China's legislature, the National People's Congress, passed a new Corporate Income Tax Law ("CIT Law") on March 16, 2007, that eliminates many of the tax incentives that had typically been available to foreign invested manufacturing companies while reducing the current corporate income tax rate from 33% to 25%. Foreign investors should be aware that the new law which is set to take effect on January 1, 2008, reflects a more selective attitude towards foreign investment as well as a leveling of the playing field for domestic-invested companies and foreign invested companies.
The new law consolidates the two separate tax regimes for domestic-invested companies ("DEs") and foreign invested companies ("FIEs") that has existed for over a decade into a single system and fundamentally changes existing tax incentive policies. One of these changes involves the termination of general tax holidays for foreign invested manufacturing and export-oriented enterprises. These incentives typically provided a 2-year income tax exemption beginning with the first year of profitability followed by a 50% reduction of income taxes for an additional 3-year period.
While the new CIT Law grandfathers existing FIE tax holidays, for FIEs whose tax holidays have not yet begun because they have not yet had their first year of profitability, their tax holidays shall be deemed to commence from 2008 and run for 5 years. This may result in a partial or complete loss of the incentive depending on when profitability is actually reached. The new CIT Law also appears to have ended the tax refund available to foreign investors that reinvested the dividends they received from their FIEs in China. This incentive was not available to domestic investors under the old tax law.
The new CIT Law reflects four tax reform themes that China seeks to develop:
- a less complicated tax system;
- a broader tax base;
- a lower tax rate; and
- a stronger tax administration.
The new law includes two exceptions to the new flat rate for domestic and foreign invested companies: one for qualified small scale and thin profit companies which will be subject to a rate of 20% and another for encouraged high-tech companies which are to be subject to a rate of 15%. The new incentive policies aim to encourage technology innovation and transfer, basic infrastructure construction, agriculture development, environmental protection and natural resources conservation. While the new CIT Law outlines the new incentive policies, it provides few details as to the precise meaning of the terms used or how they will be applied.
In addition to the tax incentive changes, the new law introduces the concepts of "Tax Resident Enterprise" (TRE) and "Special Tax Adjustment" (STA) and incorporates other anti-tax-evasion rules which are expected to have significant impact on foreign invested companies in China. The TRE provisions expand the scope of authority of China's State Administration of Taxation ("SAT") to allow it to tax the off-shore income of foreign enterprises whose effective management functions for off-shore operations are located in China.
The TRE is, in effect, the mirror image of a permanent establishment ("PE") by which China (and most other countries) tax offshore companies whose activities and presence in the country cross a threshold such that they are deemed to be doing business in China and subject to income tax. TRE targets those foreign enterprises that have their management function in China for operations outside of the country.
The CIT base is also different for PE and TRE. In the case of PE, a foreign enterprise's China source income is subject to taxation, while the worldwide income of a TRE could be subject to tax in China. Foreign companies with regional headquarters or management offices in China will need to carefully monitor the interpretation and implementation of the TRE concept.
The new CIT Law devotes an entire chapter to STA. The objective of these adjustments is to enable the SAT to tax a wide range of activities that are regarded as transferring income outside of China. The primary focus will be on transfer pricing. To this end, the SAT has begun issuing notices to local tax bureaus to strengthen their ability to analyze transfer pricing issues. The new law incorporates a general provision granting the SAT the power to determine whether a transaction is structured without a reasonable commercial purpose and consequently to adjust the applicable tax. STA rules expand the SAT's anti-tax-evasion authority to include comprehensive enforcement of transfer pricing, capital impairment and tax haven abuse restrictions. To avoid some of these risks, FIEs may negotiate advance pricing agreements with the SAT by which transfer pricing or transfer pricing mechanisms are negotiated in advance. The first Sino-U.S. advanced pricing agreement was recently announced providing the taxpayer with assurance that neither China nor the U.S. would later attack its transfer prices.
A number of questions remain regarding how the new CIT law will be implemented. The answers to these questions are important to foreign investors, whether they have established a business presence in China or are contemplating doing so. The State Council, China's highest administrative body, which will promulgate the detailed implementation rules, has not yet indicated when the rules will be available. Given the substantial changes to China's tax laws and policies contained in the new CIT Law, foreign investors that already have investments in China will need to analyze their impact and update their tax profiles to comply with the new rules. For those considering entering the China market, a careful analysis on the new CIT Law both as to incentives and taxation is required.
Richard Goetz is the leader of law firm Dykema's International Practice Group. Dykema provides advice and services on a wide range of issues to businesses with international operations, both international companies with activities in the U.S. and U.S. companies conducting business abroad. He can be reached at [email protected] or 313-568-5390.