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New Enterprise Income Tax law
Rather unsurprisingly, the new PRC Enterprise Income Tax Law was enacted at the Fifth Session of the 10th National People's Congress on 16 March 2007 and will be effective 1 January 2008. Despite not having been publicly released before, most interest groups were already well aware of the main provisions of the new Law, since they had had sight of a draft version in December 2006 from various sources. There were no significant changes between the draft and final versions of the Law.
Although the new Law is very brief and many details have yet to be fleshed out in the upcoming Detailed Rules and Regulations (DRR) and subsequent circulars, there is no doubt the new Law will bring about fundamental change in China's corporate tax system and in the way in which enterprises structure their businesses in China. Having said this, the new EIT Law is still just a start.
a) What are the main changes?
The main changes introduced by the Law are summarized as follows:
* The new Law will apply to both domestic enterprises and foreign investment enterprises (FIEs). Historically there have been two separate corporate tax systems in China, with the system applicable to FIEs offering significant incentives, most of which were not applicable to domestic enterprises.
* Taxpayers are now defined as "Resident Enterprises" and "Nonresident Enterprises". The definition of "Enterprise" is not clear, but the chances are that the concept of "taxpayer" may be broader than under the two former Laws combined.
* The standard tax rate is 25%.
* Most of the incentives available to FIEs have been abolished, although a five-year grandfathering period will be provided. Incentives are still available in limited industries and ventures such as Hi-Tech, Infrastructure, Environmental Protection, etc., although the scope and significance of these incentives will be far smaller than under the former FIE rules.
* A new feature of the incentives is that many are not directly related to tax rates. Methods like special deduction allowances, special credits and special depreciation/amortization methods will be available.
* Certain prevailing international tax concepts are introduced, such as cost-sharing, thin cap rules, controlled foreign company ("CFC") rules, and arm's-length pricing.
* A five-year grandfathering period is allowed for "pre-enterprises." However, the details still have to be given in the upcoming DRR.
b) How will it affect my existing business?
Given China's reputation for many years as a "low tax jurisdiction" for manufacturing FIEs, tax planning usually focuses on maximizing incentives and reducing local tax. There are numerous success stories where zero taxation has been achieved through a combination of tax holidays and reinvestment credit techniques. For many multinational companies, China generates foreign-source income taxed at low rates, something which has helped to push down the effective group tax rate. China will now become a country with an effective tax rate that is at the higher end of the scale and this will change the entire picture.
In the meantime, business costs in the coastal regions of China have risen significantly in recent years. This circumstance, coupled with an individual income tax rate capped at 45%, has led many business leaders to consider moving certain existing functions outside China for tax and nontax reasons. For instance, Vietnam is becoming highly competitive in the manufacturing sector and Hong Kong and Singapore are still competitive locations for regional headquarters and regional trade, especially from a tax standpoint. Furthermore, China's business, legal and foreign-exchange environment are far more relaxed than 10 years ago and the infrastructure (such as financial, logistics, IT and human resources) is much more developed. 10 years ago, a foreign investor had to go to China to do business with the Chinese, but now the Chinese can be found doing business anywhere in the world. Against this backdrop, the restructuring of the existing China-related supply chain on a regional scale becomes possible and can generate huge operating cost and tax savings.
Although not addressed in the new Law, it is possible that the Chinese Government may unveil certain policies relating to tax incentives for developing the manufacturing sector in the mid-western part of the country. The chances are that there will be a certain preference for basing regional headquarters in coastal areas such as those already earmarked by the Shanghai and Beijing regional authorities. The types of incentive envisaged are, however, still uncertain at this stage.
Historically, under China's tax incentive-based foreign investment model, the structure of a foreign investor's business in China had certain unique characteristics. It was common practice for many multinational groups to set up tens, if not hundreds, of legal entities in China. The reason for this is not hard to understand. Each new legal entity meant a new tax holiday for the multinational. There were also many tax and nontax considerations, such as regulatory complexity, controllership, transfer pricing, group consolidation (loss utilization), etc. With most, if not all, of the incentives having now disappeared, it is a good time for foreign investors to review their existing business structure and see what can be improved from both a business and a tax standpoint.
Many believe that the new Law is good news for enterprises in the services sector, which have historically been taxed at 33%, since they will see a significant cut in their tax rate. Having said that, China's business tax system is still problematic. Since it is a tax based on gross revenues, business tax may still, in fact, push up the effective tax rate significantly. Although business tax reform is also on the Chinese Government's agenda, it will take time.
The new Law has many positive aspects. The proposal to disallow the allocation of overheads was dropped at the last minute and cost-sharing is now allowed by law. Although detailed rules are not yet available and there are other considerations, such as business tax, these new developments should be important considerations when revisiting your China structure.
There are many other considerations for existing businesses in China. Should I change my holding structure in view of the uncertainty about the dividend WHT exemption policy? How can I maximize the grandfather benefits? Many of these questions will remain unanswered until more detailed rules emerge. However, as things stand today, it is not too late to revisit or rework your overall China tax strategy.
c) What if I'm a newcomer? How do I structure a new business?
In a TEI conference organized recently in Shanghai, many tax executives shared the view that although China would increase the tax rate (for FIEs), their respective multinational groups were still optimistic about their investment in China. The opportunities in the next ten years are enormous and investors are eager and anxious to seize them. The concern from a tax expert's perspective is how businesses can be structured in a tax-efficient way. In this regard, there are many new considerations following the enactment of the new EIT Law.
The "Resident Company" and "Effective Management" concepts, coupled with several rulings on PEs made recently by the Chinese Government, may change how a new business vehicle is structured in China. Transfer pricing will be another critical consideration.
In the past, foreign investors seemed to select their business vehicles by a process of "natural selection": Representative Office, service FIE, trading FIE, manufacturing FIE, Chinese Investment Holdco, etc. at different stages of development in China. The key consideration when choosing the right business vehicle was often not tax, but rather capital requirements and limitations on the scope of business. The tax implications were also closely related to the type of business vehicle selected.
The new Law, however, adopts more of a substance-over-form approach. In keeping with the spirit of the new Law, a Representative Office engaging in activities beyond its allowed scope may trigger a number of serious permanent establishment (PE) issues. A services company/sourcing company may help to reduce the PE risk, but the transfer pricing strategy needs to be carefully planned. Some statistics show that currently around 60%-80% of FIEs are in a loss-making situation, and many believe that things will be fine so long as a profit is being made. However, it is not necessary true that this will remain the case in the next 10 years as China is now entering into an era of international taxation.
It is advisable for newcomers to perform a thorough tax and functionality analysis before they decide on the appropriate business structure in China.
Another critical consideration is the appropriate holding vehicle. Historically, since all dividend remissions from a FIE are withholding ("WHT") exempt, it really doesn't matter whether a Cayman Islands or BVI company is being used. It is still not clear whether this preference will be kept or grandfathered. Even if it is retained, the preference will no longer be at state law level. Accordingly, it would be wise to seek a jurisdiction with an attractive tax treaty with China when designing the holding structure.
d) Looking ahead
The new EIT Law is just one of a series of changes in China's tax and legal system in the coming years. China will experience significant changes in the next ten years in relation to its civil law, foreign trade and investment regulations, stock market regulations, indirect tax regime, accounting rules, customs and the social security tax system, etc. This environment is much more dynamic than any well-developed western economy.
These changes will, however, move China into a more transparent market economy environment and lead to a level playing field for everybody. We suggest that an investor should take a proactive approach to planning its business in the context of such changes in order to achieve the best business and tax results.