Recent changes to Chinese tax law has dramatic tax implications for foreign investors in the People’s Republic of China. Despite the changing tax landscape, there are still opportunities to take advantage of current tax law.
On January 1, 2008, the 2008 Enterprise Income Tax Law ("Tax Law") was enacted in the People’s Republic of China (the "PRC"). Foreign companies and other investors face significantly increased tax burdens under the Tax Law: it abolishes the preferred tax treatments for Foreign Investment Enterprise ("FIE") while also imposing withholding taxes for dividends expatriated from China. As a result, FIE will face a 25% income tax and a 20% withholding tax for profits remitted abroad via dividends.
Despite the new tax law, there are still tax advantaged opportunities still exist in China. Certain categories of FIEs may still obtain tax incentives by qualifying as a High and New Technology Enterprise ("HTE"). Eligible FIEs will have the opportunity to reduce corporate income taxes to 15% and decrease their withholding tax. Another method of reducing the tax burden is through the use of special purpose vehicles established in countries with favorable tax treaties. The appropriate solution in any particular case depends upon the type of investment and the nature of the company.
Tax Incentives for High and New Technology Enterprises
The Ministry of Science and Technology, the Ministry of Finance and the State Administration of Taxation have jointly issued the Administrative Regulation governing the Recognition of High Technology Enterprises (“Regulation”), which sets forth the criteria and procedures for establishing HTEs. Under the Regulation, the HTE must:
1. Be established within China (excluding Hong Kong, Macau and Taiwan);
2. Be in existence for more than one year;
3. Continuously conduct R&D activities that transform intellectual property into products and/or services;
4. Possess its own IP rights; and
5. Carry out business within the scope of the Catalogue of High and New Technology Domains Specifically Supported by the State.
In addition to these requirements, the Regulation sets forth guidelines to further refine the expectations placed upon an HTE. Thirty percent of the employee population should have university degrees, among which at least 10% should engage in R&D. Sixty percent of total R&D expenditures should be incurred in China. Finally, income derived from high technology products or services should account for more than 60% of the total annual income for the FIE.
A successful application for HTE status will result in a license for three years.
Unfortunately, while the Regulation sets forth procedures for obtaining HTE status, the actual logistics of applying are complex and prone to delays. Because of the complex application and approval process, it is unlikely that HTE licenses will be issued before the early part of 2009. During the application process, the FIE will be forced to pay the non-advantaged rate of 25%.
Adopting Treaty SPV Investment Structure
Under previous regulations, China did not tax profits from FIEs that were expatriated off-shore dividends. A typical foreign direct investment structure for China would entail the use of an off-shore special purpose vehicle established in a tax haven such as the British Virgin Islands. This special purpose vehicle would then funnel the investment to the on-shore FIE, such as a wholly owned foreign enterprise, or to foreign interests in a joint venture. This structure previously allowed foreign investors to expatriate dividends without incurring any taxes.
Under the Tax Law, the dividends, interest and royalties expatriated from China are subject to a tax withholding rate of 20%. For foreign investors, this represents a significant reduction in their net returns. In order for foreign investors to reduce this withholding tax obligation, foreign investors now need to look into tax treaties between China and other foreign countries.
China has executed tax treaties with many countries. The treaties that were executed with Barbados, Mauritius, Singapore, Hong Kong, and Ireland all have provisions that affect the level of withholding tax on expatriated funds. In all those treaties, the withholding rate for dividends is set at 5%. Thus, a company could take advantage of these treaties by using a special purpose vehicle established in any of these countries. This structure would reduce the standard 20% tax withholding to 5%. Of course, the tax burden of the relevant treaty countries would have to be factored in to complete the total tax analysis. Below is a chart illustrating the withholding tax based upon various tax treaties.
|Holdco Jurisdictions||Barbados||Mauritius||Singapore||Hong Kong||Ireland|
|Dividend WHT||5%||5%||5% for >=25% ownership, 10% otherwise||5% for >=25%ownership, 10% otherwise||5% for >=25% ownership, 10% otherwise|
|Royalties WHT||10%||10%||10% (industrial equipment 6%)||7%||10%|
|Capital Gains WHT||Exempt (expected renegotiate of treaty in next 12 months)||
Taxable if >=25% holding, otherwise exempt; all realty co taxable
|Taxable if >=25% holding, otherwise exempt; all realty co taxable||Taxable if >=25% holding, otherwise exempt; all realty co taxable||Exempt, except for real estate rich|
The Tax Law significantly impacts the operations of the FIE in China. However, through proper tax planning, opportunities to significantly reduce tax exposure in PRC still exist.