Managers of foreign financial institutions ("FFIs") 1 operating in China have experienced the impact of significant tax reforms. In this alert, we analyze new changes introduced at the end of 2008, and their implications for the taxation of FFIs. We also explore potential solutions for FFIs experiencing problems created by these changes.
1. The Changes
1.1 Enterprise Income Tax ("EIT")
Following the implementation of the new Enterprise Income Tax Law and its implementation rules (the "New EIT Law"), effective from 1 January 2008 2 , both foreign invested enterprises and domestic invested enterprises are now subject to a standard EIT rate of 25%. This uniform approach also applies to FFIs and their Chinese competitors, i.e., domestic financial institutions ("DFIs").
Before the New EIT Law, FFIs were required to withhold income tax for overseas loans when paying interest to their overseas lenders. However, this requirement was usually not enforced3.
On 24 November 2008, the State Administration of Taxation ("SAT") clarified 4 the New EIT Law's tax withholding requirement for interest paid to overseas lenders: as of 1 January 2008, all FFIs must withhold EIT at a rate of 10% of their interest payments to their overseas lenders, unless a tax treaty applies and sets a lower rate.
1.2 Business Tax ("BT")
The Provisional Regulations of Business Tax and the corresponding implementation rules were revised on 5 November 2008 (the "New BT Regulations"). These amendments took effect on 1 January 2009.
According to Guo Shui Fa No. 9 issued by SAT in 2002, interest from interbank loans is exempt from BT. But it was unclear if interest of loans between FFIs and overseas banks ( "Overseas Interbank Loans") was also exempt from BT. In practice many tax authorities allowed such interest of Overseas Interbank Loans to be exempt from BT, despite the uncertainty.
The New BT Regulations resolve the uncertainty by specifically requiring BT to be paid in China if either the service provider or receiver is in China. This means that from 1 January 2009 interest payments from Overseas Interbank Loans may attract 5% BT unless SAT formally indicates otherwise.
As such, an FFI needs to be aware of its obligation to withhold 5% BT from its interest payments to overseas lenders on any Overseas Interbank Loans. Notwithstanding the New BT Regulations, interest from interbank loans between FFIs and Chinese domestic lenders still appear to enjoy the BT exemption.
The original BT Regulations created special treatment for foreign currency relending businesses, i.e. a FFI as a relender was taxed on the difference between interest it gained from its customer and interest it paid to its original lender.
The New BT Regulations ended this special treatment from 1 January 2009. Now, a re-lender must pay 5% BT on the full amount of interest paid to it by a customer. This obligation applies irrespective of the currency of the loan. No deductions are allowed either.
As a result, FFIs are exposed to additional BT costs for their re-lending businesses.
2. Impact on FFIs
Although China has opened its banking industry to FFIs in keeping with its World Trade Organization commitment5, FFIs are still subject to legal and practical restrictions on developing their RMB businesses. Compared with DFIs, FFIs are less able to raise RMB funding and have to rely on overseas affiliates to finance their lending businesses. The recent changes in EIT and BT may affect a FFI in the following manner:
- if the FFI borrows money from an overseas affiliate, the FFI must withhold 10% EIT, subject to a favourable rate of an applicable tax treaty. The FFI is also obliged to withhold 5% BT on any interest paid to this affiliate from 1 January 2009;
- if the loan is re-lent by the FFI, the FFI must pay 5% BT on the full amount of the interest that it receives from the subsequent borrower as of 1 January 2009.
For example, a Swedish bank lends EURO 1 million to its Chinese branch, which subsequently lends the money to a Chinese customer. The interest due from the Chinese branch to the Swedish bank is EURO 40,000 and the interest due to the branch from the Chinese customer is EURO 60,000.
The Chinese branch must withhold 10% EIT on the interest paid to the Swedish bank. There is a double tax treaty between Sweden and China, that caps the withholding rate at 10% which is the same rate set by the EIT Law. The tax treaty also stipulates that the 10% EIT paid by the Swedish bank in China can be fully credited against its income tax payable in Sweden.
The Chinese branch must withhold and pay 5% BT of the interest it pays to the Swedish bank and must also pay 5% BT on the full amount of interest it receives from the Chinese customer without offsetting as the BT paid by the Swedish bank and the Chinese branch is not covered by a tax treaty.
In this example, due to the EIT and BT changes, the total tax liability has increased from EURO 3850 (i.e. 2850 + 1000) to EURO 7550 (i.e. 2550 + 5000). Note that although the Swedish bank may benefit from the tax treaty, if it has no taxable income in Sweden it may not immediately be able to get the EURO 4000 EIT credit that it has paid in China. If so, the EURO 4000 should be included as part of the tax cost of the transaction unless Swedish tax legislation allows such credit to be offset against future tax liabilities.
3. Comments on Solutions
To minimise the increase in the tax obligations caused by the recent tax changes, FFIs may structure their businesses to benefit from applicable bilateral tax treaties. For example, a FFI may borrow from overseas lenders in countries/regions that have favourable tax arrangements with China. However, before any businesses are restructured, an analysis of the relevant tax treaties must be undertaken.
3.1 Withholding Tax Rates
China is party to tax treaties with many countries/regions that set a maximum tax rate for interest income at 10%. However there are still some tax treaties that cap tax rates below 10%. For example, China's tax treaties with Singapore, Hong Kong, Austria, Israel and the United Arab Emirates provide a maximum tax rate of 7% on interest income and China's tax treaty with Kuwait sets a tax rate of 5%.
Where a FFI borrows money from a lender that is resident in a country/region with whom China has a tax treaty, that lender may have the chance to benefit from a lower rate of EIT in China.
3.2 Methods for Elimination of Double Taxation
Tax treaties provide mechanisms to protect against the risk of an individual or corporate entity being taxed twice where the same income is taxable in two jurisdictions. The most widely used mechanism is the tax credit, based either on a fixed rate or on the actual tax paid.
Fixed Tax Credit
China has signed a number of tax treaties that allow 10% of interest paid by a foreign resident in China to be credited against taxable income in the corresponding foreign country/region, such as Japan, Sweden, Canada, Denmark, Norway, Netherlands, Poland, and Australia. Some tax treaties offer higher tax credits, for example, the tax treaty with Germany allows 15% of interest paid in China by a German tax resident to be credited in Germany, regardless of how much actual withholding tax it has paid in China. China is also party to tax treaties which set a higher fixed tax credit at 20% of the interest, e.g. its tax treaties with Singapore, Kuwait, United Arab Emirates, Thailand, Cyprus and India.
Actual Tax Credit
China's tax treaty with the United States allows the actual tax for interest paid in China by a United States resident to be fully credited in the United States. This mechanism is also adopted by Hong Kong, Malaysia and the United Kingdom.
Theoretically, an overseas lender from a country or region with a fixed tax credit at 10% of the interest or actual tax credit can remove the burden of the 10% EIT withholding obligation in China. Similarly, an overseas lender that is tax resident in a country or region with fixed tax credit higher than 10% may even benefit from the difference between the tax credit and the 10% EIT actually withheld in China.
Please note, however, that in certain cases the tax credit cannot be used until the overseas lender is sufficiently profitable in the relevant foreign country/region. This could be an issue for many overseas banks that have been hit by the recent financial crisis.
When selecting an overseas lender, FFIs should consider the availability of any favourable withholding tax rates and tax credits in addition to any other considerations. For example, a Singaporean tax resident enjoys a capped withholding tax rate of 7% and a fixed tax credit amount of 20% of the interest whilst a German tax resident is subject to a withholding tax rate of 10% and a fixed tax credit of 15%.
By structuring the offshore lending through a favourable tax jurisdiction, it may be possible to mitigate the negative consequences of the New EIT Law. However, careful planning is necessary to avoid triggering any treaty shopping provision which China now applies on an increasing scale.
Unfortunately, the current tax treaties do not apply to BT. In this respect, FFIs may consider optimizing their BT exposure by restructuring their current business models and reducing their reliance on overseas funding. In principle this would involve expanding RMB businesses and focusing more on the Chinese domestic funding market. However, there are uncertainties in achieving these goals as the business development of FFIs are generally subject to strict supervision by the Chinese authorities.
1 FFIs include incorporated foreign funded banks with independent legal status and branches of foreign banks in China.
2 The New EIT Law has a substantial impact on FFIs in terms of preferential treatment, tax deduction etc. This alert does not elaborate on these aspects.
3 Guo Shui Fa  No. 186.
4 Guo Shui Han  No. 955
5 Regulations on the Administration of Foreignfunded Banks, which took effect as of 11 December 2006