, a company’s assignees may find they can deduct costs previously not available to them.
5. Annual tax returns and tax refunds:
- Employees can benefit from considerable reductions to taxable income through the new deductions. On a month-to-month basis, the ability to have deductions factored into payroll withholding will mean benefiting from a real-time reduction in taxes. U.S. expatriates should review the overall impact of the deductions and whether the reduced tax burden could result in additional U.S. federal tax.
- As employees can request deductions be taken through payroll, U.S. businesses with local operations should work closely with human resources and payroll teams to understand and plan for the potential administrative burdens this may pose. Where elections are being made, companies may want to teach employees to understand the changes and the process for claiming deductions.
An important change is the criteria for which an individual may file a tax return. Deductible expenses may be taken via a tax return going forward and so an individual who has suffered withholding would be able to claim a tax refund. For U.S. employees who claim a foreign tax credit on their federal tax return, any balancing tax payments or refunds on a Chinese tax return will impact their U.S. taxes. Individuals should assess potential changes and whether a residual U.S. tax liability could arise if China taxes are reduced.
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