What are the available corporate income tax incentives for companies in China? Are there any special tax incentives for foreign invested companies?
The new corporate income tax primarily abolished tax incentives available to foreign invested companies and removed tax preference geared to geographic locations. New preferential tax treatment aims to encourage industries and activities in various ways such as tax reduction or exemption, reduction of taxable income, tax holidays, reduced tax rates, tax credit and super deduction. Some major tax incentives for qualified PRC companies are summarized as follows:
- Tax Reduction/Exemption on Income from Qualified Technology Transfer. Income of up to RMB5 million derived from qualified technology transfer within a tax year is exempt from tax, and any income in excess of RMB5 million is taxed at a 50% reduced rate.
- Reduction of Taxable Income. 10% of the income derived from the comprehensive utilization of resources is deductible in calculating income tax liability.
- Tax Holiday. Starting from the first income generating year, qualifying public infrastructure facility projects, environmental protection, and energy- and water-saving projects are entitled to a three year tax exemption followed by a three year 50% reduced tax rate.
- Reduced Tax Rate. High and new technology enterprises are entitled to a 15% reduced tax rate.
- Tax Credit. Investment in qualifying environmental protection equipment, energy and water conservation equipment, and production safety equipment is entitled to a tax credit in the amount of 10% of the investment price. The excess credit can be carried forward for five years.
- Super Deduction. For a period of more than two years, 70% of a venture capital investment in a small and midsize unlisted high and new technology enterprise may be deducted from the company’s taxable income.
What are the top challenges that foreign companies have in China with respect to tax issues?
China tax authorities are now strengthening their revenue collection efforts and imposing penalties for noncompliance. In particular, transfer pricing has become a major focus for tax authorities. They have expanded their efforts in training tax officials at the local and state levels. Independent departments dedicated to fighting tax avoidance have been formed in major cities, and the number of officials involved in tax avoidance cases is increasing. Also tax officials have become more sophisticated in terms of transfer pricing investigation and their level of transfer pricing knowledge. In recent years tax authorities have launched a number of transfer pricing audits mostly targeting those multinational companies with a significant number of cross-border transactions with related parties. The new corporate income tax law awarded tax officials the authority to make retroactive adjustments for up to 10 years as well as introduced late payment interest for transfer pricing adjustments, which was waived under the old corporate income tax system. The price for noncompliance can be very high, and it is therefore essential that foreign operators in China review their tax positions, especially their transfer pricing policies, and have a well managed tax compliance program in place to reduce the risk of audits and investigations.
What types of cross-border transactions are eligible for tax deferral treatment under the new M&A tax rule?
Under the old corporate income tax law, foreign investors were allowed to transfer their equity interest in a PRC company on a cost basis without recognizing any gain or loss in the course of group restructuring. This preferential treatment is abolished under the new tax law. According to the M&A tax rule promulgated recently, only the following types of cross-border transactions are entitled to a tax deferral:
- Transfer by a non-resident company to its 100% owned non-resident company of its interest in a China-based company, provided that the PRC capital gain withholding tax rate for the transferor parent is the same as that of the transferee subsidiary and the transferor parent does not transfer its interest in the transferee subsidiary within three years after the equity transfer.
- Transfer by a non-resident company to its 100% owned PRC resident company of its interest in another PRC resident company.
- Transfer by a PRC company of its assets/equity to its 100% owned non-resident subsidiary in exchange for the subsidiary’s equity interest.
In addition the transaction must satisfy the following conditions to qualify for tax deferral treatment: (i) the transaction must have a bona fide business purpose and the primary purpose cannot be that of reducing, avoiding and deferring tax payment, and (ii) the original business operating activities of the target company must continue for 12 months after the reorganization.
What are the risks of using an offshore shareholding structure?
Offshore holding companies are widely used by foreign investors to structure their investments in China. The foreign investors will be able to enjoy the treaty benefits such as a reduced rate of dividend, interest and capital gain if the intermediate holding company is in a jurisdiction with a favorable tax treaty with China. However with the issuance of several rulings in recent months, the offshore holding structure no longer proves to be a viable tax planning vehicle in certain cases, and the entitlement to tax treaty benefits does not seem automatic.
In one ruling, the tax authority found out that a holding company in Singapore does not have any commercial substance. It does not carry on any business activities and has minimal registered capital. The tax bureau decided that the holding company was set up with the primary purpose to take advantage of the preferential treatment under the Sino-Singapore tax treaty and to reduce or avoid tax payments. The tax bureau determined that the holding structure failed the “commercial viability test” under general anti-avoidance rules in China and thus redefined the transfer of the interest in the Singapore holding company as a de facto transfer of interest in the China-based subsidiary and denied the benefit of the Sino-Singapore tax treaty.
In another ruling, the tax authority rejected the application of a capital gain tax provision in a Sino-Barbados tax treaty in a disposal by a Barbados company of its PRC investment. The tax bureau concluded that the Barbados company does not have an adequate presence in Barbados to be considered a resident of Barbados. Although its is registered in Barbados, it does not have management there, all its three directors are US nationals and no director is based in Barbados. More importantly, the tax authority is concerned about the pre-structuring of a series of transactions and an apparent tax avoidance motive – e.g., the short timeframe between the establishment of the Barbados company and acquisition of the China-based company as well as that between the acquisition and disposal of the China-based company. The tax authority finally concluded that the transactions are structured to take advantage of the favorable capital gain rate under the tax treaty and denied the application of the treaty.
The offshore holding structure is under increased scrutiny by the tax authority. It is important that foreign investors review their holding structure to ensure that it has sufficient business substance and commercial activities as well as to maintain proper documentation that will support the reasonable business purposes of the holding company and withstand challenges from the tax authority.