Foreign-invested enterprises (“FIEs”) based in China who engage in production can benefit from many different tax incentives, but most incentives will depend on the nature of the industry, or the location of operations. This article provides an overview of tax incentives and other issues applicable to manufacturing FIEs. For more specific coverage of tax incentives available to high-tech companies, please see the accompanying article.
“Engaged in production”
In order to qualify for manufacturing-related tax incentives and other preferential tax treatment, the FIE must be actively engaged in one of the following industry sectors:
(i) machinery manufacturing and the electronics industry;
(ii) energy industry (excluding the exploitation of petroleum and natural gas);
(iii) metallurgical, chemical and building materials industries;
(iv) light, textile and packaging industries;
(v) medical apparatus and pharmaceutical industries;
(vi) agriculture, forestry, animal husbandry, fishery and water conservancy;
(vii) construction industry;
(viii) communication and transportation industry (excluding passenger transport);
(ix) scientific and technological development, geological surveying and industrial information consultancy that directly serve the purpose of production, and maintenance service for production equipment and precision instruments;
(x) other industries as determined by the State Council's departments in charge of taxation
FIEs that merely purchase goods for resale, or engage in activities such as assembly, packaging, servicing, etc., without adding to the overall composition of the goods, will not classify as “engaged in production” and will not be treated as manufacturing enterprises. Likewise, FIEs that only invest in manufacturing enterprises and provide management, training or agency services will not be considered as “engaged in production”.
FIEs with less than 25 percent foreign capital contribution cannot benefit from preferential tax treatments normally available to FIEs.
Taking a tax holiday
Newly established manufacturing FIEs will normally be exempt from enterprise income tax (“EIT”) for two years from their first year of profitability, followed by a supplementary three-year period of a 50 percent reduction in EIT. This assumes that the FIE has a scheduled operating life of at least 10 years. FIEs investing in certain special industries, with a scheduled operating term of at least 15 years, may even be entitled to an additional five-year 50 percent tax break.
In general, once started a tax holiday will continue for the relevant period, regardless of whether the enterprise incurs losses, but if the operating term is shorter than the required minimum period the FIE will be obliged to refund any EIT exemptions or reductions.
Once the tax holiday expires, if the value of the FIE’s exports forms 70 percent or more of total annual output, then a 50 percent reduction in EIT will apply for that particular year.
Tax refunds for reinvesting profits
Foreign investors who reinvest their share of profits to increase the registered capital of the FIE, or to invest in a new FIE, can claim a 40 percent refund of the EIT already paid on the reinvested capital. Reinvesting in technologically advanced enterprises or export-oriented enterprises will attract a 100 percent refund. However, any EIT refund must be repaid if the reinvested capital is withdrawn within five years.
Import duties and VAT - exemptions and refunds
Foreign investments in China are classified as: “encouraged”, “restricted” and “prohibited”. Normally, FIEs in the “encouraged” category are entitled to import capital equipment for their own use free of any import taxes or duties. This includes FIEs that export all their products, although they must first pay import VAT and customs duty on capital equipment imported for their own use, and then reclaim the taxes and duties over a five-year period (at a rate of 20 percent per annum). If the customs authority cannot verify that all the FIE’s manufactured goods were exported in any year, no further refunds will be made and any past refunds must be repaid.
“Encouraged” projects where the foreign investor has contributed at least 25 percent of the total registered capital may qualify for a VAT refund on purchases of Chinese-made equipment, provided the equipment is brand new and is bought with cash. If the equipment is sold, transferred, divested or leased out within five years, the local tax bureau in charge of VAT refunds can demand repayment in part or in full.
In certain cases, the FIE can offset 40 percent of the cost of the Chinese-made equipment against the amount of EIT due in the year of purchase that exceeds the amount of EIT paid in the previous year. The main criteria for this tax concession are that the project is “encouraged” and involves a technology transfer, the equipment is purchased for own use, and the cost of the equipment is less than the total amount of the foreign investment.
All manufacturers in China, FIEs and domestic firms alike, who export their goods are eligible to receive a partial refund of the input VAT paid on raw materials or other components used in manufacturing the exports. Despite some prevarication by the tax authorities as to which method of calculation to use, the method currently used is “exempt, set-off and refund” (”ESR”), whereby:
(i) “Exempt” means that output VAT is not levied on the export sale of goods.
(ii) “Set-off” means that input VAT paid on the inputs that are used to produce goods for export can be set off against the output VAT collected on domestic sales.
(iii) “Refund” refers to a partial refund of input VAT that cannot be fully set off against the output VAT collected on domestic sales.
The Implementing Rules of the Law of the People’s Republic of China concerning Tax Collection and Administration authorize the tax authorities to use the following methods in adjusting taxable income resulting from non-arm’s-length transactions:
(i) “Comparable uncontrolled price method” (“CUPM”). The taxable income is determined in accordance with the price in identical or similar transactions between non-affiliated entities;
(ii) “Resale price method” (“RPM”). The taxable income is determined in accordance with the reasonable re-sale profit margin to be gained from the price at which the goods are re-sold by an affiliated enterprise to independent entities;
(iii) “Cost plus method” (“CPM”). The taxable income is determined based on the mark-up achieved by a comparable seller in similar transactions with independent entities, plus reasonable costs and fees;
(iv) Other reasonable methods.
The State Administration of Taxation (“SAT”) recognizes the inherent challenges in compiling appropriate comparability analysis, and therefore encourages the local tax authorities to adopt new methods of calculation such as the profit split and the transactional net margin methods. Most recently, the SAT introduced the Implementation Rules on Advanced Pricing Arrangements (“APAs”) for Related-Party Transactions with effect from September 3, 2004.
In 2003, the SAT sought to clarify the definition and treatment of “special cases” justifying transfer-pricing adjustments going back 10 years. According to the SAT, “special cases” include the following situations:
(i) Accumulated transaction amounts with related companies that reach RMB 100,000 or above
(ii) The taxable income that may be increased after adjustment, based on paper audit, is RMB 500,000 or above
(iii) Having business transactions with enterprises located in tax havens
(iv) Failure to disclose transactions with related enterprises or filing false declarations, and failure to provide relevant pricing standards.
In addition to transfer pricing adjustments that may result in additional taxes, violations may also be subject to late payment surcharges and fines. In serious cases of tax evasion, criminal liability may also be incurred.
Under the 1998 Transfer Pricing Rules, it is an implicit requirement for taxpayers to maintain contemporaneous documentation since they only have 60 days to respond to tax authority notices relating to transactions with affiliates. New rules allow for the possibility of a 30-day exemption. Information to be provided to the authorities includes any records of sales and purchases, financing, provision of labor services, assignment of tangible and intangible assets and rights thereto, as well as data used for pricing calculations and materials used for costing the provision of services.
In 2004, the SAT launched joint tax audits of FIEs, targeting the tax avoidance activities of large-scale multinationals that conduct business with affiliates inside and outside China. In particular, the authorities will focus on companies that report inconsistent profits, those that have been accumulating substantial losses year on year, or those that record consistently low levels of profit, yet continue to expand their business operations.
Tax reform – or crystal ball gazing?
China’s reform of EIT, VAT, individual income tax, property tax, consumption tax, etc., is part of a comprehensive program designed to simplify the tax system, broaden the tax base, lower tax rates and improve tax collection.
The separate EIT systems for domestic firms and FIEs are expected to be integrated. The standard EIT rate of 33 percent is likely to be reduced to between 24 and 27 percent. Most tax incentives for FIEs may disappear altogether, although some technology-based tax breaks will remain. Any new law is very unlikely to be passed before March 2006, with effect from January 2007 – although grandfathering arrangements will be introduced for existing tax breaks yet to run their course.
Although China’s VAT system is expected to move from a production-based model to a consumption-based model, so as to allow VAT input credits on equipment purchases, this will not greatly benefit FIEs as most can already import equipment VAT exempt.
In the area of transfer pricing, it is expected that there will be further changes relating to distribution arrangements in China, and greater use of APAs, including bilateral and multilateral APAs. From a foreign investor’s perspective, it is critical to establish coherent transfer pricing policies, consistent with global practice, and fully supported by appropriate documentation and written records. The introduction of thorough audits, and the possibility of 10-year retroactive pricing adjustments reinforce the need for thorough preparation and consistent approach to transfer pricing arrangements.