2008 Tax Rate Changes in China

Editor: Michael D. Koppel, CPA, PFS

The Enterprise Income Tax Law (EITL) will become effective in China on January 1, 2008. It was approved at the 10th National People’s Congress of China, which concluded on March 16, 2007. The function of the EITL is to streamline the new tax rates and allowable deductions for domestic and foreign-owned enterprises. This law could affect U.S. companies doing business in China in several ways.

New Tax Rates

China’s new tax rate under the EITL is 25%, which is higher than the 15%–24% rate many foreign-owned enterprises positioned in allotted foreign investment zones currently receive, but it is lower than the 33% rate currently applied to domestic-owned enterprises.

The new rate, however, will not go into effect immediately. It will be phased in over a five-year transition period for foreign-owned enterprises, which will thereby reduce the impact of the tax increase.

Effect of tax rate change: Domestic-owned enterprises in China will enjoy a cut in taxes. This, in turn, affects U.S. companies that work with domestic-owned enterprises, such as through contract manufacturing arrangements. U.S. companies should be aware of any and all tax decreases when negotiating contracts and contract renewals.

The 1%–10% tax rate increase for foreign-owned enterprises will most likely not drastically alter the amount of foreign business in China—mainly because emerging domestic markets in mainland China and Asia are becoming too large to overlook. However, foreign-owned enterprises that plan to move to China exclusively to cash in on lower manufacturing costs may be affected by the increased tax rate.

Mitigation of tax rate increase: High-tech businesses that promote technological development are eligible for a preferential tax rate of 15% under the EITL. What “technological development” is subject to the 15% preferential tax rate, however, is not clearly defined. Forthcoming regulations might offer further details, but it is anticipated that the rate will be applied rather liberally.

Venture capital enterprises—those engaged in start-up investments—as well as foreign and domestic companies involved in environmental protection, production-safety projects, infrastructure construction, and water conservation also qualify for the preferential tax rate.

Tax Holiday Repealed

Current regulations allow eligible foreign-owned enterprises to attain approval for an initial two-year tax exemption and a further three-year, 50% tax rate reduction (2+3 tax holiday). For foreign-owned enterprises that have taken advantage of the 2+3 tax holiday, the EITL allows them to be grandfathered under the current rules and continue to benefit from the tax incentives for the remaining period.

However, if the foreign-owned enterprise has yet to produce adequate income to overcome all current and carryforward losses, it is not considered to have utilized the 2+3 tax holiday and therefore may not be grandfathered under the current rules. Those companies’ tax holiday rights are then forfeited through the remaining period.

Example: X, a U.S. company, started operating in China in 2005 and received the required approvals for the China start-up enterprise to qualify to begin the 2+3 tax holiday in 2005. The China start-up enterprise reported a loss in 2005 because of initial start-up costs but reported a profit in 2006 that was less than the amount of loss reported in 2005. If this China start-up enterprise does not create enough profit in 2007 to cover the 2006 net loss carryforward, it will not be grandfathered under the 2+3 tax holiday and will not be eligible to take advantage of the tax holiday through 2009. Instead, it will have to follow the regular income tax rates under the EITL, without reduction.

Permanent Establishments and Transfer Pricing

Under the EITL, a newly introduced concept of “place of management” may determine tax residency. If a foreign company that is not incorporated in China has a place of effective control and management in China, it may be recognized as a China tax resident. Foreign enterprises may be considered Chinese residents without intending to be, if they do not consider these new residency rules when coordinating management-level meetings in China.

The EITL approves cost-sharing arrangements and advance pricing agreements and underscores transfer pricing documentation requirements. It is projected that the permanent establishment issues and transfer pricing enforcement will become a priority for the Chinese tax administration due to the recently installed provisions under the EITL.

If you would like additional information about these items, contact Mr. Koppel at (781) 407-0300 or mkoppel@gggcpas.com.