Corporate Income Tax in China

Corporate income tax is a hot topic in China at the moment with the recent majority vote in the National People’s Congress to harmonise the income tax rates for Foreign Invested Enterprises and domestic firms. It is believed that the move signifies a shift towards moving China in line with international practices.

The new laws, which were passed on 16 March 2007, have been the subject of protracted debate and speculation for a considerable time now. They will become effective as of 1 January 2008, heralding the beginning of a new era of investment in China, with there no longer being any preferential treatment given to Foreign Invested Enterprises (FIEs) over their domestically funded counterparts. Pockets of favourable treatment will remain, however, in industries that the authorities wish to channel investment towards.

The changes have been brought about largely because Chinese firms were often struggling to compete with their foreign rivals, something the Chinese authorities believed to be unfair, particularly given China’s recent accession to the World Trade Organisation. Under the current legislation, FIEs are entitled to a host of tax incentives which were set up to encourage high level, high profile investment in the country. The resulting Foreign Direct Investment was intended to be used to further improve levels of infrastructure and other key factors pertaining to the investment decision of a foreign firm.

Existing taxation structure

At face value the previous tax structure was essentially uniform with all firms, regardless of the source of their funding, paying the same proportion of their profits in tax. There existed a base rate of 30% to which a surcharge of 3% could be added by local authorities, although in practice this is generally waived. FIEs have been able to take advantage of an extensive range of incentives based on the industry sector of their business, or their geographical location, provided they have agreed to a statement of commitment to operate in China.
Firms in the manufacturing sector can be exempt from paying any tax whatsoever for the first two years of making an operating profit and a 50% reduction in the standard tax rate for three years thereafter. In addition, there are a host of other tax benefits to foreign firms including a base rate of 15% to manufacturers in designated Economic and Technological Development Zones or businesses in Special Economic Zones. There are further tax rates of 24% available to productive FIEs located in the various development zones and cities, dependent on the location of the project.
Additional tax breaks can be made available to FIEs if they chose to reinvest their share of profit, capital reserve, or enterprise and development and expansion reserve. Rebates of up to 40% are possible provided that the aforementioned assets are reinvested for a period of five years or more, although this is conditional on the reinvestment being channelled into increasing existing capital stock or into another FIE. Alternatively, if the profits are reinvested into an export-oriented industry or a technologically advanced industry then the firm is entitled to receive a rebate on the tax already paid on the profit share that has been reinvested.

The new system

Many of the above incentives for foreign firms are to be either altered in some part or abolished completely under the new laws, the impact of which has been and is likely to remain a matter of considerable speculation. The salient points of the new laws are a revised standard tax rate of 25% applicable to Chinese and foreign firms, a preferential rate of 20% available to certain low profit making enterprises, and a 15% rate for new or high technological enterprises. These are the main rates to be applied to the majority of companies but there are further sub-clauses in the law which will allow particular firms to gain some tax benefits.

Some of the new tax incentives are detailed below:

  • Sectors where there is investment in agriculture, forestry, fisheries and infrastructure
  • Sectors where investment is in venture and environmental protection
  • Start-up high technology industries will be given preferential treatment if they are supported by the State and located in so-called Special Economic Zones (SEZs) or the Pudong district of Shanghai.
  • ‘Super’ reductions given to firms producing original research and development, and new technologies.
  • Direct tax reduction has been replaced with a preferential system for labour and welfare services, and others which make efficient use of resources.

The key point to note is that there has been a considerable shift in emphasis of the new legislation towards environmental industry rather than just attracting business regardless of its nature or impact on the environment. Incentives in place in China since its markets were opened up to overseas investment have served a purpose very well. FDI has reached unprecedented levels and growth has averaged almost double digits in China for almost thirty years, but it is now believed that existing incentives are no longer necessary to maintain growth. Indeed, the 25% rate is still a more attractive option than much of Europe, the United States and some of its Asian neighbours.

Who will it affect?

The new laws are likely to have a widespread effect, for obvious reasons, but some parties will be affected more than others. Quite how the effects will be spread is unclear but it is worth specifying some of the parts of the new law in order to see their possible impacts.

Apart from the specifics of the law the basic 25% rate will have an immediate effect. Manufacturing firms will certainly be hit as they will no longer be entitled to any kind of tax breaks. As a result they could face anything up to a 15% rise in the amount of tax they have to pay. Whilst large firms may be able to afford such a rise, indeed many have seen the rate hike coming for some years now and have adjusted their tax structures accordingly, it could be the smaller firms that are hardest hit. It could be difficult to compete in the market when up to one quarter of their profits are taken away in tax; it will lower the return on their investment.

There will no longer be a 50% reduction of corporate tax for production-oriented foreign-funded enterprises or any exemption for export-oriented firms. There will, however, be leniency afforded to firms who have already been promised tax breaks; that is those that have invested in China before the passing of this new law. Firms founded before the implementation of the new law will either receive a five year period of grace where they will be subject to a gradually increasing tax rate, or they will be entitled to complete the period of tax exemption which they were promised. Additionally, firms not currently making an operating profit will be permitted to have the benefit of tax benefits beginning 1 January 2008.

What happens to investment in China is a question that can only be answered with time. Firms will undoubtedly have to rethink and reorganize their investment plans to minimise their tax bill in order to maximise their Chinese investment. But investment in the country is not expected to waver too much; the Chinese market has more to offer than tax incentives alone. Investment provides access to a huge labour force, infrastructure is becoming increasingly sophisticated and tax rates remain attractive in comparison to many competing nations.

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