Growing Mkts of East South Asia

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Growing Marketsin East and South Asia

Tax Planning International: Special Report


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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 theworld.

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; Taxtreatment 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 East and South Asia0 0 9 is publishedby BNA International Inc., a subsidiary of The Bureau of

National Affairs, Inc., Washington, D.C., U.S.A.

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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 inthis Report is accurate at the time of publication.

Growing Markets in East and South Asia0 0 9 forms part ofBNAIs Tax Planning International: Special Reports, a series of

Reports focusing on key topics in international tax.


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The material contained in this Special Report is written by tax specialists who are experts in the laws of theirown jurisdiction. Tax and legal matters are frequently subject to differing opinions and points of view, thereforesigned 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 thedate of publication, tax laws around the world are subject to change and therefore readers should consult theirtax adviser before taking any action related to the content of this Report.


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Contents

Growing Markets in East and South Asia

Indonesia

The tax and legal framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Graham Garven and Jim Nichols

Tax treatment of cross-border service activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Michael Gordon and Jim Nichols

Holding and financing strategies for investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Graham Garven and Jim Nichols

Investing in real property: Some key tax aspects . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17Michael Gordon and Jim Nichols

China

The tax and legal framework. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Mario Petriccione and William Zhang


Mario Petriccione and William Zhang


Mario Petriccione and William ZhangInvesting in real property: Some key tax aspects . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

Lewis Lu and Mario Petriccione

Vietnam


Ninh Van Hien


Ninh Van Hien

Holding and financing strategies for investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37Ninh Van Hien

Investing in real property: Some key tax aspects . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

Ninh Van Hien

Korea


Jae Won Lee and Na Rae Lee


Jae Won Lee and Deok Hyun SeoHolding and financing strategies for investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

Jae Won Lee and Deok Hyun Seo

Investing in real property: Key tax implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

Jae Won Lee and Chung Wha Suh


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Contents

Malaysia

Outline of the corporate tax regime . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

Leanne Koh Li Ann

Tax treatment of cross-border service by non-residents . . . . . . . . . . . . . . . . . . . . . . . . 55

Peggy Then

Holding and financing strategies for investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59Nicholas Crist

Tax planning for real estate investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63

Chew Theam Hock

The Philippines


Jim Nichols, in consultation with KPMG Manila


Jim Nichols, in consultation with KPMG ManilaHolding and financing strategies for investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73


Investing in real property: Some key tax aspects . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75


Pakistan


Shabbir Vejlaniand Asif Ali Khan


Shabbir Vejlaniand Asif Zia


Shabbir Vejlaniand Asif Zia

Investing in real estate: Some key tax aspects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

Shabbir Vejlani

India

The tax and legal system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

Amarjeet Singh

Taxation of cross-border services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95

Amarjeet Singh

Holding companies and financing operations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

Amarjeet Singh

Real estate investment: Key regulatory and tax aspects . . . . . . . . . . . . . . . . . . . . . . . 101

Amarjeet Singh


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Indonesia

The tax and legal frameworkGraham Garven andJim 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 ofgovernment.

Indonesia is the worlds 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 limitedliability 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 iscontrolled 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 aregenerally 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


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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 distributedomestically 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 countrys 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 parents 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 itsforeign 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 inIndonesia 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 enterprises

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


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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 (individualand/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 pricingprinciples 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 100percent 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 KPMGs Indonesian firm.

Jim Nichols is a Tax Manager in KPMG Londons InternationalCorporate Tax practice, specialising in Emerging Markets.

For further information, please contact the authors by email at:[email protected] and [email protected]

Indonesia: The tax and legal framework


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Tax treatment of cross-borderservice activities

Michael Gordon andJim NicholsKPMG 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 clients

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 atax 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 Indonesiansource 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, whichgenerally 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) aresubject 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


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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

importers 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 wordingin 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 Indonesias 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 combinedagreements, 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-15percent. 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 ofservices 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


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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.

Indonesia: Tax treatment of cross-border service activities

Table

Country/Territory

Technical serviceswithholding tax?

Constructionproject PE?

Services 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 NoSwitzerland 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 KPMGsIndonesian firm.


For further information, please contact Graham Garven ofKPMG Indonesia and Jim Nichols by email at: graham.garven@

kpmg.co.id and [email protected]


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Holding and financing strategiesfor investment

Graham Garven andJim NicholsKPMG 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 toprovisions 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 fromIndonesian 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 dividendwithholding 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


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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 andaccounting 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 swapagreement 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 maynot be justified by a potential interest withholding tax saving of

10 percent.

B. Deductibility of finance costs for an acquisition ofshares

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 taxplanning 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 islikely 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/Territory

Capital gainsprotection on

share disposal?

Maximumdividend

withholding taxa

InterestWithholding Tax

Australia No 15 10

China Yesb 10 10

Kuwait Yes 10 5

Netherlands Yes 10 10c

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 ofimmovable property located in Indonesia.

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

Graham Garven is a Tax Partner with KPMGs Indonesian firm.

Jim Nichols is a Tax Manager in KPMG Londons International

Corporate Tax practice, specialising in Emerging Markets.For further information, please contact the authors by email at:

graham.garven@ kpmg.co.id and [email protected]

Indonesia: Holding and financing strategies for investment


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Investing in real property:Some key tax aspects

Michael Gordon andJim NicholsKPMG 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 venturecompany 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, theproperty 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

owners land at the developers 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 anIndonesian 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 thegeneral 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 ofcommercial 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 beginningthe 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;


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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 estatecompany

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 Indonesias tax

treaties deny this exemption if the assets of the Indonesian

company are principally immovable property located inIndonesia. 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 thereare 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 treatedas 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 KPMGsIndonesian firm.


For further information, please contact Graham Garven ofKPMG Indonesia and Jim Nichols by email at: [email protected] and [email protected]

Indonesia: Investing in real property: Some key tax aspects


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China

The tax and legal frameworkMario Petriccione andWilliam 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

Peoples 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 asendangering 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 aWFOE 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


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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 Peoples Congress

promulgated the new Corporate Income Tax Law of the

Peoples 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 foreignparticipation 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 enterprises 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 enterprises 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 otherenterprises 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


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Tax treatment of cross-borderservice activities

Mario Petriccione andWilliam ZhangKPMG 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 businessagent. 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-sourceincome

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

persons 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. Inparticular, 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


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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 Chinas 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 any12-month period. As will be seen in the table, some of Chinas

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 customers 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 clients

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 clients premises gives

rise to a PE.

Another important difference among the PE Articles of Chinas

treaties is in the duration that a construction, installation orassembly 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 relevantperiod, 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 whichtreaty 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,

China: Tax treatment of cross-border service activities

Table

Country/ territory Technical services withholding tax? Service PE? Construction project PE?

Australia No Yes 6 months 6 months

Austria No Yes 6 months 6 months

Barbados No Yes 6 months 6 months

Canada No Yes 6 months 6 months

Cyprus No Yes 12 months 12 months

France No Yes 6 months 6 months

Germany No Yes 6 months 6 months

Hong Kong No Yes 183 daysa 6 months

Hungary No Yes 12 months 12 months

Ireland No No 6 months

Italy No Yes 6 months 6 months

Japan No Yes 6 months 6 months

Mauritius No Yes 12 months 12 months

Netherlands No Yes 6 months 6 months

Singapore No Yes 6 months 6 months

Spain No Yes 6 months 6 months

UK Yes 7%b No 6 months

US No Yes 6 months 6 months

a The Second Protocol to the China-Hong Kong Double Tax Arrangement which has taken effect from June 11, 2008 replaced the six months requirement with183 days in determining the service PE.

b But generally no withholding tax under domestic law.


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but this may well change as a result of the attention given to

this subject in many other countries and at OECD level.

IV. Other points to be considered

Of course, there will be considerations other than the above

that need to be taken into account in deciding how to carry

out business with China. First, and most obviously, in many

cases a PE will be unavoidable whatever the applicabledouble tax treaty. In such circumstances the choice will be

between taxation on a PE basis and setting up a local

subsidiary. A PE may give more flexibility (for example, profits

can be remitted to head office as they arise and the relevant

taxes have been settled rather than only after the financial

accounts for the year have been prepared and the transfers

to reserves required by law have been made), as well as

eliminating the charge to dividend withholding ta

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