“Establishment”: A Core Concept in Chinese Inbound Income Taxation

A basic similarity between the Chinese approach to international income taxation and that of many other countries is the two-tiered system China uses to tax inbound foreign investments: some items of income earned by foreigners are taxed on a gross-income basis, primarily by way of withholding, while others are taxed on a net-income basis, through the filing of annual tax returns that account for both income and expenses. In the U.S., as a comparative example, whether an item of income is subject to one or the other mode of taxation turns upon whether the foreign recipient of income is engaged in a “trade or business” in the U.S. and whether the income is “effectively connected” with such U.S. trade or business. In China, a similar determination for a foreign non-individual taxpayer depends on whether the foreign entity’s income is effectively connected with an “establishment or site” (“jigouchangsuo,” or “establishment” for short) in China.2 The existence of this point of resemblance between Chinese and American inbound income taxation is in itself unsurprising. There is, after all, the income tax treaty concept of “permanent establishment,” which determines whether the business profits of an enterprise are taxable on a net-income basis in the country where the income arises. This suggests that most countries adopt some combination of taxation on the basis of net and gross income for inbound investments. However, U.S. tax lawyers generally are careful in distinguishing between domestic and treaty law concepts. In the U.S., for example, the “U.S. trade or business” concept carries most of the weight in determining whether foreigners might be taxable on a net-income basis, whereas the “permanent establishment” concept performs, for the most part, a secondary function in determining how a nonresident would be taxed in the U.S. Similarly, it is prudent to expect that the “permanent establishment” concept would not capture how other countries draw the line between net- and gross-income basis taxation, and this determination for a foreign investor in China will rest on the interpretation of the domestic Chinese concept of “establishment.” How China has drawn this line in the past, and how it might redraw it in the future, is the subject of this Article.

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