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VOICES FROM THE INDUSTRY: U.S. companies should evaluate Chinese tax changes

June 11, 2007

Over the past three decades or so, foreign investment has been fueling China's economic growth.

Companies from around the world have flocked to meet the needs of the largest population in the world: 1.3 billion citizens and counting. Shifts in China's political climate have made this Asian country ripe for commerce, and foreign companies-especially in the United States-have rushed in.

Many U.S. manufacturers have been lured to China by tax holidays and reduced tax rates on income generated from their operations in China.

However, on March 16, the People's National Congress of China voted to change that, approving the Unified Enterprise Income Tax Law of the People's Republic of China, also known as the EIT Law. This law aims to bring taxes paid by foreign-owned companies into line with those paid by domestic Chinese companies, which the Chinese government believes will level the playing field. This change obviously will have a significant impact on American-owned companies.

So what does this mean to your business? Take a look at the EIT Law:

What will the tax rate be?

On Jan. 1, 2008, American-owned companies in China that enjoy a current tax rate of 15 percent will see an increase to 25 percent, while domestic companies that currently are taxed 33 percent will see a decrease to 25 percent.

EIT is imposed on the income non-resident enterprises earn in China, including dividends, royalties, rents, capital gains and other items identified as China-source income. China's interest in keeping and attracting high-tech companies allows for some exceptions to the new law. High-tech enterprises will be eligible for a 15-percent tax rate, which is how many foreign companies will be classified. Small-scale enterprises also will receive a lowered tax rate of 20 percent.

What about tax incentives?

Tax holidays available under the current tax law (Foreign-Invested Enterprises Income Tax Law, or FIE) will be eliminated, though certain tax holidays will continue for some key industries and projects. New income tax law temporarily grandfathers incentives that were already granted. The EIT Law will gradually eliminate these across-the-board incentives.

Is this law retroactive?

Companies established in special, lower-tax zones before March 16, 2007, will continue to enjoy the current preferential tax rates until the old rates are phased out, which will occur over a fiveyear period.

Companies that are enjoying the twoyear exemption and three-year 50-percent reduction may continue to apply the incentives until the tax holidays are used up.

The business-purpose rule

The business-purpose rule allows the tax authority to make adjustments if a company makes "arrangements with no reasonable commercial purpose" to reduce its taxable income.

If your company is already invested in China, closely examine the new law to determine exactly how it affects your company and what protocol you must follow to be temporarily grandfathered into preferential tax rates. If you're interested in investing in China, consider a high-tech focus, because high-tech companies enjoy a lower tax rate.

U.S. companies need to be aware of the increase of Chinese protectionism. In response to an ongoing debate that advocates restricting further foreign penetration into its economy, China is attempting to encourage the development of domestic companies.

The new income tax law supports this initiative, causing a significant shift of tax burden that may cause foreign companies to re-examine the economics of their Chinese operations.

That's not to say U.S. companies should steer clear of China. China's economy is booming, expanding at about 10 percent a year. Living standards have improved, and a middle class has formed, opening the door of opportunity for U.S. investment.

American businesses need to stay on top of new tax laws and other changing facets of the global economic climate wherever they occur, but this is especially critical in today's dynamic Chinese market.



Simmons is a partner at Indianapolis-based law firm Baker & Daniels LLP, where she leads the firm's environmental law and international practice groups. Views expressed here are the writer's.
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