Impact Of New Enterprise Income Tax Law And New China-Hong Kong Tax Arrangement On Financial Institutions, written by Deloitte on September 21, 2007
The new Enterprise Income Tax Law (New Law), promulgated on 16 March 2007 and effective on 1 January 2008, will replace existing tax laws and regulations governing domestic enterprises, foreign enterprises (FEs), and foreign-invested enterprises (FIEs).
Circular Guoshuihan [2007] No. 403, issued by the State Administration of Taxation (SAT Circular) on 4 April 2007, provides guidance on the interpretation of the Mainland China-Hong Kong double tax arrangement that entered into effect on 1 January 2007 in the case of Mainland China.
1. What are the new tax rates for foreign financial institutions according to the New Law?
Under the New Law, foreign-invested financial institutions are subject to the new general 25% rate as from 1 January 2008. Since these institutions are subject to a 33% rate under the existing Foreign Enterprise Income Tax Law, the new rate will result in a drop of eight percentage points.
Foreign-invested banks set up in Special Economic Zones (SEZs) are currently subject to a reduced rate of 15%, regardless whether they engage in hard currency or RMB business. When set up in the other designated zones, foreign-invested banks may enjoy the 15% rate for hard currency business. For SEZs and certain other zones designated by the State Council (e.g. Pudong), the reduced 15% rate is expected to be increased in phases up to 25% through annual two percentage point increases under the five-year grandfathering provision in the New Law.
2. Are there any tax holidays for Foreign-invested banks (FIBs) under the New Law?
Yes. FIBs set up in the SEZs or zones designated by the State Council have been eligible for tax holidays, consisting of a one year full tax exemption, followed by a two year 50% tax reduction if certain conditions are satisfied. The conditions are expressed in Article 75(5) of the FEIT Detailed Implementation Rules issued in 1991. They are “the capital contribution of the foreign investor or the funds for business activities allocated by the head office bank to the branch bank exceeds US $ 10 million; the period of operations is ten years or more shall; application by the enterprise and approval thereof by the local tax authorities”
3. What is the tax residence test in the New Law?
There are two now - the place of incorporation and the place of effective management.
Current tax law relies solely on the place of incorporation to determine the residence of an enterprise for tax purposes. Domestic enterprises and FIEs are taxed on their worldwide income, whereas FEs are taxed only on certain Mainland China-source income if the FE does not have a permanent establishment (PE) in Mainland China. If there is a PE, all income effectively connected to the PE will be taxable.
The New Law adds an additional test to determine residence as from 2008: the “place of effective management” test. As a result, an FE that is “effectively managed” in Mainland China will be deemed to be a Chinese tax resident and, thus, subject to Mainland China’s Enterprise Income Tax (EIT) on its worldwide income in the same manner as a domestic enterprise or FIE.
4. How to interpret the “Six Months in any 12-Month Period” in determining a PE?
Although an FE might not be resident in Mainland China, it must still manage its PE risks. FEs that have a PE in Mainland China will be taxed in Mainland China on income attributable to the PE. For example, a securities company or other investment advisor would normally seek to leverage the PE provisions under a tax treaty between its home country and Mainland China to obtain better protection from Chinese taxation. For such companies in Hong Kong, the New DTA (effective from 1 January 2007 in the case of Mainland China) provides that a PE will be created in Mainland China if the Hong Kong company furnishes services, including consultancy services, in Mainland China for a period or periods aggregating more than six months in any 12-month period. This rule does not require that there be any office or other fixed place of business in Mainland China.
The SAT Circular contains a somewhat rigid interpretation of the word "month" for this PE determination. In counting the 12-month period, it may start from any date of “arrival” and end at any date of “departure”. In addition, a "month" can only be eliminated from the six-month period if the Hong Kong company does not have any employees present in Mainland China for a continuous period of 30 days. Following this logic, presence for one day in Mainland China by one employee could constitute a "month", and any such aggregate six "months" in any 12 months could create a PE for a Hong Kong company in Mainland China.
Under the SAT Circular, this PE interpretation also applies to other tax treaties where no specific guidance previously has been provided with respect to calculation of a “month”. In other words, the impact of this new interpretation on the counting of days for PE purposes will be far-reaching since it is not limited to Hong Kong but applies to other countries that have concluded tax treaties with Mainland China that include six-month service PE rules (e.g. the treaty with the U.S.).
5. What other new regulations are provided in the New Law? )
1) New controlled-foreign company rules
The New Law includes a controlled foreign corporation (CFC) rule that will apply to domestic enterprises that control overseas subsidiaries. In brief, the undistributed earnings of an overseas subsidiary might have to be included in the taxable income of its domestic enterprise parent even though no actual dividend has been paid. Chinese FIs will have to review the position of their subsidiaries in Hong Kong and other countries in light of this new rule.
2) New General Anti-Avoidance Rule
The New Law includes a broadly drafted general anti-avoidance rule (GAAR) that allows the tax authorities to make adjustments where an enterprise has entered into an arrangement that reduces taxable revenue or income and has no commercial purpose.
3) New Thin Capitalisation Rule
The New Law includes a broadly worded thin capitalization provision that will disallow a deduction for interest expense on related party borrowings that exceed specified ratios (not yet announced). The most likely targets for the new thin capitalization rule will be foreign FIs that operate in Mainland China either through subsidiaries or other establishments.
4) Specific Incentive for Venture Capital
The New Law provides a specific tax incentive to venture capital funds established in Mainland China, which allows such funds a deduction against their taxable income for a certain percentage of their investments in industries encouraged by the Chinese government. In the absence of detailed rules under the New Law, venture capital funds may apply a recent tax circular for guidance on how the tax deduction mechanism is to apply. Under this circular, after two years of investment in small and medium-sized and unlisted high/new tech enterprises, a venture capital enterprise may deduct 70% of its original investment in the qualifying investees against its taxable income, subject to certain conditions.
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