Since the early 1990s, China has maintained a dual income tax system for foreign invested enterprises ("FIEs") and domestic enterprises. Preferential tax treatment like lower tax rates, tax deductions and tax holidays offered to FIEs was designed to attract foreign investments to China. This has resulted in a substantial tax payable differential between domestic enterprises and FIEs and also encouraged the practice of "round tripping" whereby domestic enterprises first set up companies offshore before making inbound FIEs investment. The differential will now be removed by the new Enterprise Income Tax Law ("New Tax Law"), which was promulgated by the National People’s Congress on 16 March 2007 and will come into effect on 1 January 2008. The New Tax Law has significant impact on those doing business and structuring investments in mainland China.
New Tax Rate
Article 4 of the New Tax Law provides that enterprise income tax shall be levied at the same rate of 25% regardless of whether the enterprise is domestic or foreign owned. Presently, the standard concessions for an FIE include top income tax rates of 15% and 24% (depending on factors such as location, industries etc) and these rates may only come into effect after a 2-year tax holiday and 3 year at half-rate tax. Domestic enterprises pay a standard enterprise rate of 33% which may be reduced depending on regions and sectors.
The two-year tax holiday and three-year half tax policies for manufacturing and exported oriented FIEs will be abolished as the "Income Tax Law for Enterprises with Foreign Investment and Foreign Enterprises" will be annulled as of the effective date of the New Tax Law (Article 60).
The New Tax Law further provides a transitional period or a "Grandfather Rule" for existing FIEs established before the effective date. Article 57 provides that tax incentives already approved will be allowed to continue to 2012. If a particular FIE tax incentive ends after 2012, it would deem to have started in 2008. Existing FIEs which have started their tax holidays will continue to enjoy the remaining holidays while those that have not started (e.g. due to no profit in the past) will have their tax holidays calculated commencing from the effective date of the New Tax Law (Article 57), irrespective of whether it is a profit or loss year. All such tax incentives will terminate on the expiry of the transitional period in 2013.
Tax Resident Enterprises
Foreign enterprises with effective management based in China may be deemed as "resident enterprises", consequently, their worldwide income will be taxed in China. Article 2 stipulates that a "resident enterprise" is an enterprise established in China according to PRC laws or an enterprise established in other countries (regions) pursuant to their laws but the effective management is located in China. Based on the New Tax Law, the tax authorities will be empowered to deal with cases where offshore companies are established with effective management and control in China but pays no Chinese tax.
Pursuant to the New Tax Law, tax benefits will be provided mainly according to the types of industries. Locations or regions will only be given secondary consideration.
Preferential tax treatment for hi-tech enterprises at national level will be applied nationwide. Enterprises’ expenses in purchasing specialized equipment for environment protection, energy and water saving and production safety will enjoy a certain tax deduction (Article 34). Enterprises engaging in agriculture, fishery, environment protection, energy and water saving and income from technology transfer (and others set out therein) will be entitled to tax reduction or even tax exemption (Article 27). All this reflects China’s long-term objective to enhance growth from advanced technology industries (instead of labour-intensive manufacturing) with environmental protection, and at the same time, to support the primary industries in view of her large peasant population.
The New Tax Law specifies new regulations on transfer pricing issues between related parties. Article 41 stipulates that for transactions between an enterprise and its related party which do not comply with the arm’s length principle and which result in the reduction of taxable income, the tax authorities shall have the right to make adjustment by reasonable methods. Following international practice, Article 42 further provides that advance pricing agreement between related parties may be discussed and negotiated with the tax authorities.
Article 45 also provides for the prevention of tax avoidance through the use of tax heaven companies by taking into account the portion of the undistributed profits attributable to the resident enterprise when computing the taxable income of such resident enterprise in China.
In addition, Article 47 strengthens the power of the tax authorities through general anti-avoidance provisions.
Although the tax rate will be increased upon the commencement of the New Tax Law, it will not necessarily discourage foreign investment from entering China. China attracts foreign investment for various reasons and the low tax rate is only one of them. Others include the potential market of 1.3 billion population, annual GDP growth of about 8%, relatively stable government and ample supply of low-cost labour.
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