REGULATIONS
Major Changes to China Corporate Tax Law
May 31, 2007
John Rieger, AFP

On March 16, 2007 the National People's Congress on China passed the unified Enterprise Income Tax law (EIT). This eight chapter, 60 articles revision to the current tax law is intended to modernize and to bring China's tax system in line with global tax norms.

China has had a very aggressive tax policy in place to attract companies to the country being especially focused on companies that could produce a product which can be exported to other countries. Along with the attractive tax structure, China has a very competitive wage structure which has attracted companies to set up business in the country in addition to attracting foreign companies with the ability to tap into the local market offered many advantages. The incentives to attract foreign investment has been so successful, the country is now in a position to reduce these incentives.

Foreign Investment Enterprises and Foreign Enterprises
To understand what kind of tax incentives have been in place but will now be changes, two important business entities need to be understood. The FIE and the FE. A Foreign Investment Enterprise (FIE) includes foreign companies established in the Peoples Republic of China (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.

Corporate Income Taxes
The basic corporate tax rate on profits had been 33% (30% national rate and 3% local rate). However, the Peoples Republic of China (PRC) had a much reduced tax rate for foreign businesses doing business in China. This reduced rate of approximately 15% was in place to attract foreign direct investment (FDI) into the country. The WTO and domestic companies had 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 until now.

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.

General Provision of New Tax Rules
The new law will tax most corporations at a rate of 25%. This will be a reduction in tax for domestic companies which have been tax at a basic rate of 33%. For FIEs and FEs who have enjoyed tax holidays and rates as low as 10%, this will generally mean an increase in the corporate income tax rate. There will be lower tax rate of 20% for qualified smaller companies and companies with small profit (a progressive tax rate). For FIEs subject to a lower tax rate, there will be a phase-in period of 5 years before the higher rate fully impact them.

High Tech and Other Incentives
Some technology companies within certain geographical locations will enjoy incentives of a reduced tax rate to 15%. High tech companies approved by the state located in special economic zones and the Pudong New Area would be eligible for the reduced corporate tax rates. There will continue to be some tax incentives in geographic regions for "encouraged enterprises" which are located in the western region.

A tax reduction may also be available for companies engaged in agriculture, forestry and animal-husbandry. Incentives are also available for environmental projects, energy/water conservation projects and R&D.

Level Playing Field
The intent of the new rules is to create a level playing field between foreign companies and domestic companies. For several years, the Chinese government has provided attractive tax incentives to foreign companies in order to attract business activity to the country and have been under pressure from the WTO and domestic businesses to change the incentive structure.

Tax Resident Enterprise
The new tax law introduces the "Tax Resident Enterprise" (TRE), a company which will be subject to income tax on worldwide income. A non-TRE would be subject to Chinese tax only on its China sourced income. This would trigger tax on FIEs registered in China and FEs whose effective management is based in China. The concept goes beyond the traditional "Permanent Establishment" rules.

The definition of a Nonresident Enterprise is one which is incorporated or organized outside of China with its effective management based outside of China.

Transfer Pricing Rules and Anti-Avoidance Rules
The new tax law does introduce some new rules on transfer pricing and anti-avoidance. The intent here is to limit a company's ability to set up multiple entities both within the jurisdiction and outside in order to manage the profit and the related taxes. The new laws generally provide for the following new measurers:

• Provides tax authorities with the ability to adjust taxable income where business transactions are arranged that lack a business purpose.
• Authority to limit the allowance of interest expense for companies determined to be too thinly-capitalized.
• "Controlled Foreign Corporation Rules" (CFC) for Chinese shareholders if the CFC retains profit within a low-tax jurisdiction without a valid business purpose. In these circumstances the Chinese shareholders may be taxed on their share of the undistributed profits.
• A clause that allows the authorities to impose an interest levy on tax adjustments made under this section

The authorities will look at related-party transactions on loans and income activity and will have the authority to shift the taxable impact if the transaction has no business purpose.

Timing
The new corporate laws are to become effective for years beginning after January 1, 2008.

Withholding Tax Uncertainty
Companies need to proceed with caution on their planning for withholding tax on profit repatriation. The general provision is for a new flat withholding tax of 20%. FIEs have enjoyed a withholding exemption on dividends and for interest, rents and royalties, they have been subject to a 10% withholding rate. Tax treaties may apply which could lower the withholding rate. Companies may which to wait for additional clarity on this issue.

Additional Regulations Needed
The tax document provides only the basic rules on the changes and will require that further regulations be worked on during this year to provide additional explanation to companies on how to actually apply the new rules.

Foreign Investment Planning
The old incentives made economic sense for China. They encouraged foreign investment and capital. The Chinese have been extremely successful in developing a dynamic economic base. Today, there is less concern about securing large amounts of foreign investment and more concern about controlling excessive and uncontrollable growth. Making sure that economic risk and financial volatility does not compromise the country through the reduction of these types of tax incentives represents a prudent move on their part. Incentives under the new tax law will still encourage investment in high technology and environmental activities, so foreign and domestic companies would still find a tax advantage in investing in these areas.

From a view of a business interested in doing business in China, it may be time to consider looking at structuring your activity using off-shore entities in jurisdictions with favorable tax treaties. However, watch out for the new transfer-pricing rules. There are still tax advantages for businesses interested in entering the activities listed above that would qualify for the lower tax rates attributed to R&D or that are in the environmental area.

Summary
The tax changes are good for China and for healthy global competition. The favorable tax treatment for foreign companies had been in place to attract companies. With China enjoying a 10%+ GDP annual growth rate, it no longer needs to provide incentives to attract business and it is time to allow the domestic market to compete on an equal footing with foreign companies.

A 25% corporate tax rate is in line with other large economies and should calm WTO concerns. Companies considering entry into the Chinese market will want to carefully evaluate their corporate structure, take careful consideration of these new rules and not rely on the prior tax laws and tax incentives when making their decisions.

Copyright © ChinaForum 2007