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China’s enterprise income tax law, passed by the National People’s Congress on March 16, will bring about the most important changes the tax system has ever seen, due to the combination of the scale of the changes and the sheer importance of China to the global market, and the strategies of so many multinationals.

The new law will become effective next January 1 and provides unified treatment for foreign-invested enterprises (FIEs) and domestic enterprises.

This ostensibly comes in response to a perceived unfairness in the current system that provided preferential rates and tax holidays to many FIEs, and a belief that these preferences are no longer needed as a result of China lifting key restrictions on the operations of foreign businesses since its accession to the World Trade Organisation in 2001.

However, the position of foreign companies has been that domestic companies have historically been non-compliant in paying taxes; thus a levelling of the tax system would only make sense if there were a corresponding commitment to enforcement of the rules on domestic companies.

The law has a number of key provisions, but the most basic and important change is an increase in the tax rate applicable to many FIEs and a removal of traditional tax holidays. For example, a typical production-oriented FIE has been able to get a holiday of two years tax free and three years at half the applicable rate beginning from the first year of profitability – in many areas and industry sectors the standard income tax rate of 33 per cent could be lowered to 15 or 24 per cent.

The headline rate of 33 per cent will fall to 25 per cent, but many companies who built their business plans based on expectations of the availability of tax holidays and preferences are going to need to re-think their strategy.

There are still rumours that a withholding tax on dividends from FIEs could be introduced, but prospects remain unclear. If one were instituted, FIEs would need to restructure their China investments to take advantage of bilateral tax treaties Beijing has signed with a number of countries.

The focus of China tax planning must shift from seeing the country as a low-tax jurisdiction, where it is desirable to recognise profits, to a relatively high-tax jurisdiction in which the goal is to minimise profits. This means looking at strategies that would remove functions and risks from China operations. This is easier said than done as China has changed from being solely a source of supply to a real business destination for many MNCs.

In China’s developing tax landscape, MNCs face many new changes and almost certainly a substantial increase in their tax burden. An effective China tax strategy will require a long-term focus that will truly move functions and risks outside the country.

The author heads the tax group as a partner with Baker & McKenzie in Shanghai

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