The National People's Congress of the People's Republic of China ("China") has adopted on 16 March 2007 the long-awaited "PRC Enterprise Income Tax Law" which will become effective as of 1 January 2008. The Enterprise Income Tax Law will unify enterprise income tax regimes applicable to foreign enterprises, foreign invested enterprises and domestic enterprises. Undoubtedly, the issuance of the Enterprise Income Tax Law is a significant milestone in China's tax history since the last tax reform in 1994.
The newly issued Enterprise Income Tax Law will unify the two different tax systems under which both foreign invested enterprises and domestic enterprises will be subject to the same Enterprise Income Tax Law with the same corporate tax rates, unified tax deduction standards and preferential policies.
1. Major Changes
The major changes between the Enterprise Income Tax Law and the existing tax laws and regulations governing enterprise income taxes can be summarized as follows:
The Enterprise Income Tax Law defines "enterprises" as taxpayers. In this respect, a branch of a domestic enterprise will no longer be treated as a taxpayer for tax purposes even if the branch "independently prepares accounts" and the tax liability of the branch will be borne by its parent company. The extent of tax liabilities are determined by the residency status of the taxpayers, which are divided into two types: "resident enterprises" and "non-resident enterprises" based on the combined standards of "place of incorporation" and "place of effective management". However, the Enterprise Income Tax Law does not stipulate how to determine the place of effective management of an enterprise.
Unified Enterprise Income Tax Rates for Foreign Invested Enterprises and Domestic Enterprises
The new Enterprise Income Tax rate is twenty-five percent (25%).
The Enterprise Income Tax Law provides for reduced tax rates under any of the below circumstances:
- Fifteen percent (15%): applicable to qualified high-tech enterprises;
- and Twenty percent (20%): applicable to small scale enterprises earning small profits.
The unified tax rates, reduce the tax burdens of domestic enterprises which used to be subject to a thirty-three percent (33%) tax rate and to a certain extent increase the tax burden of foreign invested enterprises which are mostly enjoying various tax incentive treatments and have been subject to lower tax rates in the past. Notably, the new Enterprise Income Tax rate is lower than the average tax rates of neighbouring countries and will thus try to maintain China's attractiveness to foreign investors.
New Tax Preferential Policies
The Enterprise Income Tax Law provides for various "industry-oriented" tax preferential policies rather than the existing "geographybased" incentives, which is a significant shift from the existing tax laws.
In addition to the reduced tax rates for small scale enterprises and qualified high-tech enterprises, different degrees of preferential treatments will be granted to start-up enterprises and enterprises investing into technology development, labor and welfare services, environmental protection, energy conservation, production safety, and continued investment in farming, forestry, husbandry, fishery and infrastructure development.
More importantly, the Enterprise Income Tax Law will revoke the existing five-year tax holiday (i.e. two-year exemption and subsequent three-year half reduction of applicable tax rate) for productionoriented foreign invested enterprises, as well as extensions of such tax holidays (e.g. the 50% deduction of applicable tax rates available to advanced technological or export-oriented foreign invested enterprises). However, the expected "grandfathering rule" will provide transitional relief to affected foreign invested enterprises:
- Enterprises that have been approved to be set up before the promulgation date of the Enterprise Income Tax Law, i.e. 16 March 2007 and are subject to lower tax rates under the existing law (e.g. foreign invested enterprises in special economic zones) will be eligible for a five-year grandfathering period during which the tax rates will gradually increase to the unified rate of twenty-five percent (25%);
- Enterprises that have been approved to be set up before the promulgation date of the Enterprise Income Tax Law and enjoy a certain type of preferential tax deductions and exemptions (e.g. tax holidays for production-oriented foreign invested enterprises) may continue to enjoy such benefits during the five-year grandfathering period. For those foreign invested enterprises which have not yet made any profits and thus have not commenced their "tax holidays" period, their preferential periods will be deemed to commence from the effective date of the Enterprise Income Tax Law, i.e. 1 January 2008.
Non-resident enterprises will be subject to withholding tax on dividends, interest, rentals, royalties, capital gains or other income derived from sources in China that is not effectively connected with an establishment or a place of business in China, at the rate of twenty percent (20%) or a more favourable rate based on the relevant tax treaties. It is still unclear whether the existing favourable withholding tax rate of ten percent (10%) will be extended to non-treaty country recipients.
Unified Computation Of Taxable Revenue And Deduction Standards
The Enterprise Income Tax Law states the scope of taxable income as well as the non-taxable and exempt income.
Most importantly, it unifies the tax deductions for all enterprises in China by allowing to deduct reasonable expenditures on an actual basis. Currently, domestic enterprises are generally not allowed to deduct the portions of wages in excess of stipulated limits, whereas foreign invested enterprises can deduct wages actually paid.
The deduction for welfare donations made by enterprises is limited to twelve percent (12%) of the total annual profit.
Improved Anti-avoidance Measures
The Enterprise Income Tax Law contains various anti-avoidance provisions, which empower the tax authorities to make tax adjustments in tax avoidance cases.
Enterprises shall report to the tax authorities about their transactions with affiliated parties to facilitate potential transfer pricing audits by tax authorities. New "controlled foreign company" (i.e. foreign companies controlled by Chinese residents or resident enterprises) rules and "thin-capitalization" rules have been introduced to combat tax-avoidance. Interest surcharge will be imposed on any tax adjustments made accordingly.
Undoubtedly, the Enterprise Income Tax Law will increase the tax burden for many foreign invested enterprises, particularly those currently enjoying preferential tax policies.
The new Enterprise Income Tax Law sets up general principles on unifying two sets of existing income tax laws applicable to foreign invested enterprises and domestic enterprises. Certain issues remain, which may be solved once the State Council has issued detailed implementation regulations, which are expected in the next few months. These open issues in the Enterprise Income Tax Law include in particular the following items:
- how to determine the "cut-off-date" for those foreign invested enterprises established before the promulgation of the Enterprise Income Tax Law which may enjoy the grandfathering treatment – is the date of approval or registration or date of capital contribution relevant;
- the standards to determine "small scaled enterprises earning small profits" and "qualified high-tech enterprises in need of the State support";
- how the lower Enterprise Income Tax rates of existing foreign invested enterprises will gradually increase to the standard rate of twenty-five percent (25%);
- how to determine the place of effective management of an enterprise, and
- finally how to enact the anti-avoidance rules.
Foreign investors need to review their existing tax planning schemes and take into consideration the potential impact of the changes to the Enterprise Income Tax Law on their future investments and M&A transactions in China.
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.