Source：Pricewaterhousecoopers

On 16 March 2007 China's top legislature, the National People's Congress ("NPC"), passed the long-awaited China Corporate Income Tax Law ("CIT Law") by dominant majority vote.  This CIT reform is undoubtedly a significant milestone in China's tax history since the turnover tax reform in 1994.

This reform aims at establishing an income tax regime that reflects four main themes: "Simplified Tax System", "Wide Tax Base", "Low Tax Rate", and "Stringent Administration".  The new regime earmarks the consolidation of two separate enterprise income tax regimes for domestic-invested enterprises ("DEs") and foreign-invested enterprises ("FIEs") into a single regime.  In addition, the Law provides for a fundamental change in China's tax incentive policy in shaping and directing the future development of the country.  It is interesting to note that the Law is expected to result in a reduction of income tax revenue by as much as Rmb 93 billion, within which collection from DEs may reduce by some Rmb 134 billion and collection from FIEs may increase by some Rmb 41 billion.

Key Aspects of CIT Law

CIT Law will come into effect on 1 January 2008.  It contains 8 chapters and 60 articles as follows:

Like previous income tax laws, CIT Law mainly provides a framework of general tax provisions.  Important details on the definition of numerous terms as well as the interpretation and specific application of various provisions are left to the detailed implementing regulations and supplementary tax circulars.  The State Council will be promulgating the detailed implementing regulations within this year to facilitate the application of the new Law.  Given that the current tax regime has in it a myriad of circulars and directives issued by various authorities over the past two decades, it will be a daunting task for the State Administration of Taxation and Ministry of Finance to review, align and clarify the on-going applicability of many existing circulars, whilst taxpayers in China are faced with uncertainty on tax positions over many important issues.

Please see Appendix for a summary of the key changes resulted from CIT Law as well as our observations of the related potential implications.

General Commentaries

1.Timing

Although foreign investors in the manufacturing sector or located in the tax incentive zones are generally adversely affected by the new Law, the Chinese government considered the timing of reform appropriate against a very strong Chinese economy and strong investors' confidence towards China.  Indeed, China considers that the unlevelled tax playing field after WTO accession is inequitable to the Chinese enterprises and must be changed.

2.Tax Rate

The new CIT rate is 25%.  A lower tax rate is available for qualified small and thin-profit companies (20%) and for qualified high/new technological enterprises (15%) without geographical limitation.

With the removal of tax holiday for general manufacturing and export oriented activities, some FIEs could face as high as a 15%-point increase in income tax (from 10% to 25%) which is significant to the bottom line and adversely affects the return on investment.  This said, Chinese government viewed that the 25% rate is generally competitive in the neighbouring region.

FIEs which are currently subject to 33% should immediate benefit from the new rate.  On the other hand, FIEs established before the promulgation of the new Law ("Old FIEs") which enjoy a lower rate today will not face an immediate tax rate increase to 25%.  For them, the new tax rate will be gradually phased in over five years.

3.New tax incentive policy

The new regime adopts the "Predominantly Industry-oriented, Limited Geography-based" tax incentive policy, which is a significant deviation from the existing regime.

Key emphasis is placed on "industry-oriented" incentives aiming at directing investments into those industry sectors and projects encouraged and supported by the State (see Appendix).  The Law clearly reflects the government focus on technological development, environment protection, energy conservation, production safety, venture capital and continuing investment in agriculture, forestry, animal husbandry, fisheries and infrastructure development.  The Law defers to the State Council to propose the scope and definition of eligible projects and adjust such scope from time to time in accordance to the Country's need.

With the cancellation of the general manufacturing tax holidays, FIEs engaging in certain traditional industries (e.g. manufacturing low-end products, labour-intensive production) will face with negative impacts.  For these enterprises to qualify for tax incentives under new law, they will have to consider new measures such as raising the high/new-tech content of their products and production technology, as well as purchasing capital goods for enhancing environmental protection, water and energy conservation, and production safety in order to qualify for new investment tax credit.

In order to provide transitional relief to the adversely affected taxpayers due to the cancellation of tax holiday benefits, existing FIEs will be able to enjoy their existing tax holiday treatments until they expire in accordance with the current law.  Please see grandfathering treatments for Old FIEs in Appendix.

As mentioned, limited focus is placed on the "Geography-based" incentives.  Under CIT Law, new high/new-tech enterprises that are specified as supported by the State established in the Special Economic Zones and the Pudong New Area would enjoy certain transitional preferential tax treatments.  Whilst details are vague as to the nature of such preference, this rule may suggest that high/new tech enterprises established in these zones may receive more attractive preferences.  Further, the preferential tax treatments for "Encouraged Enterprises" located in the Western Region will remain.

4.Anti-avoidance

CIT Law devotes an entire chapter entitled "Special Tax Adjustments" to anti-avoidance.  This reflects the theme of "Stringent Administration".  This chapter reinforces the determination of the State to crack down tax arrangements with the main purpose of avoiding taxes and to strengthen the administration over transfer pricing ("TP") between related parties.  This Chapter paves the legislative foundation for more robust TP disclosure and documentation requirements.  With far-reaching implication is the introduction of four new measures to combat tax-avoidance, namely:

(i)	a general anti-avoidance provision that empowers tax authorities to adjust taxable income where business transactions are arranged without reasonable business purpose;
(ii)	specific "thin-capitalisation" rules under which interest associated with borrowings of a company regarded as exceeding prescribed debt/equity ratio may be disallowed;
(iii)	"controlled foreign corporation" rules ("CFC") under which Chinese shareholders may be taxed on their portion of undistributed profits as retained by CFCs in certain low-tax jurisdictions without valid business reasons, and
(vi)	an "interest levy" clause which seeks to impose interest on any tax adjustments made under this Chapter.  China does not currently subject TP adjustments to penalties and surcharges.

5.This Chapter also provides positive development.  Cost-sharing principle is formally adopted into the Law for both joint development of intangible assets and provision/receiving of common services of group companies.  However, since China may not have much experience in implementing cost sharing arrangements ("CSA"), it remains to be seen as to the practical aspect of this rule.  Actual experience suggests that extra care and significant effort is required to negotiate, substantiate and sustain the tax positions of CSAs.

6.Withholding tax reduction and exemption

Unlike the current income tax law, CIT Law does not specifically exempt withholding tax on dividend payable to foreign investors.  It does not specify if the provisional reduction in the withholding tax rate (10%) currently applicable to interest, rental, royalty, and other passive income derived by foreign companies from China would survive.  It shall be noted that CIT Law, however, provides for the possibility of withholding tax exemption or reduction for China source income, the details of which have not been published.  Hence, we expect that this issue will be clearly addressed in the implementing regulations.

Conclusion

The new CIT Law brings a fundamental change of China tax policy towards foreign investors.  Existing foreign investors shall review their tax profile, conduct impact analysis and revisit their current tax planning structures against the new tax regime in China.  For investments at the planning stage, impact of the additional income tax burden on the project return should be considered in the course of commercial decision.

There will be a need for new thinking and strategy to minimise China income tax.  All investors shall consider a comprehensive review on how their FIEs may optimise and take advantage of the new forms of tax incentives under the new regime.  We particularly welcome the move of China to adopt more sophisticated tax incentive measures including super deduction and investment tax credit which appears to be accessible to taxpayers in general.

Indeed, the current CIT reform has gone through a long process.  But, the promulgation of CIT Law only marks the beginning of another chapter.  There are still many unanswered questions on important matters relevant to foreign investors.  The State Council will oversee the drafting and promulgate the detailed implementation rules with the support of the State Administration of Taxation and Ministry of Finance.

CIT Law has unified the tax rate, tax incentives, and expense deduction rules for DEs and FIEs, but unification of tax treatments is far from complete.  This work would go beyond the basic provisions of the new Law.  For instance, the tax treatment of business restructuring like merger, acquisition, equity transfer, like kind exchange, in-kind contribution etc. are currently very different between FIEs and DEs and needs to be aligned.

PwC will continue to monitor the development of the CIT reform and share our information and analysis with our clients and business associates to help them understand the impacts.