Changes are afoot with Mainland China's tax system, write Joseph Lam and Anthony Hung.
China unifies enterprise income tax law
The China National People's Congress passed the new unified enterprise income tax law on 16 March 2007.
The primary objective of the reform is to create a level playing field and a standardised and transparent fiscal environment that favours fair competition for all enterprises (including local and foreign equity based enterprises) in China in line with its obligations under the World Trade Organization.
It is anticipated that the tax reform is likely to help to enhance development of China's economic structure and modernisation of various industries in China. The new unified enterprise income tax law will be effective from 1 January 2008.
The new law seeks to unify the scope of application, tax rate, tax deductions, and preferential tax policies for both FIEs (foreign investment enterprises) and domestic enterprises. An FIE is a sino-foreign equity joint venture, a cooperative joint venture or a wholly foreign-owned enterprise established under the Foreign Investment Law in China. Major areas of the tax reform affecting foreign companies and investors are as follows:
Tax residency concept
Under the new law, the extent of income tax liability is governed by the residency status of the taxpayer.
There will be two types of taxpayers: resident enterprises and non-resident enterprises. A resident enterprise is established in China under Chinese law, or has its place of effective management in China. A non-resident enterprise is established under foreign law, and has its place of effective management outside China. It could either have set up an establishment or a place of business in China or just derive income from sources in China.
The new law, however, does not contain details of how the place of effective management of an enterprise is determined.
According to the relevant provision in the new law, resident enterprises will be subject to tax on their worldwide income.
Non-resident enterprises that have set up an establishment or a place of business will be subject to tax only on income from sources in China. Non-resident enterprises will be subject to withholding tax on dividends, royalties, interest, rentals, capital gains or other income derived from sources in China that is not effectively connected with an establishment or a place of business in China.
Tax rates
The standard corporate income tax rate under the new law is 25 per cent for all enterprises, except for small-scale enterprises earning a small profit, where the tax rate will be reduced to 20 per cent. A small-scale enterprise is not defined in the new rule.
New tax incentives
The new preferential tax policies will focus on designated industries rather than geographical locations. Such policies are designed to encourage energy and resources savings, environmental protection, and development of high technology.
The new law will revoke the existing five-year tax holiday (i.e. two-year tax exemption and three-year 50 per cent reduction of applicable tax) for qualifying production oriented FIEs, as well as the extension of such tax holiday in form of 50 per cent reduction of the applicable tax previously available to production oriented FIEs exporting 70 per cent or more of their products manufactured in China.
While the new law specifically provides that production oriented FIEs established prior to the date of promulgation of the new law (16 March 2007) can enjoy the above mentioned five-year tax holiday, the new law does not address whether production oriented FIEs established during the period from 16 March 2007 to 31 December 2007 (that is, before the effective date of the new law on 1 January 2008) can enjoy the five-year tax holiday.
This may be clarified in the implementation rules of the new law which are to be promulgated in due course.
Grandfathering of tax policies
The new law merely sets out the overall direction, scope and guiding principles of future preferential tax policies and adjustment to the existing preferential tax policies. For FIEs that currently receive tax incentives such as tax exemption and tax reduction, the new law provides the following grand-fathering treatments:
for FIEs that receive a reduced income tax rate of 15 per cent (for those located in Special Economic Zones Shenzhen, Zhuhai, Shantou, Xiamen and Hainan) or 24 per cent (for those located in Coastal Open Economic Zones), such FIEs will be eligible for a five-year transition period to the unified rate of 25 per cent
for production FIEs which have not fully utilised their five-year tax holiday (i.e. two-year exemption and three-year 50 per cent reduction of the applicable tax rate), they will be allowed to continue to receive such a tax holiday during the five-year grandfathering period. For those FIEs that have not yet embarked on their tax holiday, the holiday will be deemed to have commenced from the effective date of the new law.
Anti-avoidance measures
Certain anti-avoidance provisions are included in the new law which empower the tax authorities to make tax adjustments and impose interest surcharge in tax avoidance cases.
Specifically, the new law will tighten related-party transactions reporting requirements, introduce new controlled foreign corporation rules and new thin capitalisation rules, as well as general anti-avoidance rules to counteract tax avoidance arrangements.
For instance, according to the 'controlled foreign corporation' (CFC) rules under the new law, Chinese shareholders may be taxed on their share of undistributed profits in CFCs established in certain low-tax jurisdictions in the absence of valid business reasons.
Withholding tax reduction and exemption
Unlike the current Foreign Enterprise Income Tax law, the new law does not specifically exempt withholding tax on dividends payable to foreign investors.
It does not specify if the provisional reduction in the withholding tax rate from 20 per cent to 10 per cent currently applicable to interest, rental, royalty, and other passive income derived by foreign companies from China will continue.
It is to be noted that the new law, however, provides for the possibility of withholding tax exemption or reduction for China source income, the details of which have not been published. Therefore, it's expected that this issue will be addressed in the implementation rules of the new law. The China State Council will formulate detailed implementation rules pursuant to the passing of the new law by the NPC in due course. It is expected that the new law and its detailed implementation rules will take effect at the same time.
Given the new tax reform, foreign investors should take into consideration the potential impact of the proposed changes under the new law on future investments or mergers and acquisitions in China.
Companies in certain industry sectors such as energy and resources, environmental protection, and high- technology sectors will be able to receive preferential income tax treatment (for example, 15 per cent tax rate for technology sectors).
It is expected that large domestic enterprises and foreign multinational companies as well as industry groups or associations will be lobbying for favourable treatment of their businesses or industries during 2007.
Export Valu e- Added Tax (VAT) Refund Rates
The current Chinese VAT regime allows exporters of goods to obtain certain refund of their input VAT incurred in the importation or local purchase of raw materials at various stages of production conducted in Mainland China.
The amounts of VAT refund vary depending on the export VAT refund rates applicable to the specified type of goods. The input VAT could be refunded fully, partially or with no refund at all.
On 18 June 2007, the PRC Ministry of Finance and State Administration of Taxation jointly issued a circular Cai Shui [2007] No.90 (Circular 90), which introduced significant reduction in China's export VAT refund rates for most products effective from 1 July 2007. The coverage as well as the magnitude of this round of export VAT refund rates reduction is remarkable compared to those of the previous rounds.
Circular 90 affects 2831 commodities falling into the following categories which bear the characteristics of high-energy consumption and high pollution and/or those that involve low-technology and low value-adding manufacturing processes:
animal and vegetable products
base metals, minerals and their products
construction materials
chemical products
electrical and mechanic appliances
garment and textile articles
The magnitude of the reduction in VAT export refund rates is not nominal.
According to the current export VAT refund policies in China, the VAT implication for selling Group B commodities as export is that part of the input VAT paid will become cost to the exporters who may or may not recoup the same back from the foreign buyers through increase in selling prices of the relevant products.
The VAT implication for export sale of Group C commodities is that the entire input VAT paid becomes cost to the exporters. The exporters of Group A commodities could be facing the toughest change because their exports would be subject to 'deemed domestic sales' VAT treatment, i.e. they are no longer entitled to any VAT export refund.
Not withstanding these, there may be different assessing practices in different locations of China.
Other common commodities not affected by Circular 90 but with export VAT refund rates having been revised in the past rounds of export VAT refund rates reduction are as follows:
export VAT refund rate
electronic and electrical appliances (13 per cent)
furniture (11 per cent)
computer hardware (13 per cent)
mobile phones (13 per cent)
Circular 90 has far reaching impacts as follows:
increasing the cost of exports from China which in turn increases the cost of purchase to foreign buyers
reducing the incentive of performing export sales by manufacturers in China which encourages them to switch to domestic sales within China
affecting the evaluation of setting up manufacturing bases in China by foreign investors.
It is obvious that the current round of export VAT refund rates reduction in China serves as a tool used by the Mainland Chinese government to narrow down the huge trade surplus between Mainland China and the US by means of discouraging exports from China. However, its effectiveness remains to be seen.
Joseph Lam is executive director regional tax and Anthony Hung is senior China tax manager at Baker Tilly Hong Kong.
