The Chinese government encourages domestic and foreign investment in advanced technologies. It has promulgated a series of preferential tax policies to stimulate and promote the production of high-tech products, provision of high-tech related services and technology transfer into and within China.
From a tax preferential policy perspective, high-tech companies are normally referred to as 'technologically advanced enterprises' and 'new-and-high-technology development enterprises' (NHTDE). TAE status is granted to those enterprises that utilise international advanced know-how, technologies and equipment, and take a leading role in product quality and technical capability in the domestic market. NHTDE status is granted based on a prescribed set of criteria, including the academic qualifications of the enterprise's personnel, the size of its high-tech sales and R&D expenditure and, most important, it must be located in one of the new-and-high tech zones.
In accordance with the government's declared tax policy, tax preferences are changing from geography-based to industry-based. New tax preferences announced for software development/manufacturing, integrated circuit (IC) design and production, and foreign-invested research and development centres are good examples of this trend.
Taxpayers may face practical difficulties in trying to take advantage of these tax incentives. They may arise from the business model adopted by the company or because of an overlap in/conflict between jurisdictions of different government authorities.
Tax incentives available include income tax holidays and reduced income tax rate, VAT refund, business tax exemption and customs duty and import VAT exemption.
ENTERPRISE INCOME TAX
The normal enterprise income tax (EIT) rate for a Chinese domestic enterprise is 33 percent, while it is 30 percent, plus a 3 percent local income tax, for a foreign-invested enterprise.
A software enterprise would be eligible for a tax holiday of two-year exemption followed by three-year 50 percent reduction of EIT, starting the first profit-making year. To qualify, the company must have more than one self-developed software product or own the copyright to certain software products. However for most foreign-invested software enterprises, the copyright of the software products normally rests with their overseas affiliate. This is a major obstacle for a foreign-invested software enterprise to qualify as a 'software enterprise.'
The rules also provide for special requirements on personnel composition, R&D expenditure (at least 8 percent of annual software sales revenue), the percentage of software sales revenue (at least 35 percent of annual total income), and the percentage of sales revenue for self-developed software products (at least half of sales revenue of software).
When a qualified software enterprise meets one of the following conditions, it may further qualify as a 'key software enterprise':
-the annual revenue for sales of software exceeds Yn1bn;
-the annual export revenue exceeds US$500,000 and the export of software accounts for at least half of the total annual revenue; or the export revenue of software accounts for 70 percent or more of the total annual revenue; or
-the sales revenue ranks top five in certain areas of software industry. Once qualified as a key software enterprise, the enterprise may enjoy a reduced EIT rate of 10 percent.
IC design enterprises follow the same EIT preferential policies as software enterprises described above. Their IC design revenue must account for at least 30 percent of their annual total income.
Enterprises engaged in the production of ICs, which are scheduled to operate for more than 10 years and can meet one of the following conditions, are eligible for a reduced EIT rate of 15 percent and a tax holiday of two-year exemption followed by three-year reduction of EIT:
-producing ICs with line width of less than 0.25μm; or
-having an investment of more than RMB8bn.
The production of ICs with line width of less than 0.8μm would only be entitled to the above described tax holiday.
Until the end of 2010, where an investor is engaged in the production or encapsulation of ICs directly reinvests its share of after-tax profits in the same enterprise or in another enterprise of the same business, 40 percent of the EIT paid on the reinvested share of after-tax profits could be refunded.
Those investors directly reinvesting in such enterprises that are located in western China, could be eligible for an 80 percent refund of the EIT paid on the share of aftertax profits reinvested. If the enterprise qualifies as a technologically advanced enterprise, all of the EIT paid on the share of the foreign investor's after-tax profits could be refunded upon the foreign investor's reinvestment.
R&D 'SUPER DEDUCTION'
Profit-making enterprises are also allowed to deduct 150 percent of actually incurred R&D costs for EIT purposes, if such costs for the current year are 10 percent greater than the previous year.
VALUE ADDED TAX
A regular VAT payer that develops and sells software products of its own, or imports software products into China for localisation and sales, is eligible for a refund on its VAT burden exceeding 3 percent. 'Localisation' is defined as the 'redesign, modifications and improvement, changes/transformation, and so on, made to the imported software.' Pure translation of the imported software into Chinese will not qualify as localisation.
Imported software products must be registered with the China Software Industry Association in order to enjoy the VAT refund. Localised imported software products must also be assessed and certified by the association. In practice, however, the association seldom approves the localisation of imported software products due to the lack of a feasible regulation/guideline.
A similar refund policy on IC products is available. Effective until the end of 2010, a regular VAT payer that develops and sells its own IC products is eligible for a refund on its VAT burden exceeding 3 percent.
BUSINESS TAX Income derived from technology transfer, technology development, the provision of technical consulting services and other technical services could be exempt from business tax upon receiving approval from the tax authorities. If the technology is transferred from a foreign enterprise, the exemption requires approval from the State Administration of Taxation.
Since application for business tax exemption must be lodged by the transferee of the technology, the foreign transferor of the technology has to seek the co-operation of its Chinese customer. Many Chinese companies would rather withhold the business tax from the technology fee payments, rather than assisting its foreign counterpart in applying for the exemption.
If there are other elements included in the technology transfer agreement, such as a trademark or patent, part of the royalty will not be eligible for business tax exemption. If the non-qualified portion cannot be separated from the licensing fee, the tax authorities may reject the exemption application.
Moreover, it is specified that business tax should be paid first while the application for exemption is in process. The amount paid can either be offset against any future business tax payable or refunded one year later when there is no or insufficient business tax for offsetting purposes. This would affect cashflow.
CUSTOMS DUTY AND IMPORT VAT
To encourage the importation of high-tech equipment and technology, China offers customs duty and import VAT exemptions.
Equipment and related technology, parts and accessories imported by an enterprise for its products listed in the China Catalogue of New and High Technology Products could be exempt from customs duty and import VAT. Software fees payable for importing advanced technology as listed in the catalogue are also eligible for the exemption. Many application software and ICs are in the catalogue. Equipment and related technology, parts and accessories imported by foreign-invested R&D centres for technology renovation purposes are exempt from customs duty and import VAT. R&D centres can also enjoy customs duty and import VAT exemption on the importation of laboratory and testing equipment for its own use.
In practice, the Chinese customs offices are not implementing the exemption on software fees due to the lack of an implementation regulation/rule from the Customs General. It is understood that the Ministry of Finance and the Customs General are in the process of drafting the implementation rules that should also cover the method and channel of obtaining certification on 'new-and-tech' products.
It was reported recently that the General Customs Office has conducted several customs audits on the payments of customs duty and VAT on licensing fees. Customs offices will examine how a Chinese entity actually brings in its software products and whether any licensing fee is payable on them. If software products are imported into China through tangible media such as CD-ROM and the importer is required to pay licensing fees to an overseas entity, the customs office would normally impose customs duty and import VAT on the licensing fees. Although these audits may only be isolated instances, they reflect the fact that the importation of software products is not free from customs duty and import VAT.
Investors should carefully study the implications and plan for their operations in China in order to maximise the benefits from the various tax inventive policies available.
This article was written by Edward Shum, partner, and Rex Chan, senior manager, of PricewaterhouseCoopers Beijing.