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Client update: China - 29 March 2007

PRC enterprise income tax reform

In brief: On 16 March 2007, the PRC National People's Congress passed the PRC Enterprise Income Tax Law , which, from 1 January 2008, will unify China's enterprise tax rules by replacing laws applying separately to foreign-invested enterprises and domestic enterprises. Partner Campbell Davidson (view CV), Senior Associate Toby Grainger and Consultant John Li take a look at some of the key changes.

Application of the law

The PRC Enterprise Income Tax Law (the EITL) imposes income tax on 'enterprises' (being enterprises and other entities excluding wholly individually-owned enterprises1, partnerships and branches2) which derive income from sources within the PRC.

Enterprise taxpayers are categorised under the EITL as either 'resident enterprises' or 'non-resident enterprises'. Resident enterprises are those incorporated in the PRC or incorporated outside of the PRC but which have their place of effective management located in the PRC. Non-resident enterprises are those enterprises incorporated outside of the PRC with their place of effective management outside of the PRC, but which:

  • have set up an establishment or place of business in the PRC; or
  • have not set up an establishment or place of business in the PRC, but derive income from sources within the PRC.

The EITL does not, however, address what constitutes a 'place of effective management' for determining whether an enterprise is resident in the PRC. This issue may be clarified in the detailed implementing rules to be issued by the State Council.

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Income tax categories

The EITL states that enterprises must pay income tax in accordance with one of the following categories:

  • resident enterprises must pay income tax on their worldwide income;
  • non-resident enterprises with an establishment or place of business in the PRC shall pay income tax only on income derived by their establishment or place of business in the PRC and on offshore income that is 'effectively connected' (this term is not defined) to their establishment or place of business in the PRC; or
  • non-resident enterprises without an establishment or place of business in the PRC or non-resident enterprises with an establishment or place of business in the PRC, which derive income unrelated to their establishment or place of business in the PRC, shall pay income tax only on income derived from sources within the PRC.

Non-resident enterprises will be subject to withholding tax on dividends, interest, rentals, royalties, capital gains or other income derived from sources within the PRC at a rate of 20 per cent (subject to any tax treaties, most of which provide for a 10 per cent withholding tax on dividends, interest and capital gains).

Capital gains from the transfer of equity in a foreign-invested enterprise (FIE) by a foreign enterprise are currently subject to 10 per cent withholding tax and FIEs are exempt from paying withholding tax on dividends paid to their foreign shareholders. Foreign investors will need to wait for the State Council's implementing rules to obtain clarification on whether the EITL will change the tax treatment in these instances.

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New uniform tax rate

The introduction of the uniform tax rate brings to an end the preferential treatment afforded to FIEs, including in some cases income tax rates of 15 per cent and tax holidays. (Most PRC domestic companies currently pay tax of 30 per cent at national level and three per cent at local level). The uniform enterprise income tax rate under the EITL is 25 per cent, however, small-scale enterprises earning a 'small profit' are subject to a 20 per cent rate, while a 15 per cent rate applies to 'encouraged' hi-tech enterprises.  Unfortunately, the EITL does not define what constitutes 'a small-scale enterprise', 'small profits' or an 'encouraged hi-tech enterprise'.

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Grandfathering of tax incentives

Notably, the entitlements to tax refunds for reinvestment of FIE profits and tax holidays enjoyed previously by production FIEs have not been included in the EITL.

The EITL revokes the existing five-year tax holiday (ie the two-year exemption and three-year 50 per cent reduction of tax) for production FIEs and any extensions of such holidays.  The EITL does, however, permit those enterprises that have not fully used their five-year tax holiday to continue to receive the benefits of the tax holiday for a five-year transition period. Those FIEs entitled to a holiday but have not yet begun their tax holiday because of the failure to make a profit are entitled to their incentive for five years from the year of the EITL's implementation.

In addition, those FIEs on a reduced tax rate will have their tax rate gradually increased over the five-year transition period. The EITL no longer allows any relief for export-oriented companies.

The rules regarding the transition of existing tax incentives still leave a number of issues unresolved, for example:

  • the EITL does not state how the reduced tax rates applying to FIEs in Special Economic Zones will increase to 25 per cent within the transition period; and
  • the grandfathering treatment applies to FIEs allowed to set up before the promulgation of the new law; however, it is not clear at what point the FIE is 'set up' for this purpose. Does it equate to Ministry of Commerce approval, registration with the State Administration of Industry and Commerce or is it the date the investor makes its capital contribution?

It is hoped the detailed implementing rules when they are released will help remove the areas of uncertainty.   

Footnotes
  1. The 'wholly individually-owned enterprise' refers to an entity established in accordance with the provisions of the Wholly Individually-owned Enterprises Law , that is invested in by a PRC natural person, the property of which is owned by the investor personally, and the debts of which the investor assumes unlimited personal liability. A wholly individually-owned enterprise (unlike a one-person limited liability company) is not subject to a minimum capitalisation requirement.
  2. The branch's PRC headquarters is subject to income tax on a consolidated basis.

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