As of the 21st January, 2005 there are new calculation methods for bonus payments which may have a significant impact on Individual Income Tax (IIT) liabilities. The new regulation, Guo Shui Fa [2005] No. 9, issued by the State Administration of Taxation (SAT) is retroactively effective from 1st of January, 2005. While the payment of an annual bonus was regarded as a separate monthly salary in terms of IIT as stipulated by Guo Shui Fa [1996] No. 183, the IIT payable on such bonuses should now be calculated by applying the following methods:

- The applicable tax rate for annual bonuses as well as the amount of quick deduction will be identified by dividing the annual bonus by twelve. For instance, if the annual bonus was RMB 360,000, the following calculation applies:

RMB 360,000 / 12 = RMB 30,000
Based on this figure, the corresponding tax rate is according to the Individual Income Tax law of the PRC 25% and the amount of quick deduction is RMB 1,375.
The IIT payable on the bonus is thus RMB 360,000 × 25% - RMB 1,375 = RMB 88,625.

- In case the employee’s monthly salary is less than the standard monthly deduction, the identification of applicable IIT rate and quick deduction follows the following procedure: The difference between monthly salary and standard deduction is to be subtracted from the annual bonus before dividing the amount of annual bonus by twelve. For instance, the monthly salary of an Expatriate and annual bonus amount to RMB 3,500. According to Chinese Individual Income Tax laws, Expatriates enjoy a standard deduction of RMB 4,000. The IIT payable will be calculated in the following way:

((RMB 3,500 – (RMB 4,000 – RMB 3,500)) / 12 = RMB 3,000 / 12 = RMB 250
The corresponding tax rate is 5% while the amount of quick deduction for this tax bracket is zero.
The IIT payable on the bonus is thus (RMB 3,500 – (RMB 4,000 – RMB 3,500)) x 5% - RMB 0 = RMB 150.

According to the new regulations, the calculation method described above is only applicable once a year for each tax payer for the payment of annual bonuses. This is particularly important if individuals receive multiple bonuses, as the choice in terms of which is the annual bonus may be an important one. In addition, although the annual bonus selected must be linked to the performance of the individual or the company, this is not rigidly defined in the regulations leaving some scope for interpretation on this point. In this case, consultation with the relevant expert fully briefed on the recent changes is advisable to maximize tax efficiency.

The overall result has been a shift in emphasis where primarily using year end bonuses may result in lower tax liabilities than through having several smaller bonuses throughout the year. The most significant impact is on all other bonuses (particularly quarterly and semi-annual ones) as they are now included as part of the monthly salary in which they are incurred. As a result, the firm’s bonus policy may need to be altered to minimize IIT liability arising from the regulation change.

New regulations for the franchise industry termed “Administration Measure on Commercial Franchise Operations” have taken effect from 1st February, 2005. These are in line with China’s WTO commitments and replace the “Measures Concerning Administration of Commercial Franchising” (for Trial Implementation). Overall, the recent changes to the franchising business in China have resulted in the legal framework becoming more detailed and comprehensive, which has consequently reduced investor uncertainty in the industry due to the vague nature of the older regulations.

The rules provide clear definitions, franchise models, qualifications for the parties involved, a framework for the agreement, a specific section on foreign investment and details on intellectual property issues. According to the new regulations the following two franchise models are allowed:

- The franchisor can grant a franchise to a franchisee directly (with no sub-franchising rights)
- The franchisor can grant a franchisee the exclusive rights to a designated region (they then have the right to sub-franchise)

The regulations moreover clarify the qualification requirements for being a franchisor and franchisee. Key examples of these requirements include:

- Long-term capability in training and guiding franchisees in operation
- Able to maintain a steady supply of merchandise as well as quality control system
- Operating at least two sales outlets for over one year in China directly by itself or its subsidiary or holding company

This last point is particularly noteworthy, producing a barrier to market entry which industry incumbents will be pleased to see.

A key section of the Administration measure (Chapter 7) is focusing on foreign investors. According to this section, Foreign Invested Enterprises (FIEs) can not be involved in prohibited industries as stipulated by the “Investment Catalogue Guiding Foreign Investment Industries”, and existing FIE have to expand their business scope if they want to take advantage of the new measures. Furthermore, this section states that investors from Hong Kong, Macau and Taiwan are also governed by the new rules. Other areas of the new regulations tighten up on intellectual property issues such as in the area of confidentiality agreements.

LehmanBrown Comment: With earlier regulations, a lack of specific provisions in terms of foreign involvement in franchising has led to problems due to it being quite a grey area in legal terms. These uncertainties often served to make the franchise business model somewhat inefficient as it has inherent legal issues that need to be addressed. This in turn led to less foreign confidence and investment in this sector until the situation was clarified. Now, franchising has been opened up more to foreign investors as they can now adopt the franchise business model that domestic investors do. The new regulations are more clearly structured and provide a good legal framework to work from, which will boost foreign involvement in this area.

Authorities take tough stance as Individual Income Tax amnesty ends

The 2004 tax amnesty for outstanding Individual Income Tax (IIT) payments has come to an end and companies now need to be prepared for a tough new stance from the tax authorities. The tax amnesty lasted 9 months and was widely regarded as being quite flexible to tackle the issues concerned. However, any issues now outstanding will not be viewed favourably. Formally announced on 11th of March, 2004, Guo Shui Fa [2004] No. 27 initially set out the amnesty period to end on 30th of June, 2004. However, this was later extended to the 31st December, 2004. The tax amnesty allowed foreign residents or their withholding agents to remit overdue tax payments on, or prior to the end date of the amnesty period. If these problems were reported to the local tax bureau concerned, there would be no penalties applied under the terms of the amnesty.

Underpayment of IIT has proved to be a problem for many expatriates due to their high mobility and issues regarding differing enforcement of the relevant regulations by different local tax bureaus. Many expatriates were previously not keen on coming forward as they thought the tax authorities would not be lenient with what may have been honest mistakes in the tax calculations. Not only would the penalties for rectifying the problem be high in financial terms (a 0.05% surcharge per day of any overdue taxes and a 50% to 500% penalty of the tax underpaid): If the authorities believed there was a case for tax evasion then the individual could be prosecuted and imprisoned.

In practice, this new tougher stance will likely mean impending and rigorous audits of expatriates in terms of IIT. The State Administration of Taxation (SAT) announced in October 2004 that information will be published in the media about these delinquent payments once the tax amnesty was over. Finance managers need to have double-checked these issues as there is consequently potential to seriously damage PR if the full measures are taken, since:

- details of the information can be posted at tax collection venues, in the written press or on the internet
- the names of offending individuals, institutions or firms will be highlighted in addition to…
- their related information such as tax-file numbers, identification numbers and outstanding taxes

To further add to the PR damage, the taxation authorities are keen to regularly update the status of the outstanding debt until it is cleared (on a quarterly basis for firms and every six months for individuals)

Consequently, individuals and companies need to be sure their affairs are in order to avoid the potential individual embarrassment and PR damage that can occur now that the amnesty is over.

New regulations have come into force to improve the efficiency of the capital markets in the area of Initial Public Offerings (IPO). The main new rule is termed the “Circular on Issues Concerning the Trial Implementation of the Initial Public Offerings Pricing Inquiry System” and took effect from the 1st January, 2005. Before companies and their underwriters can launch an IPO, they now need to consult 6 different types of institutions before being althey can set the share offer price. These include finance companies, securities firms, trusts, securities investment fund management companies, insurance institutional investors and (notably) qualified foreign institutional investors (QFII).

By opening up consultation to a wide range of qualified groups, the accuracy of the pricing of any new IPOs will undoubtedly be increased. With efficient stock markets being characterized by prices set out by the equilibrium of ‘average’ investor opinion, the reforms mark a major step forward in the evolution of Chinese stock markets. In addition, the importance of institutional investors in the process is boosted and the broad range of institutions involved may consequently help to raise the absolute levels of capital in the overall system. Finally, measures have also been put in place in the area of prudential regulation to improve the internal systems of IPO sponsors and to build a solid competitive base to aid the reforms. To conclude, the new regulations should be welcomed as positive step forward towards the overall goal of efficient capital allocation within the Chinese economy.

Professional Services

Taxation

Financial Accounting

Management Solutions

Business Management