INTERNATIONAL TAX FACTSHEET
China and Australia have become significant trade and investment partners, a phenomenon that has risen with the resources boom and it looks set to continue well into the future.
It will be difficult for Australian businesses to ignore the booming Chinese economy, however coupled with the investment opportunity are investment risks. Australian investors need to be mindful of China's laws and regulations, particularly key tax issues.
Prior to 2008, China had two income tax systems: one applicable to all foreign invested enterprises and foreign enterprises with significant tax incentives to attract investment into China, the second applicable to Chinese enterprises.
From 1 January 2008, these tax systems were unified under the Enterprise Income Tax Law (EITL), which meant that some of the tax incentives previously attractive to foreign investors were tightened and preferential treatment significantly diluted.
Under the new system, tax incentives no longer focused on the ownership or location of the enterprise but rather on the economic and social benefits of development. The nature of the investment became more important.
For example, an enterprise that qualifies as a high and new technology enterprise now pays a reduced rate of 15% tax, compared to the normal 25%. However, it is vital to understand the criteria that provide access to the tax concession.
Despite the shift in tax preferential treatments of granting incentives only to special regions in the entire country from a regional development orientation to an industry based one, the government authorities of ethnic autonomous regions may decide to give full or partial exemptions of the EIT to enterprises located in their region, specifically with regard to the local portion of the enterprise tax.
It is still advantageous to position an enterprise within these special economic zones and the Shanghai Pudong New Area or Western region.
China has undergone a rapid development of its taxation system since economic reform, adopting many Western-style laws such as:
- Residence/source-based taxation
- Thin capitalisation
- Transfer pricing
- Controlled foreign corporation riles
Australian investors will be somewhat familiar with these rules, however China did not just 'borrow' any country's international tax system. Rather the EITL has included different ideas, rules, principles and practices from various sources. These include commentaries and guidelines from the OECD, as well as a number of elements found in foreign countries such as statutory rulings and practices, case law, administrative rulings and practices and World Trade Organisation agreements. Chinese policy makers also incorporated their own thinking to adapt to Chinese conditions.
There are some pitfalls that Australian investors should be aware of. The tax treatment of a partnership, for example, is very different to Australian rules.
Firstly, foreign partnerships are subject to the EITL, whilst partnerships organised in China are treated as a transparent entity. Secondly an enterprise partner is not able to use its share of loss from the partnership to offset its income, but rather offset the partnership future profit which must be used within five years or be lost. Thirdly, the character of the partnership income does not generally flow through from the partnership to individual partners. Capital gains are generally taxed at 20% to the individuals, however if a partnership derives capital gains, the individual partner has to treat such distribution as a business income to a progressive rate, with a marginal rate of 35%.
The Individual Income Tax Law (IITL) is a standalone legislation that regulates individual and sole proprietor taxpayers in China. When Australian investors establish a Chinese operation or send Australian employees into China to expand the business, the IITL should be considered.
Originally designed to tax foreigners on their Chinese income, it contains various rules to narrow the tax base of foreigners. China only seems to tax foreigners on Chinese-sourced income unless they spend a significant amount of time in China.
Foreigners receive a higher standard deduction and enjoy various tax exemptions for fringe benefits. These benefits do not apply to local employees. Although the IITL applies both to foreigners and Chinese nationals, foreigners receive more tax concessions, a situation similar to the EIT before reforms in 2008.
China's tax legislation doesn't come close to Australia's in volume - it is a mere 2420 words and the EITL occupies just six pages.
However the piecemeal fashion of China's evolving tax system means that there is no single tax law governing taxation as outlined above. Additionally, tax law is accompanied by regulations which contain detailed provisions concerning the scope of tax, taxable persons, charging provisions and more. The tax law gives the State Council broad power to issue detailed regulations, hence those regulations often expand the basic law significantly.
The State Council may also issue notices or other circulars interpreting the regulations, often addressing principal areas, whereas detailed tax circulars are issued by the Ministry of Finance (MOF) and the State Administration of Taxation (SAT).
The circulars are binding on tax authorities and in effect have the force of the law. Chinese courts do not have general power to interpret tax legislation and the tax provisions often contain residue clauses which again open the door for the government to add more rules later on.
The SAT is responsible for the collection and administration of taxes and China has two collection systems: the State tax bureau system and the local tax bureau system.
The State tax bureau are authorised to be in charge of the collection and administration of EIT for foreign invested enterprises and foreign enterprises.
Each State tax bureau is directly responsible for the tax bureau at above level. Tax registration with the local tax authority is essential and withholding agents are widely used to collect tax at source.
Any payment including dividends, interest, rentals, royalties, proceeds from equity transfer and service fees to a non-resident enterprise requires the payer in China to comply with the exchange control conditions of the State Administration of Foreign Exchange (SAFE) in order to buy the required foreign currency. The bank will require the payer to present a tax certificate. Without it, Australian investors cannot repatriate their profits.
Under the withholding and exchanged control rules, the payer will have to pay the tax first and then obtain the tax certificate for remittance. This gives the State Administration of Taxation opportunity to examine the facts and documentation before issuing a tax certificate.
It has been a long-standing practice for many Australian investors to structure their investment into China by interposing an offshore immediate special purpose vehicle (SPV) to provide capital gains tax protection and/or a reduced dividend withholding tax.
A number of tax circulars have been issued by the SAT to address treaty 'shopping' issues. These include proof of tax residence, beneficial ownership and indirect capital gains from equity sales.
China normally follows the OECD approach on many international tax issues, but again it has added the Chinese flavour to protect its tax base. Australian investors need to review the current holding structure or implement the holding structure with sufficient substance or commercial activities to avoid the risk of being disregarded under the substance over form principle.
It is not an easy task for Australians to navigate through the Chinese tax system when considering investment there. Primary facie, China has adopted a lot of international norms in an effort to bring more transparency to its tax system and attract foreign investment.
However China is by a large a very different culture, political system and legal system to Australia, hence it is paramount to be mindful of these differences.
If you are considering investing in or expanding to China, contact Matt Zhou on 02 9957 4033 to discuss your options.
Download PDF Version Features of Chinese Income Tax Law
Last updated March 2012. This factsheet is provided for information purposes only and is correct at the time of publishing. It should not be used in place of advice from your accountant