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Navigating through Taxing times in China

Tax and Finance

Let’s face it; tax is confusing enough as it is without the legislation itself being unclear. Thankfully, China’s State Administration of Taxation (“SAT”) recognised that its Corporate Income Tax (“CIT”) law had fallen into this trap. Recently, the SAT has issued Circular 79 to clairfy the timing of income recognition, the tax treatment of certain expenses and the determination of the tax base for fixed assets under the CIT law.

Income Recogntion

Circular 79 addresses the recognition of particular types of income including rental income, income arising from debt restructuring, capital gains from the transfer of equity interests, as well as dividends, profits and other investment income.

Rental income

Under the Detailed Implementation Rules (“DIR”) to the CIT, rental income arising from the provision of the right to use fixed assets, packing materials or other tangible assets is required to be recognised for tax purposes on the payment dates set out in the relevant contracts. Circular 79 clarifies that where the lease contract spans more than one calender year and the rent is paid in advance, the rental income can be spread evenly over the leasing period and recognised as taxable income in each of the years within the lease period.

Income arising from debt restructuring

Income derived from debt restructuring is required to be recognised as taxable income on the date that the debt restructuring contract or agreement comes into effect.

Capital gains derived from equity sales

Circular 79 reiterates the CIT law by stating that income from equity sales is calculated as the difference between the sale proceeds and the purchase price, and that the retained earnings and reserves attributable to the equity sold cannot be deducted from the sale proceeds.

Note also, that Circular 698 requires non-resident sellers to file tax returns and pay CIT within 7 days of the earlier of the transaction date specified in the sales contract, and the date the sale proceeds are received. For more information on Circular 698 please see our February 2010 article.

Dividends, profits and other investment income

Dividend income is required to be recognised on the day it is resolved to make a distribution of profits or convert retained earnings into equity. Note that the conversion of share premiums into equity is not required to be recognised as income, and therefore the cost base of the shareholder’s investments will not be increased.

Tax treatment of certain expenses

•    Expenses incurred in the generation of tax-exempt income

The CIT law specifically states that expenses incurred in the generation of non-taxable income are non-deductible. However, it is silent on the deductibility of expenses relating to tax-exempt income. Circular 79 clarifies this situation by stating that unless otherwise specified, expenditure incurred in the generation of tax-exempt income is deductible.

•    Start-up expenses

Circular 79 specifies that expenses incurred in the start-up period are not to be considered losses in the current period, rather they must be either deducted in the first year of operations or be amortised over a period of 3 or more years in accordance with Article 9 of Circular 98. Please note that once a taxpayer elects to apply a particular method, that method cannot be changed.

•    Entertainment expenese

Under the CIT law up to 60% of business entertainment expenditure can be treated as deductible for tax purposes, however, the deduction is capped at 0.5% of the entity’s total revenue for the year. Circular 79 clarifies that for entities engaged in equity investment (including group headquarters and venture capital investment companies), the level of dividends received and capital gains received from share transfers can be used as the basis for calculating the point at which the deduction for entertainment expenditure will be capped.

Determination of tax base for fixed assets

Circular 79 specifies that in situations where a fixed asset has been put to use and the entity hasn’t received all the invoices relating to the purchase of the asset due to a construction payment not being settled, the entity can temporarily use the purchase price specified in the relevant contracts for depreciation purposes. However, Circular 79 also specifies that an adjustment must be made to reflect the actual purchase price within 12 months of putting the asset to use.

Application date

It should be noted that Circular 79 does not specify an effective date, however, as it relates to the CIT law it is believed that it should retroactively applied from 1 January 2008.

VAT

Now that we’ve looked at income tax it’s about time we looked at an indirect tax such as value added tax (“VAT”). The major change to China’s VAT rules is that general VAT taxpayers are now able to deduct input VAT incurred on the purchase of fixed assets. This reform also abolished the preferential import VAT treatment available to foreign-invested entities, including the exemption from VAT on equipment for R&D centres.

Those of you with R&D centres will already be aware that because R&D centres are not general VAT taxpayers, they are unable to credit input VAT incurred on the purchase of fixed assets against output VAT. However, you may not know that this was an unintended effect of the VAT reform, and is one that the Chinese government has been trying to rectify ever since.

In order to resolve this issue the Ministry of Finance, the General Administration of Customs (“GAC”) and the SAT jointly issued Circular 115 which grants an import VAT exemption on “equipment” imported by R&D centres and a full VAT refund on “equipment” purchased by R&D centres that was manufactured in China. “Equipment” means experimental equipment and appliances which are required to carry out scientific and technological research, development and teaching.

Provided that certain criteria are met, the import VAT exemption is available to foreign-invested R&D centres, whether they are independent legal entities, R&D departments or branches of foreign-invested entities. The criteria vary depending when the centre was established.

For R&D VAT exemption criteria please click here.

Numerous R&D centres are able to receive a refund for VAT incurred on the purchase of Chinese manufactured equipment, including, centres meeting the criteria outlined above, national engineering R&D centres, state key laboratories, enterprise technical centres and other qualified centres that have been approved by the National Development and Reform Commission, the Ministries of Finance and Science and Technology, GAC, or the SAT.

Whilst the exemption and refund policies outlined currently ‘fix’ the problem caused by the 2009 VAT reform, they are only a temporary fix, because the benefits under Circular 115 are only valid until 31 December 2010. This means that in order to get the benefit of these VAT relief measures you need to act now and assess whether you will qualify under the exemption.

For any further details please contact Joanna Doolan, Tax Partner at Ernst & Young and co-ordinating partner for the Ernst & Young NZ China Overseas Investment Network joanna.doolan@nz.ey.com and Florence Wong Senior Manager at Ernst & Young florence.wong@nz.ey.com