China has fulfilled almost all its commitments to the World Trade Organization (WTO) since joining it more than five years ago, and with new tax regulations, it has finally met one of its last pledges.

The National People's Congress (NPC) met earlier this month to discuss numerous topics associated with China's future, including China's Corporate Tax Law. The law was ratified by the lawmakers as they concluded their annual full session in Beijing.

Corporate Income Tax Law

On Friday, March 16th 2007, the NPC adopted the enterprise income tax law with 2,826 votes for and 37 against and 22 abstentions. This has come after years of criticism that the original dual income tax mechanism was unfair and unjust to domestic enterprises. The long awaited law will take effect from 1st January 2008, changing China's existing rates for domestic firms (33 percent) and overseas invested companies (15 or 24 percent) to a unified rate of 25 percent. This will finally provide domestic and foreign enterprises with a level playing field for the first time since the economic reforms began in the 1980s.

Foreign funded firms have been enjoying the favorable tax structure as stipulated in the Income Tax Law for Enterprises with Foreign Investment and Foreign Enterprises since 1991 as originally foreign companies faced various investment restrictions when entering the market. But over the years the government realized that they could not grant this preferential treatment forever. As the government sees it, the foreign firms have to be treated equally, given that China has opened nearly all its markets to foreign players.

In fact as far as the Chinese government is concerned, the 25 percent tax rate is low compared to most other countries. Government data shows that the average corporate income tax rate in 159 countries and regions was 28.6 percent in 2005-2006, with the average rate in the Chinese mainland's 18 neighboring countries and regions being 26.7 percent.

Major Changes

Preferential policies will still be provided to high technology, environment protection, energy saving and production safety firms. The law also clarifies tax-deduction policies. The following are the major changes to the tax law:

- Foreign firms that are established before 1st January 2008 and that enjoy preferential tax rates now until 31st December 2007 will be given a five year grace period for the new rate to be phased in. With the tax rate being raised by two percentage points every year. A number of such businesses have already started internal adjustments to offset the impact of a unified tax rate.

- High-technology firms, such as biotech and aerospace companies or companies that the State decides need major support will be allowed to pay a tax rate of 15 percent.

- Venture capital enterprises and companies that invest in environment-protection, energy and water conservation and work safety will be eligible for a fuller range of preferential tax treatment. Details have not yet been specified, but will be stipulated in the implementation rules.

- Eligible small low-profit-earning companies will be allowed to pay a tax rate of 20 percent

- Existing tax breaks for firms investing in infrastructure like ports, docks, airports, railways, highways, power and water conservancy that supported by the State will remain in force.

- Tax breaks for firms in the agriculture, forestry, stock raising and fisheries sectors will continue.

- The existing 50 percent tax break for export-oriented foreign companies and the preferential tax treatment for manufacturing-oriented foreign firms will be discontinued.

- Firms that make efficient use of resources and raw materials and enterprises that provide public service will no longer be given direct tax breaks for exemptions, but will benefit from new preferential tax rates.

- New high-tech firms that need priority support from the State and are located in a special economic zone like Shenzhen or in a State Council-appointed special area like Shanghai's Pudong New Area will receive a "transitional" tax preferential treatment.

- Existing preferential income tax policies aimed at encouraging enterprises to invest in economically underdeveloped western regions will continue.

Other Amendments

The draft law no longer uses the "independent economic accounting" criterion to define a taxpayer, replacing it with the legal person definition, which is in line with international practices. Along the same line of international practices, "resident enterprises" will be required to pay tax on both domestic income and income from abroad, whereas "non-resident enterprises" will have to pay tax only on income earned within China. Whether a company is resident or non-resident depends on combined standards of "place of registration" and "place of effective management". One item which will be clarified are the articles on preventing tax evasion through transfer pricing among associated enterprises through tax havens and other methods.

Benefits to Chinese Companies

A lower tax rate means higher profit for domestic banks. A bank will see a 1 to 1.5 percent profit gain if the income tax is cut by 1 percent. Therefore if it is lowered from 33 to 25 percent, domestic banks could realize an added profit of 8 to 12 percent. For example, the Industrial and Commercial Bank of China (ICBC), which has a pre-provision profit of RMB 78 billion in 2005, it means as added gain of RMB 6 billion.

Domestic manufacturing companies involved in some traditional sectors would be among the major beneficiaries. Most of such firms now have to pay a 33 percent income tax because they neither enjoy the favorable tax rates like the overseas firms, nor any of the tax reductions given to domestic high-tech businesses.

Sectors such as food and beverages, iron and steel, coal, papermaking and non-ferrous metals, too, stand to gain from the tax cut. Commercial vehicle enterprises such as China National Heavy Duty Truck Group Corp and bus giant Yutong Group may benefit as most of their funds come from domestic investors.

It is expected that some domestic manufacturers may seek independent and national brands. As some firms now earn most of their profit from joint ventures, which enjoyed the preferential tax rates, rather than their own wholly-owned Chinese companies.

Situation for Foreign Companies

By the end of last year (2006), China has approved the establishment of 594,000 overseas-funded enterprises, with a total registered capital of USD $691.9 billion. Last year, overseas-funded companies paid RMB 795 billion (USD $101.9 billion) in taxes - 21.12 percent of China total tax revenue. It is estimated that the tax hike for overseas firms would stand at USD 43 billion more a year after an increase to 25 percent but the increments will reduce this burden initially to only USD 8 billion more a year.

Apart from the increased income tax, foreign companies will also be wiped from some other tax incentives, including pre-tax reduction and tax rebate for re-investment.

Many experts and analysts have voiced their concerns regarding the unified tax rate, fearing that it could hurt the inflow of overseas direct investment in China. They fear that it would cause foreign firms to change their investment strategy in China in the long term. However a research report from the World Bank analyzed that stable political situation, sound economic development, broad market, rich labor sources as well as increasingly upgraded business infrastructure and government service in China are the major factors attracting foreign investment. If this is the case it is important for existing companies in China as well as incoming investors to have a clear strategy for income repatriation and dividend remittance.

Yue Yuen Industrial (Holdings), the world's largest maker of branded sports shoes, including Nike, which has factories in China, Vietnam and Indonesia, now enjoys an average tax rate of only 2%, with four plants in Southern China, employing more than 130,000 people. The company is not sure how the new law will impact their structure; however abundant human resources, good infrastructure and a huge market are also important factors making it desirable to increase their investment in China. The company is now considering setting up a new plant in inland China.

It is also expected that this new change in the tax law will spur more scientific development and a move into the "green business" by companies already established in China in order to take advantage of the high-tech preferential treatment. General Electric (GE) for example has announced it will invest USD $50 million in its Shanghai-based technology center for products serving environmental protection, including more efficient airplane engines and wind power generators, seawater desalination technology and energy-saving bulbs.

It is also anticipated that overseas, particularly Hong Kong service companies, such as consultancy, financial service firms and retailers, will make a move into the market as previously they were subjected to a 33% tax rate (same as domestic companies). At the same time, it is predicted that some manufactures now may rush to the mainland to set up their factories before the law comes into effect as they will be given a five year grace period.

Although the impact of the tax reform will vary depending on the type of industry and its location, it will definitely affect the privileged status and competitive advantages long enjoyed by foreign companies in China.

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