China’s new Enterprise Income Tax law, passed by the National People’s Congress on March 8, should have surprised no one.
Beijing had long telegraphed its intention to unify the disparate tax rates paid by foreign-invested and domestic companies, with the former paying as little as 15 per cent and Chinese enterprises taxed at 33 per cent or even higher. Shanghai-based Bank of Communications, for example, is estimated to have paid a 70 per cent tax rate in 2004.
Under the new law, all companies will be taxed at 25 per cent. Foreign investors who have campaigned for “national” – by which they mean equal – treatment when it comes to market access could hardly complain. “The new tax law provides a level playing field,” says Becky Lai, a tax services partner with Deloitte.
If the enforcement of a new unified rate was as far as the new law extended, adapting to it would be easy enough. But beyond the law’s headline changes, its small print contains important provisions that could force foreign companies to alter their China investment structures radically.
Under China’s old tax regime, investors could take refuge behind borders. If a company was not incorporated in China then it could rest assured that it would have few if any mainland tax liabilities. “Because money is mobile you can [book] a financial transaction anywhere,” Ms Lai notes.
This made life easy for everyone from Hong Kong-based companies with cross-border “contract processing” operations to investors domiciled in popular tax havens, such as the British Virgin Islands.
No longer. Under China’s new tax law, a company’s “place of effective management” will determine liability. A Hong Kong-based company whose executives spend most of their time across the border, in effect exercising control there, could be deemed to be operating in China and therefore liable to its higher tax rates.
As a result, it is crucial for such companies to establish a real presence in Hong Kong and be able to demonstrate that they exercise operational control from the territory. This is especially true for Hong Kong companies that outsource manufacturing operations to “contract processing” factories across the border.
“If you are a contract processor you [could be deemed to] have a permanent establishment [in China]. You have to pay Chinese tax,” says Lee Chee Wing, also a tax partner with Deloitte. “They (the Chinese tax authorities) are really waving a red flag.”
Mr Lee notes that even Hong Kong-based investment bankers who spend much of their time doing initial public offering work across the border could be deemed liable. “The Chinese would just say ‘thank you very much’,” he says.
Ms Lai adds: “You need to hire people [in Hong Kong]. You need to create some kind of presence in Hong Kong.” Otherwise, she says, “you might be falling into the [China] residence trap”.
For companies and executives that do split their operations and time between China and Hong Kong, to limit potential liabilities Mr Lee and Ms Lai recommend “ring-fencing” their activities in both jurisdictions and documenting “where you do what at what time”.
Investors with export-only contract processing operations should also consider restructuring them into wholly foreign-owned enterprises, which would allow them to sell into China’s domestic market.
China’s new law could also make life more complicated for investors based in tax havens that do not have double tax agreements with China. At present, such companies do not have to pay withholding tax on their China investments. As of January 1, however, they will be subject to a 20 per cent withholding tax.
“This is quite a serious development for them,” Ms Lai says. “The British Virgin Islands has a disadvantage because it doesn’t have a DTA [with China].”
Beneficiaries of this crackdown should include tax-efficient jurisdictions that have already concluded DTAs with China. Examples include Hong Kong, Barbados and Mauritius, all of whom have agreements with China that cap investment vehicles’ withholding exposure on dividends, interest and royalties at 5-10 per cent.
Hong Kong and Mauritius-based investors are also exempt from capital gains withholding taxes on investments in which they hold less than a 25 per cent stake. For investments in which they hold 25 per cent or more, capital gains are taxable.
Barbados’s DTA with China is by far the most favourable, as it also exempts capital gains regardless of the size of an investor’s holding. Ms Lai, however, notes that the agreement between China and Barbados could be revised in future.
For those investors based in tax havens not protected by China DTAs, they have until the end of the year to restructure. Options include rebasing themselves in jurisdictions with China DTAs, but they will have to demonstrate a real presence in their new homes.
Whatever solutions they do seize upon, they will have to move fast before the changes take effect next year. “These seven months are critical,” Mr Lee says. “Time is of the essence.”