In an effort to further encourage investment in China, the Chinese Tax Administration (SAT) has initiated rules that allow for the deferral of withholding taxes on certain dividends as long as they are reinvested in an encouraged Chinese entity. These rules, which were recently released in the SAT’s Circular 88, are effective immediately.
Requirements for tax deferral treatment
The withholding taxes on these distributions / reinvestments can be deferred provided that all of the following conditions are met:
- The foreign investor must use the funds to make a direct equity investment in an eligible Chinese entity. Eligible investments may include capital increases, capital injections, and share acquisitions. Unless otherwise specified, purchases of shares in publicly listed companies or related parties are not eligible.
- Eligible profits include retained earnings, dividend income, profits, and other earnings of the Chinese operation.
- Tax deferred distributions must be directly transferred to an eligible Chinese company. The funds (or other eligible assets) may not be transferred through any intermediary – only direct investments are eligible for tax deferral.
- The reinvestment must be made in an encouraged project listed in the Catalogue for the Guidance of Foreign Investment Industries and Catalogue of Priority Industries for Foreign Investment in Central and Western China jointly released by the China Ministry of Commerce and NDRC.
Pre-recording and post-management
The SAT requires a “pre-recording and post-management” method for foreign investors who plan to utilize the deferral option, which includes the following:
- Foreign investors are required to provide documentation showing that all tax deferral treatment conditions were met by the profit-distributing company.
- The applicable tax authority may verify that taxpayers have properly taken advantage of this option. If a foreign investor fails to meet all deferral conditions, they may face administrative penalties and interest for late payment of withholding taxes.
Circular 88 is effective immediately and may be applied retroactively to January 1, 2017. Any foreign investors who have paid withholding tax but who are eligible for the tax deferral benefit can claim tax payments within three years of the original payment date for withholding taxes paid.
Any foreign investors who have paid withholding tax but who are eligible for the tax deferral benefit can claim tax payments within three years of the original payment date.
Open questions and tax deferral versus tax exemption
Circular 88 specifies the conditions for tax deferral treatment, the effective date, and the consequences of noncompliance. There are also several areas in the new rules that require further clarification including the applicability of these rules to non-corporate entities and how the rules apply to certain sale, merger, or other transactions.
It is important to note that the taxes on profit distributions used for reinvestment are tax deferred, not exempt from taxation. As such, foreign investors that subsequently sell or liquidate holdings in China that previously received tax deferral are required to pay the taxes due within seven days.
Who are qualified foreign investors?
According to Article 9 of Circular 88, non-resident companies as defined in China's corporate income tax law are eligible. As such, it may be difficult for other foreign investors (such as individuals, partners, trusts, and other investment entities) to apply for tax deferral.
What is included in profit distributions?
According to the SAT, profit distributions include retained earnings derived from the effective date as well as prior to the effective date of Circular 88 but not yet distributed.