China Passes Sweeping Tax Law Change Affecting Foreign Investment Enterprises
Global Services Tax Alert, May 2007
On March 16, 2007, the Chinese government enacted a new corporate tax law that takes effect January 1, 2008. This change will have a significant impact on the taxation of foreign invested enterprises operating in China.
New foreign invested manufacturing enterprises in China are no longer eligible for a two-year tax holiday. However, if the foreign invested enterprise was in existence prior to the March 16, 2007 China tax law change, it may gradually transition to the new 25 percent tax rate over the next five years starting on January 1, 2008. Foreign invested enterprises currently under tax holiday are permitted to use their remaining holiday under the terms of the existing law, but must commence using their holiday starting January 1, 2008.
In the past, foreign investors in Chinese manufacturing operations were eligible for a two-year, 100 percent tax holiday followed by a 50 percent income tax rate reduction for the next three years. The prior China income tax rate for companies not eligible for a tax holiday was 30 percent.
The fate of China’s 3 percent local tax is uncertain until new regulations are announced.
Certain high and new technology enterprises are eligible for a 15 percent tax rate. Additional deductions for qualifying research and development expenses will continue.
Anti-avoidance
Transfer pricing disclosure and documentation will now be required for all related party transactions. The new reform also cracks down on tax arrangements with the main purpose of avoiding taxes. Some additional new measures that have been introduced to combat tax-avoidance are as follows:
- Tax authorities will have the power to adjust taxable income where business transactions are arranged without reasonable business purpose.
- Specific "thin capitalization" rules under which interest associated with borrowings of a company regarded as exceeding a prescribed (but not yet announced) debt/equity ratio may be disallowed.
Withholding tax reduction and exemption
Unlike the current tax law, the new reform does not appear to specifically exempt withholding tax on dividends payable to foreign investors. The law does not specify whether the provisional reduction in the withholding tax rate (10 percent) currently applicable to interest, rental, royalty, and other passive income derived by foreign companies in China will survive. The Corporate Information Technology Law, however, provides the possibility of withholding tax exemption or reduction for China source income. We hope for additional regulations and clarification on these items from the Chinese government in the next few months.
Evaluate your current tax position relative to China’s new tax regime
Foreign investors must now consider how this fundamental change in China’s tax policy impacts their global tax planning. In the past, foreign invested enterprises may not have been concerned about how much income they reported in China since such income was tax exempt. Many companies also implemented global structures to take advantage of the now expired Chinese tax holidays. As such, foreign investors may now wish to consider conducting an impact analysis and revisit their current tax planning structures compared to the new China tax regime. For investments in the planning stage, we would recommend that companies consider the impact of the additional income tax burden on the project’s return on investment, cash flow plan, and other areas.
For additional information on how the new Chinese tax law applies to current or planned foreign investment enterprises, please contact Scott Sneckenberger at 248.375.7348 or scott.sneckenberger@plantemoran.com.
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