International investors have two critical concerns when making a tax plan: obtaining the most favorable treatment available and avoiding tax disputes.

How to benefit from China's favorable tax treatment for foreigners

In order to draw in foreign capital and technology, China has continued to draft favorable tax policies. These policies have remained fundamentally unchanged even in today's market-oriented economy in which fair competition and equal treatment for foreign and domestic firms are being sought. However, investors should expect varied tax rates depending on factors such as investment area, industry, company set-up, amount of investment and duration of contract.

Area

The Special Economic Zones (SEZs) offer the lowest tax rate: in Shenzhen, Zhuhai, Shantou, Xiamen and Hainan, the corporate income tax (CIT) is 15% whether the company is engaged in manufacturing or service. In the Economic Development Zones (EDZs) in Guangzhou, Tianjin and Shanghai, the 15% rate is limited to companies involved in production. In all other areas, the rate is 33%.

Industry

Lower CIT rates are offered for foreign investment in industries such as energy, transportation, seaports, piers, machinery, electronics, agriculture and hi-tech.

Company Status

Foreign companies with headquarters in China (defined a, "tax-resident company" in Chinese tax law) receive more tax benefits than companies that do not have headquarters in China ("non-tax-resident company").

Amount and duration of investment

Favorable tax treatment is also linked to large investments with a long time frame. Here are some examples:

• To receive 15% CIT rate, foreign banks and financial institutions with establishments in SEZs and other specially designated areas must have over US$ 10 million in investment or operation capital and with a commitment of more than 10 years.
• A foreign-owned manufacturing venture with tax-resident status must hold a minimum 10-year business contract to obtain a two-year tax exemption and a three-year 50% tax rate reduction beginning from the first profit-making year.
• A tax-resident foreign company in Hainan SEZ or Shanghai Pudong New Development Zone investing in infrastructure projects such as airport, pier, railway, public road, or power station must hold a 15-year contract to receive a five-year tax exemption and a five-year 50% tax reduction.

Re-investment

The government will refund 40-100% of a foreign company's CIT on the profit from re-investment, subject to certain restrictions. Foreign companies investing in high-tech development and research will also be tax exempt or receive a 50% tax cut on royalties.

By combining benefits, a foreign company might pay an average CIT rate of 3.75% for its first ten years of operation, if the tax plan is well designed,

Avoiding problems

Foreign investors should pay special attention to the following cases.

Operating one company or branch in China

• When operating a multinational corporation in the home country and in China, consider stationing corporate headquarters in China if the tax burden is less than in the home country. The Credit Method adopted by most countries allows investors to avoid international double taxation and take advantage of the lower tax rate country. However, when applying to the Chinese tax authorities for tax credit, be prepared to prove that taxes paid to the home country were income tax related. Also, the original receipt for the same tax year from the home country's tax administration should be submitted.
• If a corporation has a branch in a third country, tax credit from the home country and the third country must be filed for separately. The Chinese tax authorities will not accept an application for combined credit from these two countries.
• If a company is only operating a branch in China, taxes on stock dividends, loan interests and royalties which have been levied outside China can be treated as credit for expense deductions but not as CIT credit.
• If a company is tax-resident and only operating in China, any stock dividends from this company's investment in other companies in China will not be calculated into this company's income to avoid double taxation because the dividends are from after-tax profits. However, please note that any expenses or losses from such investment shall not be used as deductions for taxable corporate income.

Operating more than one company or branch in China

The Chinese government allows a foreign investor to set up more than one company in China. In this case, the investor may choose any one of his companies to fill the combined tax return. When these companies are given different tax rates and when profits and losses differ from one company to the other, tax calculation should be based on the rules of reasonable counterbalance between profit-making and loss-making companies.

To avoid a charge of tax evasion:

• Taxes on net counterbalanced profit shall be paid according to the rates applicable to the profit-making company (depending on location, industry and terms of contract);
• The loss-making company can use profits from the following tax year to cover the losses. Any net profit after counterbalance shall be taxed at the rate applicable to the company, and
• If income from another branch in the previous year is used to counterbalance the losses, it is taxable at the rate applicable to the company.

Pricing adjustment for related companies

Today, nearly 3/4 of total world trade transactions are internal transactions by multinational corporations. Therefore, the Chinese government, as well as the majority of governments in the world, requires related multinational enterprises to adjust their taxes to arm's length prices (normal

trading prices between two or more unrelated or unaffiliated companies), if the business activities are originally priced as internal transfer. The activities include transfer of goods, labor supply, borrowing and lending of funds.

When a company's China branch is involved in any of the above activities with related companies outside China, the following three points should be kept in mind in making such adjustments:

• Enterprises are defined as related when the following criteria are met: there exists indirect or direct ownership or a controlling relationship in capital, management and operation and trading between two companies, or two companies are owned or controlled by a third company.
• When making price adjustments for trading activities between related enterprises, the following sequences should be observed:
• Comparable Uncontrolled Price treats these trading activities as the same or similar activities between unrelated companies,
• Resale Price treats the trading as resale to a third unrelated company but makes some adjustment on gross profit rate,
• Cost-Plus Price is based on the cost, expenses and profit adjustment.
• When filing tax returns, foreign companies should also submit documents containing standard prices related to their business with related-enterprises. China's tax authorities may readjust taxes if they do not accept pricing schedules. In that case, supporting cases must be provided.