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Foreign-Related Tax Policy and Development of the Tax System
di Cheng Faguang,
Deputy Director of the
State Administration of Taxation
in "Beijing Review", 42(1999), n. 4

I. Tax Reform

To meet the development needs of a socialist market economy, China began to reform its industrial and commercial tax system and adopted a revenue-sharing tax system in 1994. It was an all-round structural reform under the guideline of "unifying tax laws, fairly sharing tax liabilities, simplifying the tax system and rationally delegating power''.

The reform embraced six principal taxes, including turnover and enterprise income taxes, and the majority of local taxes. Afterward, foreign-funded enterprises, foreign enterprises and foreign nationals enjoy the same tax treatment as Chinese enterprises and nationals, except for enterprise income tax and some local taxes.

Restructuring of the turnover tax is the most important part of the reform, as its revenue accounts for three-quarters of total proceeds from industrial and commercial taxes. The new turnover tax system, applying to both Chinese and foreign-funded enterprises, facilitates the principle of fairly sharing tax liabilities and setting competition on an equal footing, and meets the requirement of standardizing the value- added tax (VAT).

The reform of enterprise income tax covered domestic enterprises. A separate income tax was maintained for foreign-funded enterprises.

The reform of personal income tax aims to establish a unified system applicable to all Chinese citizens and foreign nationals working in China. After the reform, a threshold of 800 yuan is allowed for deduction per month. For foreign nationals and Hong Kong, Macao and Taiwan compatriots, the threshold is, inter alia, 3,200 yuan per month.

The reform also involves the refinement of natural resources tax, the imposition of land appreciation tax, and the abolition of taxes on transactions in market fairs and of draught animals, and on fuel, bonus and salary.

Through the 1994 reform, the original 32 industrial and commercial taxes were reduced to 18, with 12 applicable to foreign-funded enterprises and foreign nationals. The tax system is greatly simplified and becomes more rational. However, much work needs to be done to improve the system.

1. Improving personal income tax. This now follows a scheduled system. In the future, it will be replaced by one combining a scheduled and a comprehensive system. Taxable items will be increased, and allowable deductions set more rationally.

2. Unifying enterprise income tax for Chinese and foreign-funded enterprises. To ensure fairness in liability, promote competition on an equal footing and gradually grant national treatment to foreign-funded enterprises, taxes on Chinese and foreign-funded enterprises will be unified, although necessary preferential taxes maintained. Successful overseas experiences will be referred to in an effort to regularize enterprise income tax, making it simple and highly efficient.

3. Improving the local tax system. Efforts are called for to formulate estate and gift taxes, and reform urban construction and maintenance tax and land occupancy tax.

4. Refining VAT. The administration of value-added tax will be strengthened.

II. Preferential Policies to Encourage
Foreign Investment

Preferential tax policies to encourage foreign investment are mainly embodied in the enterprise income tax.

1. Reduced tax rates in defined areas. For enterprises located in special economic zones and production enterprises located in economic and technological development areas, the income tax rate is reduced to 15 percent. For foreign-funded production enterprises located in coastal open cities and areas, in riparian cities, open border cities and provincial capitals in inland areas, as well as foreign-funded enterprises located in tourist and holiday resorts, a reduced 24 percent income tax rate is applied.

2. Reduced tax rates for defined trades and projects. A 15 percent income tax rate is applied to the following:

* Sino-foreign joint ventures engaged in harbor and wharf construction;

* Foreign banks and Sino-foreign jointly funded banks located in special economic zones and in areas authorized by the State Council, with foreign investment or capital input exceeding US$10 million and the term of operation surpassing 10 years;

* Projects located in open economic areas with foreign investment exceeding US$30 million and a long term set for investment recovery; and

* Energy, transportation and harbor and wharf construction projects.

3. Preferential policies for defined industries and projects in the given time.

* Foreign-funded production enterprises scheduled to operate for no less than 10 years are exempt from income tax in the first two profit-making years and enjoy a 50 percent reduction in the ensuing three years.

* Foreign banks and Sino-foreign jointly funded banks scheduled to operate for no less than 10 years are exempt from income tax in the first profit-making year and enjoy a 50 percent reduction in the ensuing two years.

* Sino-foreign joint ventures engaged in harbor and wharf construction scheduled to operate for no less than 15 years are exempt from income tax in the first five profit-making years and enjoy a 50 percent reduction in the ensuing five years.

4. Preferential policies to foreign investors for establishing export-oriented or technologically advanced enterprises. In the wake of the expiration of the legal term for tax reduction and exemption, export-oriented enterprises set up by foreign investors, with the output value of exported products reaching or surpassing 70 percent of the total output value in a tax year, enjoy a 50 percent reduction of enterprise income tax. If the tax rate is under 10 percent subsequent to the 50 percent reduction, a 10 percent rate shall apply. Technologically advanced enterprises funded by foreign investors may enjoy a 50 percent reduction of enterprise income tax for another three years following the termination of the legal term for tax reduction and exemption. If the tax rate is under 10 percent subsequent to the 50 percent reduction, a 10 percent rate shall apply.

5. Preferential policies for the transfer of advanced technology. Royalties from the transfer of special technologies used in such areas as agriculture, forestry, animal husbandry, scientific research, energy, transportation and other key technological fields enjoy a 10 percent withholding income tax. Those offering advanced technologies and favorable terms are exempt from the withholding income tax. Foreign investors deriving income from profits of foreign-funded enterprises in China are exempt from income tax.

6. Preferential policies for foreign investors to expand investment in China. Foreigners already investing in Chinese enterprises, who directly reinvest their share of the profits to increase their registered capital, or use the profit as capital investment to establish other enterprises scheduled to operate for no less than five years, are allowed a 40 percent refund on tax paid on the reinvested amount. For foreign investors who reinvest in China to establish or expand export-oriented or technologically advanced enterprises scheduled to operate for no less than five years, the full refund is allowed.

In order to attract direct foreign investment, the Chinese Government decided, in 1998, to reinstate exemption from tariffs and VAT on machinery and other equipment imported by foreign-funded projects involved in areas encouraged by the State.

III. Necessity for the Readjustment of
Foreign-Related Tax Policy

China's foreign-related tax system was established and developed in the process of deepening the reform and opening program beginning in 1979. Several laws were promulgated in 1980 and 1981 by the third and the fourth sessions of the Fifth National People's Congress (NPC), including the Income Tax Law of the People's Republic of China on Sino-Foreign Joint Ventures, the Income Tax Law of the People's Republic of China on Foreign Enterprises and the Personal Income Tax Law of the People's Republic of China. It was also clarified that foreign-funded enterprises were liable to industrial and commercial consolidated tax, urban real estate tax, and vehicle and vessel usage license and plate tax. Thus, a comprehensive foreign-related tax system was formulated involving income, turnover and local taxes.

In April 1991, the Fourth Session of the Seventh NPC adopted the Income Tax Law of the People's Republic of China on Foreign-Funded Enterprises and Foreign Enterprises, establishing a unified income tax system by abolishing the previous Income Tax Law on Sino-Foreign Joint Ventures and the Income Tax Law on Foreign Enterprises.

For foreign-funded and foreign enterprises, the tax system reform mainly covers the restructuring of the turnover tax. In December 1993, the Fifth Session of the Eighth NPC decided that, effective from January 1, 1994, foreign-funded and foreign enterprises should be subject to the Provisional Regulations on Value Added Tax, the Provisional Regulations on Excise Tax and the Provisional Regulations on Business Tax promulgated by the State Council. Meanwhile, the Regulations on Industrial and Commercial Consolidated Tax were abrogated. As a result, a unified turnover tax is levied to both domestic and foreign-funded enterprises. This helped change the pattern featuring the application of different turnover taxes to domestic and foreign-funded enterprises, representing a significant step toward the unification of the taxation system.

Since its formulation, the foreign-related tax system has remained a separate structure from the domestic tax system. This basically catered to the needs of China's reform and economic development at the time and played an important role in mobilizing revenue, attracting foreign capital, introducing advanced technology, expanding international economic exchange and safeguarding the country's economic rights and interests. Following the establishment of the target of building a socialist market economy, however, the separate foreign-related tax system no longer meets the needs of economic restructuring and development. So, the introduction of a unified tax system is essential.

The different tax treatment for foreign-funded enterprises mainly lies in income tax. In 1991, when the two income tax laws for foreign-related enterprises were merged, appropriate readjustment was made in preferential policies for income tax, with focus on sectors encouraged by the State. These policies contributed greatly to attracting foreign investment, especially investment in coastal areas. But the obvious policy discrepancies between foreign-funded and domestic enterprises have brought about some problems, including the following:

1. Regional discrepancies at multiple levels in existing preferential tax policies hamper foreign investment in the development of border, remote and poor areas. At the same time, it also triggers harmful competition between local governments by willfully formulating preferential policies, leading to unnecessary losses for the State.

2. Current preferential policies to certain industries fail to stand in tandem with the national industrial policy. These policies are mainly geared to production enterprises. However, tax regulations cannot list all manufacturing industries when defining production enterprises. They only generally categorize enterprises into several major industries. Judging from the national industrial policy, some "production'' enterprises are not included in the category encouraged by the State, while some others, traditionally defined as "non-productive'', are in the list encouraged by the State under the present industrial policy.

3. Complicated tax incentives bring about difficulties in implementation, thus lowering the transparency of laws and regulations and providing some taxpayers with chances to take advantage of policy loopholes.

According to the tax system reform plan, it is an important task in the coming years to readjust and unify the two existing enterprise income laws.

IV. Export Tax Refunding

Following tax reform, foreign-funded enterprises established after January 1, 1994, are, as domestic enterprises, liable to the same unified regulations on VAT, excise tax and business tax. The problem of increased tax liabilities by refunding is non-existent. These enterprises may, pursuant to the provisional regulations on VAT, claim refund of relevant input tax for products directly exported.

It is a common international practice to offer tax refund for exported products. Generally speaking, the refund rate is dependent on the statutory tax rate.

The State Council decided that, as of July 1, 1995, the refund rate for exported goods should be lowered according to the actual tax burden. The readjusted refund rates were as follows: 3 percent for farm produce and coal, 10 percent for industrial goods using farm produce as raw materials and other goods entitled to a VAT collection rate of 13 percent, and 14 percent for goods entitled to a VAT collection rate of 17 percent. Soon afterward, the State Council decided to revise the refund rate again. Effective from January 1, 1996, the previous refund rates of 10 percent and 14 percent were respectively reduced to 6 percent and 9 percent, while the refund rate for farm produce and coal remained unchanged. However, in the second half of 1997, in order to promote the export of products of certain industries, the State Council consecutively approved the readjustment of the refund rates for products produced by the textile, shipbuilding, coal mining and building materials industries.

In accordance with the aforementioned refund rate, foreign trade enterprises are liable to VAT payment prior to refunding. Manufacturing enterprises handling exports independently or via proxies (including foreign-funded enterprises approved and established after January 1, 1994) should adopt the method of "exemption, credit and refund'' as an alternative to collection prior to refunding at the stipulated rate with the refunds calculated at the FOB price.

From January 1, 1999, all foreign-funded enterprises will get the tax refund for their exported products pursuant to the aforementioned regulations. As a result, there is basic uniformity in the tax refund policy for both domestic and foreign-funded enterprises.

V. Reform of Tax Collection and
Administration System

After several years of experiments, a brand-new tax collection and administration system has been established. On the basis of self-assessment and improved taxpayer service, and backed up by a computer network, collection has been centralized, with inspection conducted over key tax payers. The major contents of the new model include:

1. Establishing a self-assessment system. Self-assessment is a basic requirement for a modern tax administration system. The taxpayers' awareness of the importance of tax payment will be enhanced through the adoption of scientific, simplified and convenient tax reporting and payment procedures, and the means of tax reporting and payment will be standardized. The original practice of sending tax collectors to taxpayers to ask for payment will be replaced by the self-assessment method which requires taxpayers to assess their own liabilities, file their returns and pay tax on their own.

2. Establishing a taxpayer service system that combines the efforts of both tax authorities and social intermediate agencies. The major task is to enhance tax officials' awareness of service, which includes the establishment of a tax law notification system to publicize laws, administration statutes and regulations and other tax-related documents, the founding of tax legislative databases at central and provincial levels, the establishment of declaration halls in cities, county towns and other places where transportation is convenient and taxpayers are relatively concentrated, and the development of tax service agencies to provide service for taxpayers.

3. Establishing a computerized administrative and monitoring system. Computers are being widely applied to consultation, registration, invoice selling, filling acceptance, collection, accounting, statistics, inspection, target selection for inspection and all other phases of tax administration.

4. Establishing a complete tax inspection system. Inspection will be the priority of tax administration and the most powerful guarantee for the implementation of the new tax system.

VI. Tax Relations Between the
HKSAR and China's Mainland

In accordance with the Basic Law, after reunification, Hong Kong is a special administrative region of the People's Republic of China. According to the principle of "one country, two systems'', capitalism will be retained in Hong Kong. As a special administrative region exercising a high level of autonomy, Hong Kong practices independent laws and tax system. It enjoys the power to formulate tax legislation, design its own tax categories, items and rates, confer tax concessions on its own and make its own decision on other tax affairs. After the reunification, tax laws and regulations exercised in inland areas are not applicable to Hong Kong.

1. The relationship between Hong Kong and the mainland with regard to concluding and implementing tax treaties. According to Article 153 of the Basic Law, "The application to the Hong Kong Special Administrative Region of international agreements to which the People's Republic of China is or becomes a party shall be decided by the Central People's Government, in accordance with the circumstances and needs of the HKSAR, and after seeking the views of the government of the HKSAR.'' In addition, consultation and agreement with the other signatory party is indispensable for the final decision of whether or not to apply the treaties to Hong Kong.

Reviews of the practical operation of the 57 tax treaties China has signed with other countries have found that none of them is applicable to Hong Kong, because the taxes covered in all these treaties are only applicable to the mainland.

Since the conclusion of tax treaties is based on the result of negotiation between the two signatory parties on their own tax systems, requiring one signatory party with two different tax systems to negotiate with another signatory party having a unitary tax system is bound to encounter technical barriers when coming to specific articles, not to mention the difficulties in implementation.

Besides, Article 151 of the Basic Law stipulates, "The Hong Kong Special Administrative Region may, on its own, using the name ?ong Kong, China', maintain and develop relations and conclude and implement agreements with foreign states and regions and relevant international organizations in the appropriate fields, including the economic, trade, financial and monetary, shipping, communications, tourism, cultural and sports fields.'' In agreement with the essence, the HKSAR may conclude and implement tax treaties and maintain or develop tax relations with other countries, areas and international organizations using the name "Hong Kong, China''.

2. Issues related to investment and tax payments by Hong Kong compatriots on the mainland. After reunification, policies applicable to foreign companies, enterprises, economic organizations and foreign nationals are still applicable to investment by Hong Kong compatriots and their income from the mainland. The Central People's Government will continue to encourage Hong Kong compatriots to invest in the mainland. Those who fulfill their tax obligations in accordance with related laws and regulations can continue to enjoy the preferential tax policy granted to foreign investors.

Article 116 of the Basic Law stipulates, "The Hong Kong Special Administrative Region shall be a separate customs territory.'' After reunification, trade (purchase and sales of goods, excluding service) between Hong Kong and the mainland are still regarded as transactions between the People's Republic of China and foreign companies, enterprises or other economic organizations and individuals. That is to say imports from Hong Kong to the mainland are still exempted from or enjoy a reduced rate of custom duties, as well as value-added tax and consumption tax, in accordance with the tax law. The mainland's exports to Hong Kong may be entitled to refunds (or exemption) in accordance with related regulations.

3. Avoidance of double taxation. This is an issue that attracts widespread attention from Hong Kong business circles. Given the existing tax practice in Hong Kong and the mainland, the problem of double taxation can be resolved automatically in most cases because Hong Kong practices tax jurisdiction of source principle (i.e. no levy of tax on income obtained outside Hong Kong) and the mainland has the stipulation that tax paid overseas may be credited. For possible double taxation, the State Administration of Taxation and the HKSAR Government reached an arrangement on double taxation avoidance at the beginning of 1998, which went into force last April in the HKSAR and in last July on the mainland.