New Corporate Tax Regime Introduced in China, Tax Breaks Axed for Foreigners

Towards a Unified Corporate Tax Regime

A new corporate tax law was introduced at the National People’s Congress (NPC) today, paving the way for the equalisation of the corporate tax rates paid by overseas and local companies to be levied at 25%, with Chinese companies currently being taxed up to 33%, in comparison with their foreign counterparts paying as little as 15% in corporate tax. The move came after domestic enterprises voiced strong calls for unifying tax rules. Finance Minister Jin Renqing emphasised that the corporate tax reform had been put in place as the long-standing tax regime put Chinese companies at a competitive disadvantage, thereby obstructing the development of a unified market with standard and fair competition. According to Finance Minister Jin, the corporate tax reform is expected to collectively cost foreign companies a total of 43 billion yuan extra annually. The new law, which is set to take effect from 1 January 2008, is however to be phased in gradually over a five-year period to cushion the blow to foreign enterprises already operating in China. As such it will provide companies currently qualifying for income tax rates of 15-24% with a five-year adjustment period. In an effort to boost investment in the high technology sector, the new tax law is reportedly set to provide a preferential 15% rate for companies operating in this area with many foreign companies falling within it. Meanwhile it will also provide concessional tax rates for “low-profit enterprises” as well as various tax breaks, aimed at conserving resources and the protecting the environment. However, as the full text of the draft law has not yet been made public, details regarding several of the measures are as of yet not clear. Foreign companies are thought to broadly be in support of the new corporate tax regime, which will increase transparency, despite calling for it to be applied on a level playing field.

The End of an Era

China's preferential tax regime for foreign companies has aided the country immensely in making the now booming economy one of the largest destinations for FDI. However, domestic companies have long voiced complaints over the tax regime, calling for the establishment of a level playing field. The country’s entry into the WTO in 2001 ushered in an era of increased foreign competition, making it pivotal for domestic companies to be competitive. Since entering the World Trade Organization (WTO), China has further faced growing pressure to end the practice of offering tax breaks to foreign companies, as this is seen as a discriminatory act under WTO rules. The timing of the tax reform further owes to the changing nature of the Chinese economy. When introduced, the dual tax rate system sought to attract foreign investment as part of the country’s opening strategy. However, China is no longer in desperate need of outside funds having attracted more than half a million foreign companies and US$60 billion in investment in 2006 alone.

Beneficiaries of the New Tax Regime

The corporate tax reform will immediately benefit private Chinese companies, which have long been lagging behind foreign investors and the state sector on the government’s list of priorities. However, the new law is also set to have a number of other winners, including China’s large state banks, which have seen income and revenue tax usurping close to a soaring 50% of their pre-tax profits, and there is speculation that the government may take gradual steps to phasing out the revenue tax as well, according to the Financial Times. The China Construction Bank, one of the country’s top three lenders, estimated that the corporate tax reform will mean that it pays 25% less in tax per year based on the 2006 tax bill

Outlook and Implications

The NPC is expected to approve the corporate tax bill next week with the rubber-stamp body having so far never rejected a piece of legislation submitted by the government, paving the way for it to take effect from 1 January 2008. Although the tax bill was expected to add 43 billion yuan to foreign firms’ collective tax bill annually, observers do not believe that it would have much of an adverse impact on FDI levels, which continue to flow into the economy apace. This is partly because many foreign companies operating in China find themselves within the high-technology sector, which will be exempted from increased corporate tax. Meanwhile, a corporate tax rate of 25% still leaves China in a competitive position vis-à-vis its neighbours in the region, with the five-year grace period playing an important role in mollifying concerns on the part of foreign companies over the reform. It further serves to free Chinese companies of a tax burden that has long put them in an unfavourable position—a feasible move given the fact that China has become a magnet for overseas investment, making it unnecessary to entertain a corporate tax regime geared towards attracting foreign capital. Although the government’s fiscal revenues are set to shrink by around 93 billion yuan (US$12 billion) as a result of the tax reform amounting to 2.5% of the total levied in 2006, this is not expected to impact significantly on the government, which has emphasised that this is affordable. As such, the legislation is part of larger trends aimed at trying to shift the economy away from its dependency on exports in the longer term, as well as tackling China’s mounting environmental problems. It comes along with several other measures at this year’s NPC that will make for greater transparency in investing in China, including China’s first private property law, which is also expected to be passé this year.