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| Apr 2007, Issue 8 |
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New tax ruling on "corporatization" of foreign bank branches in China
In response to the unclear tax issues arising from the recent applications by various foreign banks to convert their existing branch network in China into a locally incorporated bank, the PRC State Administration of Taxation has issued a new tax circular Cai Shui [2007] No.45 on 28 March 2007 to clarify various taxation treatments on this subject.
In particular, the new circular offers a set of preferential tax policies aiming at giving relief on a number of potential tax inefficiency that may arise in the foreign bank "corporatization" exercise.
Read more...... Expand / Collapse
The new circular sets out briefly the following major tax relief:
- Neither Business Tax nor Value Added Tax will be levied on asset or equity transfer transactions arising from the branch corporatization exercise.
- Assets can be transferred from the existing branch network to the newly incorporated bank at net book value, thus resulting in no capital gain to be recognized in the transfer transaction.
- Accumulated tax loss of the existing branch network can be carried forward to the post-corporatization new bank.
- Unexpired tax holiday of the existing branches can be enjoyed by the new bank after the corporatization.
- The new bank and its newly registered branches after the corporatization should be entitled to consolidated corporate income tax ("CIT") filing.
- The existing branches' business contracts and operating capital on which stamp duty has been levied before the corporatization should not be subject to another level of stamp duty again when the contract and capital are rolled over to the new bank after the corporatization.
- Deed tax will be exempt on the transfer of legal title of the real estates property from the existing branch network to the new bank.
The above tax relief offered in the new circular is based on the principle that this foreign bank corporatization exercise is essentially a roll-over of the existing business run by the branch network of the foreign bank to the newly incorporated bank.
The new circular is seen to be an important tax development to support foreign banks to smoothly go through their local branch corporatization exercise. This circular earmarks a new era for foreign banks to manage their tax affairs in China. With the release of the new CIT law and the recent trend on local branch corporatization exercise, foreign banks are moving toward a new operational tax environment which undoubtedly presents new tax challenges.
Impacts of China's new Corporate Income Tax Law on foreign invested financial institutions
As alerted in our last News Flash, the newly enacted China's Corporate Income Tax Law ("CIT Law") which will take effect from 1 January 2008 will have various impacts on foreign invested enterprises ("FIEs") and foreign investors.
We addressed the rationale for the CIT reform, described the key features of the Legislation and provided our observations in the articles below:
In this issue, we would share our in-depth observations regarding the impacts brought by the new CIT law specifically to the foreign investors who have financial institutions ("FIs") established and investments made in China. Read more...... Expand / Collapse
Impacts on foreign invested banks, insurers and security firms
- Tax rate and tax holiday
The new CIT rate of 25% should be welcomed by foreign invested FIs, in particular the foreign invested insurers, foreign invested asset management companies and security firms which are currently subject to a Foreign Enterprise Income Tax ("FEIT") rate of 33%. Their CIT rate will drop to 25% right on the effective date of the CIT Law.
Foreign invested banks, existing in the forms of foreign bank branches or joint ventures with local partners, could also enjoy an immediate reduction of CIT rate from 33% to 25% on their Renminbi ("RMB") business, whereas their foreign currency ("forex") business currently subject to a reduced rate at 15%/18% would be gradually increased to 25% over a 5-year grandfathering period, i.e. running from year 2008 to 2012. The details of the gradual increase in tax rate during the grandfathering period are yet to be available until the Detailed Implementation Rules come to light. The overall blended rate for foreign invested banks may not be worse off.
The tax holiday of one year exemption followed by two years half reduction (so called "1+2 tax holiday") over forex business of foreign invested banks is removed in the new CIT Law. However foreign invested banks that were approved for establishment before the publication of the new CIT Law (i.e. 16 March 2007) are entitled to enjoy the unused tax holiday until its expiry as a kind of grandfathering treatment. The main concern that remains unclear for those newly set up foreign invested banks is: which date is regarded as the "approval date for establishment" in the new CIT Law, i.e. the issuance date on the Approval Certificate or the one on the Business license? The Detailed Implementation Rules may provide clarification.
The grandfathering treatment also applies to FIs which were established in special economic zones before the publication of new CIT Law and are currently subject to 15% preferential FEIT rate. These "old" FIs should be entitled to have their CIT rate gradually increased from 15% to 25% over the 5 years grandfathering period.
- Location consideration
The tax incentive policy will change from "Predominantly Geography-based" to "Predominantly Industry-oriented, Limited Geography-based". FIs to be newly established in special economic zones would no longer enjoy special tax incentives. We expect that market potential would replace tax factors as the driving concern for FIs in selecting location for their new business in China in the future.
- Deduction limitations
The CIT reform is aimed at creating a level playing field for FIEs and domestic enterprises ("DEs"). As a result, the FIEs and DEs will be subject to the same criteria and caps in terms of expense deduction for tax purposes. As the new CIT Law only provides for a framework of principles, it still remains to be seen whether the deduction caps, especially for reserves/provisions made by FIs would be relaxed or tightened.
- Tax combined filing and tax consolidated filing
Same as the existing FEIT Law for FIEs, the new CIT Law requires an enterprise to perform combined filings for its non-separate legal business units/branches within China. This requirement should enable foreign banks that have incorporated their various Chinese branches into an integrated Chinese subsidiary with branch network to enjoy tax combined tax filing in the future. For foreign bank branches which do not intend to undergo the local corporatization exercise, the new CIT Law does not appear to create any barrier for these multiple foreign bank branches in China to apply for tax combined filing given the existing FEIT regime has already permitted a precedent to do so based on a tax circular (Guo Shui Han [2006] No.2). However, the new CIT Law continues to disallow tax consolidated filing amongst separate legal enterprises unless otherwise permitted by the State Council. Foreign financial services groups with multiple subsidiaries and holding company in China may need to wait and see whether the PRC State Council would introduce some specific guidelines for them to seek for permission on group tax relief.
- Thin-capitalization rule
Foreign invested banks are always subject to various ratios, e.g. capital adequacy ratio, liquidity ratio, loan to deposit ratio imposed by regulators in China. The thin-capitalization rule in the new CIT Law which prohibits enterprises from deducting excessive interest expense on related party loans has undoubtedly imposed another compliance requirement on FIs. Given that the related party debt/equity ratio of FIs could easily exceed the normal range of enterprises in non-financial sectors, it is desirable if the acceptable ratio could be more relaxed for FIs in the Detailed Implementation Rules to be formulated by the State Council.
Impacts on investment management sectors
- Tax resident enterprise and effective management institute concepts
The "Tax Resident Enterprise" ("TRE") concept is introduced into the new CIT regime whereby TREs are subject to China income tax on worldwide income. Non-TRE is only subject to CIT on China sourced income unless it generates offshore sourced income that is effectively connected to its establishments in China.
A TRE is referred to 1) any enterprise that is established within China; and 2) any foreign enterprise ("FE") whose effective management institute is based in China. The 2nd condition brings a fundamental change to China's CIT regime. The tax rate shall be 25%.
However, the definition of "effective management institute" is not available in the new CIT Law and expected to appear in the Detailed Implementation Rules. Private equity funds and hedge funds, even though established in foreign jurisdictions, have to pay special attention to the "effective management institute" concept. If any entity within a group, especially the fund itself or its general partner is construed as having its effective management institute based in China, its worldwide income could be exposed to CIT at 25%. We expect that the investment management companies of the funds could be most vulnerable to China income tax exposure under the "effective management institute" concept because it is not uncommon for foreign funds to send senior executives into China to source deals and to involve in making investment decision within China. Experience tells that even if the definition of "effective management institute" is set out in the Detailed Implementation Rules, the determination of "effective management institute" could be a very controversial subject matter between Chinese tax authorities and foreign enterprises.
- Withholding income tax ("WHT") rate
Like the existing FEIT Law, the standard WHT rate on passive income derived by FEs from China will stay at 20% in the new CIT Law. However, it is unclear whether the current WHT exemption policy on dividend and the provisional reduced WHT rate of 10% on other passive income derived by FEs would survive under the new CIT regime. This could significantly impact on the project return of foreign funds.
The offshore financiers of the funds will have similar concerns as to the WHT rate on the interest received from China. Of course, those foreign parties concerned may invoke double tax treaty protection to apply the lower WHT rates on dividends and interest derived from China. Subject to the clarification in the Detailed Implementation Rules, these parties may need to consider using special purpose vehicles set up in the double tax treaty countries/regions for achieving the lower WHT rate benefit.
- Tax incentive to venture capitals
The new CIT Law provides for a special tax incentive to venture capitals established in China, i.e. if a venture capital enterprise invests in sectors that are specially supported and encouraged by the State, a certain percentage of its investment may be used to credit against its own taxable income.
Despite the absence of further details, such as how and when to determine the creditable investment, provided in the new CIT Law, a recent tax circular Cai Shui [2007] No.31 ("Circular 31") which takes effect retrospectively back to 1 January 2006 may indicate the general perception of the Chinese tax authorities on this matter. According to Circular 31, after 2 years (inclusive) of investment in a small to medium sized and unlisted high/new tech enterprise, a venture capital enterprise may use 70% of its original investment in the investee to credit against its own taxable income provided that the venture capital enterprise and the investee can satisfy some criteria. It is possible that similar incentive stipulated in Circular 31 may continue to apply under the new CIT regime.
- Taxation on underlying investments
The new CIT regime will provide tax incentives for projects in encouraged sectors such as infrastructure projects, primary industries, say agriculture, energy/water conservation projects as well as high/new-tech projects. Sector funds may need to evaluate its investment strategies to invest in the right sectors/projects which can offer the best post-tax earnings.
Impacts on all FIs with foreign investment
- New anti-avoidance chapter
The new CIT Law devotes an entire chapter to address the anti-avoidance measures. This signifies the determination of the China tax authorities to enforce more stringent tax administration in future to deter and counter tax avoidance. More careful planning will be necessary for banks and security houses in introducing innovative structured finance products for their customers as these products may be subject to closer scrutiny by the Chinese tax authorities under the "business substance test" laid out in the general anti-avoidance provision. Transfer pricing of related party transactions continues to be the key concern of the Chinese tax authorities. There would be more stringent requirements on provision of transfer pricing information to the tax authorities.
- Other practical concerns
After 15 years of evolutions, there are hundreds of existing tax circulars and notices which set out preferential tax treatments on the financial service sector. The implementation of the new CIT Law may cause the revocation of many of them and introduction of new ones, which could create uncertainties and confusion in the interim. Typical questions include:
- Whether the existing tax exemption on capital gain/dividend on investment of B shares/H shares would still be applicable under the new CIT Law?
- Whether cross border inter-bank interest payment would still be exempt from WHT under the new tax regime?
- Whether the current preferential cost-recovery taxation treatment on foreign investment on non-performing loans would remain unchanged in the future?
- Would the current tax regime on asset securitization be workable in the future?
- Would the tax deductibility on various statutory reserves/provisions for foreign insurers be carried forward to the new CIT regime?
- Would the existing tax principle in relation to taxation of close-end and open-ended funds in China still be applicable in the future?
- Would head office charges to foreign branch still be acceptable as tax deduction under the new tax regime?
The challenge ahead
The Financial Services sectors in China have undergone rapid deregulation over the last few years. This has presented tremendous challenge in the China financial services tax regime which is still in the state of flux. The existing China tax framework has not yet confirmed various important uncertain tax positions, such as taxation of derivative products, tax status of qualified foreign institutional investors, permanent establishment issues on various investment banking activities. The upcoming China corporate income tax reform creates new opportunities and uncertainties for foreign FIs to develop tax efficient strategies for their business activities in China. Anti-avoidance provisions in the unified tax law also poses new threat to foreign FIs on tax compliance and planning issues. The need for foreign FIs to perform an operational tax risk review on their business in China is of paramount importance.
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