New tax law in the People's Republic of China is moving away from traditional models to one offering incentives for both foreign investors and domestic taxpayers, writes Joe Yu.
A unified approach
Under the old People's Republic of China (PRC) tax regime, foreign-invested enterprises (FIEs) and domestic companies (DCs) operated under two different income tax schemes, the FEIT law and domestic company income tax regulations.
In order to attract foreign investment, the FEIT law offered various tax incentives that were not available to domestic companies.
However, the overall direction of tax law and policy has shifted away from a philosophy of granting special tax preferences to induce foreign direct investment and towards a more unified system that universally applies tax incentives to both FIEs and domestic taxpayers.
Further, there are strong indications that China is increasingly moving away from using policy as an instrument to attract foreign investment and towards a comprehensive system of collecting tax revenue from any party with a taxable presence in China.
First, there is greater attention being paid to transfer pricing. There is also anticipation that a controlled foreign corporation regime will be adopted. There are anti-avoidance rules and new rules broadening the scope of entities considered to be tax residents in China.
Therefore, in an effort to unify the separate regimes into one and enable all enterprises to compete on a level playing field, PRC income tax reform was formally passed into law, the PRC Enterprise Income Tax Law (the 'new law'), on 16 March 2007. The new law became effective on 1 January 2008.
The most significant changes either in the new law or from various sources are summarised as follows:
Firstly, the new law unifies the income tax rate at 25 per cent for both DCs and FIEs.
However, a preferential tax rate of 15 per cent is still applied to certified high and new technology enterprises that are heavily supported by the state. Among the 159 countries and regions worldwide that implement enterprise income tax, the average income tax rate is 28.6 per cent. The average income tax rate of 18 countries geographically urrounding China is 26.7 per cent. In this respect, the 25 per cent rate regulated in the new law is below the surveyed average.
There are some changes in expense deduction. First, there was no deductible limit for public welfare donations incurred by FIEs under the old FEIT law.
However, it now clearly stipulates that donations to public welfare can be deducted up to a maximum of 12 per cent of an enterprise's annual profit. Also, advertising and promotional expenses are allowed to be deducted on an actual basis if they do not exceed 15 per cent of the enterprise's annual revenue.
Any advertising expenses exceeding 15 per cent can be carried forward to future years. Under the old law, FIEs were not subject to a limitation on the deduction of advertising expenses. There are some stricter rules regarding expense deductions, but also some new incentives to encourage certain industries, such as a pre-tax super deduction of R&D expenses actually incurred.
The super deduction can be carried forward for up to five years if the deduction is not fully utilised in the current year. Furthermore, it allows the salary deduction limits and salary expenses currently imposed on DCs to be deducted on an actual basis for enterprise income tax purposes.
As already stated, China is increasingly moving away from using policy as an instrument to attract foreign investment. Hence, certain preferential tax treatments were abolished.
These include the two-year income tax exemption followed by a three-year 50 per cent reduction of the tax rate for manufacturing FIEs, the extended tax holiday for export-oriented FIEs, and the reinvestment tax refund.
But, the Chinese government stipulates many unified preferential policies for both FIEs and DCs. For example, tax policies that were only applicable to high-tech enterprises in the National High-Tech Industrial Development Zone are now implemented nationwide with a preferential tax rate of 15 per cent.
In addition, enterprises that purchase special equipment that is used to protect the environment, reduce the consumption of energy and water, and enhance manufacturing security can claim a certain percentage of their expenditure on such equipment as a tax credit.
Furthermore, revenue that is derived from qualified environmental protection, energy and water-saving projects and technology transfers, can enjoy a tax reduction or exemption. Many concepts are being adopted for the first time in the PRC tax system.
In general, the old preferential tax treatments granted to overseas firms have definitely helped China attract overseas investment, technology, and expertise.
However, some policies have not complied with current international practices and have had some negative effects on the development of a market economy.
The unification of the two laws enables DCs and FIEs to use the same principles and criteria in calculating their taxable income. This will foster more balanced economic growth and development and encourage the consistent treatment of FIEs and DCs, both of which are crucial for China.
Joe Yu is a senior manager of the Ernst & Young Beijing tax practice. He has over 16 years experience in advising major taxpayers and multinational clients in areas such as tax compliance regulations, inbound investment structuring, transfer pricing, and initial public offerings as well as M&A. Yu has also assisted domestic Chinese clients with PRC taxation and transborder issues. Yu's experience covers the many aspects of structuring investments in China, and he has served clients operating in a wide range of industries including pharmaceuticals, hi-tech, real estate and hotel services.
