China has recently passed significant legislation in the areas of property and enterprise income tax. Jack Flader reviews these important legislative changes.
China 's top legislative body, the National People's Congress (NPC), during the Fifth Session of the Tenth NPC on 29 June, 2007, passed significant legislation in the areas of property and enterprise income tax. The purpose of this article is to provide a brief review of these important legislative changes.
THE PROPERTY LAW
The NPC is known to have consulted a wide audience of professionals and the public, and to have read the divisive draft Property Law seven times over a 13-year period, prior to a decisive vote of 2,799 for, 52 against, 37 abstentions and one 'no vote'. The 247 articles of the Property Law, which came into effect on 1 October, 2007, sets out that "the property of the state, the collective, the individual, and other obligees is protected by law, and no units or individuals may infringe upon it". Basically, the NPC had for the first time enshrined in Chinese law the equal protection of state, collective and private property, and analysts were quick to applaud this landmark step in the development of China as a leading global economy.
The NPC outlined the following reasons that necessitated enactment of the Property Law:
The Property Law covers six broad areas,which are briefly described below.
In drafting the Property Law, the drafters indicated it was fundamental that the Property Law adhere to and express the principles of the socialist economic system by unswervingly consolidating and developing public ownership, and encouraging, supporting, and guiding the development of non-public ownership.
The drafters recognised that public ownership must be dominant, while the state defined and protected ownership rights in a manner that communicated the advantages and stimulated the development of all forms of ownership.
The Property Law was enacted under the civil code, which recognises the equal protection of the law afforded to all members of society. In the socialist market economy, there are different forms of ownership that must enjoy the same rights, observe the same rules, and accept the same responsibilities. If members of society are not provided with equal protection, or if dispute resolution or legal responsibilities vary, then the socialist market system will fail. The Property Law also clearly states that equal protection does not necessarily mean that different forms of ownership play the same role or perform the same function in the national economy, i.e., public ownership is paramount.
State-owned property is defined in the Property Law to include natural resources and infrastructure belonging to the state, property of government departments institutions sponsored by the state, and other similar property. Protection of state-owned property was strengthened by stipulating that:
The Property Law seeks to define and protect the rights of rural collective economic units by allowing decentralised operation by households under a contract. In addition, to grant farmers a long-term guarantee of land use, all such contracts may be renewed upon expiration in accordance with the law. It is important to note that the restriction on transfer and mortgage of such land was not modified, albeit the right to sub-contract was granted. The same rules were extended to collectives that developed since the 1950s in cities and towns through the creation and operation of state-owned enterprises.
The most significant aspect of the Property Law is recognition of the rapidly developing economy, and the impact that has had on private property rights. The Property Law delineates that:
In recognising increased flat ownership, the Property Law delineates condominium rights including:
The drafters of the Property Law were cognizant of the fact China has a large population with insufficient cultivated land, which currently equals approximately 122 million hectares, or 0.09 hectares per person. This is less than one-third of the world average. In addition, the Outlines of the Eleventh Five-Year Plan approved at the Fourth Session of the Tenth NPC required that the country must have 120 million hectares of land retained for cultivation by 2010. Given this, the Property Law affords special protection for cultivated land through strictly restricting the transformation of agricultural land into land for construction. Of equal importance, the Property Law states that, in the interest of the public, land owned by collectives and houses erected thereon may be expropriated. Compensation shall take the form of:
Recognising real-life situations, the Property Law clearly indicates that no unit or individual shall embezzle, misappropriate, illegally share, withhold, or default on compensation for expropriation.
THE ENTERPRISE INCOME TAX LAW
The NPC successfully ended special treatment for foreign investors with a decisive vote on the Enterprise Income Tax Law of 2,826 for, 37 against, and 22 abstentions.
The 60 articles of the Enterprise Income Tax Law, which will come into effect on 1 January, 2008, set a unified income tax rate of 25 per cent for domestic and foreign-invested enterprises after nearly two decades of a dual system where foreign invested enterprises generally enjoyed preferential rates. It is believed that the previous preferential tax treatment contributed to the establishment of 594,000 foreign-invested enterprises and capital inflows of approximately US$692 billion over the past two decades. At the same time, foreign-invested enterprises paid approximately US$102 billion in taxes, representing about 21 per cent of China's total tax revenue.
Most analysts were impressed with China's demonstration of a commitment to the World Trade Organisation's requirement of a fair environment for competition, and did not think the modifications would necessarily slow down foreign investment.
In addition, given the continued preferential treatment for certain industries and geographic areas, many foreign invested enterprises have simply changed their business plans to continue enjoying the lower tax rate.
The NPC outlined the following reasons that necessitated enactment of the Enterprise Income Tax Law:
The drafters of the Enterprise Income Tax Law were guided by the following principles:
The Enterprise Income Tax Law covers five broad areas, which are briefly described below.
China's current enterprise income tax is 33 per cent for all enterprises. However, foreign-invested enterprises under certain circumstances are taxed at 24 per cent or 15 per cent. In addition, domestic lowprofit enterprises are taxed at special rates of 27 per cent or 18 per cent. The drafters of the Enterprise Income Tax Law recognised that too many brackets had been contributing to a relatively large disparity between nominal and effective income tax burdens of various types of enterprises. With that in mind, a unified enterprise income tax rate of 25 per cent will be implemented. The drafters decided on that percentage after reviewing the average rate of 28.6 per cent in 159 countries around the world, and the average rate of 26.7 per cent of 18 of China's neighbouring countries.
The Enterprise Income Tax Law integrates existing preferential policies in the following manner:
The Enterprise Income Tax Law allows for a five-year transition period for enterprises enjoying preferential tax treatment before promulgation of the Enterprise Income Tax Law. This transition period will not apply to enterprises that have not made any profits.
The Enterprise Income Tax Law includes the following changes to definitions in the existing system:
Taxable income of an enterprise is the amount remaining from its gross income in a tax year after excluding, exempting, or deducting certain income, expenses, and carry-forward losses from previous years.
The following definitions apply:
Deductions of expenses include a limited deductible salary and wage system for domestic enterprises, and an actual salary and wage deduction system for foreign invested enterprises.
In addition, the Enterprise Income Tax Law unifies deductions for various actual expenditures of enterprises and expenditures related to an enterprise's fixed assets, intangibles, long-term prepaid expenses, investment assets and inventory, prescribes standards for deducting expenditures for charitable donations, and defines the scope of non-deductible expenditures.
The Enterprise Income Tax Law seeks to standardise the administration of enterprise income tax, make tax payments easier, and reduce the cost for both taxpayers and tax administrators.
The current practice is that domestic enterprises pay tax locally as independent economic accounting entities, while the parent companies of foreign-invested enterprises make consolidated tax payments. The Enterprise Income Tax Law provides that a resident enterprise establishing operational entities without 'legal person' status shall calculate and pay enterprise income tax on a consolidated basis.
Tax avoidance in China is a serious problem, and the authorities are aggressively fighting against the same. The Enterprise Income Tax Law targets avoidance through transfer pricing among associated enterprises, as well as general anti-avoidance rules, and articles against thin capitalisation and avoidance through "tax havens".
The Property Law and Enterprise Income Tax Law both demonstrate an awareness that, due to the rapidly developing economy of China, the law will be constantly changing for many years to come. An understanding of this fact is fundamental to success in arguably the fastest growing country in the world.
Jack W . Flader, Jr., CEO and Group Managing Director