Equal treatment

China has been considering unifying the income tax laws that now separately apply to foreign investment enterprises (FIEs) and domestic enterprises. The timing of the unification is related to China's imminent likely membership of the World Trade Organisation (WTO). However, there are other factors at play, including the overall state of the economy.

Most large state-owned enterprises have either undergone a restructuring or reorganisation to prepare them to operate in a competitive market economy. In the past, foreign investment has been an important source of funding for domestic enterprises. However, the recent growth of the stock market has provided another source of financing for state-owned enterprises.

Bias against domestic enterprises
FIEs have enjoyed 20 years of preferential tax treatment. Although the statutory income tax rate of 33 percent (consisting 30 percent state tax and three percent local tax) is the same as the statutory rate for domestic enter-prises, the effective rate for FIEs is around 12-15 percent. Domestic enterprises are generally subject to an effective tax rate of 27 percent, indicating a bias against them.

But since the gap between domestic enterprises and FIEs has moderately reduced in areas such as competitiveness, financing, management techniques, domestic enterprises believe that they are ready to compete with the FIEs on common ground, and therefore should be treated the same under income tax law. The WTO also addresses the equal treatment issue, which is welcomed by domestic enterprises.

Continuity of provisions in the existing law should be the top concern – will the tax incentives be inherited by the new tax law and will these incentives be allowed to phase out naturally instead of being terminated suddenly?

The current Foreign Enterprise Income Tax Law, introduced in 1991, expanded the tax holidays from one-year exemption plus two-year 50 percent reduced tax rate, to two-year exemption plus three-year 50 percent retrieval rate. The retrieval rate has been built into the current law so as to placate foreign businesses worried about the fate of their favourable tax treatment. Production-oriented FIEs in special economic zones (SEZs) and coastal open areas automatically benefit from 15-24 percent reduced tax rates.

From an economic and political stand-point, it is unlikely that the beneficial tax treatments will disappear overnight. Rather, a phase-out period is likely to be implemented to allow a smooth transition. Grandfather rules may provide relief for FIEs that wish to set up their businesses before the new law is introduced.

It is speculated that the unified income tax law will address a few guidelines and principles on who would be qualified for future incentives. These include companies involved in advanced technology, infrastructure or environmental protection sectors, and enterprises located in western provinces.

The other major concern is the reinvestment refund, which is unlikely to be retained by the unified income tax law. This incentive is in the form of an income tax refund if there is a reinvestment of profit in an existing FIE or in setting up another FIE. The refund rate depends on the type of industry the FIE is engaging in a 40 percent general rate or a 100 percent preferential rate.

Speculation on new tax rate
Comments made by government officials on the future unified income tax rate indicate that the rate could be somewhere between 25-30 percent because the tax rates of most countries in the region fall in this range. But this is a simplistic approach, since it ignores the reality of a country's particular economic condition.

A 30 percent level would not be a more attractive proposition than is offered under existing legislation. A level of 25 percent would seem to be well justified since it would make China competitive regionally and would be in line with a worldwide trend to reduce income tax levels.

Despite the withholding income tax rate having been reduced to the current 10 percent from 20 percent last year, it is likely that the unified income tax law will reinstate the rate to 20 percent. Those foreign investors seeking a reduction will have to rely on application of relevant provisions in tax treaties.

The new income tax law is likely to shift beneficial tax treatment from coastal provinces and cities to inland regions, and towards specified industries such as high-technology and software development.

Incentive to invest in the west
The tax incentive policy to companies investing in mid-west regions has been officially announced to be good for 10 years starting 2001. Autonomous region governments are given the authority to reduce tax rates at their own discretion. Mid-west provinces will be the first to be allowed to open up industries that are now restricted to foreign investors, such as retailing, banking, telecoms services and insurance.

Even if the mid-west regions offer more beneficial tax incentives, they will still face difficulty in attracting the same amount of investment as SEZs and open coastal cities because of their various disadvantages such as poor infrastructure, an inefficient distribution system and a shortage of skilled workers and managers. Moreover, the incentives to SEZs and coastal open cities are unlikely to be removed because of their high profile and the amount of capital already invested in these places.

It is speculated that the new income tax law will probably take effect in 2003, assuming the drafting stage is completed this year and the legislation manages to be passed at the National People's Congress in 2002. A half-year transition period may be needed to avoid a repeat of the confusion and administrative chaos experienced by taxpayers in 1994 when both the value-added tax and business tax laws were promulgated on December 13, 1993 but took effect only two weeks later.

As a consequence of a unification of the corporate income tax laws, other tax laws such as value-added tax law, business tax law and individual income tax law may also be amended to take into account the impact of WTO membership.

This article was written by Doris Yang, partner of PricewaterhouseCoopers' Beijing office, and Jonathan Jia, manager of the Beijing office. The Beijing office is located at 18/F Beijing Kerry Centre, 1 Guanghua Road, Chaoyang district, Beijing 100020, telephone: +86 (10) 6561 2233.