Transfer Pricing _ China and tax gross up on intercompany invoice

 It is required to change your current billing model for this transaction.

The current flow China entity (Trainer cost) -> US entity (Enterpreneur)  -> SG entity (invoicing entity to the customer) is not compliant because it doesn't reflect the economic substance of the transaction.

1. The Core Principle: "Arm's Length" & Economic Substance

The China tax authority's response is based on a fundamental global tax principle: Transfer Pricing 

• Economic Substance: The entity performing the service (China) must charge a fair, market-based price ("arm's length") to the entity that is benefiting from that service (SG which holds the contract with the end customer)
• China entity is performing work in China, so it must earn a taxable profit in China for that work.
• The Problem:  flow (Beijing -> the US) breaks this link. China entity is doing work for SG, but billing a third party (US entity). The tax authority sees this as an artificial arrangement that potentially shifts profit out of China.

2. How the "Last Resort" Subcontracting Model Must Work

This model is intended to make the billing follow the actual flow of services.

 * Step 1 (Prime Contract): SG (Singapore) signs the main contract with the China customer for $80,000.

 * Step 2 (Subcontract):  SG signs a separate intercompany agreement with China to perform the on-site training services.

 * Step 3 (Service & Invoice 1): China performs the training. It then issues an invoice directly to SG for its services. This invoice must be for its costs plus a markup (e.g., costs of $10k + 10% markup = $11,000 invoice).

 * Step 4 (Service & Invoice 2): US (as the IP owner) issues its 95% "IC cost" invoice directly to SG.

This directly answers your question: "This means that China does not raise invoice to entity that invoices customer?"

Answer: No, it means the opposite. In the subcontracting model, China must raise an invoice to the entity that invoices the customer (SG).

The part of your current structure that must change is: China to invoice all trainer costs to US. This is the step the tax authority is rejecting.

3. Comparison of Models

Seeing the two flows side-by-side makes the conflict clear.

Model A: Your Current (Problematic) Structure

 * Customer pays $80k to SG.

 * China performs the service, then invoices its costs (e.g., $10k) to US.

 * US then invoices 95% of revenue ($76k) to SG.

 * Result: China shows no profit from the entity it actually provided the service to. This is a red flag for the China tax authority.

Model B: The "Subcontracting" (Compliant) Structure

 * Customer pays $80k to SG.

 * China performs the service, then invoices its arm's length price (e.g., $11k) directly to SG.

 * US invoices its IP/royalty fee directly to SG.

4. The Critical Question This Raises: The 95% Calculation

This new, compliant model creates a significant problem that must solve internally.

If  SG receives $80,000 but has to pay:

 * $11,000 to China (for services)

 * $76,000 (95% of $80k) to US (for IP)

...then SG would lose $7,000 ($80k - $11k - $76k = -$7k). This is clearly not the intention.

This means the 95% calculation must be re-evaluated.

The 95% "IC cost" from US is almost certainly intended to be 95% of the net revenue (or profit) to be split, not 95% of the gross invoice.

Here is how that would likely work:

 * Gross Revenue (to SG): +$80,000

 * Less: Local Subcontracting Cost (to China): -$11,000

 * = Net "Profit to be Split": $69,000

 * US (IP Owner) Share (95%): $69,000 * 95% = $65,550 (This is the IC invoice from US to SG)

 * SG (Invoicer) Share (5%): $69,000 * 5% = $3,450 (This is SG's retained profit)

In this compliant model:

 * China earns a $1,000 taxable profit in China (satisfying the tax authority).

 * SG earns a $3,450 taxable profit in Singapore.

 * US receives the remaining $65,550 profit.

Need to confirm this new billing flow and, most importantly, the new basis for the 95% IC cost calculation with her internal finance and tax teams.

 

Tax Gross-Up on China VAT 

the Chinese customer will almost certainly have to account for 6% VAT on the $53k invoice you send from Singapore.

However, they will not pay it to you. They will almost certainly withhold it and pay it directly to the Chinese tax authorities. This creates a significant cash-flow problem for you, as your calculation will leave you short.

Here is a breakdown of the two separate tax events and the problem they create.

The Two Separate VAT Transactions

The key to understanding this is that there are two distinct transactions, each with its own VAT consequence.

 (1) Transaction 1: The Internal Cost (China to Singapore)

   * What happens: Your China entity provides services to your SG entity. The service is performed in China.

   * VAT Consequence: This is a taxable service in China. Your China entity correctly charges your SG entity 6% VAT.

   * The Cost: As you noted, this 6% ($3k, assuming a $50k cost base) is an unrecoverable "sticky cost" for the SG entity.

   * Your Action: You correctly identified this cost and added it to your price, raising it from $50k to $53k to cover it.

(2) Transaction 2: The External Sale (Singapore to China)

   * What happens: Your SG entity (a foreign company) invoices the Chinese customer for services that were performed in China.

   * VAT Consequence: This is considered an "imported service" under Chinese tax law. Because the service is consumed in China, it is subject to Chinese VAT (6%).

(SG entity as a foreign company invoices the Chinese customer for svcs performed in China. Under China's "place of consumption" rules, these are considered imported services and are subject to VAT. Because SG entity is not registered for VAT in China, the law requires the Chinese customer to act as a withholding agent and pay that 6% VAT directly to the tax authorities)

   * The Problem: Your SG entity is not registered for VAT in China, so it cannot issue a VAT fapiao (invoice). The responsibility to pay the VAT shifts to the buyer.

   * The Mechanism: Withholding / Reverse Charge: The Chinese customer is legally required to act as a withholding agent. They must calculate the 6% VAT on your invoice and pay it directly to the Chinese tax authorities on your behalf.

Why Your $53k Price Will Fail

Let's walk through the cash flow based on your proposed $53k invoice.

 * Your Invoice: SG entity sends an invoice for $53,000 to the Chinese customer.

 * Customer's Calculation: The customer receives the $53k invoice. They are required to withhold 6% VAT (and possibly minor surcharges).

   * VAT to Withhold: $53,000 X 6% = $3,180

 * Customer's Payments:

   * Payment to Chinese Tax Bureau: $3,180

   * Payment to Your SG Entity: $53,000 - $3,180 = $49,820

 * Your Financial Result:

   * Your total costs (list price + internal VAT): $50,000 + $3,000 = $53,000

   * Your total cash received: $49,820

   * Your Net Loss: $49,820 (Revenue) - $53,000 (Cost) = -$3,180

You have effectively paid the 6% VAT twice: once as an unrecoverable cost from your internal transaction, and a second time as a withholding from your external revenue.

The Solution: "Grossing-Up" the Invoice

To achieve your goal (receiving $53,000 to cover all your costs), you must calculate an invoice price that accounts for the 6% withholding. You need to "gross-up" the price.

Here is the formula:

How the Correct Calculation Works

 * Your Invoice: SG entity sends an invoice for $56,383 (rounding up).

 * Customer's Calculation:

   * VAT to Withhold: $56,383 X 6% = $3,382.98

 * Customer's Payments:

   * Payment to Chinese Tax Bureau: $3,382.98

   * Payment to Your SG Entity: $56,383 - $3,382.98 = $53,000.02

 * Your Financial Result:

   * Your total costs: $53,000

   * Your total cash received: $53,000 (approx.)

   * Your Net Result: Breakeven (as intended)

Critical Action Items

 * Review the Contract: The contract with the customer is paramount. It must explicitly state that the SG entity will receive its fee "net of any and all local taxes and withholding," or it must use the "grossed-up" price. If the contract just says "$53,000," you will only receive $49,820.

 * Check for Other Withholdings: The 6% VAT is not the only risk.

   * Surtaxes: There are often small surtaxes (e.g., Urban Maintenance and Construction Tax) calculated on top of the VAT, which can increase the withholding slightly.

   * Permanent Establishment (PE): This is a major risk. Having a trainer (an employee or contractor of one of your entities) physically performing services in China for a customer could create a "Permanent Establishment." If your activities create a PE, the profits from this project (not just the service fee) could become subject to Chinese Corporate Income Tax (CIT), which is a much higher withholding (often 10% or more).

Given the structure you've described, this transaction carries a high risk of both VAT withholding and potential PE creation.