Tax Risks on Expatriates when Applying for Tax-free Rental Benefits
Expatriates that live and work in China continue to enjoy certain privileges when it comes to individual income tax (IIT) on their income, namely tax-free deductions for
- language training,
- school, and
- home leave travel.
The Chinese government has created these benefits to establish a favorable work environment for foreigners, which has contributed significantly to the Chinese economy's growth in recent decades. These benefits may lose effect at the end of 2021, but for now they remain an important part of an expatriate’s package in China.
Most foreign employees and their employers generally know which benefits are tax-deductible but are not always aware of the significant tax risks if some of these benefits are challenged. Failing to comply with the specific State Administration of Tax (SAT) regulations can lead to severe penalties and even legal prosecution.
Reasonableness of Rent Deductions
In practice, misunderstandings often arise on how to apply the tax deductions correctly. The policies regarding the rental tax-deductions cause the most confusion; for example, we often read that the maximum deductible tax amount is 50% of the total salary, as long as the employee can provide a rental fapiao to their employer.
In fact, Chinese law does not actually set any limitation on the proportion of income that can be spent on tax-deductible rental; it only emphasizes the need for reasonableness. Under the Notice of the State Administration of Taxation on Issues concerning the Implementation of an Individual Income Tax Levy or Exemption on Allowances of Foreign Individuals (Cai Shui Fa  No. 054), expatriates may declare rental expenses not subject to IIT on the following conditions:
- The compensation shall not be paid in cash (whether to the landlord or to the employee as reimbursement).
- The rental amount must be reasonable and be supported by valid fapiao.
Nowadays, an employer is left to make its own judgment on whether or not certain income should be subject to IIT, and to complete tax filings on time, and afterward the tax bureau can conduct random spot checks to confirm that all has been done correctly. If the tax bureau determines that the IIT filing for tax-free items does not comply with the law, then this is regarded as tax evasion and can have serious consequences.
The tax bureau will recover the unpaid tax from the employee and will usually charge a late fee of 0.05% per day. Moreover, the employee can be fined at between 50% and 500% of the unpaid tax; and as the withholding agent, the employer can be penalized at between 50% and 300% of the tax that it should have withheld. Moreover, if the employee has already left China or if the employer is deemed to have actively assisted the employee to avoid taxes, then the tax bureau may decided to charge the avoided tax, late fee and penalties directly to the employer.
As the law states that tax-free rental income should be "reasonable", the tax office has a lot of discretion to determine whether the employee and the company have acted so. As guidance, Shanghai tax bureaus will usually focus on the following when completing spot checks:
- The lease agreement must be signed by the landlord that has the building property certificate, and the employee must actually live there. In the case of a sublease, a sublease agreement must be signed as endorsement.
- The rental should be paid directly to the landlord and the landlord must issue the fapiao (legal invoice) to the employee or the employer based on the lease agreement. If the landlord is an individual, they will need to go to the tax bureau where the property is located to issue the fapiao. All items in the fapiao should comply with current regulations.
- The rental should be based on the lease agreement. The local tax bureau will also verify that the amount of rent is in line with local market prices.
- Within the same period, a property can only be used by one person to claim the tax-free benefit. If there are multiple tenants simultaneously, then they may need to sign lease contracts with the landlord separately. The local tax bureau will then consider whether the total monthly rent is reasonable.
- If necessary, the tax bureau will require other supporting documents and may ask to interview the landlord.
Companies and individuals should always make sure that they comply with the requirements of their local tax bureau, and should always keep the above materials on file so that they can immediately respond to a tax bureau's inspection. Moreover, where international companies outsource their IIT tax filing work to an external agent or corporate service provider, they should double-check that the service provider is familiar with the requirements for deductions and is able to stay up-to-date with all policy changes.
R&P is a full-service law firm; our tax department supports foreign clients and their Chinese subsidiaries on tax-relates issues in China. Many clients outsource their administrative and compliance functions to R&P's affiliate Acclime China, which provides a full range of services including custodian of stamps and licenses, treasury, payroll, and accounting + tax filing assistance. For more information, please contact Gina Chen ([email protected]), Maarten Roos ([email protected]) or your familiar contact person.