Taxing times for China's foreign firms
By Olivia Chung

HONG KONG - The good old days of preferential tax treatment for foreign companies in China are set to end as of January 1, 2008, but Chinese tax advisers say they may see some light amid the pending financial gloom - that is if the Beijing bureaucrats can agree on common definitions for situations such as when, exactly, an equity transfer is legally deemed to have occurred.

Following years of criticisms that the dual income tax mechanism was unfair to domestic companies, the National People's Congress (NPC), approved the new Corporate Income Tax Law on March 16 this year. It sets a unified income tax rate for both domestic and foreign companies of 25%, rather than the 15% rate the foreign enterprises have enjoyed for decades. Domestic firms are currently subject to a 33% rate.

Income tax from domestic enterprises accounted for more than 17% of the total income tax collected in China in 2006, while foreign invested enterprises accounted for only 4%.

Beijing has said it will unveil details of the new rules "soon" and some tax advisers are also busy anticipating the new rules and say they believe foreign businesses may be able to find some wiggle room in order to pay lower taxes.

For instance, the new law says in principle that preferential rates could be granted to businesses in "high-tech" industries and for those making "small" profits. The vague, undefined terms have also raised concerns that the rules could be abused. Su Ming, deputy director of the research institute of the Ministry of Finance, said that Beijing's new details would "solve any technical issues" that might arise before January 1.

She said the tax rate for "low-profit" companies will be 20% for a grace period of five years and it would remain at 15% for high-tech companies, though definitions for "low profit" and "high tech" have yet to be revealed.

According to tax consultants, tax waivers for dividends and capital gains will end, and new regulations concerning transfer pricing will also be enacted. Transfer pricing is the price that is assumed to have been charged by one part of a company for products and services it provides to another part of the same company, in order to calculate each division's profit and loss separately.

Cathy Jiang, tax and China business advising services partner for PricewaterhouseCoopers in Hong Kong, said one of the most effective ways for foreign companies to mitigate their tax bill in China is to set up a holding company in a tax-treaty-friendly country or city such as Hong Kong or Singapore and then transfer the equity interests to the new holding company.

"The equity transfer may qualify to be transferred at cost (ie, tax free reorganization) if completed by December 31, 2007," Jiang said. "The current tax-free reorganization concession on the restructuring of shareholding of foreign invested companies may no longer be available after 2007."

After that, Jiang said, there are more questions than solutions at the moment.

"When would a transfer be considered to be immpleted by the tax authorities? Will transferring shares to a tax-treaty-friendly company be the only way to reduce the additional withholding tax on dividend? The legislation is not explicit on the timing of completion of a transfer," she said.

The Beijing bureaucrats themselves can't agree, she pointed out. "The Ministry of Commerce's view is that the effective date of equity transfer should be the date of obtaining its approval certificate, but the State Administration of Tax tends to consider the completion of amendments to the business license as the completion date of the transfer. Therefore, foreign companies are facing very sensitive [issues] of timing on the equity transfer," she said.

An official with the financial department for German-invested companies in Beijing said transfer pricing could still be the best way for the company to pay less taxes in China. But in order to significantly dodge Chinese tax officials, it could also mean unethical, perhaps illegal, behavior. If the company inflated the cost of raw materials and labor, and exported products at artificially low prices it could also transfer part of the profits to its sister company in other country to capitalize on lower tax rates there, he said.

However, another important change in the tax regulations gives Chinese authorities more rights to investigate companies using transfer pricing to evade taxes, Jiang said. And more detailed financial documents will be required, she added.

"Under the new transfer pricing provisions of the new income tax law, companies are required to provide documents like financial analysis and benchmarking studies to tax bureaus in relation to all related-party transactions, which is more comprehensive than the old law which only required the companies to disclose the information as an attachment with the annual income tax return," Jiang said.

"However, as long as one follows the [transparent] transfer pricing methodology, it can still be a way for foreign companies to help mitigate the tax costs in China," she added.

Jiang said under the law, companies entering into structuring, restructuring, financing and other business arrangements should be prepared to justify the transactions with valid commercial reasons.

Liu Tianyong, head of Beijing Hua Shui Law Firm, echoed Jiang's views and added that foreign companies will find it more difficult to prevent tax officials from investigating overseas bank accounts and shell companies or fake or failed domestic companies posing as foreign companies.

Olivia Chung is a senior Asia Times Online reporter.

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