International Update
China to Implement Unified Enterprise Income Tax Law, by Mary K. Thomas, CPA, JD
Effective January 1, 2008
The 10 th National People’s Congress of China concluded March 16, 2007, after approving the Enterprise Income Tax Law (New Tax Law) that will become effective January 1, 2008. The Enterprise Income Tax Law aims to streamline the new tax rates and allowable deductions for both domestic and foreign-owned enterprises.
New Tax Rates
The New Tax Law combines China’s tax rate at 25 percent, which is higher than the 15 to 24 percent rate currently enjoyed by many foreign-owned enterprises located in special foreign investment zones, but is lower than the 33 percent rate currently applicable to domestic-owned enterprises.
The new tax rates will phase in over a five-year transitional period for foreign-owned enterprises in order to cushion the impact of the tax increase.
Effect of Tax Rate Change
Doing business for domestic-owned enterprises in China just got cheaper. Therefore, U.S. companies that utilize the services of domestic-owned enterprises, such as through contract manufacturing arrangements, should be aware of this decrease when negotiating future contracts.
It is not expected that the one to 10 percent tax increase for foreign-owned enterprises will significantly alter the flow of foreign business into China, mainly due to the emerging domestic markets in mainland China and Asia, which are too large to overlook. However, those foreign-owned enterprises moving to China to solely take advantage of lower manufacturing costs may be influenced by the increased tax rate.
Mitigation of Tax Rate Increase
The New Tax Law provides for a preferential tax rate of 15 percent for high-tech businesses that promote technological development. What constitutes technological development subject to the preferential tax rate of 15 percent is not well defined. Further details may be available in the forthcoming regulations, but it is expected to be applied rather liberally.
Other entities that qualify for the preferential tax rate include venture capital enterprises – those that are involved in start-up investments – as well as foreign and domestic companies engaged in infrastructure construction, environmental protection, water conservation and production-safety projects.
Tax Holiday Repealed
Under current rules, qualifying foreign-owned enterprises are able to obtain approval for a two-year tax exemption and additional three-year, 50 percent tax rate reduction (“2+3 tax holiday”). Under the New Tax Law, foreign-owned enterprises that have taken advantage of the 2+3 tax holiday will be “grandfathered” under the current rules and may continue to enjoy the tax incentives for the remaining available period.
However, a company is not considered to have taken advantage of the 2+3 tax holiday, and therefore may not be grandfathered under the current rules, if the foreign-owned enterprise has yet to generate sufficient income to overcome all current and carry-forward losses. Such companies will forfeit their tax holiday rights through the remaining period.
For example, suppose that a U.S. company began operations in China in 2005 and obtained the necessary approvals for the China start-up enterprise to qualify for the tax holiday beginning in 2005. Suppose further that due to initial start-up costs, the China start-up enterprise incurred a loss in 2005, but reported a profit in 2006 that was less than the amount of loss reported in 2005. Under this example, if the China start-up enterprise does not incur enough profit in 2007 to overcome the 2006 net loss carry-forward, it will not be grandfathered under the tax holiday and may not take advantage of the tax holiday through 2009. Instead, it will be subject to the regular income tax rates under the New Tax Law, without reduction.
Permanent Establishments and Transfer Pricing
Under the New Tax Law, tax residency may be determined by a newly introduced concept of place of management. A foreign company that is not incorporated in China may be recognized as a China tax resident if its place of effective control and management is in China. Foreign enterprises should consider these new residency rules when organizing management level meetings in China or they may be inadvertently considered to be a Chinese resident.
The New Tax Law emphasizes transfer pricing documentation requirements as well as endorses cost sharing arrangement and advance pricing agreements.
Based on the provisions under the New Tax Law, it is expected that permanent establishment issues and transfer pricing enforcement will become a priority for the Chinese tax administration.
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Mary K. Thomas, CPA, JD, is the director of International Tax Services for Weaver and Tidwell LLP, one of the largest certified public accounting firms in the nation with offices in Dallas, Fort Worth and Houston.