China is one of the biggest buzzwords in global commerce today. Changes in Chinese company tax law can be relevant for  multinational corporations with existing operations, or contemplating investment in the PRC. The new China Enterprise Income Tax (“EIT”) law is a milestone in the history of the PRC tax system, ending nearly three decades of preferential tax treatment for foreign invested enterprises (“FIE”) over domestic enterprises (“DE”) and bringing both under the same tax code. What are the main changes of which a Belgian business needs to be aware before the law comes into effect on 1 January 2008?

China’s new EIT law mainly provides a general framework of tax provisions. It looks more like a “policy statement”. The detailed  rules, as well as the interpretation and application are left to regulations and supplementary tax circulars. The detailed implementing regulations are expected to be released later in 2007.

For those companies with operations in China or contemplating investment in China, it is time to take action on re-evaluating their tax profile and grasp the tax planning opportunities following the key changes in China’s new EIT law.

Change in Tax rates 
To level the playing field for DE and FIE, a unified income tax rate of 25 % has been established. Reduced rates of 15 % and 20 % are available for high-technology enterprise and qualified small and thin-profit enterprise, respectively. A 20 % withholding tax rate is adopted. However, it is not clear whether the current reduced withholding tax rate of 10 % would survive. (Currently, dividends repatriated to foreign investors by FIE with at least 25 % registered capital held by foreign shareholders are exempted as one of the tax incentives offered by the Chinese government.)

New Tax Incentive Policy 
China is attempting to move up the value chain. Therefore, the development of technology-led sectors and high-value capabilities has become a key policy focus. Deviating from the geography-based tax incentives of the existing regime, the new law adopts a predominantly industry-oriented tax incentive policy. A series of tax breaks are introduced to promote high-technology, environmental protection and energy-saving industries.
Most tax incentives currently available only to FIE shall be gradually phased out over the next 5 years including:

• "Two plus three" tax holiday for manufacturing FIE
• Three-year tax holiday extension applicable to high-tech FIE;
• Extended 50 % rate reduction for export oriented FIE
• Preferential tax rates of 15 % and 24 % in certain regions
• Tax refund on dividend reinvestment.

Grandfathering Arrangements 
In order to buffer the reform’s impact and shift to the new regime smoothly, a five-year “grandfathering” period shall be granted for FIEs established before the promulgation of the EIT law, which was 16 March, 2007. (Shang Ban Fa Han [2007]No. 59, issued by the Ministry of Commerce on 23 April 2007, further defines the cut-off date as the date of approval of the set-up by the Ministry of Commerce.)

• FIE enjoying the reduced tax rate of 15 % or 24 % under the existing law will be eligible for a five year transition period during which the tax rate will gradually phase up to the unified tax rate of 25 %.
• Manufacturing FIE that have not yet used their five-year tax holiday will be allowed to continue to enjoy the holiday during the grandfather period. If the five-year tax holiday has not yet begun due to accumulated losses, the holiday will be deemed to commence upon the effective date of the EIT law (i.e. 1 January 2008).

Enhanced Anti-avoidance Rules 
With a view to cracking down on tax arrangements designed primarily to avoid taxes, besides the existing transfer pricing rules, the EIT law introduces controlled foreign corporation rules (CFC), thin-capitalization rules and general “catch all” anti-tax avoidance rules, which give the tax authorities a stronger hand in assessing and collecting taxes. It signals an aggressive approach by the Chinese tax authorities to review currently implemented tax structures and provides the tax authorities with ample opportunities to make adjustments as they consider necessary in the absence of a reasonable business purpose.

All the new rules should have a sweeping impact on taxpayers in China.

Tax Resident 
Following international practice, the new law introduces a concept of “management or control” in determining tax residency. Resident enterprise is defined as an enterprise which is established in China under PRC laws, or which has its place of effective management in China. Where a non-Chinese enterprise is managed or controlled in China, it may be deemed to be Chinese tax resident and hence will be subject to direct taxation on its worldwide income.

The impact of the EIT law will differ depending on the type of industry and its location. That said, it will inevitably affect the privileged status and competitive advantage enjoyed by foreign investors in China in the past three decades.
FIE, especially those currently receiving tax incentives, will see an increase of their income tax burden in China. The time is ripe for them to review their tax profile and revisit their current tax planning structure to ensure effective tax rates in China are appropriately managed. Foreign investors contemplating entry into the Chinese market should consider the impact of the additional income tax burden on the project return in the course of the investment decision.

The withholding tax rate on passive income derived by non-resident enterprises from China stays at 20 % in the new EIT law. However, it is not clear whether the current withholding tax exemption on dividend remittance and reduced withholding tax rate of 10 % on other passive income will survive. This could significantly impact the after-tax return of foreign investors, especially financial institutions.

With the increased scrutiny of transfer pricing and increased income tax burden, foreign investors with operations in China should carefully evaluate and assess their transfer pricing to ensure compliance with the arm’s length principle, and appropriate planning strategies.

Given the announced abolition of tax holidays, acquiring an existing FIE to enter the Chinese market could be more appealing for foreign investors, compared with setting up a new FIE (a typical planning technique under the outgoing law to refresh the tax holiday entitlement). Under the grandfathering arrangement, the foreign investor may be able to inherit the favourable tax treatment by acquiring an existing FIE in a share deal.

The overhaul of the Chinese income tax regime presents both challenges and opportunities for foreign investors. Companies that do business in China are urged to review the impact of the new law on their China operations and consider appropriate action as soon as possible. The following points may require immediate attention.

• Tax resident: With the introduction of the “place of effective management” test in the new residency rules, foreign enterprises with a “substantive presence” inside China need to be careful of the potential risk to be deemed a PRC resident for tax purposes. For multinationals moving regional headquarters to China, particular attention should be paid to corporate governance arrangements.
• Withholding tax: Due to the uncertainty as to the implementation of the new withholding tax rule, one might consider the repatriation of profit through dividend distribution prior to the re-imposition of the dividend withholding tax. Planning in dealing with passive income may be needed.
• Dividend reinvestment refund: FIE need to speed up the dividend reinvestment refund claim process for those eligible FIE and make sure they can secure the benefit before the end of 2007, which may be the final year that this refund is available.
• Tax incentives: Foreign investors should evaluate the new tax incentives under the EIT law and consider how to incorporate them into their operations in China. There is a clear focus on the activities involving high-tech and R&D.
• Transfer pricing: Given the increased transfer pricing risk and the opportunity to use more sophisticated transfer pricing arrangements, such as advanced price agreements and cost sharing arrangements, it is advisable that FIE act immediately to review their transfer pricing policies and consider proper tax planning strategies.

The EIT law will bring major changes to the way that foreign investors do business in China. Given the dynamic tax environment, and the many unanswered questions around the practical application of the law, it is imperative to monitor evolutions closely in the coming weeks and months - the new tax implications could well have an effect on a business’ strategy in China.