China: The Formation Of A Foreign Intermediary Holding Corporation In A Favorable PRC Treaty Jurisdiction May Offer Tax Benefits Under The New PRC Enterprise Income Tax Law

Last Updated: 6 July 2007
Article by Gerald P. Towne and Na Li

On March 16, 2007, China's 10th National People's Congress enacted a new PRC Enterprise Income Tax Law (EIT Law). When the EIT Law takes effect on January 1, 2008, it will dramatically alter the manner in which China taxes Foreign Invested Enterprises (FIEs). In essence, the new EIT Law will eliminate entirely the preferential tax regime for FIEs. Originally designed to attract foreign investment in China, the preferential tax system has been in effect since the 1980s, and its change will have a major impact. This article describes the primary impact the new EIT Law will have on Chinese companies that have gone public, or that are planning to go public in the United States. This article also describes certain tax strategies available to such Chinese companies to alleviate some of the negative tax consequences attendant to the new EIT Law. As discussed in greater detail below, perhaps the most important strategy involves inserting a foreign intermediary holding corporation (FIHC), which is domiciled in a jurisdiction that is a party to an income tax treaty with the PRC (a Treaty Jurisdiction), between the Chinese company and the U.S. publicly-traded corporation.


A large number of Chinese companies are going public in the United States, either through traditional public offerings or alternative public offerings, including share exchanges or reverse mergers with publicly-traded U.S. shell corporations. Most Chinese companies undergo a restructuring before going public. The restructuring typically involves a share exchange between the stockholders of the Chinese Company and a newly-formed FIHC. The FIHC is typically domiciled in a Treaty Jurisdiction, such as Hong Kong or Mauritius, or a non-Treaty Jurisdiction, such as the British Virgin Islands or the Cayman Islands. The result of this type of transaction is that the Chinese company becomes a wholly-owned subsidiary of the FIHC, and the former stockholders of the Chinese company become the owners of all the equity of the FIHC. Because the Chinese company is wholly-owned by the FIHC, it typically qualifies as an FIE under existing PRC income tax law. To go public in the United States, the FIHC often effects a share exchange or a reverse merger with a U.S. public shell corporation. Under the resulting ownership structure, the FIE is owned by the FIHC, which is owned by the publicly-traded U.S. corporation.

Two PRC tax considerations are of primary importance to the FIE under the structure described above. The first is the imposition of the enterprise income tax on the FIE, and the tax holidays and incentives that reduce that tax. The second is the imposition of a withholding tax on dividend payments made by the FIE to its foreign owners.

Existing PRC Income Tax, Holidays, and Incentives. Under existing PRC law, absent a tax holiday or other tax incentive, a Chinese enterprise is subject to Chinese corporate tax at the uniform tax rate of 33 percent (30 percent central tax rate, plus 3 percent local tax rate). That said, China's tax system has offered tax holidays and incentives since the 1980s, when the PRC government developed a rather complicated tax system to attract foreign investment, capital, and technology. To qualify for these tax benefits, a foreign investor must conduct its business in the PRC through a qualified FIE. While most of the tax holidays and incentives apply to FIEs that are engaged in manufacturing activities, other criteria also qualify an FIE for special tax treatment. For instance, if such an operation is in a location that meets certain geographical criteria (e.g., within a special economic zone and open coastal cities), the PRC income tax rate is 15 percent, rather than the normal 33 percent. In addition, if the FIE qualifies under a so-called "two plus three" rule, the FIE is entitled to a 100 percent income tax holiday during its first two profitable years and a 50 percent tax holiday during the subsequent three years.

Existing PRC Withholding Tax. Current law imposes a withholding tax on gross income derived from PRC sources that is not otherwise subject to PRC tax. This is tax that a Chinese company must withhold from any payment of dividends, interest, royalties, and certain other payments made to non-PRC persons, and then remit to the PRC Ministry of Finance. Under existing PRC law, however, dividend payments made by an FIE to its foreign investors are exempt from this withholding tax. In addition, payments of interest, royalties, and rents made by an FIE are withheld at a preferential rate of 10 percent.

The New EIT Law

Starting on January 1, 2008, the preferential tax treatment for FIEs will be progressively eliminated. In essence, the new EIT Law will incorporate principles similar to U.S. tax principles. For example, under the EIT Law, no distinction will be made between companies based on the origin of their capital. In addition, the EIT Law will introduce the concept of tax residency: it will tax PRC residents on their worldwide income, and non-PRC residents on their PRC source income and effectively-connected income. The new EIT Law will also adopt measures to prevent the avoidance of PRC tax, including rules similar to the rules in Subpart F of the U.S. Internal Revenue Code governing controlled foreign corporations. In effect, the new EIT Law invokes the principle of nondiscrimination between domestic and foreign enterprises long championed by the World Trade Organization, albeit to the disadvantage of foreign enterprises in this instance.

New PRC Income Tax, Holidays, and Incentives. Under the EIT Law, FIEs and domestic-invested enterprises will now face a unified tax rate of 25 percent. Consequently, the PRC tax burden of domestically-invested enterprises currently subject to a 33 percent tax rate will decrease, while the PRC tax burden of FIEs currently subject to a tax rate as low as 15 percent will increase. Moreover, the new EIT Law repeals the two-year, 100 percent tax holiday and the three-year, 50 percent tax holiday for manufacturing FIEs, as well as tax exemptions based on geographical criteria (e.g., those for special economic zones and open coastal cities). Notwithstanding these changes, tax incentives for central and western regions are expected to be retained.

Under the EIT Law, companies involved in agriculture, fishery, forestry, and infrastructure projects will retain the tax incentives or reductions they currently enjoy. Additionally, new sector-based tax incentives will be created. In particular, venture capital funds involved in start-up investments and companies investing in environmental protection, industrial safety, or water and energy savings will receive preferential treatment. These incentives will apply regardless of the location of these companies in China. Also, certain high-tech companies that receive official approval will be subject to a reduced tax rate of 15 percent. A super-deduction for research and development investment under existing law will also be preserved.

FIEs that were established prior to the date of publication of the EIT Law (March 16, 2007), and which currently benefit from tax holidays or exemptions, will be granted a five-year transition period during which they will gradually adapt to the new regime. It is expected that the income tax rate will be raised by 2 percent each year until it reaches 25 percent. FIEs that have not started their two/three-year tax holiday must do so beginning on January 1, 2008. The objective is to establish a level playing field for all enterprises by 2013. No transition rules will apply to FIEs established on or after March 16, 2007.

New PRC Withholding Tax. The EIT Law contains a general provision that provides for a 20 percent withholding tax. At this time, it remains unclear whether the current preferential withholding tax rates applicable to FIEs (such as full exemption for dividends, or the 10 percent preferential rate for royalties, rents, or interest) will remain in place after January 1, 2008, and, if not, whether they will be phased out immediately or over time. Clearer guidance on this issue is expected later this year. Unless and until such guidance is issued, it is prudent for FIEs to assume and prepare for the possibility that the withholding tax on dividend payments made to its foreign investors will be immediately increased from 0 to 20 percent as of January 1, 2008.

PRC Income Tax Planning

In light of the impending changes in PRC tax law, it is appropriate for FIEs to consider tax strategies that may alleviate some of the negative tax consequences attendant to the new EIT Law. With regard to the new PRC income tax regime, two tax planning strategies are obvious. First, where appropriate, an FIE may want to accelerate income recognition events to take advantage of existing favorable tax rates, holidays, and incentives. Second, where appropriate, an FIE might want to employ strategies that will reduce PRC income tax, going forward. For example, an FIE might want to investigate the possibility of qualifying for the sector-targeted tax holidays and incentives available under the new EIT Law or separately incorporating any business divisions that would otherwise qualify for such tax holidays or incentives. As another example, an FIE may want to outsource certain activities or functions to a low-tax Treaty Jurisdiction in an effort to decrease tax expense.

PRC Withholding Tax Planning

While PRC income tax planning strategies may appear obvious, perhaps less obvious are the planning strategies available to alleviate the impact of the new 20 percent withholding tax. In the opinion of the authors, these strategies are twofold. First, if the FIE expects to pay a dividend in the near term, the FIE should ensure that the dividend is paid before the new EIT Law goes into effect on January 1, 2008. Second, the FIE should review and, if necessary, restructure its ownership structure. For example, if the FIE is not currently owned by a Treaty Jurisdiction FIHC, the FIE might want to insert a Treaty Jurisdiction FIHC into the structure in order to take advantage of reduced withholding rates under the applicable treaty. In cases where the FIE is currently owned by a non-Treaty Jurisdiction FIHC, the FIE might want to remove the non-Treaty Jurisdiction FIHC from the structure and insert the Treaty Jurisdiction FIHC by merging the former into the latter, with the latter surviving. If the FIE is currently owned by a Treaty Jurisdiction FIHC, the FIE might want to undertake to determine whether an alternative Treaty Jurisdiction offers a treaty with more favorable terms.

Choosing a Treaty Jurisdiction

When choosing a Treaty Jurisdiction, many factors need to be considered in light of the individual circumstances of the FIE and its investors. However, for purposes of choosing a Treaty Jurisdiction that will alleviate the impact of dividend withholding taxes, five factors are primary: (1) the maximum withholding rate on dividend income specified in the applicable treaty; (2) the other terms and their relevance to and impact on the FIE and its investors; (3) the stability of the applicable treaty and the Treaty Jurisdiction; (4) the tax system of the Treaty Jurisdiction and its impact on the FIE and its investors; and (5) the location of the Treaty Jurisdiction.

China's income tax treaties with Hong Kong, Barbados, Mauritius, and Ireland each provide for a maximum withholding rate on dividend income of no greater than 5 percent. Based on a generic analysis outside the scope of this article, it appears that PRC tax practitioners have narrowed the playing field to Hong Kong and Barbados. The appropriate choice between these two jurisdictions will depend on a variety of factors specific to the individual FIE and its investors. For example, if the FIE's investors expect or intend to sell shares in the FIHC, this factor may weigh in favor of choosing Barbados. However, if the permanency of the restructuring is of importance to the FIE's investors, i.e., the investors want more certainty that the applicable treaty will not be renegotiated on less favorable terms, this factor may weigh in favor of choosing Hong Kong.

Before an FIE undertakes a restructuring or chooses a Treaty Jurisdiction for an FIHC, it is important to consult an experienced tax advisor.

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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