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How will the law's passage affect your company?
On March 16, 2006 the National People's Congress of China (NPC) passed the long awaited China Corporate Income Tax Law (CIT LAW). This is undoubtedly the most important new tax
legislation in China since the turnover tax reform of 1994. It will take effect on January 1, 2008. The new law consolidates the Enterprise Income Tax Provisional Regulations (which currently apply to PRC* domestic enterprises ["DE"])
and the Foreign Enterprise Income Tax Law (which currently applies to foreign investment enterprises ["FIEs"] and foreign enterprises). The new law introduces a new tax rate (25%) for both DEs and FIEs.
The law indicates that:
A. Detailed rules for its implementation will be formulated by the State Council.
B. Where a tax treaty concluded between the PRC and a foreign government contains provisions which differ from those of the new law, the treaty provisions will prevail.
I. THE FOUR CORNER STONES OF THE CIT LAW ARE:
1. Tax simplification
2. Widening of the tax base
3. Lowering tax rates
4. Tax anti-avoidance
II. SUMMARY OF SIGNIFICANT CHANGES UNDER THE CIT LAW:
1. Taxpayers
Under the new law income tax liability is determined by the residency status of the enterprise. Taxpayers are classified as either a "Resident Enterprise" or a "Nonresident Enterprise."
"Resident Enterprise" refers to an enterprise that is established under Chinese law and regulations or has its place of effective management in China. Resident Enterprise's will be subject to tax on worldwide income. A foreign enterprise
with effective management in China will be deemed to be a Resident Enterprise and subject to China tax on its worldwide income. The law does not indicate what constitutes effective management.
"Non-resident Enterprise" refers to an enterprise that is established under foreign laws and regulations and has effective management outside of China. A Non-resident Enterprise is subject to tax on China source income only. Under current
law generally nonresident enterprises include those with at least a 25% direct foreign investor.
2. Tax Rates
A standard corporate income tax rate of 25% will be introduced. This is lower than the current 33% tax rate on domestic enterprises and higher than the 24% or 15% rate applicable to certain foreign enterprises. A maximum statutory
withholding tax rate of 20% will be introduced. Currently, dividends from FIEs to their foreign shareholders are exempt from income tax. It appears that the new law will remove this exemption.
The law contains a general statement that where a tax treaty concluded between the PRC and a foreign government contains provisions which differ from those of the new law, the treaty provisions will prevail. Presumably this includes
withholding rates agreed by treaty.
3. Expense Deduction
A set of unified expense deductions will be adopted for all enterprises. Under the current laws, domestic enterprises cannot deduct certain wages that exceed stipulated limits. No such limitation is currently in place for FIEs. The
proposed law will make all wages deductible on an actual basis.
Additional deductions will be allowed for research and development to produce new products, processes and technologies, and for salaries paid to disabled employees and other employees to be stipulated.
4. Non-Taxable/Exempt Income
The following are exempt from corporate income taxes:
A. Certain government grants.
B. Interest income from state bonds.
C. Dividends between qualified resident enterprises.
5. Anti-Avoidance
Various anti-avoidance provisions are contained in the law. They include:
A. Additional reporting requirements of related-party transactions.
B. Thin capitalization rules.
C. Controlled foreign corporation rules.
D. Transfer pricing provisions.
E. Provisions to re-characterize tax motivated transactions.
6. Tax Incentives
Various new incentives will be introduced. They include:
A. A reduced tax rate of 15% for "Encouraged" high technology enterprises, irrespective of location.
B. A 20% preferential rate for qualifying start-up companies.
C. Preferential treatment for enterprises investing in
environmental protection, energy or water savings, or
industrial safety.
D. Venture capital enterprises which engage in investments encouraged by the state will be entitled to deduct a percentage of the investment.
7. Transition Rules
FIEs that enjoy 15% or 24% tax rates will see the 25% rate phased in over five years. FIEs subject to a fixed term tax holiday will be entitled to retain their tax holiday until the termination of their holiday period. Where such
entities were formed prior to March 16, 2006 and have not yet begun to take advantage of their tax holiday due to losses their period of beneficial treatment will be deemed to commence when this law is implemented.
III. ACTION PLAN
1. Transition Rules
Since the new law will become effective on January 1, 2008, FIEs formed prior to the enactment date will not face the new tax rate immediately. For them, the new rate will be phased in over five years. Therefore, it is important for FIEs
formed before March 16, 2007 to evaluate their business structures in order to take full advantage of the phase in rules.
2. Transfer Pricing Studies
One of the four corner stones of the CIT LAW is to stop tax avoidance. The new law reinforces the determination of the Chinese government to stop tax arrangements whose main purpose is tax avoidance. It will give the State new
enforcement authority to prevent illegal transfer pricing arrangements among related parties. Guidelines for more disclosures on transfer pricing arrangements will be promulgated. Accordingly, transfer-pricing studies are
encouraged.
3. Increase Capitalization
"Thin-capitalization" rules will be introduced by the new law. Those FIEs that are thinly capitalized should consider increasing their capital in order to avoid the disallowance of interest paid to related parties.
4. Dividend Reinvestments
This might be the last year in which FIEs can capitalize on dividend reinvestment refunds.
5. Dividend Repatriations
This will be the last year to repatriate dividends to foreign parent companies without any withholding taxes.
6. New Residency Rules
Foreign companies might want to reevaluate their level of presence in China in order to avoid being considered as Chinese residents and subject to the new CIT LAW.
7. Treaty Planning Strategies
Foreign companies that are doing business in China might want to consider tax treaty planning strategies for passive income and permanent establishment issues.
8. Transactions with Related Entities
The proposed law includes a general anti-tax avoidance rule that allows tax authorities to assess additional taxes and penalties on related party transactions that are deemed to lack reasonable business purposes. Management of FIEs might
want to re-examine their arrangements with related entities to make sure these arrangements meet the reasonable business purpose rules.
It is widely anticipated that the Chinese government will issue new regulations to clarify the new law and provide guidance on its implementation. Check with your tax advisor if you are a manufacturer doing business in China or planning
to do business in China.
* PRC - People's Republic of China
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