China's new Unified Enterprise Income Tax (EIT) Law and Detailed Implementation Rules (DIR) took effect on 1 January 2008. Various Chinese authorities - such as the State Council, the Ministry of Finance, the State Administration of Taxation (SAT), the Ministry of Science and Technology and other regulatory government bodies - have issued a number of circulars and regulations to clarify various issues regarding the implementation of the new law.

Under the new Unified EIT Law and DIR, all enterprises are subject to an income tax rate of 25%. However, enterprises that qualify as "High and New Technology Enterprises" will enjoy a reduced tax rate at 15%. This has made the definition of such enterprises a focus of attention, both domestically and abroad.

In April 2008, the Chinese government issued "The Measures of High/New Technology Enterprises" and the "Catalogue of High/New Technology Supported by the State" to provide standardised procedures and methods for assessing the eligibility of a company in this respect. These guidelines are retroactive to 1 January 2008. Gary James, our Tax Services Partner, has written a comprehensive article on this subject in the Summer 2008 issue of Insight, our quarterly newsletter. To read this article, please visit http://www.gthk.com.hk/web/repository/insight/Summer08/01.html

The EIT Law devotes an entire chapter to "Special Tax Adjustments", and the DIR provides further elaboration on anti-avoidance provisions. These include the regulation on transfer-pricing documentation requirements, cost-sharing arrangements, thin-capitalisation rules, controlled foreign corporation rules, general anti-avoidance rules, and the levy of a special interest of 5% on transfer-pricing adjustments.

In April 2008, the SAT also issued the "Draft Administrative Regulations on Special Tax Adjustments" (the Draft) to solicit comments. The 13 chapters and 120 articles of this document contain proposed guidelines for the implementation of the anti-avoidance provisions included in the "Special Tax Adjustments" chapter. These would likewise to be retroactive to 1 January 2008.

The Draft redefines the threshold for related-party transactions from a 25% shareholding to one of 20%. It also requires every taxpayer with annual related-party transactions of RMB20 million or more to prepare and complete its contemporaneous documentation in five areas by 1 June of the following year. Taxpayers with annual related-party transactions of less than RMB20 million will be exempt from the documentation requirements.

The Draft proposes the transfer-pricing methods and formulae for calculating various types of related-party transactions. It also defines the eight types of enterprises that will be selected for transfer-pricing audits and adjustments. However, related-party transactions between enterprises inside China that have the same effective tax rate will not normally be selected for these audits.

In addition, the Draft also proposes that an Advance Pricing Agreement (APA) may be unilateral, bilateral and multilateral. However, an enterprise will only be eligible for an APA if its related-party transactions exceed RMB100 million and if it has been operating for more than ten years. Generally, smaller operators that have been established in China for a relatively short time will not qualify for an APA.

The Draft proposes that parties to a Cost-Sharing Agreement (CSA) involving intangible properties are not required to pay any royalties. This eliminates the imposition of a Chinese withholding tax at 10% and business tax at 5%. Regarding the CSAs for services, the Draft specifies that they should generally be applied to group purchasing and group marketing planning activities, and that the relevant service CSAs must be approved by the SAT.

A Controlled Foreign Corporation (CFC) is defined in the Draft as a foreign enterprise that is controlled by a company or individual that is resident in China for tax purposes, and which has been established in a country that has an effective tax rate which is 50% or less than the new EIT rate of 25% (i.e. 12.5% or less). The undistributed profits of the CFC would be included in the taxable income of the Chinese shareholders who each holds at least 10% of its voting shares.

On the issue of Thin Capitalisation, the Draft provides that if the debt to equity ratio of a company exceeds a standard ratio, then the interests paid on the excess debt will not be tax deductible. While the Draft describes the formulae for calculating the debt-to-equity ratio, it does not define what the standard ratio would be. This will probably be announced in separate circulars in future. Non-deductible interest paid will be regarded as a dividend to its recipients, and it will be subject to a withholding tax if it is paid to an overseas party. It should be noted that only related-party debts would be considered in calculating the debt-to-equity ratio. The Draft also provides that - if its debt-to-equity ratio exceeds the standard percentage - a company may prepare contemporaneous documentation by 1 June of the following year to prove that this ratio is "at arm's length".

The Draft also empowers PRC tax authorities to initiate general anti-avoidance investigations of enterprises in the following situations:

	abuse of tax incentives;
	tax-treaty shopping;
	abuse of corporate organisation forms;
	frequent transactions with tax havens; and
	other arrangements that have no bona-fide commercial purposes.

Both the form and substance of an arrangement would be considered, and the tax authority may disregard a tax-avoidance arrangement and reallocate the revenue, costs, profits and tax deductions to reflect the actual substance of the business that it relates to. To protect the interests of taxpayers, the Draft specifies that any general anti-avoidance investigations and adjustments should be reported to the SAT for its approval.

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