On December 25, 2009, the MOF and the SAT jointly released Caishui  No. 125 (“Circular 125”) to provide the detailed foreign tax credit rules (please refer to our China Tax Bulletin March 2010 for more information about Circular 125). Although Circular 125 has made foreign tax credit more feasible, there were still a lot of technical and procedural questions left unanswered.
The SAT issued Announcement  No. 1 (“Announcement 1”) on July 2, 2010 to set out the comprehensive implementation guidelines on foreign tax credit, including clarifications on the applicable rules and the illustrative examples. Announcement 1 became retroactively effective from January 1, 2010. Despite this, the taxpayers are allowed to calculate unclaimed foreign tax credit for 2008 and 2009 pursuant to Announcement 1.
A resident enterprise is eligible for both direct and indirect foreign tax credit, while only direct foreign tax credit is available to a nonresident enterprise. Announcement 1 clarifies that an enterprise, which is established outside China and has its place of effective management within China, will be deemed to be a resident enterprise and enjoy both direct and indirect foreign tax credit.
Taxable Foreign-Source Income
Under Section 4 of Announcement 1, the taxable foreign-source income used to calculate foreign tax credit should be the amount of the pre-tax foreign-source income, minus the deductible costs and expenses determined under the PRC tax rules. To calculate the pre-tax foreign source income, the foreign taxes directly paid by an enterprise will be grossed up. For dividends eligible for indirect foreign tax credit, the foreign taxes indirectly borne by an enterprise will be grossed up.
Allocation of Common Expenses
To calculate the taxable foreign-source income, an enterprise can deduct various typical expenses. There is a question on how to allocate the common expenses. According to Circular 125, where the common expenses incurred within and outside China relate to both China and foreign-source income, those expenses can be allocated to each foreign jurisdiction at a reasonable ratio and then be deducted from the income sourced from such a foreign country. Section 12 of Announcement 1 defines the reasonable ratio in reference to the following:
- A ratio of assets in one country to the total assets;
- A ratio of income from one country to the total income;
- A ratio of payroll in one country to the total payroll; or
- Any other reasonable ratio.
Once decided, the allocation ratio should be filed with the incharge tax authorities for record filing purposes. It cannot be changed without a good reason.
Announcement 1 touches upon the taxable year issue in a number of areas. First, dividends are generally recognized upon the adoption of a distribution resolution. Under Announcement 1, the timing of recognition will not be affected, whether dividends are actually distributed in a taxable year different from the year of the adoption of the resolution, or whether dividends are distributed out of the after-tax profits in prior years. Similarly, interest, rents, royalties and capital gains should be recognized on the payment date stipulated in the relevant agreements, even if the actual payment is made in a different taxable year.
Second, pursuant to Section 36 of Announcement 1, where a foreign branch’s taxable year is different from the Chinese taxable year, the Chinese taxable year in which the foreign branch's taxable year ends should be used for the purpose of calculating foreign tax credit.
Third, the taxable year in which income from a controlled foreign company (“CFC”) is recognized must be determined in accordance with the CFC rules. Announcement 1 does not elaborate on how to apply the foreign tax credit rules to income from a CFC.
Carryover of Foreign Branch Losses
The foreign branch losses incurred in one particular country cannot be used to offset against the taxable income sourced from either China or other countries. As a result, the foreign branch losses in the current year shall be carried over to offset income sourced from the same foreign country in the subsequent five taxable years. Section 14 of Announcement 1 states an exception and allows an indefinite carryover of the non-actual losses. The term of “non-actual losses” refers to the part of foreign branch losses that cannot be used to offset against the domestic income. Where the sum of the current profits and losses sourced from China and all foreign countries is zero or positive, all non-actual losses are allowed to be carried forward indefinitely. On the other hand, where the sum is negative, the part of foreign branch losses in excess of the total profits will continue to be subject to the fiveyear carryover limit. Only the part of foreign branch losses no more than the total profits are considered the non-actual losses and will be carried over indefinitely. Regardless, an enterprise is required to keep track of the respective losses and their carryover status.
Under Sections 27 and 28 of Announcement 1, domestic losses, which have offset against foreign-source profits, cannot be used to offset against domestic profits in the subsequent years. Where an enterprise with domestic losses has income sourced from several foreign countries, it can freely choose the order of the source countries to offset the income received from them.
Carryover of Excess Foreign Tax Credit
Announcement 1 restates that the tax credit limitation will be zero, when the sum of taxable income from China and foreign countries is zero or negative. The excess foreign tax credit can be carried over for the subsequent five years. Nevertheless, the foreign tax directly paid and indirectly borne by an enterprise in the current year will be credited against the enterprise income tax due first, before the excess foreign tax credit from previous years can kick in. This restriction on the usage of the excess foreign tax credit certainly makes it easy to expire. The enterprise is required to provide the information on the foreign tax credit carryover with its annual enterprise income tax settlement.
Creditable Foreign Income Tax
Foreign tax credit is calculated based on the amount of the creditable tax on foreign-source income. Section 15 of Announcement 4 emphasizes that the creditable tax must be levied on an enterprise’s foreign-source net income, regardless of how it is named in different jurisdictions. The creditable tax is limited to the amount of tax supposedly and actually paid.
Indirect Foreign Tax Credit
Announcement 1 clarifies several rules with respect to indirect foreign tax credit. First, the 20 percent equity threshold applies to direct and indirect holdings as well as the sum of indirect holdings at each tier of the holding structure. Second, if dividends are distributed from multi-year cumulative after-tax profits, indirect taxes borne by an upper tier enterprise on dividends will be the sum of the indirect taxes borne on cumulative profits at each year end. Third, for the purposes of calculating indirect taxes borne by a resident enterprise, the residency countries of the first-tier foreign subsidiaries will be treated as the source countries, where the second and lower-tier foreign subsidiaries are in different countries. Based on this rule, it is possible to set up a holding company in one particular country to combine income received from both a high-tax country and a low-tax country in order to raise the tax credit limitation.
Tax Sparing Credit
The simplified method to calculate foreign tax credit does not apply to tax sparing credit. Pursuant to Announcement 1, the amount of a tax sparing credit will be computed as follows:
- Where an applicable tax treaty provides a tax sparing credit on a fixed-rate basis
Tax sparing credit = foreign income tax due based on the fixed-rate – foreign income tax actually paid
- Where an applicable tax treaty provides a tax sparing credit on a tax incentive basis
Tax sparing credit = foreign income tax due based on the statutory tax rate – foreign income tax actually paid
Foreign Exchange Rate
Announcement 1 addresses the foreign exchange rate issue when calculating the creditable foreign income tax in RMB:
- Where an enterprise’s recording currency is RMB, the foreign income taxes directly paid and indirectly borne will be calculated based on the foreign exchange rate as of the foreign-source income recording date.
- Where an enterprise’s recording currency is a foreign currency other than RMB, the foreign income taxes directly paid and indirectly borne will be calculated based on the foreign exchange rate as of the last day of the Chinese taxable year, in which the foreign-source income is recognized.
To apply for a foreign tax credit, an enterprise should submit to the in-charge tax authorities a tax clearance certificate or tax payment certificate related to foreign-source income, either the original or a copy. Depending on the types of foreign-source income, the enterprise is required to provide the following additional documents:
- Foreign branch income
- Financial reports of the foreign branch;
- Computation of the foreign branch’s taxable income under the Chinese tax laws and the supporting documents; and
- Audit reports issued by a qualified agency.
- Foreign-source dividends
- Organizational chart of the group;
- Bylaws of the invested enterprise; and
- Dividend distribution resolution of the invested enterprise.
- Foreign-source interest, rents, royalties and capital gains
- Computation of the taxable income under the Chinese tax laws and the supporting documents; and
- Copies of the project contracts.
In addition to the above documents, an enterprise should provide the following documents for the purposes of applying for a tax sparing credit:
- Copies of certificates or audit reports documenting the foreign tax exemptions and reductions enjoyed by the enterprise and the foreign companies it directly or indirectly controls;
- Copies of certificates documenting the enterprise’s equity interest percentage in the foreign companies it directly or indirectly controls;
- Computation of indirect foreign tax credit or tax sparing credit; and
- Financial and accounting documents of the foreign companies directly or indirectly controlled by the enterprise.
For an enterprise using a simplified method to calculate foreign tax credit, the following additional documents are required in the application:
- Foreign branch income
- An application letter; and
- Copies of tax payment certificates and the supporting documents issued by the source country.
- Foreign-source dividends
- An application letter; and
- Copies of equity certificates.
Announcement 1 provides important guidance on the foreign tax credit rules, which are critical to the elimination of double taxation. The inclusion of the illustrative examples is really surprising and commendable. Under Announcement 1, the taxpayer could seek to explore some new tax planning opportunities, such as converting per country limitation into the overall limitation. Since foreign tax credit is made available to overseas-established resident enterprises, the domestic companies contemplating outbound investments are advised to thoroughly review their strategies and holding structures. Despite those improvements, lots of issues are left unsolved by Announcement 1. For instance, it does not address the application of foreign tax credit to the income received from a CFC. Thus, we could see more clarifications in this area later on.