Implementation Regulations for the New Enterprise Income Tax Law of China

On March 16, 2007, China passed the new Enterprise Income Tax Law (the "EIT Law"), which will come into effect on January 1, 2008. The EIT Law will unify the two existing corporate income tax systems, one of which is currently applicable to foreign invested enterprises ("FIE") and the other of which is applicable to domestic enterprises. The EIT Law authorizes the State Council to issue regulations to provide detailed implementation rules. On November 28, 2007, the Detailed Rules for the Implementations of Enterprise Income Tax Law (the "New EIT Regulations") was approved in principle by the State Council. On December 11, 2007, the long-awaited New EIT Regulations were finally released. The New EIT Regulations clarify some provisions of the EIT Law; however, many uncertainties still remain. The New EIT Regulations authorize the finance and tax authorities within the State Council to issue detailed rules for many areas that were left open in the regulations. It is expected that the Ministry of Finance and the State Administration of Taxation will issue separate circulars concerning those areas.

The EIT Law and the New EIT Regulations made the following major changes and clarifications:

Defined "resident enterprise" as an enterprise either established under the law of China or effectively managed in China.

Reduced the regular income tax rate from 33 percent to 25 percent.

Introduced a 20 percent tax rate for small-scale enterprises earning small profit.

Eliminated taxes on qualified dividends paid between resident enterprises.

Provided for a 10 percent withholding tax on interest, dividends, rent, royalties, and other income derived by a nonresident enterprise from China that is not connected with the establishment of the enterprise in China.

Provided for limitations on the deduction of certain expenses such as welfare expenses, worker education expenses, entertainment expenses, advertising expenses, and donations.

Disallowed the management fees paid between enterprises.

Disallowed current deduction or amortization of purchased goodwill.

Allowed foreign tax credit for the taxes paid by direct or indirect 20 percent owned foreign enterprises.

Introduced a reduced 15 percent tax rate for high and new technology enterprises.

Granted tax exemptions or a 50 percent reduction in tax rate for qualifying investments in the agricultural, forestry, animal husbandry, and fishery industries.

Provided for a three-year tax exemption and three-year 50 percent reduction in the tax rates for qualifying investments in infrastructure facilities industries, environmental protection projects, and energy and water saving projects.

Granted tax exemptions and reductions for qualified technology transfers.

Allowed a 150 percent tax deduction for qualified R&D expenses and a 200 percent tax deduction for wages paid to disabled workers.

Entitled venture capital enterprises to a 70 percent extra deduction of cost of investment in small and medium size new and high technology enterprises for a duration of at least two years.

Allowed for a tax credit equal to 10 percent of purchase price for qualifying environmental protection equipment, water saving equipment, and safe production equipment used by the purchaser.

Confirmed transfer pricing rules.

Introduced controlled foreign corporation rules.

Introduced thin capitalization rules.

Below is a description and analysis of important provisions of the New EIT Regulations.

Resident Enterprise

An enterprise is considered to be a "resident enterprise" if it is established under Chinese law or, although not established under Chinese law, has its place of effective management in China. Such enterprises established under Chinese laws and administrative regulations are broadly defined, including business enterprises, public institutions, social groups, and other organizations that are established in China and receive income.

"Effective management" in China is thought to exist if the organization that effectively exercises management and control over production and business operations, personnel, finance and accounting, and properties is located in China. The New EIT Regulations did not offer clear guidance regarding the specific factors that determine management and control, which leaves ample room for interpreting these terms to the tax authorities. It appears from the broad definition of effective management that a nonresident board and board meetings outside China may not be sufficient for a classification of an offshore entity as a nonresident enterprise for China tax purposes.

A resident enterprise is subject to Chinese tax on its worldwide income. If a foreign company is classified as a Chinese resident enterprise for Chinese tax purposes, it may not be taxed on the dividend received from its Chinese subsidiary subject to certain conditions. Yet the deemed Chinese resident company will be subject to EIT at 25 percent on the gain on disposal of its Chinese subsidiary, not the lower withholding tax that applies to nonresident enterprises.

A resident enterprise is generally subject to EIT at 25 percent. Small-scale enterprises earning small profit will be liable for EIT at a reduced rate of 20 percent. In order to qualify for such a small-scale enterprise, a manufacturing enterprise must have taxable income of not more than RMB300,000, employees of not more than 100, and total assets of not more than RMB 30 million; a nonmanufacturing enterprise must have taxable income of not more than RMB300,000, employees of not more than 80, and total assets of not more than RMB 10 million.

Nonresident Enterprise Carrying on Business in China

A nonresident enterprise is liable for Chinese income tax on its income derived from China. If a nonresident enterprise has an establishment or place of business in China, the enterprise is subject to China tax on its income from China and overseas that is effectively connected to the establishment or place of business in China. For all income derived from an effectively connected establishment, a nonresident enterprise is subject to the regular 25 percent tax rate.

The term "establishment" in the New EIT Regulations covers a broader range of activities than does the "permanent establishment" as provided in tax treaties. An establishment includes, inter alia, "the place of provision of services" and the "business agent." The New EIT Regulations define "business agent" as any entity or individual carrying on production or business activities in China on behalf of a nonresident enterprise, including often concluding contracts...