A Uniform Corporate Income Tax Rate Comes to China

The new PRC Enterprise Income Tax Law (中华人民共和国企业所得税法)was enacted on March 16 2007 by the Tenth National People's Congress, and will be effective on January 1 2008. This law represents a milestone in the PRC tax system, signifying the end for preferential tax treatment for foreign invested enterprises (FIEs) over domestically-owned firms (DIEs).

Effects of the New Law

The new law introduces the new concepts of "resident enterprise" and "non-resident enterprise." A "resident enterprise" is an enterprise that is established in China under Chinese laws, or a foreign enterprise whose effective management is based in China. For example, an enterprise incorporated in the BVI or Bermuda whose effective management is based in China would be deemed a "resident enterprise" under the new law. The term "effective management" is not defined.

A "non-resident enterprise" is defined as an enterprise that is established under foreign law, has its place of effective management outside China, and either (i) has an establishment or place of business in China, or (ii) does not have an establishment or place of business in China, but derives income from sources in China.

Under the new law, resident enterprises will be subject to the Chinese enterprise income tax on their worldwide income, while non-resident enterprises will be taxed only on income derived from sources in China. The new law does not apply to partnerships or enterprises owned by an individual.

The new law will impose a unified tax rate of 25% on both FIEs and DIEs. There are two exceptions to this unified rate: a reduced rate of 20% may be offered to "small-scale and small-profit" enterprises, while a rate of 15% may be offered to "hi-tech" enterprises. The terms "small-scale and small-profit" and "hi-tech" are not defined. It is expected that more detailed implementation regulations will be issued in the future by the State Council.

Under the new law, expense deduction rules will be unified for domestic and foreign enterprises. For example, under current law, domestic enterprises generally are not allowed to deduct the portion of salary expenses that is in excess of stipulated limits, while FIEs are allowed to deduct salary expenses on an actual basis. The new law will allow both DIEs and FIEs to deduct salary expenses on an actual basis.

The new law will abolish the current five-year tax holiday (two-year exemption and three-year 50% reduction) applicable to manufacturing FIEs, the general tax holidays for export oriented enterprises and hi-tech enterprises, and the reduced rates applicable to FIEs located in designated locations (except the Special Economic Zones, the Pudong New Area and the Western Development Region), albeit with a grandfather clause. It is uncertain at this stage whether China will remove the current exemption of the withholding tax on dividends paid by FIEs to their foreign shareholders. Under current law, dividends received by a foreign investor from an FIE are exempt from the withholding tax.

Future preferential tax policies would likely focus on whether the investment itself is desirable (e.g., desirable investment may include investment in "hi-tech" enterprises, energy and water preservation activities, or environmental protection activities), rather than where the company is located (such as whether the company is located in special economic zones and costal open economic zones) or who the investor is (i.e., foreign or domestic). Details on these preferential tax policies are expected to be addressed by the implementation regulations that will be issued by the State Council.

Grandfathering Arrangements

For enterprises that were approved for formation before March 16, 2007, the new law provides a five-year grandfather period. FIEs located in special economic zones and costal open economic zones that are entitled to reduced rates (24% or 15%) will be eligible for a five-year transition period, and their applicable tax rates will be increased gradually to the unified rate of 25%. FIEs in the manufacturing industry that have not yet fully utilized their existing five-year tax holidays (generally, two years of exemption and three years of 50% reduction) will be allowed to continue to enjoy the holiday during the grandfather period. If the five-year holiday has not begun due to lack of profits, the holiday will be deemed to have commenced from January 1 2008.

Anti-Tax Avoidance Rules

The new law also includes provisions focused on preventing tax evasion through intercompany transactions. If a transaction lacks commercial viability but reduces taxable income or tax liability, the taxing authority may make adjustments. In particular, if a transaction between affiliated entities does not comply with the arm's length principle, the local taxing authority will have the right to adjust the income of the relevant parties. If an enterprise wants to negotiate an advance pricing agreement, it may do so with the taxing authority. Taxpayers must report the details and supporting documentation of related-party transactions, if any, to the taxing authority when filing their annual tax returns. More details on the documentation requirement are expected to be issued by the State Council.

With these significant changes to the PRC tax policy, it is recommended that foreign investors review their local and global tax postures, and possibly restructure their Chinese operations.