Working in Asia: China's New Enterprise Income Tax Law and Recent Implementation Rules
The first such set of implementation rules was released on December 11, 2007, and it provided clarity on many of the new concepts and tax incentives included in the law. Below, we summarize the law's headline provisions and the main implementation rules, and look at the impact of these measures on the investment environment in China.
Standard Tax Rate & Grandfathering Provision
- The EITL established a standard 25% tax rate (reduced from 33%), that applies to both domestic and foreign-invested enterprises. Previously, domestic Chinese firms faced a 33% tax rate, while most foreign invested enterprises (FIEs) engaged in manufacturing enjoyed preferential status that resulted in an average effective tax rate of 15% among all FIEs in China.
- A grandfathering provision is included that allows firms that enjoyed tax rates substantially lower than 25%, due to location-based and other incentives, to have their tax rates rise gradually to 25% over a 5-year period. Firms that were "approved to be established" (i.e., their business license was issued), before the EITL was enacted on March 16, 2007, qualify for this transitional relief.
- Dividend Withholding Tax: After much deliberation following the passage of the law, the implementation rules included a provision reducing the statutory dividend withholding rate from 20% to 10%.
- Withholding for Interest, Royalties, Gains, etc.: These types of income will be subject to a 10% withholding rate.
- Note for foreign investors: Several of China's tax treaties include a lower withholding tax rate for dividends and other types of income. Companies might look to ownership restructuring to help mitigate these higher rates, while being mindful of the anti-avoidance rule.
- Any firm that qualifies as a "new and high-tech enterprise" can enjoy a 15% tax rate. The criteria for qualifying for this incentive are: independent ownership of "core IP rights"; products or services included in the "State Encouraged High and New Technology Catalog," to be released later; R&D expenditure and income from high-tech products/services that each exceed a required minimum percentage of annual revenue; and a number of R&D personnel that exceeds the required percentage of all employees.
- Qualifying R&D expenditures are able to be taken as a 150% super-deduction. The implementation rules do not outline qualification criteria for the super-deduction, but do mention the development of new technologies, products or techniques. It is unclear whether or not there is a requirement that any IP created from qualifying R&D activities be the legal property of the firm performing the R&D. Any qualifying R&D costs included on the income statement are allowed an additional 50% super deduction.
- There are a number of incentives covering certain activities and industries:
- Many activities in the agricultural, fishery and forestry industries enjoy a full exemption, while other activities in these industries enjoy a 50% reduction from the standard 25% tax rate.
- Major state-sponsored public infrastructure projects will be subject to a three-year exemption, followed by a 50% reduction in the standard tax rate.
- Qualifying projects focused on environmental protection will also enjoy a three-year exemption, followed by a 50% reduction in the standard tax rate.
- Any qualifying technology transfers by resident enterprises will get an income tax exemption up to RMB5 million, and any income in excess of the cap will be subject to a 50% reduction from the standard tax rate.
- The final tax incentive of note is applicable to venture capital firms that invest, for more than two years, in private new or high-tech enterprises that are small or medium-sized. These VC firms will be able to deduct 70% of the amount of their investment from their taxable income in the second year, and unused deductions can be carried forward.
Other Notable Provisions
- Definition of Residence: The implementation rules only vaguely define concepts of management and control, but the focus is more on active management of operations than on a board of directors, oversight approach. Residence hinges on whether there is substantial and comprehensive management and control over manufacturing and business operations, including personnel, facilities/properties and accounting functions.
- "Establishment" of a Non-Resident Enterprise: The statute and implementation rules both use the term "establishment" rather than "permanent establishment," and present a broader framework than common tax treaty definitions. For example, the placement of any business agent in China to deliver or store goods would qualify as an establishment. Moreover, there is no exception for "agents of independent status." Finally, the Chinese government is attempting to treat consulting and other services performed in China as an establishment, even if the service provider does not have a place of business in China.
- Transfer Pricing Documentation: Beginning in 2008, firms will need to produce "contemporaneous documentation" for related-party transactions, including such aspects as pricing, computation methods, expenditure standards, and any explanatory notes. It is not clear as yet whether these documents will need to be filed along with annual tax returns, or can be held for any future examination by tax authorities.
- Controlled Foreign Corporation (CFC) Rule: The definition of CFC follows the U.S. statutory definition. A foreign enterprise will be considered a CFC when China resident enterprises and individuals each indirectly or directly hold 10% or more of total voting shares, and jointly hold more than 50% of total shares. "Substantial control" provisions cover circumstances when these ownership percentages are not met. Finally, for a foreign enterprise to be subject to CFC rules, the firm must have an effective tax rate of less than 12.5%
Implications & Conclusion
The EITL and subsequent implementation rules are designed to fulfill the Chinese government's main objective of leveling the playing field for domestic firms versus foreign firms, after years of special tax rates and incentives favoring foreign investors in China, especially in the manufacturing sector. In addition, with its focus on "high-tech" and other industry tax incentives, the EITL is aligned with China's overall goal of moving Chinese industries up the value chain and focusing foreign investment on higher value-added activities.
For foreign investors, these changes necessitate a reassessment of a firm's China tax strategy, and more broadly, could raise questions of overall investment strategy, China business model, site selection, and how to finance investments. Firms with established or potential investments in China should do a comprehensive review of their China tax strategy, with particular attention to how their China approach fits in with a globally efficient tax strategy. In the future, firms might have to employ more traditional tax planning methods, such as the use of different supply chain, transfer pricing, and intellectual property structures, in order to lower their China tax burden. Finally, foreign investors will want to keep apprised of future releases of implementation rules and ministry circulars, which will further clarify China's corporate tax system.