Law firms should be quick out of the starting blocks in their preparations for the new levy based on the audit system of taxation, writes Liu Tianyong
Recently, the State Administration of Taxation (SAT) published the Announcement on Individual Income Tax Issues Relevant to the Employees of Law Firms (announcement No. 53), revising in a relatively significant manner the policy on individual income tax on employees of law firms. The document was implemented on 1 January 2013, and is explained as follows for reference by relevant people in the legal sector.
Levy based on audit to gradually become the main form of levying individual income tax on law firms. As early as 2002, the SAT issued the Notice of the State Administration of Taxation on Strengthening the Levy of Individual Income Tax on Investors in Law Firms and Other Such Intermediary Firms Based on Audit (Guo Shui Fa [2002] No. 123) expressly specifying that no region could subject law firms to the method of levying tax by assessment for the whole industry, and that those law firms that fulfilled the conditions for levy based on audit should be subject to the levy of individual income tax based on audit.
In May 2010, the SAT issued the Notice of the State Administration of Taxation on Further Strengthening the Administration of the Levy of Individual Income Tax on High Income Earners (Guo Shui Fa [2010] No. 54) emphasising that individual income tax was not to be levied on tax accountant, accounting, law and other such intermediary firms by the assessment method.
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Issues clarified
In recently issuing announcement No. 53, the SAT further clarified issues relating to the levy of individual income tax on the employees of law firms.
Accordingly, levy based on audit is replacing levy by assessment and will gradually become the main form of levying individual income tax on law firms. This is an irreversible trend in the development of the legal sector and is in closer keeping with the principle of fairness in the tax system, being conducive to focusing on the tax adjustment function of individual income tax.
Different tax rules apply to persons of different status at law firms. Generally speaking, the employees of law firms are divided into four categories, depending on their status: partners, associates, part-time lawyers and general employees. The individual income tax rules that apply to the taxable income derived by these persons from law firms are not entirely identical.
More specifically:
- Partners pay individual income tax with reference to the tax heading “production and operational income of individual proprietorships” based on all of the business income of the law firm for the year, calculating the income distributable to a partner in proportion to his or her capital contribution, or other percentage specified in advance.
- Associates pay individual income tax based on the “wage and salary income” tax heading. If an associate and the law firm have agreed on revenue sharing at a certain percentage and the associate bears the case handling expenses, the balance of the revenue share derived for the month in question remaining after deduction of the case handling expenses is combined with the wage paid by the law firm, and individual income tax is paid based on the “wage and salary income” tax heading. The percentage limit of the above case handling expenses that can be deducted has been revised upward from the original 30% to 35%.
- For part-time lawyers, the applicable tax rate is determined directly based on the entire amount of his or her income – and in the case of a revenue share, the balance remaining after the deduction of case handling expenses – and individual income tax is paid based on the “wage and salary income” tax heading.
- General employees pay individual income tax based on the “wage and salary income” tax heading.
With respect to the remuneration paid to other persons engaged in a lawyer’s personal capacity, individual income tax is calculated and paid based on the “service remuneration income” tax heading.
Accordingly, law firms are required to accurately differentiate the above persons of different status, and calculate and pay individual income tax by applying the regulations appropriate to each category.
Get up to speed
During the transition period, law firms are required to create compliant accounts and systems as soon as possible. As a significant number of law firms currently use the levy by assessment method, and lack strict cost accounting and financial management systems, announcement No. 53 provides a transition period running from 1 January 2013 to 31 December 2015. Once the transition period expires, the legal sector will ultimately have transitioned to the payment of taxes in strict accordance with tax laws.
Law firms should quickly improve their financial management systems and emphasise, in the course of their daily operations, the securing and management of lawful and valid vouchers. They should accurately account for their various costs and expenses and do their best to avoid economic losses arising from failures to obtain timely valid vouchers that make it impossible to deduct such costs and expenses before taxes.
Additionally, law firms should pay strict attention to the tax costs and tax-related risks that levy based on audit entails, paying particular attention to the scope of expenses that can be deducted before tax.
For example, pursuant to announcement No. 53, the expenses for the vocational training that a lawyer undergoes, as specified by the lawyers’ association, and that he or she bears personally, may be deducted in full.
However, this does not imply that the expenses for all vocational training that he or she takes part in can be deducted. In fact, the vocational training expenses that the tax laws permit to be deducted before taxes are limited solely to those for vocational training required by the lawyers’ association, and the expenses for all other forms of training that the lawyer takes part in at his or her own initiative are not eligible for pre-tax deduction.
In short, with the continuing development and progressive compliance of the legal sector in the PRC, levy based on audit will gradually become the main form of levying individual income tax on law firms.
Against this trend and background, it is in the best interests of law firms and lawyers to comply with current tax laws, strengthen their cost accounting, enhance their financial management systems, make their best efforts to obtain lawful and valid vouchers, and strictly understand the scope of expenses that can be deducted before taxes so as to guard against potential tax risks.
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Liu Tianyong is a tax lawyer and director of Hwuason Law Firm in Beijing. He is also deputy director of the Fiscal Law and Tax Law Committee at the All China Lawyers Association
