China Tax/Business News Flash 

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Please click on the links below to view more:   Latest insights into China's new Corporate Income Tax Law and the draft detailed implementation regulations.   We reported in our March issue (2007 issue 6) of News Flash that the National People's Congress, on 16 March 2007, passed China's new Corporate Income Law ("CIT Law") which will become effective on 1 January 2008.   The CIT Law mainly provides a framework of general tax provisions.  Important details, definitions of numerous terms as well as the interpretation on application of various provisions are left to the detailed implementation regulations ("DIR") and supplementary tax circulars.  We have been closely monitoring the development and understand that a comprehensive draft of the DIR has already been circulated to and commented by various ministries, local governments and other relevant parties.  The draft DIR is being amended to reflect such feedback.  The next step is for the State Council to review and finalise the DIR which is expected to be announced in October or early November 2007.   We aim to summarise in this News Flash various important provisions in the draft DIR impacting foreign investors' operations in China.  Foreign investors are urged to evaluate the potential tax impact of these possible changes and to take proactive actions both before year end and afterwards in order to manage the new complexities brought by the new CIT Law and DIR.   In this News Flash, we address the potential DIR rules affecting the following 3 groups of taxpayers:   A. Foreign investors investing into China and/or providing financing to their foreign invested enterprises ("FIEs"); Expand / Collapse Impact to structuring and financing of investment in China by foreign investors Structuring   Currently, dividend repatriated by a foreign investment enterprise ("FIE") to its foreign investors is specifically exempted from withholding income tax ("WHT") under the existing foreign enterprise income tax law ("FEIT Law").  Under the CIT regime, such a general exemption is unlikely to be provided except it may be granted to certain high / new tech enterprises meeting various requirements (please see "Section B, Item 4c" for the possible definition of such an enterprise).  Instead, a generally reduced WHT rate, likely at 10%, may apply.  Further, the current tax-free reorganisation concession on the restructuring of shareholding of FIEs within a 100% group, may no longer be available after 2007 where the transferee of the PRC equity interest is not an enterprise incorporated in China.   In this respect, foreign investors may consider the following actions to be completed before the end of 2007:   declaring and physically repatriating accumulated retained earnings from their existing FIEs before 31st December 2007 with due considerations given to the home country's tax implications of such repatriation, so as to enjoy the current China WHT exemption on dividends.  Where the 2007 earnings are significant, the FIEs may consider to apply for special approval for remitting interim dividends although given the tight timeframe, speedy action and discussions with relevant authorities are crucial;   re-investing accumulated retained earnings of their existing FIE back into the FIE or into another FIE held by the same investor before year-end, in order to be eligible for the "re-investment tax refund" (this incentive will be repealed in the new law);   restructuring the shareholding of the FIE for it to be held by an appropriate treaty jurisdiction which has favourable dividend WHT rate with China.  Hong Kong and Singapore may be attractive (5% WHT rate for dividend generally), although it is noteworthy that a number of countries have expressed intention to renegotiate tax treaties with China in the near future including Germany and Netherlands, and hence future development shall be closely monitored.   Financing   On the financing side, the CIT Law also contains specific "thin-capitalization" rules to disallow interest deductions on borrowings from related companies if the interest-bearing loans of the enterprise exceeds a certain prescribed debt-equity ratio.  The DIR is expected to provide a definition of 'equity' to include paid-in capital, capital reserves, surplus reserves and undistributed retained profits.  In addition, there may be different prescribed debt-equity ratios for taxpayers in different industries: such as a higher ratio for financial institutions; and a lower ratio for other industries.  Further, an exception may be provided to the general rule where an enterprise is able to prove that the terms of the borrowing are at arm's length.  Therefore, foreign investors shall keep the new "thin-capitalization" rules in mind when devising financing arrangements for their China operations in order to preserve the full deduction of related-party interest expenses to the borrowing enterprises.   Other means of repatriation   Other means of repatriation by foreign investors may include royalties received from China subsidiaries in return for provision of technologies, and rental of tangible assets.  Royalties and rental income derived from China source are subject to WHT at 20% under the CIT Law although the DIR may provide a unilateral reduction to 10%.   Anti-avoidance   One should also consider the general anti-tax avoidance rules ("GAAR") in Article 47 of the CIT Law which give the power to Chinese tax authorities to make adjustments where business arrangements entered into by an enterprise are regarded as without bona fide commercial purposes and which result in reduction in taxable gross income or taxable income of the enterprise.  We understand that the term "arrangements without bona fide commercial purpose" may be defined in the DIR to mean arrangements with a major objective to reduce, exempt or delay the payment of taxes.  Obviously, under the new law, companies entering into structuring, restructuring, financing and other business arrangements should be prepared to justify the transactions with valid commercial reasons.   Close B. FIEs operating in China; and Expand / Collapse Impact to FIEs   Among others, we understand that the draft DIR may have the following important changes to the calculation of taxable income of an FIE.  These changes may be broadly categorized into the following categories: gross income, deduction of expenses (including depreciation charges), group restructuring, preferential tax treatments and special tax adjustments. Gross income   The DIR may provide elaborated details on the term Gross Income with the implications to include all receipts.  The DIR is also expected to provide better clarity on the timing as to when to recognise certain types of income as taxable under the CIT Law.   Further, the DIR may introduce the "income deeming" provision.  For instance, where an enterprise has engaged in barter trade or uses its stock, assets and services for donation, fund raising, advertising, sample, staff welfare or profit distribution, it may be deemed as if it has sold the products and services and should recognise the related income.  Although similar income deeming provision currently exists in the VAT regime, it is important to keep in mind the additional income tax impact and compliance complexity brought about by the new provision.   Deduction of expenses   General deduction criteria - the CIT Law stipulates that an enterprise can deduct reasonable expenses that are actually incurred and are related to the generation of income.  The term "reasonable expenses" is expected to be defined in the DIR as necessary and ordinary expenses incurred in the course of normal business, and the term "related expenses" is expected to be defined as expenses that are directly related to the generation of income.  As this is a principle-based rule, the taxpayers and the Chinese tax authorities may adopt their respective judgements on what may be regarded as deductible expenses, and different interpretation may lead to tax audit challenges.   Wages and salaries - the DIR may confirm that reasonable salaries and wages actually incurred by an enterprise shall be deductible without specific deduction caps.  However, there may be rules restricting the deduction of salaries and wages paid to the enterprises' major shareholders or other related personnel to within reasonable ranges.  Apparently this is another anti-avoidance measure.   Interest expense - the DIR may adopt a new term called "borrowing costs" which may carry a wider meaning than interest.  This would allow the future explanatory circulars to capture additional costs and expenses associated with borrowings under the deduction rules, which may take different forms or terminologies, such as guarantee fees, handling fees, standby fees, arrangement fees or any others.  Obviously, the purpose is to counter the tax avoidance by splitting the interest into different parts in order to get around the restriction on interest deduction.   "Business Entertainment Expense" - the DIR may only allow deduction of 50% of business-related entertainment expenses incurred by an enterprise.   Advertising expenses - the DIR may restrict the deduction of advertising expenses incurred by an enterprise in a tax year to 15% of the sales (business) income for that year.  Any excess amount may be allowed to be carried forward and deductible in future years.  Discussions have been held via various channels that such a threshold may not be reasonable nor appropriate for all taxpayers and one of the proposals is to allow enterprises an opportunity to apply for a special concession to deduct the advertising expenses exceeding this threshold, similar to the existing policy for domestic enterprises.   Sponsorship expenses - the CIT Law specifically disallows the deduction of sponsorship expenses.  However, the DIR may merely define sponsorship expenses to mean all kinds of sponsorships that are not in the nature of advertising.  With such a vague definition, it is possible to see some taxpayers having their sponsorship activities to be handled through an advertising agency to hopefully secure deduction for these expenses as advertising expenses.   Management fee - "management fees" paid to related parties are currently not deductible under the existing FEIT Law.  The DIR may allow deduction of arm's-length fees for genuine management services and/or other services paid to related parties.  However, from a transfer pricing perspective, it does not change the potential challenge on the allocation of head-office expenses of stewardship nature.   Depreciation of fixed assets - the DIR may no longer require a 10% residual value to be placed on fixed assets for the purpose of calculating tax depreciation expenses.  There would still be prescribed years of tax useful lives for different categories of fixed assets as before.  However, electronic equipment may be allowed to have shorter useful lives for tax purposes.   Amortization of acquired goodwill - the DIR may not allow the amortization of acquired goodwill for tax purposes, until the acquiring enterprise disposes of its entire business or liquidates.  This treatment entirely deviates from the current tax treatment for FIEs in similar situations which allows amortisation of goodwill over 10 years generally.  Significant tax timing difference may be caused by this draft provision, causing gains arising from taxable business restructurings to be taxed upfront to the transferor whereas the acquirer may not claim amortisation of acquired goodwill until those critical events occur.  Further, for FIEs that have previously acquired businesses with goodwill, it is uncertain whether they may be able to continue amortising their goodwill for tax purposes after 2007.   Some of the above changes are actually made to be in line with the new accounting standards in China, so as to minimise the number of the book / tax differences between the income tax filings and the accounting profits.   Corporate restructuring   The DIR may codify taxation treatments for various forms of corporate restructuring.  Corporate restructurings covered in the DIR are expected to include changes in legal form and address (domicile) of an enterprise, recapitalization, transfer of entire business assets, swapping of entire business assets, merger and spin-off, etc.  We understand that the DIR may require a general recognition of gain or loss for corporate restructurings, unless the transactions fulfil specific conditions for deferral treatment (see Item d below).  Advance confirmations with the tax authorities may be required for tax-deferral treatments.  Furthermore, the tax basis of the transferred assets in the hands of the transferee shall be determined according to how the transactions are taxed to the transferor.   As mentioned in Section A, the current tax-free reorganisation concession on the restructuring of shareholding of FIEs within a 100% group may no longer be available after 2007.   The DIR is expected to address loan restructuring as well whereby the gain or loss for the borrowers and lenders should be recognised accordingly.  Special rules may apply if the borrower and lender are related parties in order to counter "tax-avoidance driven" loan restructuring schemes.   The DIR may allow certain types of restructuring to be conducted on a tax-free or a partial tax-free basis, i.e. deferring the recognition of the full or partial gain or loss, provided that certain conditions are met.  For restructuring relating to the swapping of entire assets, the asset swapping may qualify for tax free rollover or partial tax-free rollover provided that the value of monetary assets used to make up the shortfall on the swap is less than 20% of the fair value of the swapped assets.  For restructuring relating to the transfer of entire assets, merger or spin-off, the transaction may qualify for tax free rollover or partial tax-free rollover provided that the fair value of non-share consideration used to make up the shortfall is less than 20% of the face value of the share.  This implies that for restructuring of shares and assets within a foreign investment enterprise group in China, there may be better clarity and flexibility than the existing rules.   Further, for mergers, the DIR may significantly restrict the ability of the merged entity to utilise carry-forward tax losses to an amount determined by a prescribed formula.  The limit to utilise pre-merger loss may be determined on a yearly basis with reference to the fair market value of the net assets of the merged enterprise multiplied by the interest rate of the treasury bonds issued in the same year by China with the longest maturity term.  This rule, if enacted, would be much more restrictive than the current FEIT treatments and will substantially reduce the effectiveness of the planning idea commonly deployed currently to enable the use of the otherwise expiring losses via merger.  It is uncertain whether previously merged entities would not be affected by the draft rules if enacted in the current form.   Preferential tax treatments   The CIT Law generally treats dividend income paid by a tax resident enterprise to another tax resident enterprise as non-taxable.  The DIR may exclude dividends arising from investment in publicly listed shares from this preferential treatment.   The CIT Law provides preferential tax treatments in the form of tax reduction or exemption for income arising from technology transfers meeting certain prescribed criteria.  The DIR is expected to provide more details of such criteria.  However, it appears that full exemption may only be given up to a certain threshold of income with the remaining amount only being able to enjoy partial exemption.  In other words, the magnitude of this tax incentive may not be as generous as the current FEIT treatments for the qualifying technology transfers.  In addition, the preferential treatments may be further restricted for transfers of technology between related parties.   The CIT Law stipulates a reduced CIT rate of 15% for high / new tech enterprises that are specifically preferred by the State.  The DIR may define such high / new tech enterprises with reference to the following parameters:   the enterprise should possess its own intellectual property rights in China;   a prescribed proportion of income from the sale of qualified products and technical fee income to the enterprise's total income;   a prescribed proportion of the number of employees with college degrees or certificates to the total number of employees;   a prescribed proportion of the number of R&D to the total employees; and   a prescribed proportion of the annual R&D expenditure to the total income at different levels.   If the above parameters are adopted, there is a concern whether enterprises (including FIEs) which are currently qualified and have attained the status as high / new tech enterprises would still qualify for the 15% rate under the new law.  In addition, it poses an added challenge to MNCs which do not wish to move and reside the ownership of intellectual property rights of their technology inside China.  However, we understand that this is still an area under discussion and debate within various Chinese ministries.  It is possible that FIEs which have attained the "high / new tech enterprises" status under FEIT regime may be subject to a re-assessment exercise based on the new parameters under the new CIT regime.  The existing high / new tech FIEs should pay particular attention to the new parameters and where necessary and commercially feasible, may consider making adjustments to their operations to meet the new requirements in order to secure the tax preferences after 2007.   The DIR should be providing further information and criteria for other preferential tax treatments as laid down in the CIT Law, such as taxable income reduction, investment tax credit, super-deduction, tax holidays, etc. for different types of encouraged industries, activities and projects.  We expect that the DIR would address this area by way of broad principles whilst referring to various detailed criteria, catalogues and implementation procedures being developed and to be issued by other government ministries and departments together with the Ministry of Finance ("MoF") and the State Administration of Taxation ("SAT").  With this approach, the State Council will have ample flexibility to refine the policies from time to time to cater for the changing economic and development needs of the country.   Special tax adjustments   Special tax adjustments include transfer pricing ("TP"), controlled foreign companies ("CFC"), thin-capitalization and GAAR.   Transfer pricing ("TP") has been regarded as a very important tax issue in China which has attracted much attention of foreign investors as well as FIEs.  The Chinese tax authorities have geared up their administrative regulations and enforcement over the past few years.   The DIR is expected to move a further step in transfer pricing enforcement by introducing the "contemporaneous documentation" requirement.  This would require taxpayers having related party transactions to record and compile the information of pricing / expense determination basis, computation methods and explanations, etc.  Taxpayers are expected to be able to respond to tax authorities' request for such information within a short period of time (say 30 days), and hence taxpayers will need to prepare transfer pricing documentation on a contemporaneous basis.  Having transfer pricing documentation ready would help mitigate the interest levy (see further Item f below).  We understand that the SAT is preparing a separate circular to address the related details regarding the contemporaneous documentation requirement which may be issued soon after the final DIR is announced.  FIEs in China typically have engaged in some forms of related party transactions and will need to deal with the new compliance requirements.   We expect that the "contemporaneous documentation" requirement would start to apply for related party transactions happening in the 2008 tax year.  For previous years, it is still advisable for FIEs to assess their TP profile and to prepare appropriate TP documentation as an effective tax management tool.   The CIT Law introduced a new concept of Cost Sharing Arrangement ("CSA") allowing the participants to share the joint costs incurred for the research and development of intangibles and provision / receipt of services.  The DIR would require the CSA agreement to spell out the sharing ratio and amounts of the joint costs, matching to the respective ownership, right to use and right to benefits.  The applicant for CSA would also be required to submit other relevant TP information to the Chinese tax authorities for review after the conclusion of the agreement.  The shared costs may only be deductible if the required information is duly prepared and submitted, the CSA is in line with arm's length principle, and the CSA is supported by a reasonable commercial purpose or possess economic substance.   For taxpayers seeking the acceptance of their CSA by the tax authorities, the draft DIR encourages the use of Advance Pricing Agreement ("APA") because this approach would allow the Chinese tax authorities an opportunity to review the contents and reasonableness of the CSA before the related costs are allowed for tax deduction.  Even with the DIR issued, there may still be questions on the readiness of the China tax authorities to deal with a large number of CSA applications at the initial stage of implementing the new CIT regime.  Hence, companies exploring the use of CSA shall get proper advice regarding the best possible approach to attain the desirable tax results in a time and cost effective manner.   APA is not new.  However, the DIR may allow flexibility for the tax authorities and taxpayers to cover prior years TP disputes with "roll-back" APAs.  With the higher legal status granted in the CIT Law, FIEs may consider the option of applying APA during the TP audit.  Arguably, for bilateral APAs, the FIEs might be in a better position to avoid double taxation with the new potential of roll-back application.   The CFC rules may not be a concern to most FIEs at this stage as it is unlikely, or tax efficient under the new tax regime, that MNCs would use an FIE to invest outside China.   The GAAR provisions and thin-capitalization rules have already been discussed in Section A above.  Please see previous text.   The DIR may provide details about the interest levy to be imposed on any special tax adjustments, namely: TP, CFC, thin-capitalisation, and GAAR rules.  We understand that the interest levy rate may be set at the rate of 5% above the RMB lending basic interest rate published by the People's Bank of China.  The Interest levy would be additional costs to taxpayers and hence is viewed by tax authorities as a deterrent to aggressive tax avoidance schemes.  This additional 5 percentage points may be waived, if the contemporaneous documentation for TP purposes is available.  In addition, there may be a statute barred period of 10 years for these special tax adjustments.   Close C. Foreign Enterprises ("FEs") which are deriving income from China source and/or otherwise carry on business activities in China. Expand / Collapse Impact to foreign enterprises Effective management organisation   Under the CIT Law, an enterprise established outside China, i.e., a foreign enterprise ("FE"), which has its effective management organisation in China shall be considered to be a "tax resident enterprise" ("TRE") and subject to CIT on its worldwide income.  We understand that the DIR may consider the effective management organisation to be in China if the overall management and control of the production and business of an enterprise is exercised from within China.  This general definition may not provide much sought-after guidance to FEs. If this rule is adopted, the determination of tax residency would be left to the Chinese tax authorities' interpretation in accordance to the facts and circumstances of each case.  Based on our understanding, China may apply this provision in a discretionary manner to different situations according to the tax enforcement agenda of the authorities. For instance, it may choose to adopt a lenient approach towards Regional Headquarters ("RHQs") of MNCs established in China in order to encourage more RHQs to be established in China.  Clearly, the actual interpretation of this provision shall be monitored at both the State level and local level who may take different interpretations on the matter.  FEs (and their FIEs counterparts in China) shall act on the cautionary side and review their management and control functions within China for their overseas business activities, evaluate the tax risk level, and take precautionary actions.   Permanent establishment ("PE")   The CIT Law also stipulates that a non-TRE having an establishment or place in China shall be subject to CIT on income derived by that establishment or place from sources within China and on income derived from sources outside China which is effectively connected with such establishment or place.  The DIR may adopt a definition for "establishment or place" which is very similar to that in the existing FEIT Law, but the term "business agents" within that definition may be expanded to include persons / entities which regularly represent the non-TRE in business, other than the purchase and sale of goods.  This expanded definition may potentially catch agents which regularly provide services in China on behalf of its overseas principals.  FEs should review their operations and assess if they may invoke protection from being regarded as PE in China by virtue of double tax treaties.  If not, then they may need to revise their operational arrangements with their agents in China to mitigate the tax exposure in China.   WHT on passive income from China source   Further, the DIR may generally reduce the WHT on passive income (e.g., dividends, interest, royalties, rental, gain on transfer of properties, etc.) received by a non-tax resident enterprise with no establishment or place in China from 20% to 10%.  In addition, among others, the following passive income may be totally exempt from tax:   interest income from loans made by foreign banks to banks within China at preferential rates and interest income on bonds issued by banks within China to foreign banks at preferential rates.  The "banks in China" may include those foreign invested banks in China as many of the foreign bank branches in China have undergone "corporatization" earlier this year; and   dividends received by a non-tax resident enterprise with no establishment or place in China from a high/new tech enterprise supported by the State (please see "Section B, Impact to FIEs" for the possible definition of such an enterprise).   Filing   When a non-TRE derives active income from China or income within China through a PE, the payer of the income is designated by the CIT Law to be the withholding agent.  The DIR may allow the non-TRE to file and settle the tax liabilities itself within the filing deadline prescribed by the CIT Law if the withholding agent is not able to fulfil the withholding obligation due to special reasons and the relevant tax authorities are willing to allow such self-reporting.  This provides flexibility for FEs to handle their own China tax affairs. Close Note: We wish to emphasize that the content here is prepared based on our continuous insights and dialog with the legislative bodies as well as our understanding of the draft provisions in the DIR at the time of writing.  Clearly, the draft DIR has not yet obtained statutory approval and is still undergoing further debate and changes prior to being finalised.   PwC Observations   Based on the above, the DIR would be adopting various international tax principles and practices in elaborating the provisions of the CIT Law.  The DIR would also have certain tax rules bearing closer resemblance to the new Chinese accounting standards.   Still, it is expected the DIR will not provide all the answers to the uncertain expressions in the new CIT Law.  The provisions in the DIR may cause more questions to be addressed in the form of future circulars and administrative rulings.   Many taxpayers may feel strange that elaboration of the grandfathering rules is not contained in the DIR, such as the gradual transition of tax rates from say 15% to new rate of 25% over the 5-year period.  (As far as we understand, one of the proposals being considered for 15% taxpayers is 18% for 2008, 20% for 2009, 22% for 10, 24% for 2011 and 25% for 2012 for the 5 transitional years respectively.)  A view was taken by the policymakers that it is more appropriate to address tax treatments of transitional nature in separate circulars rather than in the DIR which will be in force for many years.   On 31 August 2007, the MoF and SAT jointly issued a circular to clarify the term "enterprises which have been approved to be established before the promulgation of the CIT Law (16 March 2007)" - or so-called "Old Enterprises".  Old Enterprises refer to those companies which have performed business registration with the Administration for Industry and Commerce on or before 16 March 2007 and these companies would be eligible for the grandfathering treatments as stipulated in the CIT Law and DIR.   Note: Finally, may we repeat that information contained in this article is prepared based on our research into the latest thinking of the policymakers.  As the DIR has not yet obtained statutory approval, it is still subject to significant amendments prior to finalisation.  We will continue to closely monitor the DIR development and provide you with our commentary as soon as the DIR is released.

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