Chinese Tax System

By Klaus Koehler, Managing Director, Klako Group

Chinese Tax System

The Chinese tax system is complicated and fundamentally it is different from any other tax system around the world. The tax administration of Foreign Investment Enterprises (FIEs), including foreign representative offices, is handled by two separate tax bureaus. Generally, Enterprise Income Tax and Value Added Tax are collected by the local branches of the State Administration of Taxation whereas Business Tax and other local taxes are collected by the local tax bureau.

The normal tax year is the calendar year. Tax is collected in Renminbi (RMB) currency. Any income in foreign currency is converted into RMB at exchange rates quoted by the State exchange control authorities for tax payment purposes. Exchange gains or losses are generally taxable or deductible when realized.

Foreign Enterprise Income Tax

The standard enterprise income tax rate applicable to FIEs is 30%. However, this rate may be reduced either to encourage certain kinds of business activity or to encourage activities generally in a Special Economic Zone or other incentive areas. China has developed Industrial Zones that offer preferential treatments to FIEs looking to invest into China. The special treatment includes an Enterprise Income Tax of 15%.

Alternatively or additionally, tax holidays may apply to certain types of activity, which the State wishes to encourage, such as manufacturing entities. Manufacturing entities are provided with two years of exemption from EIT starting with the first profit-making year and a 50% reduction in EIT during the subsequent three years if their operating term is more than ten years. Technologically advanced and export-oriented enterprises may apply for a three-year extension of the 50% EIT reduction, subject to a minimum reduced tax rate of 10%. FIEs exporting 70% or more of their output in a given year are eligible for a 50% reduction in EIT in that year, with approval, subject to a minimum reduced tax rate of 10%.

Representative Offices engaged in conducting market surveys, collecting business information and liaison provided in relation to the production and sales of products manufactured by their head office may be exempt from BT and EIT. All other activities including trading, merchandising, servicing, investing, consulting and other agency activities are subject to EIT and BT.

Local Income Tax

Local income tax is levied on taxable income at the rate of 3%, giving a total standard income tax rate (enterprise income tax rate and local income tax) of 33%. Exemption or reduction in local income tax may be granted to FIEs engaged in industries or projects encouraged by the State, if the local tax authorities so decide.

Business Tax

Business Tax is imposed in relation to transactions within the PRC on services provided by enterprises. Business tax is levied on gross turnover at rates between 3% and 20%. The most common rates are either 3% or 5%. Limited exemptions from business tax may apply to some services.

Value Added Tax (VAT)

VAT applies to enterprises engaged in importation, production, distribution or retailing activities. The general VAT rate is 17% but necessities, such as agricultural and utility items, are taxed at 13%. Certain limited categories of goods are exempt from VAT.

Customs Duties

Customs duties are imposed on goods imported into or exported out of the PRC at various rates. For certain categories of goods, a zero rate may apply. Meanwhile, VAT and, if applicable, consumption tax are also imposed on the importation of goods.
Customs duties on imports are based on either general rates or preferential rates, depending on whether the PRC has reciprocal tariff agreements with the exporting country.

Customs duty and VAT are exempt on machinery and equipment by a FIE within the amount of its total investment, for its own use. Limited exemptions from customs duty may also apply to machinery and equipment and other goods, which are temporarily imported into the PRC, provided they are re-exported. The temporary importation period may be extended to one year. A bond for the duty may be required. Customs duty and VAT exemptions may be allowed on importation of raw materials for contract processing or import manufacturing. Customs duty and VAT exemption may also be available, in special circumstances, for imported machinery and equipment and related goods used in import manufacturing activities in certain circumstances.

Goods may be imported into, and exported out of, designated Free Trade Zones other such Industrial Zones, without liability to customs duty or VAT.

Consumption Tax

Consumption Tax is levied on manufacturers and importers of specified categories of consumer goods, including tobacco, alcoholic beverages, ethyl alcohol, cosmetics, skin and hair care products, jewelry, fireworks, gasoline and diesel, automobile tires, motorcycles and small automobiles. The rates range from 3% to 50%. Consumption tax is imposed in addition to applicable customs duties and VAT.

Stamp Tax

All enterprises and individuals who execute or receive "specified documentation" are subject to stamp tax. Rates vary between 0.005% on loan contracts to 0.1% for property leasing and property insurance contracts. A flat amount of RMB 5 applies to certification evidencing business licenses and patent, trademark or similar rights.

Withholding Tax

This is based on overseas invoices for services provided to an FIE. The percentage of tax varies depending on the type of industry and the nature of the service. The range is from 5% to 20%.

Dividends and Profit Repatriation by FIEs

Dividends paid or profits distributed by a FIE to foreign investors are exempt from withholding tax.

Royalties

Royalty payments to a non-resident from patent, trademark, copyright and other similar rights will generally be subject to withholding tax at the rate of 10%. That rate may be reduced through the operation of a tax treaty or by concession. Certain royalty payments may be exempt from withholding tax.

Optimize Your Tax Strategies

China has used its tax system to promote to companies that can advance its technological base and export capability. Export companies, in particular receive extended tax holidays, VAT refunds and there are no customs duty exemptions. Importers receive none of these advantages. There is a whole range of FIE industries who receive preferences, such as software manufacturers, R&D centers and technologically advanced enterprises.

Chinese tax preferences are also designed to foster growth in certain regions. An example is just by crossing the Huangpu River in Shanghai, can a company receive a lower income tax rate from 24% to 15% for FIEs. Therefore new investors coming into China should assess the tax rate in the provinces, cities, zones they are considering. Particularly in the West, special deals can be negotiated with local governments who would be willing to provide preferential tax treatments in order to receive the investment.

The new income tax law which may become effective in 2006 will raise income tax rate and remove certain preferences. Therefore, foreign investors should try to launch new ventures before 2006. The reason being preferences given out before 2006 may remain for the FIEs. An enterprise set up before the new law would possibly retain its preferences while an enterprise setup after the new law is passed would have no such chance.

The application of transfer pricing may be included in your strategy in order to minimize your foreign exchange to the parent company. A transfer price refers to the prices charged between two companies who are part of the same group. A China FIE can remit its profits out of China by selling products back to its parent company at a low price. Clearly transfer pricing can be abused and is being abused by many FIEs. Tax authorities are aware and do crack down on violators who cannot document that their transfer prices are at arm's length. Arm's length price is the price that would be charged to the third party. You can also refer to our Newsletter from December 2004 about Transfer Pricing.

Using Hong Kong as a Regional Headquarter for the China FIE will allow for further tax minimization as Hong Kong has a tax rate of 17.5% which can reach 0% if there is offshore trade occurring in Hong Kong. Having a Regional Headquarter may provide centralized activities such as logistics, planning, procurement and R&D.

Foreign investors often make the assumption that China's tax laws are straightforward and no help of experts is needed. However, there are various complex rules covering numerous aspects of FIE's business activities in China, particularly when preferential policies are provided to the FIE's. At the same time new regulations and laws are implemented regularly and investors and companies need to be updated. Although there are still loopholes in the system, foreign investors unaware of tax planning methods may face serious penalties or losses due to underpayment. It is recommended to seek advise.

If you require assistance with the above subject, please contact us at info@klako.com with your detailed questions.

All information in this report is verified to the best of our ability and is assumed to be correct at time of release; however, Klako Group does not accept responsibility for any losses arising from reliance on the information provided within.