Recent changes to Chinese tax law has dramatic implications for the tax burden of foreign investors in the People's Republic of China. Despite the changing tax landscape, there are still opportunities to take advantage of current tax law. Savvy investors that employ these strategies will have a competitive advantage in the market.
On January 1, 2008, the 2008 Enterprise Income Tax Law ("Tax Law") was enacted in the People's Republic of China (the "PRC"). Foreign companies face a new major concern under the Tax Law: it abolishes the preferred tax treatments for Foreign Investment Enterprise ("FIE") while also imposing withholding taxes for dividends expatriated from China. As a result, FIE will face a 25% income tax and a 20% withholding tax for profits remitted abroad via dividends.
Despite this new law, tax advantaged opportunities still exist in China. Certain categories of FIEs may still obtain tax incentives by qualifying as a High and New Technology Enterprise ("HTE"). By obtaining such a qualification the FIE will have the opportunity to reduce corporate income taxes to 15% and decrease its withholding tax. An alternate method of reducing tax burden is through the use of special purpose vehicles established in countries with favorable tax treaties. The appropriate solution to the tax question depends upon the type of investment and the manner of company.
Tax Incentives for High and New Technology Enterprises
The Ministry of Science and Technology, the Ministry of Finance and the State Administration of Taxation have jointly issued the Administrative Regulation governing the Recognition of High Technology Enterprises (“Regulation”), which sets forth the criteria and procedures for HTEs. Under the Regulation, the following criteria must be satisfied before a FIE will be recognized as an HTE: The HTE must:
- Be established within China (excluding Hong Kong, Macau and Taiwan);
- Be in existence for more than one year;
- Continuously conduct R&D activities that transform intellectual property into products and/or services;
- Possess its own IP rights; and
- Carry out business within the scope of the Catalogue of High and New Technology Domains Specifically Supported by the State.
In addition to these requirements, the Regulation also set forth guidelines to further refine the expectations placed upon an HTE. Thirty percent of the employee population should have university degrees, among which at least 10% should engage in R&D work. Sixty percent of total R&D expenditures should be incurred in China. Finally, income derived from high technology products or services should account for more than 60% of the total annual income for the FIE.
A successful application for HTE status will result in a license for three years.
Unfortunately, while the Regulation sets forth procedures for obtaining HTE status, the actual logistics of applying is complex and prone to delays. Given the procedural difficulties facing applicants, it is unlikely that HTE licenses will be issued before the early part of 2009. During the application process, the FIE will be forced to pay the non-advantaged rate of 25%. Despite these difficulties, companies that acquire this status early will have a competitive advantage in China.
Adopting Treaty SPV Investment Structure
In China, profits from FIEs are expatriated off-shore through the use of dividends. Under the previous regulations, there was no withholding tax for this behavior. Under the previous legal regime, a typical foreign direct investment structure would entail the use of an off-shore special purpose vehicle established in a tax haven such as the British Virgin Islands. This special purpose vehicle would then funnel the investment to the on-shore FIE, such as a Wholly Owned Foreign Enterprise, or to foreign interests in a Joint Venture. This structure previously allowed foreign investors to expatriate without incurring any taxes.
Under the Tax Law, the dividends, interests and royalties distributed are subject to a tax withholding rate of 20%. For foreign investors, this represents a significant deduction in their returns. In order for foreign investors to reduce this withholding tax obligation, one needs to look into tax treaties between China and other foreign countries.
China has executed tax treaties with many countries. The treaties that would directly impact the withholding tax were executed with Barbados, Mauritius, Singapore, Hong Kong, and Ireland. In all those treaties, the withholding rate for dividends is set at 5%. Thus, a company could take advantage of these treaties by using a special purpose vehicle established in any of the aforementioned companies. This structure would reduce the standard 20% tax withholding to 5%. Below is a chart illustrating the withholding tax based upon various tax treaties.
Please click here to view table.
The Tax Law significantly impacts the operations of the FIE in China. However, through proper tax planning and application for High Technology Enterprise, a FIE could reduce its tax exposure in PRC significantly.