Anthony Tam looks at how this tax deferral treatment policy impacts foreign investors who are planning to expand their investment in Mainland China
Under the Enterprise Income Tax Law before the change, dividends derived by a non-tax resident enterprise (non-resident entity) are subject to a withholding tax (WHT) at 10 percent unless a more favourable tax WHT treaty benefit applies. In August 2017, the State Council released measures to improve the business environment for foreign investors in China, including the proposal to allow foreign investors to enjoy a WHT deferral treatment.
On 28 December 2017, four People’s Republic of China (PRC) government bodies, namely the Ministry of Finance (MOF), State Administration of Taxation (SAT), National Development and Reform Commission (NDRC) and Ministry of Commerce (MOC) jointly issued Caishui [2017] 88 (Caishui 88), which clarifies the criteria to enjoy the WHT treatment, application procedures and responsibilities, and post-administration by the tax authorities.
Subsequently, the SAT issued one Public Note [2018] No. 3 (Note No. 3) and an official interpretation to further elaborate the Caishui 88.
The treatment would be effective retrospectively from 1 January 2017, and tax payments already settled on eligible re-investment can be refunded. The above four ministries also jointly released a list of Questions and Answers through the MOF’s official website on 28 December 2017. Refer to the website for their interpretations.
What is the preferential treatment on WHT in Caishui 88?
Foreign investors who obtain distributable profit from a PRC resident enterprise could enjoy deferral of WHT which would otherwise be imposed on the distribution, provided certain conditions are met. All of the conditions must be met.
What conditions should be fulfilled?
Direct investment – The non-resident entity shareholder must use the distributable profit for another direct investment in China
According to the Caishui 88, direct investments include:
- Injection in paid-up capital or capital reserves of a PRC resident enterprise or enterprises, whether it is the paying or another PRC resident enterprise;
- Establishing new PRC resident enterprises;
- Acquiring the equity rights of PRC resident enterprises from unrelated parties; and
- Other modes specified and accepted by MOF and SAT (a catch-all clause allowing for future expansion of activities involving Chinese entities).
However the following situations are excluded from being qualified for the tax deferral treatment:
- Injection in paid-up capital or capital reserves of publicly listed companies or acquiring shares of publicly listed companies UNLESS the investments are considered as strategic investments according to the Administrative Measures on Strategic Investment in Listed Companies by Foreign Investors (the MOC Order [2005] No. 28); or
- Acquiring the equity rights of the PRC resident enterprises from related parties.
Qualified distributable profit
This refers to the dividend, profit distributions and other returns on equity investments arising from the distribution of realized retained earnings by the PRC resident enterprise. It includes undistributed profits in prior years. The key is the retained profits must have been realized. It seems that interim dividends would not qualify unless at the time of distribution, there are indeed sufficient retained earnings.
Profits must be directly transferred to investee companies
Whether the profit is in cash or in non-cash format, the investment must be transferred directly to the accounts of investees’ accounts.
Caishui 88 specifies that if the investment is in cash, it must be remitted directly to the bank accounts of the investee companies. Before the investment is made, the cash should not be remitted to other bank accounts of other parties such as agents either in China or outside China. Similarly, cash remitted to the bank accounts of the non-resident entity and then re-invested into China would not qualify for the tax deferral treatment.
If the direct investments are in non-cash forms such as benefits in kind or securities, they must also be transferred directly to the concerned investee companies. Intermediate holding or temporary holding by other companies or individuals of the relevant profits would disqualify the foreign investor from enjoying this tax deferral treatment.
Encouraged investment projects – The invested projects or the projects undertaken by the investee Chinese entities must be encouraged projects
Encouraged projects refer to projects that are classified as encouraged under either The Industry Catalogue Guide for Foreign Investment or under the Preferential Industry Catalogue for Foreign Investment in Central and Western Regions, also revised in year 2017.
Public Note No. 3 further elaborates that operating activities in connection with these encouraged projects should be at least one of the following in order to be qualified:
- Production activities or provision of services;
- Research and development activities;
- Investments in construction projects or acquiring machinery and equipment; and
- Other activities to be specified at a later time.
According to the official interpretation, the tax preference would be enjoyed as long as the business activities of the investee are within the scope of encouraged projects at that time. Subsequent amendments to the above mentioned catalogues would not affect the already enjoyed tax deferral treatments.
Filing procedures and follow up administration
According to the Caishui 88, foreign investors that are qualified for the tax deferral treatment should file appropriate returns and provide relevant information/ documents in order to support their claims for tax deferral treatments. The relevant profit distributing enterprises should assess the relevant documents and file for records with the relevant PRC tax bureau if they consider that the foreign investors are qualified.
The PRC tax bureau will perform follow up checks on the qualifications. If it is found that the foreign investors are not qualified for deferral tax treatments under Caishui 88, the profit distributing enterprise would be treated as having failed to fulfill the WHT obligations. WHT and late payment surcharges would then be imposed. Late payment surcharge shall be computed from the date when the relevant dividends are actually paid. It is therefore recommended that profit distributing enterprises should carefully review the materials and proactively discuss with their in-charge tax authorities.
Retrospective treatment
Caishui 88 prescribes that qualified dividend received on or after 1 January 2017 are eligible for this WHT deferral. Foreign investors are entitled to claim possible tax refund within three years from the date when the relevant taxes have been actually paid. However caution should be taken in this regard as different tax bureaus may adopt different interpretations and treatments.
Withdrawal of investments
In case of future investment withdrawal by the foreign investors through equity transfer, buy-back and liquidation etc., the foreign investors should report and settle the WHT, which has been deferred to the tax bureau in charge within seven days after receiving the relevant withdrawal investment payments.
There are questions remaining in this regard. In the case of partial equity transfer, Caishui 88 is silent as to how to determine the tax-deferred portion of dividends. Which method should be used: first-in-first-out, last-in-first-out or weighted average? It can only be presumed that the first-in-first-out method would be used.
In the case of which the non-resident entity qualifies for tax treaty reduction of WHT, would the reduced WHT rate be applicable? One would think that the WHT rate at the time of direct re-investment should prevail.
Corporate restructuring eligible for special tax treatment
Caishui 88 provides a specific relief provision for non-resident entities which have obtained the tax deferral treatment and subsequently carry out an intra-group restructuring and elect for the special tax treatment. Under this provision, the non-resident investor can continue to enjoy such tax deferral treatment.
Mazars’ observation
This is no doubt welcoming news to non-resident investors who are contemplating to further invest in encouraged projects in China.
However, there are still some uncertainties that the authorities concerned should clarify in the near future.
One of them is that WHT would be re-imposed when the investment amounts are repatriated to foreign investors. In practice, it would take many years before this would happen. It seems that the Caishui 88 does not specify which party should be responsible for filing and paying the relevant WHT.
If the distribution is not in cash form but in benefits-in-kind, it is uncertain what base value adopted to compute the possible WHT when the investment amount is returned to foreign investors.
Finally, as there is no time limitation as to WHT deferral, the WHT would appear to be re-imposed as long as the investment amounts are repatriated to foreign investors, which may be many years later or even decades later. As such, do the tax authorities expect that the profit distributing PRC resident enterprises should retain the amount of WHT for indefinite period of time?
Therefore clarifications from the State Administration of Taxation are necessary.
Anthony Tam is Executive Director of Tax Advisory Services at Mazars Hong Kong.
