Overview of China's Enterprise Income Tax Code and its Implementation Rules

China's new Enterprise Income Tax Code (the “Code”) and the corresponding Implementation Rules (the “Rule,” together with the Code, the “New Tax Law”), adopted by China's National People's Congress, became effective on Jan. 1, 2008. The New Tax Law removes many preferential tax treatments originally available only to foreign investors in China, in order to provide an even playing field for domestic and foreign investors. This advisory provides an overview of sections of the New Tax Law that are typically more relevant to foreign investors, and answers questions regarding its implementation.

Who is subject to the New Tax Law?

Any Enterprise having business activities in China or receiving income in connection with such business can be subject to the New Tax Law. An “Enterprise” is defined as any business entity or organization that is not a sole proprietorship or partnership under China's laws and regulations.

Is your Enterprise a Resident Enterprise or a Nonresident Enterprise?

Under the New Tax Law, tax treatments applicable to a Resident Enterprise (“RE”) are different from those of a Nonresident Enterprise (“NRE”). Thus, it is critical for foreign investors to first determine if their Enterprise falls under the RE or the NRE regime. Here is the basic rule of determination:

An RE is any Enterprise established: (i) in China (excluding Hong Kong, Macao and Taiwan) in accordance with China's laws and regulations, or (ii) in a country or region outside of China but with a De Facto Management Organization located within China. “De Facto Management Organization” is defined as any organization or unit that comprehensively controls or manages the substantive operational functions of the Enterprise, including sales and marketing, human resources, financial and bookkeeping activities, or any other such functions.

An NRE is any Enterprise that is not an RE, but has: (i) an Operational Establishment in China, or (ii) income sourced from China. An “Operational Establishment” is defined broadly under the Rule to include any facility or establishment that provides any of the following services or functions: management, business operation, manufacturing activity, farming, natural resources exploration, maintenance and repair, marketing and sales, staffing, or construction. In addition, the Rule clarifies that an Enterprise that engages the service of any person or entity to provide such services or functions in China will be deemed as having an Operational Establishment in China.

How is an RE taxed differently from an NRE under the New Tax Law?

An RE must pay enterprise income tax to the Chinese government on all its income, regardless of whether such income is generated within or outside of China. The default tax rate for an RE, prior to any special tax treatment, is 25 percent.

An NRE that has any Operational Establishment in China is required to pay enterprise income tax on: (i) its China-source income derived from the Operational Establishment, and (ii) income derived outside of China that is actually related to its Operational Establishment (“Foreign Passive Income”). The default tax rate for an NRE with an Operational Establishment in China, prior to any special tax treatment, is also 25 percent.

An NRE that has no Operational Establishment in China is required to pay enterprise income tax only on its income sourced from China. The tax rate for this category of NRE is 10 percent.

A few general rules under the New Tax Law may help to determine an Enterprise's source of income:

• Sale of Inventory. Source of income from the sale of inventory is the place of the sale.
• Provision of Service. Source of income from the provision of services is the place where the service is rendered.
• Real Estate. Source of income from the sale or transfer of any real property is the location of the real property.
• Personal Property. Source of income from any sale or transfer of personal property is the place where the seller or transferor is located.
• Dividend and Bonus. Source of dividend or bonus is the location from which an Enterprise declares or distributes it.
• Deposit Interest, Rent and Royalty Fee. Source of interest, rent or royalty is the place where the Enterprise or individual payer is located.  

What are some important preferential tax treatments under the New Tax Law?  

While most preferential tax treatments originally available under the previous tax laws will be phased out within five years, the New Tax Law brings the following preferential tax treatments:

1. Deduction and accelerated booking of research and development costs. Under the New Tax Law, an Enterprise engaging in research and development (“R&D”) of new technologies, new products or new techniques is entitled to the following preferential tax treatments:
   
   
   • For R&D expenses incurred prior to the existence or materialization of the corresponding intellectual property, the Enterprise is entitled to deduct an extra 50 percent of the R&D costs from its taxable income.
     
     
   • For R&D expenditures incurred after and during the existence of the relevant intellectual property, the Enterprise is entitled to book an amount equal to 150 percent of its actual R&D expenditure as the capitalized cost of the intellectual property.
     
     
2. 20 percent tax rate for Qualified Small or Low-Profit Enterprises. The Code provides that the enterprise income tax rate for certain small enterprises (“Qualified Small Enterprises”) is 20 percent. Qualified Small Enterprise means:
   
   
   • Any industry Enterprise (i.e., mostly manufacturing Enterprises) with: (i) annual enterprise taxable income of ¥300,000 (about US$40,000) or less, (ii) 100 or less employees, and (iii) total assets of ¥30,000,000 (about US$4,000,000) or less; or
     
     
   • Any non-industry Enterprise with: (i) annual enterprise taxable income of ¥300,000 (about US$40,000) or less, (ii) 80 or fewer employees, and (iii) total assets of ¥10,000,000 (about US$1,333,333) or less.
     
     
3. Tax exemption and reduction applicable to income from environmental protection, energy-saving or water-saving projects. Under the Code, income derived from environmental protection and energy- or water-conservation projects (collectively, “Environmental Projects”) is entitled to reduction of or exemption from enterprise income tax. Environmental Projects include, among others, projects involving wastewater treatment, waste reduction and management, natural gas extraction and use, energy saving and waste gas reduction, and desalination operation. Income from Environmental Projects is: (i) 100 percent exempt from enterprise income taxation during a three-year period that starts to count from the taxable year during which any corresponding operational revenue is generated by the Enterprise; and (ii) subject to 50 percent reduction in enterprise income taxation during the two years following the three-year period.
   
   
4. 10 percent of investment in environmental protection equipment as tax credit. Subject to certain restrictions, 10 percent of any Enterprise's investment in equipment that can be used to enhance environmental protection, energy/water saving, or work safety (collectively, “Qualified Equipment”) constitutes a tax credit which can be used to offset the Enterprise's enterprise income tax payable. If the credit cannot be fully used in the year of expenditure, the residual amount can be carried over for up to five years.
   
   
5. 10 percent reduction for income from goods produced using certain listed resources or materials. An Enterprise, if its main raw materials used in production are listed under a “Catalog of Income Tax Beneficial Treatment Applicable to Enterprises Utilizing a Comprehensive Material Resource,” is entitled to a 10 percent reduction of the taxable income generated from the sale of its goods in calculating enterprise income tax.
   
   
6. 15 percent tax for Qualified High-Tech Enterprises. The Code provides that the enterprise income tax rate for certain types of high-tech enterprises (“Qualified Hi-Tech Enterprises”) is reduced to 15 percent. Several criteria must be met for an Enterprise to qualify as a Qualified Hi-Tech Enterprise. One important criterion is that the enterprise must own at least one core intellectual property.
   
   
7. 70 percent of investment in small to medium-sized high-tech companies can offset taxable income. An Enterprise with investments in small to medium-sized privately held high-tech companies (“Qualified Companies”) for longer than two years is entitled to deduct from its enterprise taxable income, starting after the two aforementioned years, an amount equal to 70 percent of its investment in Qualified Companies. Any unused deduction can be carried forward for future use.
   
   
8. Tax reduction or exemption for qualified gain from technology transfer. In any tax year, the first ¥5,000,000 (about US$666,667) of gain of an RE that is generated from certain qualified technology transfer is tax exempt; any portion of the gain above the first ¥5,000,000 is 50 percent tax exempt. An NRE cannot claim this benefit.

Conclusion

The New Tax Law treats domestic and foreign Enterprises with an Operational Establishment in China evenly, largely by subjecting both types of Enterprises to a uniform 25 percent enterprise income tax rate. Most preferential tax treatments that were originally available to foreign enterprises will phase out over a five-year period. While this change may result in financial pressure on foreign Enterprises doing business in or with China, it also brings planning opportunities. Depending upon a foreign Enterprise's unique business structure and goals, for instance, it may keep its Operational Establishments outside of China to take advantage of the 10 percent enterprise income tax rate applicable to NREs. On the other hand, other Enterprises may chose to be REs—to take full advantage of the special tax treatments (such as on technology transfer) available only to REs.