New PRC Tax Law —Enactment— An Initial Analytical Summary (18/04/2007)
1. What are the main changes brought about by the New PRC Tax Law?
On 16 March 2007, the Tenth National People’s Congress enacted the new Enterprise Income Tax Law (“New Law”), which unifies the income tax treatment of domestic and foreign enterprises. As expected, the new taxation system will take effect for the 2008 tax year with some provisions having immediate effect.
The New Law represents a major change in direction for China. For the past decade and a half, China has operated a dual tax system, with different tax laws and incentive rules and various differences in calculating taxable income. This has resulted in very significant disparities in the effective tax rates generally applicable to domestic Chinese enterprises and to Foreign Invested Enterprises (FIEs). The New Law eliminates these differences and introduces a level playing field.
In addition to the unification of the current laws into a single law, a number of international taxation concepts are added to Chinese legislation. In addition, China has adopted international accounting standards as from 1 January 2007, and the reactions of the State Administration of Taxation (SAT) and the local tax bureaus to these accounting changes are still ahead.
It will be important for all taxpayers, both domestic enterprises and FIEs, to understand the changes brought about by the New Law and the implications for their businesses. Some implications will be very direct; for example, the changes to the incentives regimes will directly affect the amount of tax an enterprise will pay. Some implications, on the other hand, such as the unrestricted ability for domestic enterprises to deduct salary costs, may have an indirect impact on the salary levels of domestic enterprises. Some implications will benefit certain sectors, such as service and real estate industries, while the elimination of tax exemptions for manufacturing enterprise may negatively affect manufacturing FIEs. Rules, such as the abolition of tax refunds for reinvestment, may have immediate implications, whereas others, such as the general anti-avoidance rule, will have long-term effects on operations. Changes, such as the introduction of the concept of tax residence, may have broad and significant implications, while the limit on deductions of donations, is likely to attract less attention.
2. What is the incentive tax system under the New Law?
The New Law reflects a clear shift from the current approach of tax holidays and tax rate reductions for manufacturing in general and for certain specific locations to a more focused approach on encouraged industries and social issues, along with some regional-based preferential treatment.
Existing incentives will be expanded for high-tech enterprises and R&D activities. In 2006, the Chinese government included “innovation and technological advancement” as one of China's principal long-term national strategies. The government realizes that China cannot continue to expand its economy on the back of merely producing products on a low cost basis for the rest of the world. Over time, China must move up the value-added chain, and this can be achieved only by moving to higher value products and higher value technology. Tax policy will hasten to support this objective. For example, just a few weeks before the New Law was adopted the SAT issued a circular to address the preferential tax policy for venture capital. With the adoption of the New Law, it is expected that a more complete incentive tax system with detail implementation rules will be issued in the near future.
3. What is the “Grandfather Rule” for Existing Incentives provided by the New Law?
Many existing enterprises have been granted tax holiday and tax reduction incentives. For example, an FIE engaged in manufacturing was typically granted a two-year tax holiday followed by a three-year 50% reduction of the normally applicable tax rate. The New Law provides a “grandfather rule” for these incentives, whereby incentives for projects already approved will generally be allowed to continue to their conclusion, provided they conclude by 2012. If a particular FIE’s incentives end after 2012 because the first year of profits is, for example, 2009, then the five-year incentive period will be considered to begin in 2008. Since 2008 for such an FIE is a loss year, it appears that this FIE would effectively have only one year of tax holiday (2009) and three years of the 50% reduced rate (2010-2012). Any benefits for 2013 that would have been realized under the old rules will be completely lost.
The official “announcement date” of the New Law is 16 March 2007. From the wording of the New Law, it would appear that foreign investors that have received approval from the applicable foreign investment committee before that date should have their FIE covered by the grandfather rule. While it sounds reasonable to make the approval date as cut-off date for the grandfather rule coverage, there is some concern that the New Law might be interpreted by the authorities to make the date of issuance of the preliminary business license by the State Administration of Industry and Commerce the relevant date. The preliminary business license date defines the first day of existence of a new enterprise.
It has also been reported that the Minister of Finance, Mr. Jinrenqing, has stated that the implementation of the grandfather rule will result in an incremental increase in the tax rate from 15% to 25% during the transition period, which means a 2% increase per year, i.e. 17% for 2008, 19% for 2009, etc.
The language of the grandfather rules is, of course, subject to some interpretation and it is expected that the implementation rules when issued will provide additional guidance.
4. What are the provisions of the New Law for Transfer Pricing and Cost Sharing?
The New Law focuses closely on inter-company transfer pricing. In particular, it emphasizes the following:
· If a transaction between an enterprise and a related party does not comply (resulting in reduced taxable income or tax payable) with the arm’s length principle, the local tax bureau has the right to apply reasonable methods to adjust the enterprise’s income.
· If an enterprise wants to negotiate an advance pricing agreement, it will do so with its local tax bureau. The enterprise will need to provide its pricing principles and computation methods used in business transactions with its related parties.
· Enterprises must include with their annual tax return filing the details of related party transactions. Relevant supporting documents, whether from the enterprise or its related parties, must be provided when requested.
· In the absence of valid supporting documents, the local tax bureau has the right to determine the enterprise’s taxable income.
· An enterprise and its related parties may enter into arm’s length cost sharing agreements for the joint development of intangible assets.
The significant emphasis on transfer pricing found in the New Law is likely to result in greater scrutiny of related party transactions in the future.
Although the New Law does not include such a requirement, it is widely expected that the implementation rules for the New Law or a separate circular will require the annual submission by enterprises to their local tax bureaus of certain documentation, including information on related party pricing and computation methods. (While most other countries require that enterprises maintain such information, it need only be submitted to the authorities upon request.)
Such documentation rules were expected to be issued in a separate circular in late 2006, but were delayed and have not yet been issued. While the expectation continues that such documentation rules will be issued, their potential effective date is uncertain. It appears that the rules may be effective for 2007 or, perhaps, only from 2008 if there is an unexpected delay.
5. Does the New Law encourage scientific and technological development?
In early 2006, the State Council issued a lengthy circular on actions to be taken to promote scientific and technological development. Consistent with this well publicized long-term policy, the New Law strongly subsidizes and encourages enterprises to upgrade and innovate by providing the following:
· An expansion of the current 15% reduced tax rate for state-encouraged new and hi-tech enterprises in national hi-tech development zones to such enterprises located countrywide;
· A continuation of the super deduction for qualifying R&D expenses (the current super deduction rate of 150% is expected to remain unchanged); and
· Support for venture capital enterprises focused on hi-tech and other encouraged industries by allowing deductions for a percentage of the invested amounts.
While there will often be a review of actual activities to confirm their qualification as hi-tech and/or R&D, the strong national drive toward hi-tech and innovation implies that governmental interpretations are more likely to be expansive rather than narrow.
6. Under the New Law, are some provisions focused on minimizing instances of tax avoidance?
Following international practices found in many countries, the New Law includes provisions focused on minimizing instances of tax avoidance. As such, the law includes both a general anti-avoidance rule and a thin capitalization rule.
· General Anti-Avoidance Rule (GAAR)—If an enterprise engages in a transaction or other arrangement without commercial viability that reduces taxable income or tax due, then the tax authorities may make adjustments.
· As Chinese tax officials have been, for the most part, very “form” oriented in the past, it may take some time for the new concept to be applied effectively.
· Thin Capitalization Provision—Interest expense will not be deductible to the extent it relates to debt that exceeds a specified related party debt-to-equity ratio.
Under China’s exchange control rules, FIEs have already been subject to relatively strict foreign debt-to-equity requirements. Consequently, until implementing rules are issued that include the specified ratios, it will not be known whether FIEs will be meaningfully affected by the new thin capitalization rule. If the existing exchange control debt-to-equity requirements are more stringent than the new ratios, the impact on FIEs may not be substantial.
Domestic enterprises, on the other hand, have been subject to clear debt-to-equity requirements that deny the deductibility of interest expense for related party borrowings that exceed 50% of registered capital. Therefore, the impact of the new thin capitalization rule on domestic enterprises mainly depends on what the specific debt-to-equity ratio will be.
7. How does the New Law define the Residence Concept?
Again following international practice, the New Law has partially defined residence by introducing the “management or control” concept. Where a non-Chinese enterprise is managed or controlled in China, it will be considered to be resident and, hence, will be subject to direct taxation on its worldwide income.
The principal significance of the new residence rule will be to allow the authorities to attack situations where a Chinese person or a Chinese business has set up foreign ownership of Chinese operations or investments allowing Chinese-source income to be accumulated outside China. Enterprises that may potentially be affected include overseas listed companies with bulk of their business activities in China.
The “effective management” concept is, of course, potentially much broader. As a result, it means that Chinese shareholders of foreign enterprises will have to pay careful attention to residence rules both in China and in the country in which they want the foreign enterprise to be officially tax resident. This will be equally true for foreign-based multinationals that place their Asia/Pacific regional management in China – such enterprises also will have to pay careful attention to the residence rules.
8. Does the New Law take into consideration the increasing expansion of Chinese companies overseas?
The New Law includes several provisions that recognize the increasing expansion of Chinese companies overseas. As such, the law includes the following items:
· Indirect Foreign Tax Credit—A resident enterprise directly or indirectly holding shares of foreign enterprises will be eligible for tax credits for its proportionate share of taxes paid by such foreign enterprises from which it receives foreign-sourced dividends.
· The New Law expands considerably the limited indirect foreign tax credit mechanism that applied under the old Enterprise Income Tax Law. Most importantly, since indirect ownership is included, it appears possible that tax credits from second tier and lower tier foreign enterprises may be claimed. Implementation rules should provide some guidance on this, as well as for the computations involved.
· Controlled Foreign Corporation (CFC) Rule—The new CFC rule applies to any foreign enterprise, wholly-owned or controlled by resident enterprises or individuals, that is established in a country with a tax rate significantly lower than China’s tax rate. If such a foreign enterprise does not distribute profits in a reasonable manner, then the resident enterprise must include in its taxable income its share of the undistributed profits.
· It is expected that implementation rules, when issued, will provide some indication of what “significantly lower” means. Further, it should be noted that, because the New Law only applies to enterprises, the law by its terms does not provide for the inclusion of such undistributed profits in the taxable income of individual resident shareholders. It is possible that, at some point in the future, the Individual Income Tax Law may be amended to include this provision.
9. What are the provisions of the New Law for Repatriations and Asset Sales?
The New Law provides for a flat 20% tax rate for China-source income that is not effectively connected with an establishment in China. Such income includes dividends, interest, royalties and rentals, as well as gains from the sale of Chinese assets, including amongst other things, shares in Chinese companies and real estate.
Interestingly, the old Foreign Enterprise Income Tax Law also provided for a general 20% withholding rate but with an exemption applied to dividend income. However, under subsequent circulars issued by the State Council, the full 20% tax rate has been reduced to 10% for income except dividends. Normally, the preferential treatment applies only to enterprises with more than 25% foreign investment while only certain special industries may enjoy the preferential treatment without being subject to the 25% bottom line requirement. For income derived by foreign investors that does not satisfy the above requirements, technically, the 20% withholding tax applies unless it is specifically exempted.
Because of the concessionary rates, we hope that implementing rules or other announcements might extend the concessionary 10% rate for interest, royalties, rentals and gains from asset sales. As for dividends paid by FIEs, there is wide speculation that the current zero withholding rate will be a thing of the past. Many expect that a 10% rate to be imposed.
The New Law makes a special point of providing for withholding at source for Chinese-source income from engineering and labour services. We believe that the withholding tax on such income will be 25% on the net amount. It also appears that, based on current practice in many cases, the net income will be a deemed income amount that is in a range of 10% to 40% of gross income.