On April 16, 2009, the Ministry of Finance (MOF) and the State Administration for Taxation (SAT) jointly issued the Circular on Policies Regarding Pre-Tax Deductions of Asset Losses. The Circular is retroactively applied to January 1, 2008, the date on which the PRC Enterprise Income Tax Law (the New EIT Law) and its Implementation Rules (the Implementation Rules) came into effect.  

The New EIT Law and Implementation Rules provide a definition of “losses,” and generally allow EIT taxpayers to deduct losses (minus recoverable amounts from responsible parties and insurers) for EIT purposes in accordance with the rules provided by finance and taxation authorities at the central government level. On September 1, 2005, before the New EIT Law took effect, the SAT promulgated the Administrative Measures on Pre-Tax Deductions of Property Losses,  to guide the deduction of property losses for EIT purposes. Until the Circular was issued, it was unclear whether EIT taxpayers should comply with the Measures in deducting their asset losses for EIT purposes in tax year 2008. The Circular has resolved this ambiguity, and provided EIT taxpayers and competent taxation authorities with clearer guidance on the deduction of various asset losses under the New EIT Law

Compared with the Measures, the Circular is concise and practical. First, it replaces the phrase “property losses” with “asset losses,” a new concept in Chinese law that has a broader scope than “property losses.” This change benefits EIT taxpayers since it allows for the deduction of a wider range of losses for EIT purposes. Next, the Circular divides asset losses into eight categories:  

  1. Cash losses;
  2. Deposit losses;  
  3. Non-loan bad debt losses;  
  4. Loan losses;  
  5. Equity investment losses;  
  6. Fixed asset and inventory losses due to shortage, damage, depreciation or theft;  
  7. Losses due to natural disasters or other force majeure events; and  
  8. Other losses.  

Then, the Circular explains the conditions under which each category of asset losses may be deducted for EIT purposes.  

Perhaps the most noteworthy provision of the Circular relates to the deduction of equity investment losses. Under the Circular, an EIT taxpayer investor (an Investor) is entitled to deduct its equity investment losses (less the recoverable amounts) for EIT purposes as long as one, or any, of the following conditions is met:  

  1. The investee in which the investor has bought equity (the Investee) has been declared bankrupt, shut down, dissolved or revoked, or the Investee’s business license has been deregistered or suspended;  
  2. The Investee suffers a severely adverse financial effect, incurs huge cumulative losses, and has discontinued its business operations for more than three years without a plan to resume operations;  
  3. The Investor has no control over the Investee, the investment period has expired or exceeded 10 years, and the Investee has become insolvent due to three consecutive years of losses suffered;  
  4. The Investee suffers a severely bad financial effect, incurs huge cumulative losses, and has completed the process of liquidation or the liquidation period has exceeded three years; and  
  5. Other conditions provided by MOF and SAT.  

The Circular does not limit the deductible equity investment losses that an EIT taxpayer can claim in a tax year. As long as one of the specified conditions is met, an EIT taxpayer may deduct all of its equity investment losses, without having to carry forward any portion of such losses to the next tax year. This provision benefits EIT taxpayers, as it replaces a former provision of SAT that the deductible equity investment losses of an EIT taxpayer in a certain tax year may not exceed the income generated from its equity investments and equity investment transfers in that year, and that any amount in excess of such income must be carried forward to the next tax year.  

It is also worth noting that, unlike the Measures, the Circular distinguishes between loan losses and non-loan bad debt losses by separately addressing the conditions under which an EIT taxpayer can deduct these types of losses for EIT purposes. By dedicating a separate provision to loan losses, the Circular aims to provide financial enterprises with a better understanding of how to deduct their various loan losses under the New EIT Law.  

In addition, the Circular allows an EIT taxpayer to include the irrecoverable input value-added tax (VAT) in deductible inventory losses for EIT purposes if the input VAT is irrecoverable due to inventory shortage, damage, depreciation, theft, and the like. This provision is consistent with current VAT-related laws.  

The Circular also stipulates that if an EIT taxpayer has both domestic and foreign establishments to conduct its business, it must distinguish the asset losses of the domestic establishments from those of the foreign establishments. Moreover, when calculating the taxable income of its domestic establishments, an EIT taxpayer may not deduct any asset losses suffered by its foreign establishments.  

Lastly, under the Circular, EIT taxpayers are required to provide supplementary materials to prove the existence and extent of the asset losses they claim as deductible for EIT purposes. These materials may include sufficient external evidences, financial verification by qualified agencies, technological authentication by qualified professional firms, and the like.