The State Administration of Taxation's (SAT) promulgation of Direction No. 27: "Notice on the Strengthening of Individual Income Tax Collection and Administration of Foreigners Working in China" in March this year has captured widespread attention from the Hong Kong business community. In addition to those who work in China, many people who have business operations in the Mainland have also expressed concern about the notice.

Direction 27 stipulates that foreigners or their guarantors will not be subject to further penalties if they declare and pay their overdue tax, as well as the additional 0.05 percent fine charged per day on the overdue amount. Failure to do so will result in possible prosecution and conviction if they are found guilty of evading taxes. On April 15, the Chamber invited a number of professional accountants to brief members on the issue.

Just ten years ago, few people working in China had to pay any individual income tax, but today it has become one of the government's main sources of tax revenue.

In the first quarter of 2004, total individual income tax revenues in China grew by 21.4 percent compared with the same period last year. In wealthy regions such as Guangdong, Beijing and Fujian, individual income tax revenues increased at a faster pace than any other tax category, including value-added tax, business tax and enterprise income tax. Other than income from wages and salaries, income earned from interest, dividends and bonuses are among the fastest growing taxable income sources, which clearly demonstrates that China's individual income tax regulations have been undergoing profound changes.

Individual income tax rates in China, while high compared to those in Hong Kong, are moderate compared to other countries. Income from wages and salaries in the Mainland is taxed according to a nine-grade progressive rate, ranging from 5 percent to 45 percent (for monthly income over 100,000 yuan).

The level of taxable income varies from area to area, but in general anyone earning 800 yuan or more per month has to pay income tax, while workers in big Mainland cities like Shenzhen and Guangzhou, start paying tax on incomes between 1,200 yuan and 1,600 yuan. For foreigners, including Hong Kong residents, the starting point is 4,000 yuan per month regardless of where they work in China.

The tax rate in China is around double that in Hong Kong, so while a Hong Kong resident earning HK$300,000 per year here pays about HK$30,000 in income tax to the Hong Kong government, in the Mainland, he would have to pay 60,000 to 70,000 yuan.

The current round of tax reform in China aims to unify the income tax systems for foreigners and locals. There have been suggestions that the starting point of both systems be standardised at 2,000 yuan, but to date there has been no news about any possible changes to the tax rates. As the guiding ideology of the tax reform is to lower taxes, foreigners are expected to pay less tax as a result of the adjustment, even though the starting point for collection will be lower.

Compared with Hong Kong, people in the Mainland are less aware of tax laws, which makes tax evasion and fraud more common. Collection of individual income tax is one of the biggest hurdles facing SAT and various local taxation bureaux. In an attempt to solve these problems, over the past two years SAT has stepped up its efforts to promote tax declaration and payment. Some notorious tax evasion cases, in particular the case by tax-dodging Chinese actress Liu Xiaoqing, have had a major impact. After the media reported on the case, the number of individual tax declarations jumped dramatically, especially among high-income earners.

What deserves attention is that foreigners working in their own countries usually pay tax willingly, but they seldom do so after moving to work in China. This can be attributed to China's unsound legal system. Taxation experts estimated that China loses 10 billion yuan annually in income tax payable by foreigners.

In China, foreigners generally earn more than local individuals and are therefore the main targets of the taxman. In 2001, after investigations by the tax office, workers at Microsoft China were ordered to pay overdue individual income tax amounting to 51 million yuan. In early 2003, some 52 foreign workers at Changchun's largest factory, Volkswagen, were ordered to pay 5.74 million yuan in overdue individual income taxes. Fortunately, no big cases have so far involved Hong Kong businesses.

Although Hong Kong and China have an agreement to avoid double taxation, this is of little help for people who have stayed and worked in the Mainland for less than 183 days. As a result, they must pay tax on income earned in the Mainland.

Despite SAT's release of Direction No. 27, most foreigners working in China are still taking a wait-and-see approach, with only a few opting to settle their overdue tax payments. Many foreigners worry if they do so then their employers will have to pay overdue enterprise income tax.

Presently, it is hard to judge whether SAT's initiative will achieve the desired results, and whether the taxman's commitment to investigating suspected tax-dodging foreigners lasts. At the time of writing, SAT was keeping a low profile.

Irrespective of how effective the current tax recovery exercise turns out to be, China is becoming increasingly strict about tax evasion. As the risks for failing to pay taxes are becoming more severe, Hong Kong business owners working in China need to make sure that their tax returns are up to speed.