A woman works at a collective factory in Datong, Shanxi Province. Since 1949, China’s tax system was based on a Soviet-style economic model. Now that China is moving toward a socialist market economy, tax policy reforms have been enacted. PHOTO BY JOAN LEBOLD COHEN.
The Enterprise Income Tax (EIT) is a tax law that came into effect in China on 8 January 2008. The law replaces an earlier, more complicated system that used a Western-style tax system for foreign-owned firms and another system for Chinese-owned firms. The State Administration of Taxation’s regulations of the law are available to the public.
Following the creation of the People’s Republic of China in 1949, China’s tax system was based on a Soviet-style economic model since there was no private business sector to speak of. Industry and commerce were controlled by publicly owned enterprises. State-owned enterprises delivered all their profits to the central government. The only real tax was a type of sales tax that was used to facilitate the transfer of funds from enterprises to the central government.
Starting in the 1980s, as China began its move toward a socialist market economy, a number of major tax reforms were introduced. Today the Chinese tax system looks like many other countries’ tax systems, although many uniquely Chinese features remain. For instance, there is a two-track system, the foreign track and domestic track, each with different regulations and types of administration. With respect to deductible expenses, for example, foreign enterprises can deduct the cost of wages, salaries, and employee benefits, whereas domestic enterprises can deduct only the amount of wages in accordance with the standard set by the government.
China’s tax system consists of various consumption taxes, income taxes, property taxes, and miscellaneous taxes. One such income tax is the enterprise income tax. China implemented a dual-track system of enterprise income taxation from 1979 to 2007: a Western-style tax system for foreign-owned firms and another system for Chinese-owned firms. As of 1 January 2008, this dual-track tax system ended and a new Enterprise Income Tax (EIT) law became effective for all forms of enterprises.
The process that culminated in the promulgation of the EIT took thirteen years but was relatively transparent compared to most policy changes in China. Early drafts of this tax law were widely debated and commented upon. The structure and substantive provisions of the EIT legislation are more sophisticated than its predecessors were; for example, the threshold of tax incentives is more detailed. Explanatory notes on EIT regulations by the State Administration of Taxation (SAT) are detailed and insightful but, more importantly, available to the public.
In addition to the obvious goal of raising government revenues, the EIT legislation was introduced to achieve the following objectives: to ensure equitable taxation of all businesses by ending systematic and serious discrimination against Chinese-owned businesses; to promote sustainable economic development of China’s economy; to be consistent with international tax norms and practices; and to improve efficiency in tax administration.
The EIT has become an important instrument in China’s plans to promote sustainable economic development. Attracting direct foreign investment to China remains a key policy concern. Instead of providing specific tax incentives, as do tax policies in other countries, the EIT has adopted an internationally competitive tax rate. The tax incentives are targeted at investments in small and high-tech businesses, as well as projects in agriculture, forestry, animal husbandry, fisheries, job creation, public infrastructure, environmental protection, water and energy conservation, research and development, and technology transfer.
The EIT is based on a set of fundamental principles enforced by the EIT Law and its regulations. Administrative matters related to the EIT are contained in the Tax Administration and Collection Law. EIT legislation states that a taxation year is the calendar year and that no consolidation is allowed for enterprise groups unless specifically authorized by the State Council.
The determination of taxable income is primarily a legal question. Although financial accounting is the basis for the computation of income or loss, the ultimate determination must be governed by the provisions of the EIT Law. These legal provisions override any inconsistent financial accounting principles. Revenues and expenses must be recognized in accordance with the accrual method of accounting, which recognizes income when earned and expenses when incurred regardless of when cash is received or disbursed. The principle of truthfulness requires that revenues and expenses be supported by evidence, typically invoices or receipts. The principle of substance over form requires that transactions be characterized for tax purposes in accordance with economic substance, not the legal form. The principle of realization requires that income be recognized only when it is realized, that is, when the income-earning transaction is completed.
International Tax Norms
The Chinese enterprise income tax system has undergone major reforms since the 1980s. A Western-style income tax, known as the Chinese–Foreign Joint Venture Income Tax (JVIT), was first introduced in 1980. Foreign tax terminology, structures, and concepts found their way into the JVIT, but the Chinese characteristics were overwhelmingly present. For instance, tax expenditures for social programs and subsidies are much less than they are in the West. Most taxes go toward government expenditures. China’s financial system is highly decentralized. Expenditures by local governments account for 71 percent of government expenditures. The central government has exclusive taxing powers in terms of legislation. All taxes are introduced by the central government. However, revenue from specific taxes is assigned to local governments. Overall, local governments receive about 50 percent of total tax revenues. Since 1980, the trend has been more toward internationalization as the Chinese economy has moved closer to a market system.
The Chinese have always adapted foreign ideas to meet Chinese needs. To the Chinese, because the market economy originated in the West and the market demands rational laws, which are predominantly Western laws, it was important to transplant Western laws to China and to harmonize Chinese laws with international norms. Tax laws directly affect the market, and enterprise income taxes were seen as less politically and culturally sensitive than income or sales taxes, so the process of internationalization was relatively quick.
The new EIT legislation significantly improves the efficiency of tax administration. It provides more certainty and predictability through more detailed and clearer rules for qualifications for tax incentives. In contrast, the previous system authorized the tax authorities to preapprove the qualification of eligible enterprises for tax incentives, leaving a great deal of discretion to local tax officials, The EIT also introduces new anti-avoidance rules that send a signal to taxpayers about unacceptable tax avoidance transactions. The typical examples of anti-avoidance rules involve transfer pricing and thin capitalization.
Features of the EIT Tax Law
singly, the EIT system contains many regulations and requirements, exemptions and exceptions. Following are some of the key features of the EIT legislation.
Enterprises are subject to the EIT if they are residents or nonresidents earning income from a Chinese source. Resident enterprises are subject to tax on their income from inside and outside China, whereas nonresident enterprises are subject to tax only on their Chinese-source income.
Under the EIT Law, all enterprises, regardless of ownership, are subject to the same tax rules. The term enterprise, however, is somewhat vague in the EIT legislation. According to the State Administration of Taxation (SAT), enterprise includes, but is not limited to, a corporation. The key is whether an enterprise is a legal person under Chinese civil law. (In legal terms a legal person is an individual, a groups of individuals, or even the state that can make claims against other legal persons and have those claims resolved in court.) In addition, some nonprofit entities are treated as enterprises under the EIT legislation. On the other hand, a sole proprietorship or a partnership established in China is specifically excluded from the meaning of enterprise; sole proprietors are subject to the individual income tax. A Chinese partnership is treated as a flow-through entity; that is, its income is taxable to the investors or owners. A foreign partnership, in contrast, is taxable as an enterprise under the EIT law.
According to the SAT, this rule is needed to prevent double taxation and to protect the Chinese tax base. In the case of a Chinese partnership, the assumption is that Chinese partners are taxable under the individual income tax (in the case of an individual partner) or the EIT (in the case of an enterprise partner). Treating a Chinese partnership as a conduit eliminates double taxation of the income earned through the partnership. If a foreign partnership is not taxed as an enterprise, then its income would be free from the EIT and the foreign partners would not be taxable in China.
In addition, for the first time residence is officially used as a basis for determining tax jurisdiction in the EIT Law. The term resident enterprise is defined as “an enterprise established in China or an enterprise created under foreign laws but with a place of effective management in China.” An enterprise established in China refers to “an enterprise, nonprofit entity, social organization, and other type of entity that earns income and is created in accordance with Chinese laws or administrative regulations.” As such, the test of residency is a combination of place of incorporation and place of effective management.
The basic formula for computing taxable income stipulates that taxable income equals total revenue minus excluded income minus exempt income minus deductions minus loss carryover.
The taxable income of a nonresident conducting business in China through an establishment or site is the net of deductible costs and expenses. The taxable income of other nonresident enterprises, however, is gross income.
Taxable income earned from Chinese-source dividends, interest, rent, or royalties is the full amount received. According to the SAT, a nonresident enterprise is also liable to Chinese tax on the gross amount of fees for services provided to enterprises or individuals inside China, or for providing foreign insurance to enterprises or individuals in China. The service fees and insurance premiums are treated as Chinese-source income because the payer is in China and taxable on a gross basis.
The standard rate of the EIT is 25 percent. This rate was believed to be internationally competitive. A lower rate of 20 percent applies to qualified small, low-profit enterprises. These enterprises are believed to be strategically important in creating jobs and stimulating economic growth in China, but their tax capacity is limited. To support such enterprises, a lower rate is available to them. A further lower rate of 15 percent applies to key state-supported, new, and high-tech enterprises. This reduced rate is now applicable to all qualifying enterprises, irrespective of ownership or location.
Costs, expenses, taxes, losses, and other outlays are deductible in computing taxable income. This reflects the principle that income is a net concept. According to the SAT, for an item to be deductible, it must be truthful, or real (zhenshi xing), legal, and reasonable. The expense must have been incurred and supported by evidence. Any unlawful expenditure, even if deductible under accounting principles, cannot be deducted in computing taxable income. The reasonable test requires that the expense be “normal” and “necessary” for the purpose of earning income. For mixed business and personal expenses, a reasonable allocation must be made.
Deductible costs and expenses are generally self-explanatory. These include the cost of wages, salaries, bonuses, as well as contributions to basic mandatory retirement plans, basic medial insurance plans, basic unemployment insurance plans, workers’ compensation plans, family-planning insurance plans, housing provident funds, and other social insurance plans. Contributions to supplementary insurance plans, medical insurance plans, and other plans approved by State Council are also deductible.
Nondeductible items include dividends, taxes paid under the EIT law, late-payment penalties, fines and other penalties, sponsorships, unverified reserves, and other amounts incurred for nonincome-earning purposes.
For capital assets and inventories, generally speaking, it is the historical cost, or the laid-out cost, that is deductible. The cost of fixed assets is depreciated under a straight-line method: twenty years for buildings; ten years for aircraft, trains, marine vessels, machinery, and other production equipment; five years for other instruments, tools, furniture, and other assets used in production and business activities; four years for aircraft, trains, and marine vessels used in transportation; and three years for electronic equipment.
The period of amortization is ten years for biological assets in forestry production and three years for those used in livestock production. The cost of acquiring intangible assets—such as patents, trademarks, copyrights, land-use rights, nonpatented technologies, and goodwill—is generally amortized over not less than ten years. But the cost of purchasing goodwill, such as a customer list, is deductible when the business is sold or liquidated. (Goodwill, in this case, refers to the value of a business based on expected continued customer patronage because of its name or reputation.)
A credit is a yuan-for-yuan deduction in computing tax liability. There are two types of credits recognized by the EIT law: a foreign tax credit to prevent international double taxation, and tax credits as a form of subsidies for preferred investments, such as venture capital and investment in environmental protection, energy and water conservation, and production safety.
The EIT legislation provides tax incentives to industries and projects that are specifically supported and encouraged by the state. Tax incentives take a variety of forms, including full or partial exemption, tax rate reduction, accelerated depreciation, imputed additional deductions, and tax credits.
Tax-preferred enterprises include small, low-profit enterprises; high-tech enterprises; and nonprofit organizations. Tax-favored investments are those in agriculture and fishing, infrastructure, venture capital, environmental prot
ection, and production safety, and investments in ethnic minority regions, which are often less developed.
High-tech enterprises receive several types of tax incentives, including a reduced tax rate of 15 percent; exemption of income from technology transfer; an additional deduction for research and development expenses; accelerated depreciation; and special deductions for eligible investors of high-tech enterprises.
So-called green industries or projects sometimes qualify as high-tech enterprises. In addition, 10 percent of the income is excluded from taxable income if it is derived from products made by way of “comprehensive utilization of resources” in accordance with the standard published by the central government. In addition, 10 percent of the expenditures on purchasing qualified equipment specifically for the purpose of protecting the environment are creditable against income tax. This credit can be carried forward for five years.
All things considered, the EIT is an improvement over earlier corporate taxes in China. Even though the tax law contains many regulations and conditions, these regulations and conditions are published as administrative rules and available to the public. The EIT regime clearly provides taxpayers with more certainty and predictability, and the new rules are far more detailed and transparent than any other tax rules in modern Chinese history.
Chang, Ryan, & Kadet, J. (2007, December 17). China issues implementation rules on tax unification. Tax Notes International, 1099–1105.
Li Jinyan. (2007). Fundamental enterprise income tax reform in China: Motivations and major changes. Bulletin for International Taxation, 61(12), 519.
Li Jinyan & Huang He. (2008). Transformation of the Enterprise Income Tax in China: Internationalization and Chinese innovations. Bulletin for International Taxation, 62(7), 275–288.
Wang Zhenhua. (2007, April 2). Corporate tax reform in China: Background, features and impacts. Tax Notes International, 46(1), 97–103.
Source: Li, Jinyan, & Huang, He. (2009). Enterprise Income Tax. In Linsun Cheng, et al. (Eds.), Berkshire Encyclopedia of China, pp. 726–730. Great Barrington, MA: Berkshire Publishing.
China’s past tax policies gave an unbalanced preference to foreign companies over Chinese-owned businesses. Reforms instituted in January 2008 attempt to level the playing field. PHOTO BY JOAN LEBOLD COHEN.
Enterprise Income Tax (Q?yè su?déshuì ?????)|Q?yè su?déshuì ????? (Enterprise Income Tax)