WHITE PAPER
Basics of Chinese Business Taxes
September 13, 2006
John R. Rieger, CPA

This whitepaper provides a brief, general overview of some of the corporate tax laws for the Peoples Republic of China.

Introduction
When expanding internationally, one of the important issues for a company to consider is the tax cost and administrative obligation. A country may have an attractive wage base but if the government taxes any potential savings, a company might be better off staying where it is.

China has a very competitive wage structure which makes companies look very closely in setting up business in the country. In addition, the ability to become local and tap into the local market also offers many advantages. China has had a policy in place to attract companies to the country. They have been especially focused on companies that can produce a product which can be exported to other countries.

Foreign Investment Enterprises and Foreign Enterprises
The Chinese government has focused on attracting business to China through various economic and tax incentives. Two important business entities need to be understood in relation to corporate taxes in China in order to receive tax incentives, FIE and FE. A Foreign Investment Enterprise (FIE) includes foreign companies established in the PRC, Chinese-foreign joint ventures and companies established in the PRC. A Foreign Enterprise (FE) is a foreign company that is not a Chinese legal entity but has an establishment in the PRC that is engaged in production or other business activity.

The distinction is important because an FIE will be taxed in China on its worldwide income just as any domestic company while the FE will be taxed on only the profit earned in the PRC.

Corporate Income Taxes
The basic corporate tax rate on profits is 33% (30% national rate and 3% local rate). However, the Peoples Republic of China (PRC) has had a much reduced tax rate for foreign businesses doing business in China. This reduced rate of approximately 15% has been in place to attract foreign direct investment (FDI) into the country. The WTO and domestic companies have recently been pressuring the government to introduce a unified tax regime claiming that the current system favors foreign companies and discriminates against domestic companies. There has been talk about this unification project for several years but with little movement. The last discussion suggests that tax unification could happen in 2008.

The 33% and 15% tax rate can be reduced to 24% or 15% depending on the location of the company. Companies located at coastal cities are taxed at 24% and companies located in special economic development zones can pay as little as 15% tax rate.

See also: Foreign Companies in Pudong Could Lose Tax Breaks

Withholding Rules
Dividends, interest, royalties and lease payments made to non-residents are generally subject to a 10% withholding requirement. This rate may be lower if there is an existing tax treaty between China and that country which allows for a reduced rate. For United States non-residents, the established 10% withholding rate is equal to the existing tax treaty rate. In some cases lease payments or royalty payments may be exempt from the withholding requirements.

Dividends Received by an FIE
Dividends received by an FIE are not taxable. Dividends from an FIE in the PRC and received by foreign investor are tax exempt.

Tax Incentives
There is a tax holiday of two years for a manufacturing FIE. This means that there is no tax on any profit of the company for the first two years. During the next three years there is a 50% tax rate reduction starting after the company uses up any tax losses. With the current pressure by domestic companies on the PRC to remove foreign preferences, the current tax holiday provisions could be at risk. Note that in order to be able to operate under a tax holiday, a company must receive government approval.

Losses
Companies are allowed to carry forward their tax losses for a period of five years. The current tax law does not allow for a carryback of tax loses.

Depreciation
Assets are recorded as a capital asset and may be depreciated using the straight-line method after at least a 10% salvage value is accounted for. Buildings are depreciated over 20 years, machinery and other equipment is depreciated over 10 years electronic equipment, appliances, tools and furniture are depreciated over 5 years.

Amortization
Intangible assets can be amortized using the straight-line method over a period of not less than 10 years.

Entertainment
Entertainment expenses are subject to a percentage limitation of net sales of a company in China.

• Over RMB 15 million- not to exceed .3% of net sales
• RMB 5 million to15 million- not to exceed .5% of net sales
• RMB 5 million or less- not to exceed 1% of net sales
  

Management Fees
The PRC has rules which limit the deduction of management fees paid to an overseas office or related entity. Management fees are generally not allowed as a deduction however certain administrative reimbursements may be allowed.

Employee Expenses
There is a difference between what a domestic Chinese company is able to deduct in arriving at taxable income and what a foreign company is allowed to deduct in arriving at taxable income. For the foreign company, the full amount paid to an employee is deductible. For the domestic company as of July 1, 2006 a company can only deduct 1,600 Yuan ($200.00) in arriving at taxable income. The 1,600 Yuan is an improvement from the prior limit of 800 Yuan.

Accounts Receivable and Bad Debts
Unless a company is in the business of providing credit or leases, it may not record a provision for bad debts for tax purposes. If you do qualify as providing credit or leases, a company may record a provision not to exceed 3 ½ percent for doubtful accounts provided that approval is obtained from the local tax authorities.

Accounts can be written off if the customer becomes bankrupt, dies, or has failed to repay the debt after two years. Any company expecting to do business in China better know that collecting payments is a major problem. The reason that you can write off your accounts receivable after two years is because the statutory limitation period for debt collection in China is only 2 years. Smart customers only need to drag their feet for this two year period and then there is no legal requirement for them to ever repay you. If you can do business COD, you will be in the best position.

Inventory
Inventory is generally valued at cost. An FIE may choose first-in-first out (FIFO), last-in-first out (LIFO), moving average or weighted average.

Transfer Pricing Rules
It should be noted that PRC State Administration of Taxation-China has developed transfer pricing rules which companies are required to comply with. Transfer pricing rules lay out pricing requirements when selling products between related entities from a Chinese company and a related company from another country. The rules discourage the manipulation of pricing between related entities which may have the effect of shifting profit and the related taxes from one jurisdiction to another.

Tax Treaties
On January 1, 1987 the Peoples Republic of China and the United States signed a tax treaty allowing for the elimination of double taxation. Income and the related tax may be credited in the other jurisdiction.

• Dividend Income Withholding is 10%
  
• Interest Income Withholding is 10%
  
• Royalty Income Withholding is 10%
  

Rules on Capital Gains
Asset gains are taxed as ordinary income with no special capital gains tax rate.

Land Appreciation Tax (LAT)
Real estate is subject to a land appreciation tax which is on the gain realized from a real estate transaction. The rate is progressive and ranges from 30% to 60%. The gain is the difference between the consideration received and the basis. Basis includes cost of the property, costs of developing the land and costs of any building or structure.

VAT (Value Added Tax)
China, like most other countries except the United States, imposes a value added tax at a current rate of 17%. U.S. businesses that have little or no experience with VAT should educate themselves on how this production tax works. A tax is generally applied on the value added to a product while it is in your possession. If you happen to be at the end of the production chain meaning that you will be selling the product to the consumer, you will be collecting the full value VAT. However, you will be allowed an offset against this amount for the VAT that you may have paid when you purchased the raw material or uncompleted product for sale.

On certain tangible goods the rate may be reduced to 13% if the goods qualify. There is a tax on the transfer of services and intangible goods ranging from 3% to 20% depending on what is being transferred.

Turnover Tax
A turnover tax is basically a tax on activity similar to the VAT. This is very much like a sales tax on services. The rate is approximately 5% of the revenue.

Customs Tax
Goods either imported or exported may be subject to customs taxes. The rate is dependent upon what kinds of goods are being imported. An FIE may be exempt from paying customs duty and/or VAT on certain qualifying equipment or technology imported for corporate use.

Property Tax
There is a tax on owners and users of real estate at a rate of 1.2% of the original value of the property. Local governments may offer a property tax reduction. In addition, a tax may also be assessed on the rental value of the property.

Employment Taxes
Companies only accustomed to working in the U.S. may be in for a shock on how much they need to pay in employment taxes. The required taxes in the PRC based on employees gross wages is 44%.

Disclaimer: This article provides only a brief, general overview of some of the corporate tax laws for the PRC. There are several other taxes a company may be subject to and rules on taxes which are often changing. Companies should consult a tax professional before making any business decisions. AFP is not a tax adviser.This article is not intended to provide legal, financial or professional advice of any kind.

About the Author:
John Rieger is Director of Accounting and Financial Reporting for the Association for Financial Professionals.

He is also a former Advisor on Transparency and Disclosure Issues for the Organization for Economic Cooperation and Development (OECD), corporate governance, anti-corruption, global accounting and auditing issues, as well as a former Senior Accounting & Audit Advisor for the United States Agency for International Development, Washington, D.C. Duties included Washington-based policy and project development, including project management for Central Asia and Southeastern Europe.  One of his tasks was to dismantle the payments system that had been put in place by the former Yugoslavian dictator President Tito and, with the help of the U.S. Treasury, International Monetary Fund (IMF) and World Bank, establish a legitimate banking system in the region.

Prior to that, he was a member of the United Nations Commission on Trade and Development (UNCTAD) Inter-governmental Working Group of Experts on International Standards of Accounting and Reporting, where he developed accounting standards for Small and Medium Entities, as well as a former member of UNCTAD Inter-governmental Working Group of Experts on Corporate Governance, where he developed corporate governance guidelines for developing and countries and those in transition. He also was a former member of Trust and Company Service Providers Working Group for Offshore Banking Supervisors to develop regulations for offshore trust and service providers.

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