The financial return on any investment will be much improved if the investor can relieve tax losses caused by trading losses or capital expenditure. Some tax regimes allow the group parent to elect to consolidate foreign companies and thus utilise losses. In the US new rules to allow US companies to treat most foreign companies as 'transparent' so their losses are allowed as US losses. There is often a drawback, though, that once the company turns into profit the benefits are reversed. With China this could be particularly damaging as profits exempted from China tax under the various tax holiday provisions could be subjected to the foreign tax, negating the benefit of the holiday.
Tax sparing provision
Foreign groups which have the flexibility of investing through a country where they can deduct the Chinese losses should, subject to the potential draw-' backs indicated, consider this option.
Many of China's tax treaties with other countries allow 'tax sparing relief'. This provides that in calculating any tax in the investor country, it is assumed both that full Chinese taxes have been paid regard-less of tax holidays and that these spared taxes can be offset against the investor's tax liability. For example, if a dividend was paid from a foreign-invested enter-prise (HE) to its UK parent out of profits exempted in China due to a tax holiday, the UK would assume tax at the full 33 per cent Chinese rate had been paid. At the UK's current 31 per cent corporate tax rate, this would offset all the UK tax otherwise chargeable.
Sparing can also apply to royalties, which in some cases are exempted from withholding tax in China.
Those FIEs headquartered in countries without tax sparing provisions, such as the US, may need to consider making their investment through group companies located in other countries payable to benefit from sparing relief.
Exemptions from gains
Many countries exempt foreign dividends and/or capital gains derived from significant participations in investments. These 'participation exemptions', such as that in the Netherlands, can compensate for lack of tax sparing on dividend incomes. The capital gains benefits may be attractive, though to save Chinese tax on capital gains it may be necessary to interpose a company between the participation exemption and the HE (see July CER).
Other benefits may be gained by collecting royalties and/or interest income in a country which has both a double tax treaty with China reducing withholding tax on this income and a beneficial regime for taxing these items itself.
All tax planning involving the use of intermediate holding companies must have regard to the ultimate parent company's tax jurisdiction, which might over-ride the benefits by substituting its taxes for those exempted in other countries.
This update was prepared by Charles Norris, Ernst & Young China Liaison Partner in the UK. For more information, please contact Charles Norris on (44) 171 931 4147 or Alfred Shum, Executive Partner of Ernst & Young China Division in Hong Kong on (852) 2846 9959.