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PRC tax update
New Enterprise Income Tax Law of China
The new Enterprise Income Tax Law (EIT) was enacted on 16 March 2007 to unify the income tax levied on domestic and foreign enterprises. On 6 December 2007 guidance was issued in the form of Implementation Rules. These rules bring clarity, but there are still uncertainties. What is certain is that this new law will fundamentally change the way business is done in mainland China. Following paragraphs describe and analyse the importance of provisions of the new EIT.
Resident enterprise
An enterprise is considered to be a "resident enterprise" if it is established under Chinese law, or it has its place of effective management in China. "Effective management" means management and control of an organisation over production and business operations, personnel, finance and accounting, and properties. Companies should be cautious to avoid becoming treated as China tax resident.
A resident enterprise is generally subject to EIT at 25%. Small-scale enterprises earning small profits will be liable for EIT at a reduced rate of 20%. Losses will only be available for carry forward for five years.
Non-resident enterprise carrying on business in China
A non-resident enterprise is liable for Chinese income tax on its income derived from China, subject to 25% China tax rate on its income from China, and overseas income that is effectively connected to the establishment or the place of business in China. Multinational companies should structure transactions under treaty protection as China tax treaties have a narrower definition of "permanent establishment" than does "establishment" as defined in the EIT Law and the EIT Regulations.
Withholding tax for non-resident enterprises
The EIT Regulations have implemented withholding taxes at 10% on income such as dividends, interest, rent, royalties etc., where dividends paid by FIEs to foreign shareholders were previously exempt from withholding tax. Companies may need to reconsider the holding and operating structure for China.
Deduction of expenses
The EIT Law allows an enterprise to deduct reasonable expenses actually incurred in relation to income. Major expense items and their limitations are as follows:
| Expense
item
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Deduction
limitation
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Comments
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| Employee welfare
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14% of total salary
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No carry forward
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| Union fee contribution
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2% of total salary
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No carry forward
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| Workers education
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2.5% of total salary
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Carry forward possible
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| Business entertainment
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60% of such actual expense up to 0.5% of business revenue
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No carry forward
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| Advertising
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15% of revenue
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Carry forward possible
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| Charitable contribution
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12% of profit before tax
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No carry forward
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| Management Fees
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No deduction
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Service fees are deductible
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| Sponsorship Expenses
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No deduction
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Non-advertising and not related to business activities
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Amortisation of intangible and purchased goodwill
Intangible property generally can be amortised over a ten-year period using a straight line method. For acquired intangibles, the useful life can be used as an amortisation period. The payment for purchased goodwill can only be deducted during the transfer or liquidation of the enterprise. The goodwill as a result of an asset purchase by a foreign invested enterprise can currently be amortised for ten years. The new rule disallows such amortisation and, therefore, increases the amount of taxable income associated with acquiring a business.
Reorganisations
Gains or losses on the transfer of assets should be recognised at the time of the transaction in an enterprise reorganisation unless otherwise stipulated. Furthermore, the tax basis of the assets should be determined based on the transaction price. Due to the absence of any specific relieves in the new EIT Law, companies may wish to defer such reorganisations until further clarification has been issued.
Chinese company investment
Subject to certain exceptions, if a resident enterprise directly invests in another resident enterprise, any dividends generated will be exempt from income tax. However the deemed Chinese resident company will be subject to EIT at 25% on the capital on disposal of its Chinese subsidiary, rather than the lower withholding tax that applies to non-resident enterprises. A resident enterprise must directly or indirectly own at least 20% equity in the foreign enterprise in order to qualify for the indirect tax credit for the underlying foreign income tax paid by a foreign enterprise.
Investment incentives
The new EIT law provides various tax incentives to both FIEs and domestic enterprises:
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1.
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High New Technology Enterprises (HNTE)
A preferential income tax rate of 15% is applied to HNTE. The HNTE shall possess core proprietary intellectual properties and:
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be recognised as High-New Technology supported by the Chinese Government;
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its annual research and development (R&D) expenses shall not be less than a prescribed percentage of the enterprise's annual turnover;
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its income derived from High-New Technology products or services shall not be less than a prescribed percentage of the enterprise's total income;
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its total number of R&D personnel shall not be less than a prescribed percentage of total employees of the enterprise; and
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meet any other conditions specified in High-New Technology Enterprise Management Rules.
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2. |
Venture Capital Enterprise (VCE)
A VCE shall invest in the equity of an unlisted small/medium sized HNTE for a period of more than two years. 70% of its investment can offset taxable income for the year upon reaching the two years' ownership. The excess credit can be carried forward to the following years.
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Encouraged
Business
Exemption and reduction of tax is applied to income derived from:
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agriculture, forestry, animal husbandry, fishing industries;
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infrastructure projects;
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environmental protection, energy and water savings projects; and
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technology transfers under certain conditions.
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4.
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Super-deduction on certain expenses
The new EIT law provides a 150% deduction on R&D costs and 200% deduction for disabled employees' wages.
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5.
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Recycling business
An enterprise engaged in recycling business can enjoy a 10% deduction on its total income in calculating its taxable income.
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6.
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Special deduction on qualifying expenditures
Special equipment purchased for environmental protection, energy and water saving, manufacturing safety etc. can be eligible for income tax credit for the year of purchase and usage. The tax credit equals 10% of the purchase price of such equipment. The excess credit can be carried forward for five years. Equipment disposed of or leased out within five years will have the credit clawed back.
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Accelerated depreciation
Fixed assets generally are depreciated using a straight line method over the life of assets. An enterprise may shorten the recovery period or adopt an accelerated depreciation method for the fixed assets. If an enterprise adopts a short recovery period, such recovery period can be 60% of the normal recovery period stated above. For accelerated depreciation, the double declining balance depreciation method or the sum of the years digits method can be adopted.
Transfer pricing
Chinese transfer pricing rules cover not only cross-border transactions but also related party transactions in China. The new EIT regulations list various transfer pricing methods as reasonable methods and arrangements.
Thin capitalisation
The EIT Law provides that if the ratio of related party debt received by an enterprise to its equity exceeds a given standard, the interest expense on the portion of related party loan exceeding the permitted debt-to-equity ratio cannot be deducted when computing taxable income.
Transition period
The EIT Law provides certain relief during the transition period that applies to enterprises that were established prior to 16 March 2007. The tax concessions will be grandfathered over five years and losses will only be allowed to be carried forward for five years. Companies need to carefully plan their operations in mainland China to take advantage of the concessions and any available losses.
Gary James
Tax Services
gary.james@gthk.com.hk
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