Since opening its economy to the world in the 1970s, the word "China" has been practically synonymous with low-cost manufacturing. Foreign investment poured in, attracted by a massive, cheap labour force and pulled toward one city or another by generous incentives, including preferential tax policies. These days, however, observers find China acting less and less like a developing country. It is set to become the world's third-largest economy soon, and has developed globe-spanning companies to match. Priorities are now shifting. "Quality growth" was a buzzword at the National People's Congress in March, marking an emphasis on promoting industries that enhance China's technological prowess or help reduce its social and environmental problems, while the "growth at all costs" model is receding into the past.

For China's State Administration of Taxation (SAT), acting like a developed nation now means taxing like one. With the Enterprise Income Tax (EIT) Law, enacted on January 1, the authority changed its strategy to encouraging higher-tech, higher-value industry. China's new standard corporate tax rate of 25 percent is comparable to that of Austria or Sweden. Add in the continually appreciating value of the yuan and rising CPI, and it changes the big picture for all foreign operations in China. Company managers must re-examine how their China strategy fits into their global one.

A levelled playing field

The EIT Law replaces two separate earlier laws for foreign-invested enterprises (FIEs) and Chinese firms, under which the average tax rate was 17 percent for FIEs and 33 percent for domestic companies. The new 25 percent rate for both will be phased in over five years. Future tax holidays for the manufacturing sector have been abolished, and the a 10 percent withholding tax on dividends and various other payments leaving China has been introduced. Tax incentives, though not eliminated, have been greatly reduced in scope and now focus on a narrower group of industries. Now, only companies in agriculture, infrastructure and high-tech and clean-tech companies are eligible for specific tax deductions or holidays.

"This is part of a much broader reform in the Chinese legal environment aimed at enhancing the competitiveness of domestic industry, creating worldwide Chinese leaders and brands, and bringing domestic players to the same levels of practice as foreign players," says Stéphane Vernay, a partner at the international law firm Gide Loyrette Nouel.

Of these, the conditions to benefit from tax incentives under the high-tech and new-tech (HT/NT) status attract the most attention. But so far the intellectual property (IP) ownership requirements appear burdensome, says Vernay, as multinationals "are still not at all comfortable with transferring ownership of core IP to China." However it is possible that a more relaxed definition of IP "ownership" will be acceptable.

However, what is mandated at the national level is not necessarily gospel for local municipalities and Special Economic Zones (SEZs). While the national government appears to have taken tax incentives off the table for SEZs and local governments, there is still the potential for heavy incentives for new investments at the local level. "SEZ administrative committees haven't changed their negotiating positions regarding setting up incentives, tax or otherwise," explains Vernay. "They are mainly offering tax refunds to investors. There haven't been many test cases of this yet, but the zones are quite well-organised and efficient at setting up these kinds of agreements."

Luis Coronado, managing partner for China and Hong Kong transfer pricing services at accountancy Deloitte Touche Tohmatsu, agrees. "Incentives may still exist for manufacturing, but tax incentives will only be available for R&D and high-tech industries. Other types of incentives may net out the same at the end of the day, though. Subsidised land usage, access to commodities, these are all still available."

Equal payment?

In the past, foreign and domestic firms were operating under very different systems. While foreign companies certainly enjoyed their tax advantages, they were also subject to stricter requirements for reporting and paying their taxes. According to Vernay, domestic firms made up the difference in tax rates by exploiting more lax enforcement. "Domestic companies have always been very, very 'aggressive' with their tax policies. In practice, tax rates were much lower than 33 percent. Now with the unified rate, if Chinese companies are still able to apply these accounting practices, they'll see a significant bonus."

The new law will level the playing field only to the extent that it is enforced - but the tax authority is getting savvier all the time. "There will be more and more tax audits and tax controls," says Vernay. "Five years ago, the SAT set up a team specifically to train tax auditors on transfer-pricing issues. They now have experience there and are better trained to extend their auditing ability outside of transfer pricing. They acquired licensing rights on OSIRIS" - a database of worldwide financial and accounting information - "to assess comparables for their transfer and auditing practices."

The SAT is also taking steps toward international standards with which foreign firms are typically more comfortable. The SAT is spending a lot of time training staff, centralising and developing uniform processes. Its Yangzhou training centre trains 100-200 local tax officials at a time to discuss issues and develop a consistent approach. "This is a wake-up call for companies to re-examine their transfer pricing more seriously," says Coronado.

So what will the net effect of the unified tax code be? Chinese companies will be required to self-assess the same way foreign companies have already had to. "[The law] is basically a call for domestic companies to kick the tires on their tax policies and verify that they can efficiently comply. In the long term, Chinese companies have a lot of catch up to do structurally." In other words, foreign companies should not feel specially targeted by the new law; rather, they should be looking at how they can stay ahead of new opportunities and risks it presents.

Continued uncertainty

While some of the opportunities in the EIT Law are clear, many key regulations have yet to be fully specified. "The issue this year is the timing of new regulations and rules for compliance," says Coronado. The first version of the law was published in March 2007, but the implementation rules that lay out the details for local tax bureaus to follow only began to be released in December. "Many key pieces are still missing that companies will need to report their activities properly or apply for special tax designations."

These missing pieces include important decisions on transfer pricing, eligibility for incentives, and new "thin capitalisation" provisions. In the meantime, foreign companies should examine their options and prepare to act as soon as relevant decisions are published. As of now, says Vernay, all high-tech enterprises are now being taxed at the standard rate, since the SAT has not yet issued rules for its HT/NT designations. "Their position is, 'You are welcome to apply for HT/NT designation when the rules are sent out, and we will determine your eligibility then.'" For now, he says, companies should put off making any assumptions or decisions about their future tax liabilities. "In about three months the picture will be clearer."

Despite the uncertainty, tax experts are unanimous that managers need to start preparing their companies for this year's changes as soon as possible. "It is more than having organised books and records," says Coronado. "It is more about making sure that you can do the analysis and prove to the government next year that you are allowed to adopt the corresponding transfer pricing policy or claim current deductions."

Compliance is going to be a major task, especially for companies with 50 or 60 subsidiaries in China. "You want to make your subsidiary tax reporting uniform, for efficiency and correctness. Don't approach this one by one, because you'll introduce inconsistencies, and use a lot more resources."

Being proactive

The clearest opportunity is the favourable treatment given to FIEs investing through Hong Kong holding companies, especially with respect to dividends and related taxes. Based on the tax arrangement between the mainland and Hong Kong, investment in China through Hong Kong can allow significant reductions in taxes on dividend, royalty and interest payments. Similar, though less favourable, arrangements are available through Singapore and other countries.

Eliminating tax holidays for new investments has another effect: the SAT has also reduced the advantages of having myriad business units. Over the next several years, Coronado says, "there will be a tendency to streamline, and we will see a lot of mergers and consolidation within multinationals. This is a huge opportunity to reduce the compliance burden and create more efficient operations."

Companies with business units enjoying grandfathered tax holidays should take full advantage and use those units to pursue new projects, says Vernay. For companies that do not qualify for incentives, a simpler approach is recommended. The new law will continue to disallow consolidating loss and profit across subsidiaries, meaning that building new ventures under the same entity will be the best way to balance profit and loss positions in new ventures.

Even with the tax changes, China remains a compelling destination for foreign investment. When asked to what extent multinationals were moving operations to other countries in response to tax increases, Vernay said, "For special and future projects they will certainly be looking around, but China remains a very competitive country. For investments in China you should look at the taxation, but also the flow of dividends out: The low dividend rates through Hong Kong can compensate for [rising taxes] when comparing China with other countries."

Investors seem to agree. The National Bureau of Statistics reported in March that, in the first two months of 2008, China's foreign direct investment exceeded US$18.13 billion (€11.64 billion), up 75 percent from the same period in 2007. Despite continued uncertainty about key tax details and a more level playing field with domestic firms, foreign investors are as hungry as ever to jump into the China market and compete.

The EIT Law: Key provisions

Timeline for tax increases

For foreign-invested enterprises (FIEs) that are eligible for unutilised tax holidays, the enterprise income tax (EIT) rate will gradually increase over five years, counting from the effective date of the new EIT Law. For FIEs that are eligible for a preferential tax rate of 15 percent and unutilised tax holidays under the old tax regime, a "half-rate reduction" during the unutilised tax holiday period is calculated based on the gradually increased tax rates.

Dividend withholding tax

Dividends are recognised as income from the day on which the FIE makes a resolution to distribute profits (ie, the board resolution date). The Chinese tax authorities have granted a special concession to waive withholding tax on dividends arising from pre-2008 retained earnings in order to smooth out the transition from the old tax regime to the new EIT regime.

Tax residency

Although the concept of "resident enterprises" is new to the Chinese law, it follows international standards. An enterprise is considered to be a "resident enterprise" if it is established under Chinese law or has its place of effective management in China. As a result, these companies are taxed in China on their worldwide income. "Effective management" refers to the fact that an organisation exercises management and control over production and business operations, personnel, finance and accounting, and possesses property on Chinese ground. The specific factors that determine management and control are not yet defined. The interpretation of these terms is up to local tax authorities and might result in different regulations for each jurisdiction if a clear guideline is not issued.

Anti-avoidance

The new EIT Law empowers the tax authorities to adjust taxable income where business transactions are arranged without reasonable business purpose. Related-party transactions that FIEs make as part of their global investment strategy could be considered as tax-avoidance tactics. Therefore, FIEs should prepare and systematically organise their arguments in order to meet anti-avoidance reporting requirements and/or challenges by the Chinese tax authorities.

Thin capitalisation

The "thin capitalisation" rules of the new EIT Law state that loan interest expenditure of a company which has exceeded the prescribed debt-to-equity ratio is not deductible. There are no standards specified in the law regarding the debt-to-equity ratio; the Ministry of Finance and the State Administration of Taxation are to provide these.

"New and high-tech"

To enjoy the reduced tax rate of 15 percent, a high/new technology enterprise (HNTE) must own its core intellectual property and have its products and services listed in the "Areas of High and New Technology Encouraged by the State" guidelines. Research and development expenditure and revenue from high-technology products and services must reach a certain percentage of the company's total revenue. In addition, science and technology personnel must account for a certain percentage of the total number of staff. As of this writing, the percentages to qualify as an HNTE have not yet been specified. Further clarification will be required in subsequent tax and non-tax regulations.

Companies that qualified as HNTEs under the old law should temporarily apply for the standard rate (25 percent) during the provisional EIT filings in 2008 until they are re-assessed and possibly qualify as new HNTEs based on the criteria of the new EIT Law. Quarterly provisional filing should be adopted for the first quarter of 2008 for the following types of enterprises:

• Enterprises outside the Shenzhen and Xiamen Special Economic Zones
• Non-manufacturing enterprises and domestic enterprises in the Shanghai Pudong New Area
• Domestic enterprises that were approved to file combined tax returns under the old income tax regimes