On December 6, 2007, China's State Council promulgated the Implementing Rules ("Rules") of the PRC Enterprise Income Tax Law ("EIT"). Composed of 133 articles, the Rules provide greater details on the definitions of numerous terms, provides interpretations and gives specific applications to various provisions of the EIT. Together with the EIT, the Rules became effective January 1, 2008.
Outlined below are some of the key provisions of the Rules that are likely to be of interest to foreign invested enterprises operating in China.
- Tax Incentives. An enterprise is allowed an amortized super deduction of its R&D costs if engaged in the research and development of new technology, products and processes if expenditures are capitalized as intangible assets. In addition, qualified high and new technology enterprises are subject to a lower tax rate as opposed to non-qualified enterprises whose incomes are taxed at the 25% tax rate. Moreover, income derived from environmental protection, energy and water conservation projects may qualify for three years of tax exemption plus three years of 50% tax reductions. Similarly, 10% of the total investment on equipment for environmental protection and conservation can be applied as a credit to offset enterprise tax liabilities in qualifying circumstances.
- Transfer Pricing. With respect to transfer pricing, the Rules require cost sharing agreements and other relevant documents to be submitted to the relevant authorities upon request. Related party loans for the purpose of transfer pricing are defined to include debt investments made by a related party through unrelated third parties, debt investments made by an unrelated third party, for which a related party has provided a guarantee and is jointly and severally liable, or any other debt investment indirectly made by related parties. Interest expenses paid to a related party in excess of the prescribed debt to equity ratio are not deductible.
- Anti-avoidance Tax Adjustments. Arrangements lacking reasonable commercial purposes which result in tax savings may be subject to special tax adjustments. Moreover, enterprises may be responsible for interest expenses stemming from underpaid taxes if no or improper documentation has been prepared, maintained and provided to the relevant authorities.
- Income Recognition. Gains or losses from corporate restructuring should be recognized at the time of transaction. Unless otherwise prescribed, the tax basis of the relevant assets should be revised based on the transfer price.
- Deductions. The Rules clarify the deductibility of various business expenses such as interest on loans, employee welfare expenses, eligible advertising and business promotion expenses, meals and entertainment, and purchased goodwill. Inter-company management fees, rental charges and royalty payments, however, are not ordinarily deductible.
- Grandfather Clause. Foreign invested enterprises enjoying a preferential tax rate will be given a five-year grace period through 2012 during which time they will continue enjoying the preferential rate.
The practical effect of the EIT and Rules will only be better understood in time to come as additional regulations and regulatory guidance is provided. The EIT and Rules, however, do promote certain activities by providing tax incentives, while at the same time, discouraging other activities. Thus, it is prudent for entities operating in China to review its tax planning strategies in order to avoid costly missteps and maximize benefits provided under the EIT and Rules.