The new China Corporate Income Tax Law (CIT Law) passed at the 10th National People's Congress on 16 March 2007 has caught the attention of the world, especially its provisions on the unified income tax treatment of domestic enterprises (DEs) and foreign invested enterprises (FIEs). It will come into effect from January 2008.
"This CIT reform is a milestone in China's tax history," says Danny Po, China tax partner and national M&A tax leader, PricewaterhouseCoopers (PwC) — the world's largest professional services firm with 140,000 employees in 149 countries.
The existing income tax laws were enacted when China was trying to attract foreign investment. Great changes have taken place since then. "China has entered the World Trade Organisation (WTO) so its domestic market is being expanded for foreign capital. On the other hand, more and more Chinese companies have been integrated into the world economy and are facing fierce competition," Mr Po explains. "Currently, the average tax rate applicable to FIEs is only 15 per cent but 25 per cent for DEs. If this situation continued, the DEs would be put in a disadvantageous position. The new law can create a fairer playing field and bring China's taxation system more in line with the other members of the WTO. Also, the dual tax systems lead to many complaints and their administration is both expensive and inconvenient."
The Chinese government considers the timing of the CIT Law appropriate because both the Chinese economy and foreign investors' confidence in China are strong, according to Mr Po.
"The increase in effective tax rate for FIEs will not raise more tax revenue for the Chinese government. Quite the opposite, the new law is expected to result in a net decrease of income tax revenue by as much as RMB93 billion, so the Chinese government is not looking to raise more funds through this unification of tax treatments," he advises.
Many factors can signify that the Chinese economy is in a strong position and GDP growth rate alone is not enough to explain the amount of wealth China has accumulated over the past three decades. For example, official government sources indicate that the poor population has been reduced by about 200 million since the late 1970s.
The CIT Law reflects four major themes: simplified tax system, wide tax base, low tax rate and stringent administration, says Mr Po.
Under the new law, the dual tax systems will be abolished and FIEs and DEs will both be subject to a unified tax rate of 25 per cent.
The existing tax base in China is comparatively narrow. That is partially a result of favourable treatment for FIEs, which resulted in the DEs shouldering most of the tax burden. The new law equalises the tax burden for both FIEs and DEs.
The new law will also result in lower tax rates for DEs, who have to face a standard tax rate of 33 per cent, which is a relatively high rate when compared with the tax rates of surrounding countries.
Stringent administration can be translated as being anti-tax avoidance measures. The concept of tax resident enterprise (TRE) is being introduced by which FIEs registered in China are always deemed to be TREs and therefore subject to China income tax on their worldwide income. As for non-TREs, only their China source income will be taxable. Foreign enterprises (FEs) are regarded as TREs if their effective management institute is based in China. Other key aspects include more accuracy demanded for tax filing, and tightening of the administration over transfer pricing, a tax avoidance practice referring to the overpricing of imports and/or under-pricing of exports between affiliated companies based in different countries. A general anti-tax avoidance provision empowers tax authorities to nullify any transactions without reasonable commercial substance.
The CIT Law incorporates a number of tax incentives, which signals a strategic shift on the part of the Chinese government. The new tax incentives are industry-oriented rather than geography-based. Tax reductions and exemptions are aimed at industries critical to China's future success, which include, for example, agriculture, forestry and animal-husbandry, fishery, infrastructure, environmental protection, energy/water conservation and technology transfers. While these are highly encouraged, production FIEs and export-oriented FIEs in general industries may be entitled to only limited incentives.
"China is moving away from an export-driven economy and it now encourages local consumption so as to increase the standard of living and improve relationships with other countries by decreasing its trade surplus," notes Mr Po.