In March 2007, The Standing Committee of the National People’s Congress (NPC) of China adopted a new Corporate Income Taxation Law (CIT). The law was passed with 2,826 votes for and 37 against. The CIT is due to take effect on 1 January 2008 and signals major changes in Chinese tax policy.

There has been significant debate about the upcoming changes of the Chinese tax system. With its’ WTO membership of 2001, China has been urged to put an end to preferential treatments of foreign investors and to level the playing field for domestic enterprises. As a result of the consolidation of tax levels the amount collected from domestic enterprises are predicted to be reduced by 143 billion RMB, and to be increased by 41 billion from the foreign companies. In total, the government expects a decrease in income tax revenue of about some 93 billion RMB.

Although the changes are expected to result in heavier tax burdens for foreign investors, the overall impression is that the new CIT will contribute to a more healthy and predictable business environment for both domestic and foreign enterprises. At present, domestic and foreign companies are subject to a vast web of tax laws and regulations. They are also subject to different rules. Instead of distinguishing between the tax levels of foreign and domestic enterprises, the new CIT aims to encourage specific industries, such as High- and New-Tech development, as well as projects on infrastructure, agriculture and environmental preservation. The new tax regime is also expected to continue to encourage projects in less developed regions of the country, such as in the Western rural areas.

The new CIT encompasses five major changes that are of interest to Foreign Enterprises.

Resident and Non-Resident Enterprises

First, the definitions of foreign and domestic enterprises have been changed. Currently, a branch of a domestic enterprise is regarded as a separate taxpayer for corporate income tax purposes if the branch prepares accounts independently. This condition for distinguishing taxpayers will no longer be used. The new law introduces the concepts of “Resident Enterprise” and “Non-Resident Enterprise” to differentiate between taxpayers.

Resident Enterprises are enterprises that are established in China. From next year, foreign enterprises that are established outside of China but have their effective management in the country are also considered Resident Enterprises. Consequently, these companies will be assessed tax from China on their incomes generated overseas. Non-Resident Enterprises are companies established outside of China and whose effective management is not within the country. Such enterprises will pay tax on income generated within China and on income that is not from the country but is deemed directly connected to a Resident enterprise.

The enforcement regulations that are to be passed before the Law takes effect are expected to clarify matters related to the process of distinguishing between Resident and Non-resident enterprises.

Unified Tax Rates:

As mentioned above, the new CIT unifies tax levels for domestic and foreign enterprises. The current taxation rules are based on a two-tier system where, in general, domestic companies have been subject to a nominal tax level of 33 percent. Although foreign companies have had the same tax rate as the domestic ones (i.e. 30% of income tax rate plus 3% of local tax rate), they actually could enjoy various low rates, for example, 24% and 15% for manufacturing enterprises located in old town of coastal cities and special economic zone, respectively. In practice the average tax level has been lower on both accounts. The average taxation level for domestic enterprises is estimated at 24 percent. Due to tax incentives that were especially designed to attract the foreign investment, a great deal of the foreign companies have enjoyed an average tax rate around 15 percent.

With the new law, all Resident Enterprises of a certain size will be assessed a tax rate of 25 percent. Smaller companies with limited profits will enjoy a lower tax rate but the criteria are not specified in the CIT. Meanwhile, Non-Resident Enterprises will be subject to a tax level of 20 percent on income that they derive from China.

With the new law, most Resident Enterprises will be assessed a tax rate of 25 percent. Smaller companies with slim profits will enjoy a lower tax rate. Meanwhile, Non-Resident Enterprises will be subject to a withholding income tax rate of 20 percent on passive incomes derived from China.　Such passive incomes include royalty income, interest, rent and dividend. It is expected that the enforcement regulations might reduce the withholding income tax rate to 10% for some passive incomes.

Tax Incentives

With the new CIT, tax incentives are becoming more oriented towards specific industries. This is a major shift from the previous policy on geographic development, which has allowed for generous tax rates in the Special Economic Development Zones (SEDZ) since the opening of the Chinese market. The new tax incentive policy strongly encourages technological development, which is considered the key to China’s future economic success.

In general, tax reductions and exemption treatments are beneficial to projects within the agricultural sector, including forestry, fishery and animal-husbandry. Investments in infrastructure and environmental projects are also encouraged as well as projects including certain types of technology transfers.

Due to the previous geography-based incentives, most foreign companies are registered in the SEDZ. These companies have in general enjoyed tax rates at 15 percent. For some of the companies that benefit from low tax rates currently, there will be a transitional period of 5 years before the new law takes effect. This agreement of so-called “Grandfathering” is only available to companies that were approved before the Law was passed on 16 March 2007. These companies may also enjoy a gradual increase in their income tax rate, which makes it easier to adapt to the changes. How to define “companies established before March 16 2007” and the implementation details for the tax rate in Grandfathering period will be subject to further clarification in the enforcement regulations.　In addition, the previous arrangements of tax holidays for manufacturing enterprises are removed. Companies that enjoy such benefits but have not started their tax holiday periods may be subject to a forced start date of January 2008.

Some other tax incentives are to be integrated in the new tax regime. Of major importance is that enterprises that meet national criteria for High- and New-Tech ventures will be encouraged by preferential treatment. The benefits will no longer be restricted to areas defined as SEDZ but is expected to be valid regardless of location. However, the definitions of High Tech and New Tech industries are not specified in the law, but are expected to be explained in the upcoming enforcement regulations.

Additionally, the preferential tax treatments in the Western parts of China are expected to remain in an attempt at promoting further development in the area. The enforcement regulations are expected to be more specific on this matter.

Tax Deduction Policies

Another important change concerns the guidelines for tax deduction policies. At present, the domestic enterprises face deduction caps on local salaries, donations and advertising costs. The foreign investment enterprises do not have any limitations in this regard.

With the CIT, all Resident Enterprises may apply for deductions on their research and development expenses. The new law encourages corporate social responsibility by removing the deduction caps on local salaries for all Resident Enterprises. The deduction cap on donations will be 12 percent, while deductions on advertising costs are expected to be capped at an intermediate level.

Anti- Avoidance Provisions

The new law contains various anti-avoidance provisions that target both foreign and domestic enterprises. The provisions empower tax authorities to make tax adjustments and impose interest surcharges in tax avoidance cases. The more stringent administrative process is intended to combat tax arrangements that are created solely on the grounds of avoiding taxes.

The tax authorities are in general empowered to adjust taxable income where business transactions are arranged without reasonable business purpose. For instance, Controlled Foreign Corporation Rules are being introduced as a part of the new tax regime. The rules are believed to target towards domestic investors have overseas investments. Undistributed profits parked in certain overseas low tax rate jurisdictions without valid business reason may be taxed in China as a deemed distribution. The new anti-avoidance provisions will also put stronger demands for thorough documentation from all legal entities, which will complicate transfer pricing arrangements, in particular for large foreign enterprises.

Concluding Remarks

Although the changing tax regime implies increased tax burdens for many foreign companies, the prospects are still considered positive. The Chinese economy is expected to remain strong, and the market is not likely to become less attractive to foreign investment. The tax levels remain low compared to most other countries, both within the region and in the world in general.

Among other things, the CIT is an attempt at unifying tax regulations for domestic and foreign enterprises. However, the move towards full implementation of the new tax regime is expected to cause some uncertainty and confusion for tax-payers. In the following years, the State Administration of Taxation and the Ministry of Finance will be facing great challenges to review, align and clarify the on-going applicability of the many existing circulars and directives issued by local and national authorities. Over the long run, a more comprehensive and transparent legal framework will ensure a more level and consistent playing field for companies in the Chinese market.

Companies that are doing business in China should take the new CIT into account when planning their investment strategies. For example, the geography-based incentives for the SEDZ are in general being removed but the possibility of incentives for companies investing in Western regions is high. Another opportunity is to become classified as a High- or New-Tech enterprise in order to qualify for lower tax rates. However, the impact of the overall changes will depend on the enforcement regulations.

In order to stay up to date on the up-coming tax regime changes, companies are advised to actively seek legal and financial advice through skilled and reliable sources. Business plans and strategies should be analyzed and revised to fully take the CIT changes into account. Only by doing so is it possible to both minimize increasing tax burdens as well as maximize emerging tax deductions and other potential incentives.