Issue of May

Peeling the Onion provides an in-depth analysis of the major issues facing multinationals doing business in China in today's environment. It features a regular update of regulations, taxation, business environment and accounting legislation affecting foreign invested enterprises in China.

Table of Contents

Environmental related tax concessions in China
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NEW TRANSFER PRICING PROVISIONS IN CHINA
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High Tech tax concessions in China
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Environmental related tax concessions in China

16 March 2007, Chinese authority issued new Corporate Income Tax("CIT") law, the new CIT law has taken effective from 1 January 2008. Based on the new CIT law, the enterprise which is engaged in environmental protection business can enjoy some tax incentive policies. These incentive policies for environmental protection business are:

1.Income derived from qualified environmental protection and energy or water conservation projects may be eligible for a tax exemption for the first year to the third year, and 50% reduction in CIT for the fourth year to the sixth year, starting from the year in which the project first generates operating income. Qualified environmental protection and energy or water conservation projects include public sewerage treatment, public refuse treatment, synergistic development and utilization of methane, technological innovation in energy conservation and emission reduction, sea water desalination and similar projects. The qualification criteria and the scope shall be formulated by the departments of the State Council in charge of finance and taxation in conjunction with relevant departments of the State Council, and shall be promulgated and implemented with the approval of the State Council.

2.10% of the investment made by enterprise on the purchase of special equipment for the purpose of environmental protection, energy and water conservation or production safety , may be credited against the CIT payable by the enterprise for the current year; any excess in such credit may be carried forward for five succeeding tax years. An enterprise transfers or leases the aforementioned specialized equipment within five years of the purchase shall no longer be eligible for the preferential treatment, and shall repay the amount that has been credited ageists the CIT payable.

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NEW TRANSFER PRICING PROVISIONS IN CHINA

China has enacted the new Unified PRC Enterprise Income Tax Law on 16 March 2007, which amongst other things, introduces several anti-tax avoidance provisions and new concepts on transfer pricing. In order to strengthen the transfer pricing administration, the State Administration of Taxation ("SAT") has issued the following circulars in Year 2007:

(1)Guoshuihan (2007) No. 236 ("Circular 236")
(2)Guoshuihan (2007) No. 363 ("Circular 363")

Impact of Circular 236 on processing trade in China

According to the Circular 236, Foreign Investment Enterprises ("FIEs") and Foreign Enterprises ("FEs"), which are engaged in a sole manufacturing function based on the instruction of their overseas group affiliates without any involvement in or taking any associated risks of the sales and marketing functions, production strategy, product research and development, etc., should be operating at a profit rather than sustaining a loss under the international transfer pricing principles.

In the Circular 236, the SAT clearly stipulates its view in that it expects all FIEs and FEs who perform simple production function should achieve a certain level of profitability. There are a lot of production-oriented FIEs and contract processing plants operated by FEs in South China which undertake a sole-function of manufacturing for their overseas group affiliates. For those who are currently running at a loss or a low margin should be aware of being targeted for a transfer pricing ("TP") audit.

Impact of Circular 363 on targets under TP audit

Circular 363 standardizes the TP audit procedures, which emphasizes the function and risk analysis of the TP target.

Circular 363 requires a potential TP target to complete a Function and Risk Analysis Form ("Form I") which gives a comprehensive analysis of the functions and associated risks undertaken by the potential TP target and its related companies under a transfer pricing arrangement. If the local tax authorities consider the intercompany transactions of the potential TP target should be investigated further, based on (a) the information stated in Form I, (b) the initial examination performed by local tax authorities, and (c) the information extracted from the tax return and financial statements of the potential TP target, the local tax authorities will complete a Function and Risk Analysis Determination Form ("Form II"). The local tax authorities will then submit both Forms I and II together with a report ("TP Audit Initiation Report") to the SAT to initiate a full scale TP audit.

Thereafter, the SAT will determine whether it is required to carry out a full scale TP audit on the potential TP target.

Upon completion of a full scale TP audit, apart from a TP Audit Initiation Report and a TP Audit Closure Report, the local tax authorities have to complete a Related Party Transactions Financial Analysis Form ("Form III") in respect of the TP target and submit it to the SAT. Form III includes a breakdown of export sales and local sales with related and unrelated parties, costs of sales, expenses and payments for services, royalties, technical service fees and other payments to related parties.

For those FIEs and FEs who have received Form I from the local PRC tax authorities, they are targeted for a TP audit. Special attention and due care should be taken in completing Form I as the local tax authorities will use the information from Form I to determine whether a full scale TP audit is required for that potential TP target.

We anticipate that those information / documents required to be provided in various forms under Circular 363 will form part of the basic transfer pricing documentation requirements to be imposed in the future.

Defensive strategy

The local PRC tax authorities are strengthening their transfer pricing enforcement. By taking a proactive approach to transfer pricing, you can avoid unwelcome surprises and be well prepared for a TP audit. FIEs / FEs are recommended to conduct a TP review.

A TP review provides an overall assessment of whether the inter-company transactions will be considered arm's length in case of a TP audit. The objective of a TP review is to ensure that the inter-company transactions reflect the internal economic realities of its business and conform with the arm's length standard under the prevailing PRC transfer pricing regulations and the international transfer pricing principles.

Furthermore, all enterprises are required to comply with the latest contemporaneous documentary requirements.

A foreign investment company should focus more on transfer pricing risk and ensure compliance with the PRC transfer pricing provisions.

How can we help?

We can provide the following services:

• Reviewing the transfer pricing policy
• Performing high-level transfer pricing review and benchmarking analysis review
• Documenting and supporting the company's transfer pricing policy to substantiate the arm's length principle
• Assisting in the design of transfer pricing policy to meet the company's commercial needs and to reduce the company's transfer pricing risk
• Representing the company in the handling of the transfer pricing audit / review by the tax authorities
• Drafting and negotiating an Advanced Pricing Agreement
• Assisting in negotiation with the PRC tax authorities

For more information, please contact Dickson Leung, Senior Partner (Email: dleung@lehmanbrown.com) or Carl Poon, PRC Tax Director (Email: cpoon@lehmanbrown.com)

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High Tech tax concessions in China

16 March 2007, Chinese authority issued new Corporate Income Tax("CIT") law, the new CIT law has taken effective from 1 January 2008. New CIT law rules that High Technology enterprise can enjoy tax incentive policies. In the following months, Chinese authority issued some detailed incentive policies for High Technology enterprise continuously. To better understand the tax incentive policies for High Technology enterprise, here summarize the following detail policies for reference:

Corporate Income Tax Law

The CIT Law rules that High Technology enterprise can enjoy the preferential CIT rate of 15%.

The Implementation Rules for China's new Corporate Income Tax Law

Income derived from technology transfers that meet certain conditions is eligible for CIT reductions or exemptions. Within a tax year, the portion of income from technology transfer that does not exceed RMB 5 million shall be exempt from CIT; the portion of income that exceeds RMB 5 million shall enjoy a 50% reduction.

High Technology enterprise refers to enterprises that own core proprietary intellectual property rights, and that meet all of the following conditions:

* Product(service) are within the scope prescribed in the advanced and new technology sectors eligible for key support from the state
* The portion of research and development expenditures to sales revenue is not lower than a prescribed ratio
* The proportion of the revenue derived from high and new technology products(services) to the total revenue of the enterprise in not lower than a prescribed ratio
* The proportion of the number of research and development personnel to the number of all employees is not lower than a prescribed ratio
* Other conditions prescribed by the administrative measures for assessing the qualifications of high technology enterprise

High technology enterprise can enjoy a 50% additional deduction or amortization for research and development expenditures.

A venture capital enterprise has invested the small to medium-sized high technology enterprise that has not been listed on a stock exchange for more than 2 years, 70% of the amount invested may be set off against its taxable income in the year in which the equity has been held for two years; any amount that is not set off in that year may be carried forward and set off against its taxable income in succeeding tax years.

The State Administration of Taxation(SAT)'s Notice Concerning CIT Prepayment Matters, Guoshuifa [2008] No.17

The SAT clarifies that enterprises which were recognized as high technology enterprise before 1 January 2008 should conduct provisional CIT filings based on the standard CIT rate of 25 percent until they are re-recognized as such under the new CIT law.

In order to qualify for the preferential CIT rate of 15 percent, previously-recognized high technology enterprises should be re-recognized as such according to the qualifying measures under the new CIT law.

Notice on the Implementation of Grandfathering Relief in respect of High Technology Enterprises in Special Economic Zones and Shanghai Pudong New Area, Guofa [2007] No.40

High technology enterprises established on or after 1 January 2008 in six zones can enjoy a five-year tax holiday of two years tax exemption followed by three years 50 percent reduction starting from the first revenue generating year.

The six zones include five special economic zones( Shenzhen, Zhuhai,, Shantou, Xiamen and Hainan) and Shanghai Pudong New Area.

Notice on Issuance of the Administrative Measures governing the Recognition of High Technology Enterprises, Guokefahuo [2008] No.172

Recognition criteria

High technology enterprise must meet all of the following criteria:

Qualification of the enterprise

* The enterprise should be a resident enterprise that has been established in China ( excluding Hong Kong, Macau and Taiwan) for more than one year.
* The enterprise must have owned, for the most recent three years, the proprietary intellectual property of the core technology used in its major products or services. This proprietary intellectual property must have been acquired through: self-development, purchase, donation, merger and acquisition, or exclusive licensing with a term of more than five years.

Qualifying products or services

Qualifying products or services should fall within the scope of the High Technology Sectors Eligible for Key Support from the State.

Technical personnel requirement

More than 30 percent of the enterprise's staff must be technical personnel holding at least a college degree, among whom research and development (R&D) personnel account for more than 10 percent of the enterprise's total employee's for the year.

R&D expenditures requirement

The enterprise must carry out ongoing R&D activities. Additionally, in the most recent three years, the proportion of R&D expenditures to total sales must be no less than 3 percent to 6 percent, the details are as follows:

* If the sales for the latest year is less than RMB 50 million, the proportion of R&D expenditures to total sales will be no less than 6 percent;
* If the sales for the latest year is RMB 50 million to RMB 200 million , the proportion of R&D expenditures to total sales will be no less than 4 percent;
* If the sales for the latest year is more than RMB 200 million, the proportion of R&D expenditures to total sales will be no less than 3 percent;

Furthermore, the R&D expenditures incurred in China must account for more than 60 percent of the total R&D expenditures.

Revenue requirement

More than 60 percent of the total revenue for the year must be derived from products or services with high technology.

Recognition authorities

Special units designated to administer the recognition process will be established jointly by the administrative departments of science and technology, and the finance and tax authorities at the provincial level.

Recognition procedures

* Enterprises meeting the requirements for high technology enterprises should apply with the recognition authorities.
* Upon reviewing the submissions, specialists with the recognition authorities will issue a recognition opinion.
* The recognition authorities will publish the names of the recognized high technology enterprises on a public website for 15 working days. If no objection is received, the applicant will then be granted the High Technology Enterprise Certificate
* Qualification as high technology status is effective for three years from the date of issuance of the relevant certificate. Upon expiry, the effective period can be extended for another three years, provided that the enterprise passes the re-recognition review.

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