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Impact of China's new Corporate Income Tax Law on foreign investors
On 16 March 2007 China's top legislature, the National People's Congress ("NPC"), passed the long-awaited China Corporate Income Tax Law ("CIT Law") by dominant majority vote. This CIT reform is undoubtedly a significant milestone in China's tax history since the turnover tax reform in 1994.
This reform aims at establishing an income tax regime that reflects four main themes: "Simplified Tax System", "Wide Tax Base", "Low Tax Rate", and "Stringent Administration". The new regime earmarks the consolidation of two separate enterprise income tax regimes for domestic-invested enterprises ("DEs") and foreign-invested enterprises ("FIEs") into a single regime. In addition, the Law provides for a fundamental change in China's tax incentive policy in shaping and directing the future development of the country. It is interesting to note that the Law is expected to result in a reduction of income tax revenue by as much as Rmb 93 billion, within which collection from DEs may reduce by some Rmb 134 billion and collection from FIEs may increase by some Rmb 41 billion.
Key Aspects of CIT Law
CIT Law will come into effect on 1 January 2008. It contains 8 chapters and 60 articles as follows:
| Chapter 1 |
General Provisions |
| Chapter 2 |
Taxable Income |
| Chapter 3 |
Tax Payable |
| Chapter 4 |
Preferential Tax Treatments |
| Chapter 5 |
Withholding at Source |
| Chapter 6 |
Special Tax Adjustments |
| Chapter 7 |
Assessment and Collection Administration |
| Chapter 8 |
Supplementary Provisions |
Like previous income tax laws, CIT Law mainly provides a framework of general tax provisions. Important details on the definition of numerous terms as well as the interpretation and specific application of various provisions are left to the detailed implementing regulations and supplementary tax circulars. The State Council will be promulgating the detailed implementing regulations within this year to facilitate the application of the new Law. Given that the current tax regime has in it a myriad of circulars and directives issued by various authorities over the past two decades, it will be a daunting task for the State Administration of Taxation and Ministry of Finance to review, align and clarify the on-going applicability of many existing circulars, whilst taxpayers in China are faced with uncertainty on tax positions over many important issues.
Please see Appendix for a summary of the key changes resulted from CIT Law as well as our observations of the related potential implications.
General Commentaries
- Timing
Although foreign investors in the manufacturing sector or located in the tax incentive zones are generally adversely affected by the new Law, the Chinese government considered the timing of reform appropriate against a very strong Chinese economy and strong investors' confidence towards China. Indeed, China considers that the unlevelled tax playing field after WTO accession is inequitable to the Chinese enterprises and must be changed.
- Tax Rate
The new CIT rate is 25%. A lower tax rate is available for qualified small and thin-profit companies (20%) and for qualified high/new technological enterprises (15%) without geographical limitation.
With the removal of tax holiday for general manufacturing and export oriented activities, some FIEs could face as high as a 15%-point increase in income tax (from 10% to 25%) which is significant to the bottom line and adversely affects the return on investment. This said, Chinese government viewed that the 25% rate is generally competitive in the neighbouring region.
FIEs which are currently subject to 33% should immediate benefit from the new rate. On the other hand, FIEs established before the promulgation of the new Law ("Old FIEs") which enjoy a lower rate today will not face an immediate tax rate increase to 25%. For them, the new tax rate will be gradually phased in over five years.
- New tax incentive policy
The new regime adopts the "Predominantly Industry-oriented, Limited Geography-based" tax incentive policy, which is a significant deviation from the existing regime.
Key emphasis is placed on "industry-oriented" incentives aiming at directing investments into those industry sectors and projects encouraged and supported by the State (see Appendix). The Law clearly reflects the government focus on technological development, environment protection, energy conservation, production safety, venture capital and continuing investment in agriculture, forestry, animal husbandry, fisheries and infrastructure development. The Law defers to the State Council to propose the scope and definition of eligible projects and adjust such scope from time to time in accordance to the Country's need.
With the cancellation of the general manufacturing tax holidays, FIEs engaging in certain traditional industries (e.g. manufacturing low-end products, labour-intensive production) will face with negative impacts. For these enterprises to qualify for tax incentives under new law, they will have to consider new measures such as raising the high/new-tech content of their products and production technology, as well as purchasing capital goods for enhancing environmental protection, water and energy conservation, and production safety in order to qualify for new investment tax credit.
In order to provide transitional relief to the adversely affected taxpayers due to the cancellation of tax holiday benefits, existing FIEs will be able to enjoy their existing tax holiday treatments until they expire in accordance with the current law. Please see grandfathering treatments for Old FIEs in Appendix.
As mentioned, limited focus is placed on the "Geography-based" incentives. Under CIT Law, new high/new-tech enterprises that are specified as supported by the State established in the Special Economic Zones and the Pudong New Area would enjoy certain transitional preferential tax treatments. Whilst details are vague as to the nature of such preference, this rule may suggest that high/new tech enterprises established in these zones may receive more attractive preferences. Further, the preferential tax treatments for "Encouraged Enterprises" located in the Western Region will remain.
- Anti-avoidance
CIT Law devotes an entire chapter entitled "Special Tax Adjustments" to anti-avoidance. This reflects the theme of "Stringent Administration". This chapter reinforces the determination of the State to crack down tax arrangements with the main purpose of avoiding taxes and to strengthen the administration over transfer pricing ("TP") between related parties. This Chapter paves the legislative foundation for more robust TP disclosure and documentation requirements. With far-reaching implication is the introduction of four new measures to combat tax-avoidance, namely:
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a general anti-avoidance provision that empowers tax authorities to adjust taxable income where business transactions are arranged without reasonable business purpose;
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| (ii) |
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specific "thin-capitalisation" rules under which interest associated with borrowings of a company regarded as exceeding prescribed debt/equity ratio may be disallowed;
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| (iii) |
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"controlled foreign corporation" rules ("CFC") under which Chinese shareholders may be taxed on their portion of undistributed profits as retained by CFCs in certain low-tax jurisdictions without valid business reasons, and
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an "interest levy" clause which seeks to impose interest on any tax adjustments made under this Chapter. China does not currently subject TP adjustments to penalties and surcharges. |
This Chapter also provides positive development. Cost-sharing principle is formally adopted into the Law for both joint development of intangible assets and provision/receiving of common services of group companies. However, since China may not have much experience in implementing cost sharing arrangements ("CSA"), it remains to be seen as to the practical aspect of this rule. Actual experience suggests that extra care and significant effort is required to negotiate, substantiate and sustain the tax positions of CSAs.
- Withholding tax reduction and exemption
Unlike the current income tax law, CIT Law does not specifically exempt withholding tax on dividend payable to foreign investors. It does not specify if the provisional reduction in the withholding tax rate (10%) currently applicable to interest, rental, royalty, and other passive income derived by foreign companies from China would survive. It shall be noted that CIT Law, however, provides for the possibility of withholding tax exemption or reduction for China source income, the details of which have not been published. Hence, we expect that this issue will be clearly addressed in the implementing regulations.
Conclusion
The new CIT Law brings a fundamental change of China tax policy towards foreign investors. Existing foreign investors shall review their tax profile, conduct impact analysis and revisit their current tax planning structures against the new tax regime in China. For investments at the planning stage, impact of the additional income tax burden on the project return should be considered in the course of commercial decision.
There will be a need for new thinking and strategy to minimise China income tax. All investors shall consider a comprehensive review on how their FIEs may optimise and take advantage of the new forms of tax incentives under the new regime. We particularly welcome the move of China to adopt more sophisticated tax incentive measures including super deduction and investment tax credit which appears to be accessible to taxpayers in general.
Indeed, the current CIT reform has gone through a long process. But, the promulgation of CIT Law only marks the beginning of another chapter. There are still many unanswered questions on important matters relevant to foreign investors. The State Council will oversee the drafting and promulgate the detailed implementation rules with the support of the State Administration of Taxation and Ministry of Finance.
CIT Law has unified the tax rate, tax incentives, and expense deduction rules for DEs and FIEs, but unification of tax treatments is far from complete. This work would go beyond the basic provisions of the new Law. For instance, the tax treatment of business restructuring like merger, acquisition, equity transfer, like kind exchange, in-kind contribution etc. are currently very different between FIEs and DEs and needs to be aligned.
PwC will continue to monitor the development of the CIT reform and share our information and analysis with our clients and business associates to help them understand the impacts.
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Appendix: Summary of key aspects of China Corporate Income Tax Law
| Key Aspects |
Key Changes in Unified CIT Law |
Observations |
| Concept of "Tax Resident Enterprise" ("TRE") |
- TRE concept is introduced whereby TREs are subject to China income tax on worldwide income, and non-TREs on China source income.
- FIEs registered in China are always TRE.
- Foreign Enterprise ("FE") whose effective management institute is based in China is regarded as a "TRE". This new concept goes beyond the current "Permanent Establishment" concept which taxes FEs only on their China source income.
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- The move towards taxing enterprises depending on their residency status may seem like a significant change to the taxing principles. First of all, this change is just to make China CIT regime consistent with many other tax jurisdictions and is consistent with tax treaties. DEs and FIEs are unaffected by the change because they are taxed in China anyway. An FE without its effective management institute based in China is taxed the same way as before depending on whether it has a PE or not. It is only in the cases where an FE may be considered to have its effective management based in China that will be caught under this new provision.
- The definition of "effective management institute" is not provided under CIT Law.
- FEs need to be careful about the "effective management institute" rule when they consider undertaking more regional management functions within China including regional headquarters.
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Tax Rate - FIEs |
- Standardised rate of 25%, with reduced rate of 20% for qualified small and thin-profit companies.
- 15% for encouraged high/new-tech enterprises.
- FIEs approved before the publication date of the CIT Law and currently taxed at 15% or 24% will be offered a gradual increase to 25% within 5 years.
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- High/new tech enterprises no longer need to be located within so called high-tech parks and can enjoy tax incentives wherever located.
- The definition of "high/new-tech enterprises" is not yet available. It is believed that the scope of eligible enterprises will be subject to adjustment from time to time in line of the economic development goals set by the State.
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Tax Rate - FEs |
- 20% withholding tax ("WHT") rate for passive income derived by Non-TREs.
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- The Law has not addressed whether the current provisional 10% WHT rate on passive income and the WHT exemption on FIE's dividends to their foreign investors may continue.
- CIT Law has a specific provision allowing for reduction / exemption of WHT. Hence, if China considers necessary to keep current treatment, there is a framework to grant such relief.
- Foreign investors may explore potential use of a Special Purpose Vehicle resident in treaty countries/regions to do WHT planning.
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Tax Incentive Policies |
- Tax reduction and exemption treatments are targeted primarily towards (i) agriculture, forestry and animal-husbandry, fishery projects, (ii) basic infrastructure projects; (iii) environment protection projects and energy/water conservative projects; (iv) qualified technology transfer.
- "Super deduction" is allowed for R&D expenses for new technology, new products, new craftsmanship.
- Taxable income may be reduced by a deemed deduction calculated as a percentage of investment amounts for venture capital businesses engaged in encouraged industries.
- Shorter tax depreciation life or accelerated depreciation is allowed for particular types of fixed assets due to advancement of technology.
- Reduction allowance may be allowed for revenue earned from products manufactured with comprehensive resources pursuant to the State industry policies.
- Investment tax credit is allowed on qualifying expenditures on plant and machinery for environmental protection, energy and water conservation, and production safety.
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- The tax incentive policy is shifting from "Geography-based" tax incentives to "Pre-dominantly Industry-oriented, Limited Geography-based" tax incentive policy. The new tax incentive policy is focused on high/new technology which is critical to China's future success.
- "Production FIEs" and "Export-oriented FIEs" in general industries may enjoy only limited incentives via qualifying R&D activities and capital investments, etc
- The scope of basic infrastructure projects eligible for tax preference is subject to further stipulation and adjustments by the State Council from time to time in line of the economic development goals.
- No details yet as to what are the incentives, and how to apply the new tax incentives, e.g. criteria, standards, proportion, or periods.
- Does not appear that the reinvestment tax refund benefit for FEs would survive.
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Grandfathering of previous preferential tax treatments |
- Unused tax holiday of FIEs approved to be established before CIT Law is grandfathered till the expiry. Where the tax holiday has not yet started because of tax losses, it shall be deemed to commence from the first effective year of Unified CIT Law.
- New FIEs which engage in high/new-tech industries encouraged by the State and located in SEZs and Pudong may enjoy transitional preferential treatments (to be defined).
- Enterprises in encouraged industries located in Western regions would continue to enjoy the existing tax incentives.
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- The forced start date of the holiday in 2008 appears to aim at bringing the transition period to a close as quickly as possible. It also deters FIEs from using various tactics to postpone profit-making year in order to leave the low rate to future years.
- It is unclear what transitional preferential treatments would be granted to new FIEs in high/new-tech industries located in SEZs and Pudong.
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Tax Deductions |
- Most rules similar to current law for FIEs.
- Charitable donation is limited with a cap.
- Non-deductible expenses have been expanded to include sponsorship expenses, and unverified provisions and reserves.
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- DEs will face less limitation in deducting expenses when compared to before. But FIEs will be subject to new deduction limitations, e.g. sponsorship fees. Definition of sponsorship fees is not available yet.
- CIT Law does not mention deduction caps for entertainment expenses which may be addressed in the Implementation Rules.
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Anti-avoidance Rules |
- Cost sharing is allowed in respect of intangible assets developed and shared among related parties, and for the provision and receiving of common services, as long as the sharing basis is on arm's length.
- More stringent requirements on filing and submission of related party information for TP enforcement.
- "Controlled Foreign Corporation Rules" ("CFC Rules") such that undistributed profits derived by CFCs located in low-tax jurisdictions may be taxed in China as a deemed distribution.
- "Thin-capitalisation Rule" such that excessive interest expense may be disallowed.
- General anti-avoidance provision for making adjustments to taxable revenue or taxable income where business transactions are regarded as arranged without reasonable commercial purpose.
- Tax adjustments made under the Anti-avoidance Chapter may be subject to interest levy.
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- China may not have much experience in implementing cost sharing arrangements ("CSA"). So it remains to be seen as to the practical aspect of this rule. Actual experience suggests that extra care and significant effort is required to negotiate, substantiate and sustain the tax positions of CSAs.
- Annual TP Documentation Requirements are expected to be introduced to echo to various TP provisions in the Law.
- CFC rules are introduced for the first time to tackle anti-avoidance arrangements of DEs as they invest and operate overseas.
- All the anti-avoidance provisions under this new Chapter are commonly seen internationally. Hopefully the forthcoming implementation rules will clearly establish the definitions of anti-avoidance activities and situations. Otherwise there could be disputes between taxpayers and tax authorities in practice over this matter.
- "Interest levy" on anti-avoidance adjustment will serve as "teeth" in the law.
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Tax Consolidated Filing for Groups of companies |
- Not allowed unless approved by State Council.
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- Tax consolidated filing is currently allowed for some domestic state-owned conglomerates under special approval of the State Council. It is uncertain whether FIE groups in the future may apply for consolidated tax filing in light of the "National Treatment" principle.
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Tax Filing Administration |
- Filing of annual tax return period is extended to 5 months (from 4 months now) after year end.
- Provisional reporting and payments may be made on monthly basis or quarterly basis.
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- Not clear who may be subject to monthly provisional filings. FIEs clearly prefer to continue quarterly reporting.
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