Change on the Horizon: The Future of Corporate Tax Reform

At that time, the PRC State Council issued the PRC Enterprise Tax Tentative Regulations (the Domestic Enterprise Tax Law), which became effective on January 1 1994. Two years earlier, in an effort to simplify the tax system for foreign investment enterprises (FIEs, see next page) and foreign enterprises operating in China, the National People's Congress enacted the PRC Foreign Investment Enterprise and Foreign Enterprise Income Tax Law (the Foreign-related Enterprise Tax Law), with an effective date of July 1 1991. One of the fundamental policies underlying many of the PRC tax reforms was to rationalize the separate tax regimes then existing among the various types of enterprises whether wholly domestic, foreign, foreign invested, or a combination thereof.

To date, the Domestic Enterprise Tax Law and the Foreign-related Enterprise Tax Law operate separately to tax the enterprises subject to them in a vastly different fashion. The focus now is to rationalize both systems into one.

Current Domestic Enterprise Tax Law

The Domestic Enterprise Tax Law (and its implementing regulations, hereafter the Regulations) currently imposes income tax on taxable income of PRC state-owned enterprises, PRC collective enterprises, private PRC limited liability companies, PRC joint ventures and PRC companies limited by shares (collectively, Domestic Entities) from both PRC and non-PRC sources at a 33% rate. Taxable income under the Domestic Enterprise Tax Regulations is the difference between (i) gross income, which includes income from production and business operations as well as income derived from the disposition of property, interest, leasing, royalties, and dividends, and (ii) certain specified expenses, which in certain cases are limited to amounts stipulated by implementing tax circulars (such as wages and advertising expenses).

While not setting forth specific tax preferences, Article 8 of the Domestic Enterprise Tax Regulations does provide that tax reductions or exemptions "may be practiced" by Domestic Entities upon approval by provincial governments located in provinces that need special assistance and encouragement. These regulations do not define or otherwise describe the provinces that need special assistance.

Prior to this system, Domestic Entities were subject to either (i) the Income Tax Regulations of the People's Republic of China Concerning State-owned Enterprises, (ii) the Interim Regulations of the People's Republic of China on the Income Taxation of Collective Enterprises, or (iii) the Interim Regulations of the People's Republic of China on the Income Taxation of Private Enterprises. These prior regulations imposed a generally applicable income tax rate of 55% and provided few tax preferences. This rate was retained when the Domestic Enterprise Tax Law was issued and later changed in 1994 to 33% (except for financial institutions that are taxed at the higher rate of 55%) in the first attempt to level the playing field for domestic enterprises and foreign investment enterprises. This change marked a significant step toward eliminating the differences in PRC tax treatment between Domestic Entities and their foreign or foreign-invested counterparts, but major differences still remain in the area of tax preferences, as discussed below.

Since the Domestic Enterprise Tax Law does not apply to either FIEs or foreign enterprises operating in China, foreign investors contemplating investments in China are only concerned with them when making permissible investments in Domestic Entities, such as those whose shares are listed and can be purchased by foreign investors (i.e., B shares listed on the Shenzhen and Shanghai Stock Exchanges, H shares listed on the Hong Kong Stock Exchange and, in some cases, indirectly listed in the form of depository receipts on other stock exchanges), and certain private PRC limited liability companies where a foreign minority investment is permissible.

Current Foreign-related Enterprise Tax Law

The Foreign-related Enterprise Tax Law applies to (i) "foreign investment enterprises" (FIEs), which are defined as Chinese-foreign equity joint ventures, Chinese-foreign cooperative enterprises and wholly foreign-owned enterprises established in China, and (ii) "foreign enterprises", defined as foreign entities that have establishments or sites in China engaged in production or business operations, as well as foreign entities that have no such establishments or sites in China, but have income from sources in China (hereafter, Foreign-related Entities). The main feature of the Foreign-related Enterprise Tax Law is the imposition of a uniform tax rate of 33% (30% central tax rate plus a 3% local tax rate) on all foreign business activity in China and its accompanying vast array of tax preferences. FIEs that establish their head offices within China pay tax on their worldwide income, while foreign enterprises are taxed only on China-sourced income. The Foreign-related Enterprise Tax Law also imposes a 10%¹ withholding tax on gross China-sourced income that is not otherwise subject to tax (other than dividends paid to foreign investors by foreign investment enterprises, which are currently exempt from withholding tax).²

Like its domestic counterpart, under the previous foreign-related legislation Chinese-foreign equity joint ventures were taxed pursuant to the Joint Venture Income Tax Law and all other entities and activities were taxed pursuant to a prior Foreign Related Enterprise Tax Law. Under the former, tax was imposed on the worldwide net income of joint ventures with Chinese and foreign equity investment at a rate that was 30% plus a local surtax of 10% of the basic tax, for an effective rate of 33% of net income. In addition, a 10% withholding tax was payable when joint venture profits of a foreign investor were remitted from China. Limited tax holidays were available and tax refunds were also available if profits were reinvested in China. Under the latter, tax was imposed on net China-sourced income of any foreign enterprise that had an establishment in China at rates that were graduated from 20% to 40%. In addition, there was a local tax of 10% of taxable income, and a 20% withholding tax was imposed on dividend, interest, rental, royalty and other income from Chinese sources paid to foreign enterprises with no establishment in China. The 20% withholding tax was eventually reduced to 10% on certain items.

Major Differences Remain

What is significantly different in comparing the Domestic Enterprise Tax Law and the Foreign-related Enterprise Tax Law is that by way of various forms of tax incentives Foreign-related Entities receive, almost without exception, highly preferential tax treatment. These include tax holiday periods, reduced income rates in certain geographic zones and other very generous tax preferences. Tax preferences for domestic enterprises exist, but are largely circumscribed (e.g., certain listed companies taxed at 15%, exemptions for agricultural companies, research institutes, etc.). In addition, practice has shown that Article 8 of the Domestic Enterprise Tax Regulations, which permits certain undefined preferences to be provided (discussed above), has not been used to ameliorate these differences. This differing tax treatment between Domestic Entities and Foreign-related Entities is justifiably claimed as one reason why Domestic Entities have been less competitive than their foreign related counterparts and why Domestic Entities have had no alternative but to establish joint ventures with foreign persons; sometimes to the extent that they would create purely formalistic foreign-held investments in order to take advantage of the PRC tax preferences provided for such entities. Other differences in the more detailed aspects of the way each type of entity is taxed under their separate regimes has also invited much criticism.

The Future of PRC Enterprise Tax Reform

China is scheduled to issue the Unified Enterprise Income Tax Law by the end of 2003. In part, this is necessary because WTO membership requires China to treat foreign enterprises and domestic enterprises equally. The real driving force, however, is purely domestic structural objectives. Thus, China will soon continue its history of significantly amending its enterprise tax laws every 10 years.

The Fate of PRC Tax Incentives: Which Are WTO Compliant?

While the process leading up to the promulgation of this new law currently involves the reassessment of the optimal enterprise income tax rate and an extensive review of the need for most tax incentives currently enjoyed by Foreign-related Entities, a complete elimination of all tax incentives is not likely. This is true for a number or reasons.

First of all, most tax incentives granted to Foreign-related Entities under the current foreign-related regime do not violate WTO agreements. The fundamental principle of WTO membership is that foreign companies and enterprises must be treated no worse than domestic enterprises. Incentives providing superior enterprise tax treatment to Foreign-related Entities are considered as super national treatment and do not violate the national treatment commitment. This fact has been clearly recognized by the PRC tax establishment.³ Rather, it is mainly in the area of prohibited and actionable export subsidies where enterprise tax incentives that could become the subject of a WTO dispute panel are found. However, foreign investors may have little reason to initiate (through their own governments) protests against non-WTO compliant tax incentives that benefit them. For example, under the current Foreign-related Enterprise Tax Law, FIEs may reduce their mainstream enterprise income tax rate by 50% when its annual export value constitutes 70% or more of its total annual output.⁴ While this appears to be a prohibited export subsidy, it is unclear how a claim would be presented to remove this benefit as it may be of more value to individual foreign investors than the "bigger picture" trade disparities it may cause. Notwithstanding the relatively secure position of such incentives from a WTO/trade law standpoint, it is still possible that PRC tax policymakers can use WTO entry as the reason to remove long-standing tax incentives in the name of full compliance.

Of greater relevance to WTO compliance are those tax incentives that violate the national treatment principle. On one hand, China's WTO package reveals that no foreign-related enterprise income tax incentives, whether classified as subsidies or not, will be dismantled in connection with accession.⁵ At this early stage China has merely disclosed its subsidies that are subject to notification pursuant to Article 25 of the Agreement on Subsidies and Countervailing Measures.⁶ While many (but not all) tax incentives currently utilized by Foreign-related Entities were the subject of this disclosure, an equal number of tax incentives and other subsidies concerning wholly domestic and state-owned enterprises were disclosed. On the other hand, China did not provide a complete notification of its tax subsidies, and as can be seen from the trade dialogue of China's working party, this disclosure process is far from complete.⁷

Barring the use of WTO as an excuse to remove foreign-related tax incentives, it is more likely that these wholly domestic and other undisclosed incentives that possibly violate the national treatment principle will become the future subject of WTO disputes. For example, the availability of consolidated returns for domestic group companies and their 100%-owned subsidiaries is currently not allowed for analogous Foreign-related Entity groups.⁸ This tax benefit incentive could constitute a national treatment violation. Recent experience suggests, however, that even taking a clear violation for dispute resolution under the WTO would likely be a protracted endeavour that might never be brought to bear even if a favourable ruling were obtained.

Another reason tax incentives for foreign investors will continue is the prominent role of bilateral tax treaties (of which there are currently 73), which are more directly applicable when it comes to addressing country-to-country corporate tax systems. While tax treaties do not normally create tax incentives for investors, their source rules and double tax avoidance provisions do clarify and impose some restraint on how the host country can tax its foreign investors.

Probably the strongest proponents of Chinese enterprise tax reform are the domestic enterprises that are tired of being at a competitive disadvantage to their foreign counterparts. Take the example of newly formed Foreign-related Entities that do not end up paying any enterprise tax until several years into their operations. They can carry forward, for up to five years, heavy losses incurred in the first few years of operations, and when they become profitable they can begin to take advantage of the standard two year exemption, three year reduction tax holiday given to just about any "productive" Foreign-related Entity. Additionally, there exists the possible continuation of these holidays for export enterprises and the lower 24% or even 15% rate of corporate tax for those productive enterprises formed in the hundreds of special economic zones throughout China.

State tax officials provide an additional voice for tax reform. They realize that many of the outdated incentives are abused. Abuse includes mainland-controlled Hong Kong companies that form Foreign-related Entities solely to take advantage of tax holidays, the lack of productivity in certain Foreign-related Entities and attempts to "restart" tax holidays by setting up new entities to continue ongoing operations.

First Light

Ultimately, the forthcoming Unified Enterprise Income Tax Law, as part of the task of consolidating the domestic and foreign enterprise income tax laws, will have to rationalize the application of the various enterprise income tax incentives. While an enormous number of implementing rules and supportive transitional circulars (not currently available) will be required to effect the details of this forthcoming law, a look into the draft law alone is instructive in spotting some of the major policy changes to come. A comparative analysis of the current draft of the Unified Enterprise Income Tax Law (hereafter the Draft) with both the Domestic Enterprise Tax Law and the Foreign-related Enterprise Tax Law reveals the following major policy changes.

Structural Modification of Tax Incentive Platform

The Draft appears to make a major structural departure from the current framework with regard to tax incentives. Under the current framework, many tax incentives are "hardwired" into the Foreign-related Enterprise Tax Law. For example, the well known rate reductions from 33% to 24% and 15%, and the two year exemption, three year 50% reduction tax holiday, are set forth directly in this law leaving only minor qualification details to its corresponding implementing regulations and circulars. In place of specific tax incentives, the Draft adopts vague policy statements that "allow" for future tax incentives in the form of tax reductions and exemptions, rate reductions, accelerated depreciation, investment credits, special deductions, and "other methods". In addition, the State Council will be delegated the authority to formulate a detailed incentive scheme based on the "principles of fostering the sustainable development of the national economy, encouraging the improvement of technology, maintaining consistency with national industrial policies, and being conducive to harmonious development of the local economy". Under this new platform, it appears that tax incentives will be much more fluid because NPC approval will not be needed to promulgate or rescind them. This platform makes sense from the perspective of giving the government more flexibility to enact specialized tax incentives that are up-to-date with current economic objectives. However, the conspicuous absence of specific tax incentives from the text of the law is alarming for Foreign-related Entities if these are not granted pursuant to the implementing regulations or separate circulars issued or to be issued by the State Council.

Mainstream Rate of Enterprise Income Tax

The new rate of enterprise income tax in the Draft will eventually be applied to domestic and foreign-related entities alike. The tax authorities have reserved, in the Draft, some space for the rate to be determined, including the central and local breakdown of collection. Sources indicate that a rate of between 25% and 28% is under discussion. Similar to the existing Foreign-related Enterprise Tax Law, this rate will be broken down into a central and local component, and the local tax bureau will be able to waive their component under certain circumstances.

Statutory Rate of Withholding Tax

The Draft maintains the existing maximum withholding tax rate of 20%, with a provision that the State Council may make adjustments.⁹ The 20% maximum rate may have been retained to maintain China's tax sparing credit in the agreements that it has made in its tax treaties.¹⁰ However, a cause for concern here is whether the current exemption from withholding tax on dividends will be adopted. It appears that this unique exemption may finally vanish with the new law.

Net Operating Loss Provisions

There is a debate documented in the Draft over whether the allowable period for loss carryforwards will be 5 or 10 years. The current regime for Domestic Entities and Foreign-related Entities only provides for five years. In addition, there is a debate documented in the Draft over whether loss carryforwards should be deducted first before ordinary deductions in calculating taxable income.

Consolidation

True tax consolidation (i.e., the offsetting of profits and losses among separate legal entities in a controlled group of enterprises) is not provided for in the Draft. However, certain tax officials indicate that the possibility is still under consideration. Currently, only certain major domestic conglomerates are allowed to have true tax consolidation. For other enterprises and Foreign-related Entities tax payment consolidation is only possible in a group structure.

Exclusion of Subsidiary Dividends

The Draft confirms that China's long-standing tax policy of imposing a single layer of tax on enterprise earnings will remain. Currently this policy comes with certain technical exceptions that take into account the different rates of mainstream enterprise income tax possible. For example, under the current Domestic Enterprise Tax Law, Domestic Entities must recapture income tax for dividends received from subsidiaries paying enterprise income tax at a rate that is lower than the recipient's mainstream enterprise income tax rate. It is likely that implementing regulations to follow the Draft will also take this approach.

Deductions

Domestic Entities and Foreign-related Entities alike will be able to deduct most ordinary expenses in a manner similar to what is allowed under the current Foreign-related Enterprise Tax Law. Under the current Domestic Enterprise Tax Law, expense deductions such as salaries, entertainment, advertising and donations are severely limited. In addition, the Draft adopts a matching principle for the deductibility of expenses, and doesn't allow deductions of provisions or reserves.

PRC Tax Incentives: What is the Trend?

Looking specifically at tax incentives, the trend indicates that they are sustainable after the promulgation of the Unified Enterprise Income Tax Law. Over the last 10 years, the rate of introduction of significant new tax incentives is at least once every six months. Unlike their predecessors in the 1980s and early 1990s, however, the latest wave of PRC tax incentives are much more precise with regard to the types of economic activity they seek to promote. A good example of this is the recently issued research and development tax incentive that was applied to FIEs for the first time in 1999.¹¹ This incentive offers a detailed set of desirable R&D activities and ties the benefits to actual expenditure increases. Specifically, when an enterprise's R&D spending for the current year represents an increase of 10% or more over the previous year's spending, the enterprise is entitled to an extra income tax deduction of up to 50% of the current year's R&D spending. Prior tax incentives have offered very little qualification and are mostly applied across the board. For example, almost any FIE in one of the hundreds of economic and development zones across the country, so long as it engages in some form of "production" or manufacturing, ordinarily qualifies for an enterprise income tax of either 15% or 24% throughout. In certain areas, the "production" requirement is not even necessary.

It is these across-the-board types of tax incentives that carry the highest risk of termination. Should certain across the board incentives eventually be selected for termination, they will likely be phased out over time. According to certain tax officials, phase out of this variety of tax incentives could take the form of: immediate elimination without grandfathering provisions; immediate phase out with a three year notice period; immediate elimination with grandfathering; phase out gradually year by year over three years; or a combination of each.

Certainly, transitional issues will abound and foreign investors would be well advised to begin taking inventory of their across-the-board tax incentives while initiating an examination of the newer, more refined incentives that may already apply to them.

Endnotes

1 Formerly 20%, reduced for all payments made after January 1 2000.

2 It should be noted that foreign investors in foreign investment enterprises are not subject to PRC tax by way of withholding or otherwise in respect of dividends paid to them by such entities. Foreign parties negotiating with Chinese counterparts for the establishment of FIEs should be aware that this treatment does not extend to the PRC investors in foreign investment enterprises. In contrast, PRC investors are allowed a tax credit for the indirect share of income taxes paid by FIEs with respect to the income distributed. PRC investors in foreign investment enterprises that are themselves enterprises will typically be subject to a 33% income tax rate. Hence, if a foreign investment enterprise pays dividends to a PRC enterprise from income earned during tax holiday periods or the foreign investment enterprise was subject to preferential rates out of which distributions to the PRC investor are made, then PRC income tax will be paid by such a PRC investor on receipt of such foreign investment enterprise dividends. If, however, a foreign investment enterprise pays dividends to a PRC enterprise out of income fully taxed in the hands of the FIE at a 33% rate, then no residual PRC income tax would be payable by the PRC enterprise by virtue of the tax credit on such dividends.

3 'Jing Renqing Answers Journalists Questions on Hot Tax Topics,' Zhongguo Shuiwu Bao, January 14 2002, p. 1.

4 See Article 75(7).

5 Report of the Working Party on the Accession of China, World Trade Organization, WT/MIN(01)/3, Annex 5B, p. 164.

6 Ibid., Annex 5A, p.141.

7 Ibid., Working Party Report, p. 35.

8 Notice on the Collection of Income Tax from the Large Scale Enterprises Groups, Circular (Guoshuifa [1994] No. 027), issued by the State Administration of Taxation on February 8 1994.

9 Effective January 1 2000, the State Council reduced the national withholding tax rate (for enterprises) to 10%.

10 Among countries with which China has tax treaties with tax sparing are : Australia, Canada, Cuba, Cyprus, Denmark, Finland, India, Italy, Jamaica, Japan, Korea, Kuwait, Malaysia, Malta, Mauritius, New Zealand, Pakistan, Papua New Guinea, Singapore, Thailand, the United Arab Emirates, the UK and Vietnam. Under the treaties with these countries, it is important (for China) that the statutory rate be as high as possible in contract to the actual rate, which may be reduced or is subject to a tax holiday, as the credit given in the investor country is based on the former.

11 Notice on the Deduction of Research and Development Expenses from the Taxable Income of Foreign Investment Enterprises, Circular (Guoshuifa [1999] No. 173), issued by the State Administration of Taxation on September 17 1999.