China: The Visible Hand: Taxation and Economic Control

Last Updated: 29 November 2010
Article by He Ran and Zhang Tianhui

Interview of Tony Dong by He Ran and Zhang Tianhui of King & Wood's Publications

Unlike its invisible counterpart that made 18th century economist Adam Smith famous, the Chinese government's use of taxation is one of the most 'visible hands' controlling the Chinese domestic economy today. In this article, King & Wood partner Tony Dong gives his opinion on new tax regulation encouraging M&A, structural reform and restructuring activity found in the recently promulgated Decree No. 27.

Q: What are the knock-on effects of the new tax policies on industrial development?

First of all, preferential tax policies, such as tax exemption and reduction, deferred taxation and tax deduction will encourage the development of specific industries. Through increasing tax burdens or enhancing tax collection and administration, it is possible to discourage the development of certain specific industries. For example, the period of tax collection and exemption on the transfer of residential housing has changed from 2 years to 5 years, and the real estate tax is on the next on the agenda. Measures aimed at curbing the over-heating real estate market.

Q: What industries are entitled to preferential treatment under current tax policies?

Under the Chinese tax  system, preferential tax treatment  is offered to the high-tech, software, integrated circuit service-outsourcing industries as well as to industries related to environmental protection . The infrastructure and culture industries also enjoy similar benefits.

Q: The Opinions of the State Council on Promoting Mergers, Acquisitions and Reorganization of Enterprises ("Decree No.27") indicates the elimination of the regional protectionism in cross-regional M&A. Could you suggest any solutions regarding the distribution and reallocation of local tax revenue among involved regions?

Corporate taxation is a major source of local tax revenue. The fight over the right to impose regional corporate tax  is a common roadblock in cross-regional M&A. Some local governments, becasue of the the loss of tax revenue, loss of the ability to generate tax revenue, GDP and other criteria simply choose to block cross-regional M&A transactions. Decree No.27 clearly stipulates that different regions are entitled to sign Tax Revenue Reallocation Agreements according to the enterprises' respective asset level and profitability level. These measures affirm the tax revenue distribution agreement  in settling taxation disputes among the local governments and is a breakthrough in regional taxation system.

Q: What do you think about the effect of the current government finance and taxation policies on foreign investments?

The 2008 Enterprise Income Tax Law unifies the corporate income tax rate levied on Chinese-funded and foreign-funded enterprises. Regionally-oriented preferential tax policies are replacing the industry-oriented ones. In recent years, the State Administration of Taxation ("SAT") issued several Decrees regarding enterprise income taxation policies to strengthen the regulation of tax-avoidance.

  • The unified corporate income tax rate phases out the existing tax incentives for foreign invested enterprises ("FIEs"). Furthermore, the new Enterprise Income Tax Law adopted two new criteria for the identification of "resident enterprises" and the locations of establishment and the actual management office. To some extent, this reduces the feasibility of Chinese-funded enterprises utilizing nominal foreign invested enterprises for tax evasion purposes and controls the growing number of "fake" FIEs;
  • Tax preferential policies direct foreign investment into specific industries, for example, the high-tech industry, which is intended to accelerate industry grwoth;
  • The improvement of tax revenue and the taxation system reduces both the tax risk and FDI investment risk, which is helpful in encouraging large scale of foreign investment; and
  • With improvements in the administration's ability to combat tax evasion, foreign investmented enterprises will focus more on their own investment structures and business models.

Q: The Notice of the State Administration of Taxation on Strengthening the Administration of Enterprise Income Tax on Non-resident Enterprises' Equity Transfer Income ("Circular No. 698") was issued on December 10, 2009. To what extent do the tax policies provided in Circular No. 698 affect M&A transactions in China?

Circular No.698 may bring new risks to global and regional corporate restructuring projects. In addition, Circular No.698 grants Chinese taxation authorities the right to impose tax on the indirect transfer of equity interest in resident enterprises by disposing of the equity shares of offshore holding companies. Therefore, offshore M&A now faces an additional tax burden. At the same time, Circular No.698 requires the disclosure of an enormous amount of information, which will serve as a heavy duty for corporate entities.

Under Circular No.698, enterprises must reconsider offshore holding company structures and offshore transfer arrangements, especially the location of intermediate companies ("SPA") and their business qualifications. In the future it will be crucial to conduct M&A transactions more cautiously.

It can be inferred that Circular No. 698 and relevant regulations will strengthen administration over acts of tax avoidance. Under these circumstances, M&A documentations will become even more difficult to prepare.

Q: Do you think China has already established a sound tax law system for corporate reorganization?

Currently, the PRC Enterprise Income Tax Law and the corresponding Implementing Regulations of the PRC Enterprise Income Tax Law are the legal basis for the corporate reorganization tax system. The Circular of the Ministry of Finance and the State Administration of Taxation on Promulgation of the Administrative Measures for Enterprise Income Tax on Enterprises' Restructuring Business ("Decree No. 59") and the Administrative Measures for Enterprise Income Tax on Enterprises' Restructuring Business ("Administrative Measures") provide the specifics of implementation. I believe China has established a relateively complete tax system. The newly issued Decree No.27 both helps improve the Chinese tax system and will help shape future tax systems for enterprise reorganization.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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