Chapter 3.4: Taxation Issues | Doing Business with China

Becky Lai, PricewaterhouseCoopers

Corporate taxation in China

Introduction

The existing income tax laws which affect foreign companies doing business in China are discussed in this chapter. Since the Chinese taxation system is still in a developmental stage, attention should be paid to interpretations and practices of the local tax authorities.

Currently, domestic enterprises and foreign enterprises (FE) and foreign investment enterprises (FIE) are governed by two different sets of enterprise income tax legislation.

FIEs include Chinese-foreign equity joint ventures, Chinese-foreign contractual joint ventures and wholly foreign-owned enterprises established in China. FEs include foreign companies, enterprises and other economic organizations which have establishments in China and are engaged in production or business operations or which, although without establishments in China, have income from sources within China.

Establishments refer to management offices, business organizations, representative offices, factories, places where natural resources are exploited, places where contracted projects of construction, installation, assembly and exploration are carried out, places where labour services are provided and business agents .

FIEs are subject to income tax on their worldwide income whereas the FEs are generally liable to income tax in respect of their China-sourced income.

Income tax on resident enterprises

Generally the national income tax on FIEs and FEs with establishments is levied at 30 per cent while local income tax is 3 per cent on the net taxable profit. FIEs are eligible for various tax holidays and other tax reductions and exemptions under the tax law, depending on their locations and nature of operations.

The following are the preferential income tax rates for income derived from production and non-production operations carried on by FIEs and FEs located in various special tax regimes:

Income from production or non-production businesses obtained by FIEs and FEs with establishments located in Special Economic Zones (SEZ) in Shenzhen, Zhuhai, Shantou, Xiamen and Hainan is subject to tax at 15 per cent.
Income from production businesses obtained by FIEs located in the designated Economic and Technological Development Zones (ETDZ) is also subject to tax at 15 per cent.
Income obtained by FIEs located in Coastal Economic Open Zones (CEOZ) and in the old urban districts of cities where the SEZs or ETDZs are located, and are engaged in production operations, is subject to tax at 24 per cent.
Income obtained by FIEs located in Coastal Economic Open Zones and in the old urban districts of cities where the SEZs and ETDZs are located, and are engaged in the following projects, is subject to tax at 15 per cent:
- technology-intensive or knowledge- intensive projects;
- projects with a long investment return period with foreign investment of not less than US $30 million; and
- energy, communications or port development projects.
Income obtained by FIEs located in Shanghai Pudong New Area and engaged in productive operations, energy and transportation construction projects is subject to tax at 15 per cent.
Financial institutions, such as foreign bank branches and Sino-foreign joint venture banks established in SEZs and other areas approved by the State Council, are subject to tax at 15 per cent if the registered capital from the foreign investor or operating fund transferred from the foreign head office is over US$10 million and the operation period is longer than 10 years . This applies to foreign currency business only. For renminbi currency business the normal income tax rate will continue to apply.
Enterprises located in certain free trade zones and export processing zones and in certain Western and Central areas may also be subject to a 15 per cent reduced income tax rate.

Tax holidays and incentives

In addition to the preferential tax rates mentioned above, FIEs are entitled to the following tax holidays and incentives:

Production FIEs scheduled to operate for a period of more than 10 years will be entitled to two years' tax exemption and three years' 50 per cent income tax rate reduction commencing from the first profit- making year.
After the expiry the tax exemption and reduction period, a production FIE exporting 70 per cent or more of the value of its production output in a year may pay income tax at a 50 per cent reduction for that year subject to a minimum rate of 10 per cent.
After the expiry of the tax exemption and reduction period, a 'technologically advanced FIE' may pay income tax at a 50 per cent reduction for a further three years subject, again, to a minimum rate of 10 per cent. The 'technologically advanced' status requires special certification from the local government.
FIEs engaged in special projects, such as infrastructure projects with an operation period of 15 years or more, are entitled to five years' tax exemption followed by five years' 50 per cent income tax rate reduction.
FIEs located in SEZs and engaged in service industries with foreign investment of more than US$5 million and operation period of more than 10 years, with the approval of the SEZ tax bureau , may enjoy one year tax exemption followed by two years' 50 per cent income tax reduction commencing from the first profit-making year.
Financial institutions such as foreign bank branches and Sino-foreign joint venture banks established in SEZs and other areas approved by the State Council, with the registered capital from the foreign investor or operation fund transferred from the foreign head office of over US $10 million and an operation period of longer than 10 years, may enjoy one year tax exemption followed by two years' 50 per cent tax reduction commencing from the first profit-making year. This tax holiday does not apply to renminbi currency business.
In order to induce reinvestment of profits by foreign investors, a 40 per cent tax refund is granted to the foreign investor that reinvests its share of distributed profits in the same or a new FIE for a period of more than five years. Profits reinvested by the foreign investor in the same or in a new export-orientated enterprise or technologically advanced enterprise for a period of more than five years may be granted a 100 per cent tax refund.
On repatriation of after-tax profits, no income tax is levied. In addition, dividend income received by FIEs in China is also tax exempt but any relevant loss or expenses incurred are non-deductible.
For FIEs engaged in encouraged projects that purchase China-made equipment within the total investment or FIEs purchasing China-made equipment beyond the total investment but for the purpose of technological upgrading or for producing high- technology products, 40 per cent of the costs of the domestic equipment may be used as a credit to offset the increment in the enterprise income tax liability in the year of equipment purchase as compared with that of the previous year.
If the expenditure on technology development of an FIE increases by 10 per cent or more over that of the previous year, the taxable income of that FIE for the current year, with the approval from the tax authority, will be offset by 50 per cent of the actual amount of the spending on technology development.
Newly established software production enterprises will be eligible for two years of exemption and three years of 50 per cent reduction of Enterprise Income Tax (EIT) from the first year they make profits.
Key software enterprises that fall within the state's planned arrangement that are not eligible for preferential tax exemption in a given year will have EIT levied at the reduced rate of 10 per cent.
FIEs in the Central and Western areas and under the encouraged category of the Investment Guidelines will enjoy an extension of the normal tax holiday for three years. That is, on top of the normal tax holiday of two years' exemption and three years 50 per cent reduction of EIT, the reduced EIT rate of 15 per cent will be applicable for another three years after this five-year normal tax holiday. An extended 15 per cent reduced EIT rate will be available provided that the projects l fall within the key encouraged projects category and satisfy other conditions.
Separate tax holidays will be available on the increased portion for FIEs engaged in encouraged projects for the increase of new registered capital of US $60 million or more, or increased by US $15 million which represents 50 per cent or more of the registered capital of the original FIE, subject to certain conditions and approval from the relevant tax authorities.

Local income tax

Local income tax is levied at three per cent of net taxable profit. Exemption or reduction in local income tax may be granted to FIEs located in SEZs, ETDZs and the old urban districts of cities where an SEZ is located, at the discretion of the local tax authorities.

Turnover taxes

Effective 1 January 1994 a turnover tax system consisting of value-added tax, consumption tax and business tax was introduced by the Chinese authorities. Value- added tax, consumption tax and business tax are indirect taxes charged on the gross turnover of businesses and enterprises operating in China.

Under the turnover tax system, FIEs will pay either value-added tax or business tax, depending on the nature of their businesses. Value-added tax is levied on the sales of tangible goods, provision of processing, repairs and replacement services and the importation of goods within PRC. The general value-added tax rate is 17 per cent on products and imports and a lower rate of 13 per cent is levied on certain specific products, mostly necessities.

Export sales are exempted under VAT rules and an exporter who incurs input VAT on purchase or manufacture of goods should be able to claim a refund from the tax authorities. However, due to a reduction in the VAT export refund rate of some goods, however, exporters might bear part of the VAT they incurred in connection with the exported goods.

Business tax is applicable to enterprises in the service, transport and other non-production industries as well as the transfer of intangible assets or immovable properties. Business tax rates range from 3 per cent to 20 per cent, depending on the category of the business concerned .

Consumption tax is levied on the production in China of 11 categories of goods including cigarettes, alcohol, cosmetics, jewellery, gasoline and motor vehicles. Importation of taxable goods is also subject to consumption tax but export is exempt.

Turnover tax paid, except for value-added tax, is deductible for foreign enterprise income tax purposes, because both business tax and consumption tax are considered as costs to the business or enterprise concerned. Value-added tax, however, is a tax which is borne by the end- user of taxable products and services and would not be deductible for income tax purposes.

Computation of taxable income for corporate income tax purpose

Capital gains
Gains arising from the disposal of an FIE's assets are generally included as part of the FIE's taxable income. The capital gain is the difference between the book value and the selling price of the asset.

Treatment of dividends received
Dividends are to be included in taxable income but dividends received by an FIE in China are not taxable.

Depreciation of fixed assets
Wear and tear allowances are granted on fixed assets and other capital assets used in the production of income. Except where specially approved, only the straight-line method of depreciation is allowed. In applying the straight-line depreciation method, one should assume a residual value of not less than 10 per cent of the original cost. Depreciation in fixed assets should be computed starting from the month following that in which the fixed assets are put into use.

The minimum depreciation periods for different classes of fixed assets are as follows :

premises, buildings and structures “ 20 years;
trains, ships, machinery and other production equipment “ 10 years;
means of transport (except for trains and ships), electronic facilities and equipment and
other production- related tools, facilities, furniture, etc “ five years.

Amortization of intangible assets
Intangible assets should be amortized by the straight- line method over a period of not less than ten years or the period as stipulated in an agreement relating to the said intangible asset.

Pre-operating expenses are to be amortized over a period of not less than five years.

Bad debts
FIEs engaged in the credit and leasing business may, upon approval of the local tax authorities, provide for doubtful debts at not more than 3 per cent of the year- end balances of their loans (not including interbank loans) or of their accounts receivable, bills receivable and other receivables. Such provision is allowed as a deduction for income tax purpose.

Bad debts actually written off by an FIE should be reported to the local tax authorities for examination and confirmation.

Accounts receivable may be written off as bad under the following circumstances:

bankruptcy of the debtor;
death of the debtor; or
the debt has been outstanding for over two years.

Entertainment expenses
Entertainment expenses incurred in relation to the production and business operation of an FIE have to be backed up by reliable records or vouchers, and are deductible within the following limits:

For FIEs engaging in production and retailing , where the annual net sales are 15 million renminbi or less, the entertainment expenses allowed as a deduction shall not exceed 0.5 per cent of the net sales, and for the portion above 15 million renminbi, the entertainment expenses allowed as deduction shall not exceed 0.3 per cent of such portion.
For FIEs engaging in service businesses, where the annual business income is 5 million renminbi or less, the entertainment expenses allowed as a deduction shall not exceed 1 per cent of the total business income, and for the portion above 5 million renminbi, the entertainment expenses allowed as deduction shall not exceed 0.5 per cent of such portion.

Wages, benefits and allowances
Wages, benefits and allowances paid to employees may be listed as expenses, except foreign social insurance premiums paid for employees working inside China.

Fines
Fines and penalties paid are not allowed as deductible expenses.

Donations
Only donations to approved charitable organizations are allowed as deductible expenses.

Management fees

Management fees paid to related companies are not allowed as deductible expenses.

Loss carry-overs
In determining taxable income, losses incurred by an FIE in previous years may be used for set-off against future years' profits for a period not exceeding five years.

Other issues

Transactions between related parties
All FIEs are required to conduct revenue and capital transactions between related parties on an arm's length basis. Otherwise the tax authorities have the right to disregard, vary, or make adjustments to certain arrangements that are carried out for the purpose of tax avoidance and not for bona fide commercial reasons.

Consolidation of income
An FIE or FE which has two or more business establishments set up in China may elect one establishment for consolidated income tax filing and payment purposes, however, that establishment must meet the following requirements:

It shall assume supervisory and management responsibility over the business of other establishments.
It shall keep complete accounting records and vouchers that correctly reflect the income, expenses, profits and losses of other business establishments.

Tax periods
The tax year is the Gregorian calendar year starting from 1 January and ending on 31 December.

Currency
Income tax payable shall be computed in renminbi. Income in foreign currency shall be converted into renminbi according to the exchange rate quoted by the State exchange control authorities for purposes of tax payment.

Foreign tax relief
The Chinese taxation system provides for avoidance of double taxation and prevention of evasion for taxes incurred in territories outside China under tax treaties. Tax treaties or arrangements exist with 77 countries and regions including Japan, the USA, the UK, Belgium, France, Singapore, Malaysia, Norway, Denmark, Finland, Sweden, Canada, Thailand, Germany, New Zealand, Italy, Poland, Yugoslavia, Romania, Pakistan, Switzerland, Kuwait, the Netherlands, Korea, Vietnam, Mauritius, Hong Kong, etc.

FIEs are allowed to deduct from the amount of tax payable the foreign income tax already paid abroad in respect of the income derived from sources outside China; however, the deductible amount cannot exceed the amount of income tax otherwise payable in China in respect of the income derived from sources outside China.