REGULATIONS
A Level Field: Interpreting the Enterprise Income Tax
April 30, 2007
Elizabeth Johns

"Companies that are doing business in China - or contemplating entering the Chinese market - should be aware of the new corporate tax rates beginning Jan. 2008." ARTICLE TOOLS Print Version Reprints RECENT ARTICLES Different cities, same customers China is the region's top stop for exporting Improving wire transfers Quantifying your banks' performance

Melanie Chen is a managing director of UHY Advisors, a professional services firm focusing on mid-market companies with revenues typically ranging from $25 million annually to $500 million. A graduate of Beijing University and Harvard Law School, she heads the firm's China Group, which provides tax and business consulting to companies seeking to operate in China and to Chinese companies seeking to list abroad. She recently spoke to ChinaForum about the impact of China's new single corporate tax rate, which goes into effect January 1, 2008.  

In recent years we have seen many middle market companies moving their operations to Asia, particularly China. These include manufacturing entities, of course, and also retailers.

For the remainder of the year in China, there will continue to be two sets of corporate income tax laws. One is for foreign businesses, the other for domestic companies. The tax law for foreign businesses was issued in 1991, offering various tax incentives to foreign invested companies only, including a reduced income tax rate, in some special development zones, and income tax reduction to manufacturing and export-oriented companies, not available to domestic companies. Domestic companies are subject to a regular corporate income tax rate of 33%. Foreign-invested companies enjoy a reduced rate that averages 15%. During the past 15 years, foreign investors have enjoyed tremendous tax incentives, which were meant to attract foreign investment to fuel economic growth in China.

There are two important reasons why China is introducing the new Enterprise Income Tax law, as it is called. One is to provide a tax forum where foreign and domestic businesses can compete on an even basis. Another reason is that the Chinese government no longer views the tax incentives as necessary for boosting foreign investment. Through the end of 2007, China's cumulative foreign direct investment will be close to $700 billion, while its cash reserves have already reached about a $1 trillion.

China has surpassed Japan to become the world's largest holder of foreign exchange reserves. In recent years, China's government has taken various measures to slow down the economy and encourage capital outflow instead of inflow. There is some risk of inflation and, as you know, people are concerned as to whether the currency should be appreciated much faster.

There are two significant impacts of the new tax laws on foreign enterprises. One is that the new law will adopt a 25% corporate income tax rate, which will apply to both domestic and foreign companies. This is much higher than the average rate most foreign companies have been paying. Foreign companies may therefore expect that their business profit margin may shrink in China.

But I don't think the tax factor is the most critical factor in most companies' business objectives in China, so I don't expect many companies leave once they have established a presence. Corporate objectives tend to be market-driven. For example, if a company opens a store in China and requests their suppliers to deliver goods in China, the suppliers are going to have to be located nearby.

For U.S. companies, the effect of the increase in China-related income taxes depends upon their foreign tax credits in the U.S. In other words, the income tax they pay in China may or may not receive foreign tax credit in the U.S., depending upon their particular position. Generally, U.S. companies receive foreign tax credit for income tax paid in China. Their tax costs may or may not be reduced depending upon how they utilize foreign tax credits.

Timing and implementation

The China National People's Congress had a full member meeting this March at which time the new rates were approved. Companies doing business in China prior to March 16 (the announcement date) enjoy a grandfathering period of up to five years. All others entering after the date will be subject to the new single tax rate of 25% beginning next year.

Resident enterprises

The new law adopts a new concept of resident enterprise. This will not have any significant impact on foreign invested companies because only companies that are incorporating in China or that have their management in China will be treated as resident enterprises. The difference between a resident enterprise and a non-resident enterprise is that the resident enterprise is subject to tax in China on the entity's worldwide income.

Next steps for multinationals

The most important thing for the management of U.S. multinationals currently doing business in China is to assess the impact of the new tax rate and to take this into account when they do their business projections. Secondly, they should review their foreign tax credit position and consider the impact so that they can minimize their worldwide tax burden.

And third, companies doing business in China or in the process of entering the Chinese market may want to consider other options for investment, such as Vietnam, which is becoming very desirable location for U.S. companies.

I have not seen a big jump of companies coming to China for this reason, however. Many companies are still waiting to see what will happen. By January, China will unify its corporate tax rate and honor its commitment to the WTO. Many industries that used to be closed to foreign investors or which had government protection are opening up. They have to compete on their home turf with no protection from the government at the same time that they are at a disadvantageous tax position. In order to support and encourage businesses of domestic companies, the government had to unify the rate.

It's always wise to get professional assistance, especially when it comes to forming a long-term plan. The China market is unique and the rules are beyond the comprehension of many U.S. companies. It is not just about learning what the rate is now or in the future. It is about recognizing the existing tax incentives, knowing where to locate your factory, and if you are going to be working with a partner, understanding what their level of prosperity is and what their profitability will be. A good advisor can navigate the business and cultural operating differences between China and the U.S., functioning as a bridge.

There are also many intangibles that companies may not be aware of. UHY Advisors' China Group does a lot of due diligence on prospective business partners, especially for Chinese companies to be acquired by U.S. companies, not just equities but also private equity funds. We also can work under the direction of the CPA firm of UHY llp to perform a U.S. GAAP audit for Chinese companies seeking to raise capital or go public in the U.S. This is important because the Chinese government is encouraging capital outflows as a way to reduce the pressure it is receiving from the international community, especially the U.S. government, to revalue the currency.

I believe that in the next five to 10 years, foreign companies may lose some tax incentives but they will enjoy a more transparent regulatory environment and more income protection from a legal perspective. 

The most important thing for the management of U.S. multinationals currently doing business in China is to assess the impact of the new tax rate and to take this into account when they do their business projections. Secondly, they should review their foreign tax credit position and consider the impact so that they can minimize their worldwide tax burden.

And third, companies doing business in China or in the process of entering the Chinese market may want to consider other options for investment, such as Vietnam, which is becoming very desirable location for U.S. companies.

I have not seen a big jump of companies coming to China for this reason, however. Many companies are still waiting to see what will happen. By January, China will unify its corporate tax rate and honor its commitment to the WTO. Many industries that used to be closed to foreign investors or which had government protection are opening up. They have to compete on their home turf with no protection from the government at the same time that they are at a disadvantageous tax position. In order to support and encourage businesses of domestic companies, the government had to unify the rate.

It's always wise to get professional assistance, especially when it comes to forming a long-term plan. The China market is unique and the rules are beyond the comprehension of many U.S. companies. It is not just about learning what the rate is now or in the future. It is about recognizing the existing tax incentives, knowing where to locate your factory, and if you are going to be working with a partner, understanding what their level of prosperity is and what their profitability will be. A good advisor can navigate the business and cultural operating differences between China and the U.S., functioning as a bridge.

There are also many intangibles that companies may not be aware of. UHY Advisors' China Group does a lot of due diligence on prospective business partners, especially for Chinese companies to be acquired by U.S. companies, not just equities but also private equity funds. We also can work under the direction of the CPA firm of UHY llp to perform a U.S. GAAP audit for Chinese companies seeking to raise capital or go public in the U.S. This is important because the Chinese government is encouraging capital outflows as a way to reduce the pressure it is receiving from the international community, especially the U.S. government, to revalue the currency.

I believe that in the next five to 10 years, foreign companies may lose some tax incentives but they will enjoy a more transparent regulatory environment and more income protection from a legal perspective. 

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