6. Enterprise Income Taxation in China
On 16 March 2007, the Unified Enterprise Income Tax Law was promulgated, and it came into force on 1 January 2008. This represents a major shift in taxation policy towards foreign investment and created a standard rate of tax payable by both domestic and foreign invested enterprises at 25%.
Pre-March 2007, the Chinese enterprise income tax law has treated domestic and foreign-invested enterprises differently, giving preferential tax treatment in many cases to foreign-invested enterprises to encourage foreign investment in China.
Below is an overview of the Unified Enterprise Income Tax Law and its application to existing and future foreign-invested enterprises and its impact on foreign investment in China. Beware that all tax rates set forth below are general tax rates in the Unified Income Tax Law, and where applicable they should be reduced in accordance with the relevant international treaties and arrangements.
(a) Residents vs. non-residents
Enterprises are classified into resident and non-resident enterprises under the Unified Enterprise Income Tax Law. A “resident enterprise” refers to an enterprise that is either (i) incorporated in China or (ii) whose “actual management entity” is located in China. Resident enterprises are subject to Chinese enterprise income tax of 25% on its worldwide income.
A foreign-invested enterprise is incorporated in China and is therefore deemed to be a resident of China for Chinese income tax purposes. Also under the new rules, the overseas regional headquarter of a multinational group could be deemed to be a resident of China for tax purposes if the Chinese tax authorities determines that its “actual management entity” is located in China. Factors to be considered when determining the location of the actual management entity include location of the board meetings and where the company’s books are kept.
A non-resident enterprise refers to an enterprise incorporated outside of China and whose actual management entity is also located outside of China.
A non-resident foreign investor is subject to 25% Chinese enterprise income tax on income derived from or in relation to its unincorporated establishment in China, regardless of the location of payment. As it currently stands, the foreign investor is also subject to 20% Chinese enterprise income tax (though this rate is likely to be reduced by subsequent implementation regulations) on income originated in China (i) where the income is unrelated to its unincorporated establishment in China or (ii) where it does not have any unincorporated establishment in China.
Resident with non-resident: application to foreign-invested enterprise and its overseas (and non-resident) parent
A foreign-invested enterprise incorporated in China on or after 16 March 2007 will be taxed at the full 25% on its worldwide income as of 1 January 2008. In addition, its non-resident parent is subject to Chinese income tax of 20% on income it derives from the foreign-invested enterprise, including dividends, interests and royalty payments. Where the non-resident parent has a separate unincorporated establishment in China, it is also subject to 25% of Chinese enterprise income tax on any income generated either through or in relation to the establishment. Finally, the parent will also be taxed at 20% on its other income originated in China.
(b) General computation rules
The taxation year in China is from 1 January to 31 December each year. Enterprise income tax payable during a given taxation year is calculated as follows:
Total income minus:
- Income not subject to taxation
- Tax-exempt income
- Deductions from income
- Allowable loss carry-over for the year
- = Taxable income
(Taxable income – Tax deductions) x Applicable tax rate = Enterprise income tax payable
Total income includes payments in cash or in kind from various sources, including proceeds from (i) sale of goods, (ii) provision of labour, (iii) transfer of assets; (iv) dividends, bonuses and other equity investment proceeds; (v) interest income; (vi) rental income; (vii) royalty income; (viii) donation income; and (ix) other income.
“Income not subject to taxation” and “tax-exempt income”
Both “income not subject to taxation” and “tax-exempt income” are quite narrowly defined. “Income not subject to taxation” consists mostly of (i) funding from the treasury and (ii) administrative fees and government funds collected as part of treasury administration. “Tax-exempt income” refers to (i) interest on treasury bonds; (ii) dividends, bonuses and other equity investment proceeds distributed between “qualified resident enterprises”; (iii) dividends, bonuses and other equity investment proceeds which a non-resident enterprise with unincorporated establishments in China obtains from a resident enterprise and which have actual connection with such establishments; and (iv) income of “qualified not-for-profit organisations”. For the time being there is no clear guideline for interpreting the terms “qualified resident enterprise” and “qualified not-for-profit organisation”.
Deductions from income
A number of deductions could be made from the total income, and the most common ones include (i) reasonable disbursements actually incurred and relating to the generation of income, such as allowable costs, expenses, taxes and losses; (ii) a percentage of the taxpayer’s donations for public welfare; (iii) allowable depreciation of fixed assets; (iv) allowable amortization of intangible assets; (v) a number of specific long-term deferred expenses; (vi) allowable cost of inventories; and (vi) net value of an asset upon transfer of the asset.
The tax authorities also allow further deductions from income for selected activities seen as in need of encouragement and support by the Chinese government. These include deduction from income at more than the actual amount of (i) research and development expenses incurred for the development of new technologies, products and techniques, and (ii) wages paid to disabled employees or other employees whom the state encourages one to hire. As another example, income generated by an enterprise from producing products in conformity with national industrial policies of comprehensive utilisation of resources could be used to offset its taxable income. In a last example, a startup investment enterprise engaged in startup investments seen as requiring particular support and encouragement by the state may use some of its investment amount to offset its the taxable income.
Allowable loss carry-over
In addition, a taxpayer may carry its losses forward (but not backwards) for a maximum of five years to offset its taxable income in a given year.
From taxable amount to taxes payable
As shown above, taxable amount times the applicable tax rate, and then less tax deductions will give the amount of income tax payable by an enterprise in a given year. We shall separately discuss deductions from tax below.
(c) Deductions from tax
In addition to allowing further deductions from income for selected activities in the computation of taxable income in (b) above, the tax authorities also allow for further deductions directly from the amount of taxes payable for selected enterprises and/or activities seen as warranting encouragement and support of the state.
Deductions from tax for selected enterprises
Most notably under the Unified Income Tax Law, (i) “qualified small-scale enterprise with marginal profits” (term not yet defined) enjoys a reduced enterprise income tax rate of 20%, whereas (ii) “high and new tech enterprise in need of particular support by the state” (term not yet defined) enjoys a reduced enterprise income tax rate of 15%.
Deductions from tax for selected projects/activities
Most notably, deductions and/or exemption from taxes is allowed for income derived from (i) agriculture, forestry, husbandry and fishery projects; (ii) business operations of public infrastructure investment projects which are particularly supported by the state; (iii) income from qualified environmental protection, energy and water conservation projects; and (iv) qualified transfers of technologies.
In another instance, the amount an enterprise’s investment in the purchase of special equipment for environmental protection, energy or water preservation and work safety could offset its taxes payable in accordance with a certain ratio.
(d) Transfer pricing and thin-capitalisation
Principles of “as per independent transaction” and “reasonable commercial purpose” will apply to related-party transactions. Where these principles are seen as not being adhered to in any related party transactions, the tax authorities will have the right to readjust the amount of taxes payable by the parties. On a separate note, advanced pricing arrangement with the Chinese tax authorities is permitted.
On the upside, the Unified Enterprise Income Law now explicitly allows for cost sharing by an enterprise and a related party in the calculation of taxable income for costs incurred in (i) jointly developing and accepting the assignment of intangible assets, or in (ii) jointly providing or accepting labour services.
As far as thin-capitalisation is concerned, interests will no longer be deductible in the calculation of an enterprise’s taxable income where its ratio of debt-to-equity financing from a related party is higher than the statutory standard. The term “statutory standard” remains undefined at the moment.
(e) Transitional periods
Foreign-invested enterprises incorporated after 16 March 2007
First, it should be noted that the transitional rules only apply to enterprises already in existence as on 16 March 2007, and as such foreign-invested enterprises incorporated after this date do not enjoy any transitional period, and will be taxed at the full 25% on their enterprise income from 1 January 2008 onwards.
Foreign-invested enterprises in special economic zones
Existing foreign-invested enterprises in special economic zones enjoy a 5-year transitional period during which time an enterprise’s income tax rate will be increased by 2% per year: 15% for 2007, 17% for 2008, 19% for 2009, 21% for 2010, 23% for 2011, and finally 25% for 2012 and for every year thereafter.
Foreign-invested enterprises with fixed-term preferential tax treatment
Existing foreign-invested enterprises which have been enjoying preferential tax treatments with a fixed term including the “2-year exemption and 3-year deduction at half” and “1-year exemption and 2-year deduction at half” will be allowed to continue to enjoy the lower tax rate until the fixed term expires. However, where an existing foreign-invested enterprise has failed to enjoy the preferential tax treatment due to failure to make profits, the fixed term will be deemed to start running in 2007.