On December 11, 2007 the State Council, Ministry of Finance ("MOF") and State Administration of Taxation ("SAT") jointly issued Enterprise Income Tax Law Detailed Implementation Rules ("Implementation Rules"). The Implementation Rules, together with the Enterprise Income Tax Law ("EIT Law"), went into effect on January 1, 2008. The Implementation Rules clarify the provisions under the EIT Law and supplement the general framework of the new tax regime, but still leave many uncertainties to be addressed in future circulars. We summarize below some major provisions of the Implementation Rules.
High and New Technology Enterprise Under the Implementation Rules, a High and New Technology Enterprise ("HNTE") is entitled to a 15% reduced tax rate. To qualify as an HNTE, the Implementation Rules require that the company's products and services fall within the Catalogue of High and New Technology Encouraged by the State. The company's revenue from high tech products and services, R&D expenditures, and the number of R&D personnel should also meet a certain ratio requirement. Most importantly, the Implementation Rules introduce a new condition that requires the enterprise to possess ownership of core proprietary intellectual property rights. This last requirement is in line with China's efforts in recent years to promote technical innovation and independent ownership of intellectual property rights.
Detailed regulations for assessing HNTEs are expected to be promulgated jointly by the Ministry of Science and Technology, MOF, and SAT. It remains to be seen whether companies that obtain technology through license instead of ownership will be able to fulfill the requirements of an HNTE under this new rule.
Withholding Tax on Dividends
The Implementation Rules eliminate the tax exemption on dividends paid by foreign invested enterprises ("FIEs") to their foreign investors and impose a 10% withholding tax on dividend income. However, it is far from clear under the Implementation Rules whether an FIE's profits must be physically remitted out of China before 2008 in order for it to enjoy the current zero withholding tax rate; whether the tax exemption applies to profits declared before 2008, but repatriated in or after 2008; or whether even those pre-2008 profits declared and distributed in or after 2008 can still benefit from the exemption. Subsequent circulars should clarify these outstanding issues.
With the introduction of the 10% dividend withholding tax, it is becoming increasingly important for foreign investors to effectively utilize the China treaty network and establish their investments in tax-friendly jurisdictions such as Hong Kong, Mauritius and Barbados, which provide a reduced dividend withholding tax rate under their respective tax treaties with China.
In principle, the EIT Law abolishes tax incentives available to FIEs and removes tax preferences geared to geographical location. Under the new tax regime, new preferential tax treatments are granted primarily to encouraged industries and activities. The Implementation Rules provide detailed guidance on other forms of tax incentives, such as tax reductions or exemptions, reductions of taxable income, tax holidays, reduced tax rates, tax credits and super deductions. These are summarized below.
Tax Reduction/Exemption on Income from Qualified Technology Transfer
Income of RMB 5 million derived from qualified technology transfer within a tax year is exempted from taxation, and any income in excess of RMB 5 million is taxed at a 50% reduced tax rate.
Reduction of Taxable Income
Ten percent of income derived from "comprehensive utilization of resources" is deductible in calculating the income tax liability. "Comprehensive utilization of resources" refers to the use by the enterprise in its production of raw materials listed in the Income Tax Incentive Catalogue for Comprehensive Utilization of Resources.
Certain qualifying public infrastructure facility projects, environmental protection projects, and energy- and water-saving projects are entitled, from their first income-generating year, to a three-year tax exemption, followed by a three-year 50% reduced tax rate.
Reduced Tax Rate
Reduced tax rates are referred to in the High and New Technology Enterprise section.
Investment in certain qualifying environmental protection equipment, energy and water conservation equipment, and production safety equipment is entitled to a tax credit in the amount of 10% of the investment cost. The excess credit can be carried forward for five years.
Venture capitalists investing in small- and medium-sized unlisted HNTEs for a period of more than two years can use 70% of their investment to offset taxable income for that year. If the venture capital enterprise does not have sufficient income to absorb the investment deduction, the excess amount can be carried forward to future years.
The Place of Effective Management
The EIT law introduces a new residence rule that provides that an enterprise established outside China, but with its effective management in China, is considered a PRC tax resident subject to income tax on its worldwide income. The Implementation Rules further define "effective management" as the exercise of substantive overall management and control over the production and business operation, employees, treasury, and finance functions and properties of an enterprise. The definition under the Implementation Rules seems too expansive to provide any useful guidance for a foreign enterprise with respect to those specific factors that are considered by tax authorities as significant in their determination of the existence or nonexistence of "effective management." However, because PRC tax authorities have almost no experience coping with this type of issue, how they will exercise their discretion on a case-by-case basis remains to be seen.
Under the EIT law, tax authorities are authorized to make tax adjustments when business transactions are considered to lack a bona fide business purpose. The Implementation Rules defines these transactions are those whose primary purpose is to reduce, avoid, or defer tax payments. Again, this general definition seems to leave broad discretion to the tax authorities for interpretation and assessment. To avoid becoming the target of this general anti-avoidance provision, it is essential that an enterprise be able to offer a valid business reason for any transaction into which it enters.
Transfer Pricing Documentation
Continuing a trend of recent years, transfer pricing documentation is a focus of the new tax regime. According to the Implementation Rules, "required documentation" includes transfer pricing policies, computation methods, explanations, comparables, and profit levels. In addition, such documentation must be submitted to the tax authority within the prescribed time limit – i.e., the documentation is to be prepared on a contemporaneous basis. The Implementation Rules merely outline the requirements of this new documentation; more detailed rules should be released early this year.
These new rules are expected to increase the filing and documentation requirements imposed on taxpayers and to bring the transfer pricing scheme in China more into line with international practice. Compliance with the new requirements may be time consuming and costly for taxpayers, but given the growing number of transfer pricing audits in China, the additional documentation may become an effective tool for managing the risk of transfer pricing challenges.
Thin Capitalization Rule
The EIT law denies deduction of interest expenses on loans from affiliated companies if the underlying loan exceeds a prescribed debt-to-equity ratio. The Implementation Rules provide a definition of "equity" and "debt," but leave the prescribed debt-to-equity ratio to be specified in subsequent regulations to be formulated by MOF and SAT. Experts speculate that different debt-to-equity ratios may apply to taxpayers in different industries.
Controlled Foreign Corporation Rule
The EIT Law introduces a controlled foreign corporation ("CFC") rule to deter tax evasion through the use of offshore companies in low-tax or no-tax jurisdictions. The CFC rule requires the resident enterprise shareholder to include in its taxable income the undistributed profits of a CFC. For this purpose, the Implementation Rules stipulate that the effective tax rate of the foreign company must be less than 12.5% – half of the effective corporate income tax rate in China. The Implementation Rules define a CFC as a foreign company in which more than 50% of the total combined voting share is owned (directly or indirectly) by a PRC resident enterprise or individual owning (directly or indirectly) 10% or more of the foreign company's voting shares. Notwithstanding the above shareholding threshold, a foreign company will be considered a CFC under the catch-all provision of the Implementation Rules if the PRC resident enterprise and/or individual exercises "effective control" over the CFC through such means as shareholding, financing, business or purchase and sales.
Interest will be levied on any tax adjustments under general anti-avoidance, transfer pricing, thin capitalization, and CFC rules. The interest will be computed using the standard RMB loan interest rate published by the People's Bank of China plus an additional 5 points.
The statute of limitations for transfer pricing adjustments and adjustments under general anti-avoidance rule is 10 years.
The current tax regime provides tax relief for intra-group equity transfers; if the transfer is between companies within the same corporate group, the transfer can occur at cost, and no capital gain tax will be imposed. The Implementation Rules are silent on the tax exemption for enterprise reorganization, and speculation is that tax exemptions on intra-group reorganizations will remain available only to transferees that are PRC companies, with foreign transferees no longer entitled to such tax relief. Subsequent circulars should clarify these issues.
A recent regulation clarifies that a grandfathering provision is applicable to any enterprise that has completed its business registration with the Administration of Industry and Commerce ("AIC") on or before March 16, 2007. Except for the general principles laid down in the EIT law relating to the tax preferential treatment during the transitional period, there is no information on the transition rules; the Implementation Rules leave the details to subsequent circulars. The likely scenario appears to be that an enterprise currently at 15% income tax rate will gradually see its tax rate increase to 18%, 20%, 22%, 24% and, finally, 25% over a five-year period, and an enterprise whose current income tax rate is 24% to 33% will see it adjusted to 25% in 2008.