On 16 March 2007, the tenth National People’s Congress approved the new PRC Enterprise Income Tax Law (the “EIT Law”). After years of debate between the MOFCOM and the MOF, this long awaited legislation will have sweeping effects on foreign investors in China. In particular, starting 1 January 2008, the preferential tax treatment afforded to foreign-invested enterprises “FIEs” will be dismantled progressively and a unified corporate income tax rate of 25 per cent will be applicable to most companies. This article provides a general overview of the Law’s most interesting features.
Level playing field for all companies
The preferential tax treatment for FIEs that had been in place since the beginning of the reform and open-up policy in the 1980s in order to attract foreign investment will be abolished. This policy had allowed foreign companies to establish enterprises in China which would enjoy preferential tax rates when compared to the rates imposed on domestically funded enterprises. The EIT Law puts into practice the WTO’s principles of non-discrimination and national treatment, albeit, on this occasion, mainly to the disadvantage of international investors.
The EIT Law will also disincentivise the practice of “round-tripping” by which domestic investors would establish offshore companies which, in turn, would reinvest in China in order to benefit from preferential tax rates.
Introduction of the “tax residency” concept
Once the EIT Law comes into effect in January 2008, no distinction will be made between companies based on the origin of their capital. The EIT Law introduces the concept of tax residency whereby companies will either be considered as “China tax residents” or “non-China tax residents”. A company will be deemed to be “China tax resident” if the effective management of the company is located in China. A company which is deemed to be “China tax resident” will be taxed on its worldwide income, while a “non-China tax resident company will only be taxed in China on its China-related income.
The EIT Law also states that branches of domestic enterprises will no longer be allowed to file taxes directly in their local bureau. Instead, as from the end of the fiscal year 2007, their taxes must be paid directly by their head office.
Unification of the applicable tax rate
FIEs are currently either fully exempt from enterprise income tax (for a limited period) or are taxed at rates ranging from 7.5 to 33 per cent. Under the EIT Law, FIEs will now face a unified tax rate of 25 per cent although, as mentioned below, tax incentives in certain sectors or geographical areas will remain. Domestically invested companies, most of which are currently subject to an income tax rate of 33 per cent, will see their tax burden reduced. Based on calculations performed by MOF, the unification of the rates does not make China less attractive in tax terms than its Asian neighbours, where the average corporate income tax rate is about 27 per cent. Small and thin-profit enterprises will benefit from a reduced rate of 20 per cent.
Removal of certain tax incentives
The EIT Law repeals the two-year tax holiday and three-year half-tax holiday (the “2/3 Tax Holiday”) for manufacturing FIEs as well as tax exemptions based on geographical criteria (special economic zones, open coastal cities). However, tax incentives for central and western regions are likely to be retained.
Tax incentives for investments in certain sectors
Under the EIT Law, companies involved in infrastructure projects, agriculture, fishery and forestry will retain the tax exemptions or reductions they currently enjoy. New sector-based tax incentives will be created. In particular there will be preferential treatment for venture capital funds involved in start-up investments and companies investing in environmental protection, water and energy saving or industrial safety. These incentives will apply regardless of the location of these companies in China. Hi-tech companies that receive official approval will enjoy a reduced tax rate of 15 per cent. The super-deduction for research and development investment will also be preserved.
Impact on existing FIEs – Transition period
FIEs that were established prior to the date of publication of the EIT Law (16 March 2007) and which currently benefit from tax holidays or exemptions will be granted a five-year transition period during which they will gradually adapt to the new regime. It is expected that income tax rate will be raised by two per cent each year until it reaches 25 per cent. FIEs which had not begun their 2/3 Tax Holiday, will benefit from a tax holiday period which will commence on 1 January 2008. The objective is to establish a level playing field for all companies by 2013. No such grandfathering rules will be available for enterprises which had not been set-up in China before the promulgation of the EIT Law.
Anti-tax avoidance measures
One section of the EIT Law is entirely devoted to measures to prevent tax evasion. The provisions are particularly aimed at diminishing the use of offshore transactions or companies which have been created for the sole purpose of reducing potential tax liability. In such cases, the EIT Law provides that the tax authorities will be empowered to make “the necessary adjustments” and control transfer prices. It remains to be seen how this will apply in practice.
A controlled foreign corporation rule is also adopted, by which profits distributed in tax havens by FIEs controlled by a tax resident enterprise in order to avoid taxation will be included in the tax resident enterprise’s taxable income basis. The EIT Law also introduces thin capitalization rules, which limit the possibility of deduction of interest expense when the debt-to-equity ratios of related parties exceed certain limits.
The EIT Law contains only a general provision withholding tax whereby a flat rate of 20 per cent will apply to repatriated profits. However, there is much uncertainty at the moment as to whether the current preferential withholding tax rates applicable to FIEs (such as full exemption for dividends, or 10 per cent tax rate for royalties, rents or interest) will remain in place. It is widely expected that the implementing rules to be released by the State Council in 2007 will provide clearer guidance in respect of this issue. Even if the full exemption of withholding tax on dividends is repealed, most foreign investors would still benefit from the lower rates set out in China’s extensive network of bilateral tax treaties and arrangements.
This reform will create a level playing field for all companies, although tax compliance of domestic companies is widely believed to lag far behind FIEs’ compliance. Given the temporary nature of most of the tax incentives currently in force, the five-year transition period should make it possible for most companies to use up their remaining tax holiday and to adapt smoothly to the new regime. Many areas require further clarification, such as the withholding tax rates applicable to dividends and other income paid to shareholders of FIEs, the definition of “effective management” for tax residency purposes, or the criteria used to select privileged hi-tech companies or thin-profit companies. The implementing rules which are expected to be published later this year are expected to shed some light, but until then, the precise impact of the EIT Law will remain substantially conjectural.