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Tax Issue P94/2009 10 December 2009

Tax Analysis
Authors: Beijing Andrew Zhu Partner Tel: +86 10 8520 7508 Email: andzhu@deloitte.com.cn Julie Hao Director Tel: +86 10 8512 5419 Email: julhao@deloitte.com.cn

PRC Tax International and M&A Tax Services


PRC Foreign Tax Credit Regime (I) Analysis of Existing Laws and Regulations
The Enterprise Income Tax Law (EIT Law) and accompanying implementation rules that took effect on 1 January 2008 unified the tax treatment of domestic and foreign-invested enterprises in the PRC and, at the same time, introduced several new concepts and measures, including PRC tax residence rules, controlled foreign corporation (CFC) rules, general anti-avoidance rules, and indirect foreign tax credit (FTC) rules based on the direct FTC rules in the previous law. According to our communications with relevant government departments, we understand that the State Administration of Taxation and the Ministry of Finance are in the process of drafting further administrative regulations that will interpret the relevant provisions of the EIT law and its implementation rules with a view to providing guidance on the applicability of the FTC on foreign-source income. In anticipation of this detailed guidance, this article examines the existing FTC rules. The FTC-related articles in the EIT law and implementation rules include the following: Article 23 of the EIT law establishes the "limited credit method" to eliminate double taxation, under which any excess amount that cannot be credited in the current year may be offset against tax payable in the subsequent five years. Article 24 of the EIT Law introduces indirect credit rules for the elimination of economic double taxation (i.e. double tax at different entity on the same income). Article 7 of the Implementation Rules provides a general principle to determine the source of the income and establishes a legal basis for the determination of foreign-source income. Article 77 of the Implementation Rules clarifies that income tax paid overseas subject to an FTC under article 23 of the EIT Law refers to tax that is in the nature of an enterprise income tax and that has been actually paid in accordance with foreign tax law and regulations. Article 78 of the Implementation Rules explains that the FTC limit will be computed per country but not by category (such as active or passive income), except to the extent the government authorities of the State Council in charge of finance and taxation stipulate otherwise. The credit limit is calculated based on following formula:

For more information on the subject, please contact: International and M&A Tax Services National Leader (Shanghai) Leonard Khaw Partner Tel: +86 21 6141 1498 Email: lkhaw@deloitte.com.cn

Deputy National Leader (Hong Kong SAR) Alan Tsoi Partner Tel: +852 2852 6600 Email: atsoi@deloitte.com.hk

Northern Region (Beijing) Andrew Zhu Partner Tel: +86 10 8520 7508 Email: andzhu@deloitte.com.cn

Eastern Region (Shanghai) Vicky Wang Partner Tel: +86 21 6141 1035 Email: vicwang@deloitte.com.cn

Southern Region (Hong Kong SAR) Sharon Lam Partner Tel: +852 2852 6536 Email: shalam@deloitte.com.hk

FTC limit = Total tax payable computed on income sourced in and outside China in accordance with the EIT Law and implementation rules x Taxable income sourced from a particular country / Total taxable income sourced in and outside China Article 79 of the Implementation Rules clarifies the starting point of the fiveyear period stipulated in article 23 of the EIT Law. Article 80 of the Implementation Rules stipulates that the indirect FTC is only allowed for a resident enterprise that holds directly or indirectly no less than 20% of the shares in the foreign enterprise. Article 81 of the Implementation Rules establishes that, when an enterprise applies for a tax credit, it must supply relevant tax documents issued by the foreign tax authorities for the year the tax was paid.

In the past, few Chinese domestic enterprises had investment overseas and it was rare for foreign-invested enterprises to invest outside China, so the FTC was not often used in practice even though the foreign-invested enterprise income tax law included an FTC regime (direct FTC). Further, where Chinese domestic enterprises did engage in business overseas (such as overseas contracting projects, cross-border trading, etc.), most companies chose to use the fixed rate deduction method provided in a 1997 circular (Circular Caishuizi 1997 No. 116), thereby relinquishing their right to an FTC under "limited credit method". Most taxpayers in China are therefore unfamiliar with the typical FTC mechanism. Now, with the increasing number of Chinese enterprises investing overseas, FTCs are certain to become an area of importance; correspondingly, the tax authorities are under pressure to provide guidance on the FTC system to protect the interests of taxpayers and to prevent any erosion of China's tax base. Issues to Consider: 1. Foreign-source income

1) Determination of the source of Income Article 23 of the EIT Law provides that an enterprise will be allowed to credit tax payable against tax paid overseas in the current period for: i. ii. Foreign-source taxable income by a resident enterprise; or Foreign-source taxable income by a nonresident enterprise effectively connected with the nonresident enterprise's establishments in China.

Article 7 of the Implementation Rules sets out the principle to determine the source of various categories of income, under which the source of the sale of goods is the place where the transaction takes place. It is not entirely clear what is meant by the phrase, the "place where the transaction takes place": this could be interpreted to mean the place where the contract is signed, where the goods are delivered, where ownership of the goods is transferred, etc. To comport with international practice, the Chinese authorities should provide a more specific definition of the source of income (e.g. the source for the sale of goods could be the place where title is transferred (title passage), as is the case in the United States).

Article 7 also provides that the source of interest, rental income and royalties is the place where the fees are paid or borne. Article 20 of the Implementation Rules further defines royalty income as income derived by an enterprise from the granting of the right to use a patent, non-patented technology, trademark or copyright, or other license use rights. In other words, royalty income is defined as income derived from the right to use intangibles. However, it appears that the rules are not clear on how to determine the source of income for outright sales of such intangibles. According to the Organization of Economic and Cooperative Development (OECD) definition of royalties, income from the transfer of ownership of intangibles should not fall within the scope of a royalty. The Chinese authorities should provide further guidance and a clear definition of the source of income from the transfer of the ownership of intangible assets. Although the source of income is used for purposes other than the determination of an FTC, it plays an important role in the FTC and may directly affect the calculation of the FTC limit (as shown in the above formula). To keep pace with the increasing complexity of cross-border business transactions, Chinas tax law and regulations need to contain more comprehensive and sophisticated provisions on the source of income, e.g. the determination of the source of ecommerce income, etc. 2) Interaction with anti-avoidance provisions The EIT Law introduced CFC rules that attribute to a Chinese company the proportionate share of the income of foreign subsidiaries set up in certain countries by the Chinese company even no actual dividends are distributed, provided certain criteria are met. As a result, the Chinese company will be required to include the deemed dividends in its taxable income and will be subject to immediate PRC tax on such income. The question arises in these cases whether the domestic income tax paid by the foreign subsidiaries should be creditable immediately against the PRC tax. In addition, subsidiaries may not pay withholding tax on dividends because there would be no actual repatriation (probably in a long period of time). A mechanism would be needed to track how and when to take future withholding tax credits into account. 3) Allocation of expenses between headquarters and overseas branches In determining foreign-source income, foreign expenses need to be accounted for appropriately. For example, certain expenses (such as interest, R&D expenses, advertising costs and other general administrative expenses) paid by a PRC headquarters need to be shared with the headquarters and the overseas branches. Issues that arise in this context include what principles should be followed in the expense allocation, whether taxpayers may choose certain methods for allocating expenses, and whether income and expenses should be recognized in accordance with the local accounting standards, local tax law, or in accordance with PRC GAAP or tax law. All of these factors will affect the calculation of foreign-source income and the rules on these issues need to be clarified. 2. Creditable Foreign Taxes

1) "In the nature of an enterprise income tax" Article 77 of the Implementation Rules provides that: The income tax paid overseas as stipulated in article 23 of the EIT Law refers to tax on income sourced from outside China, and in accordance with the foreign tax law and regulations, which is to be paid and has actually been paid in the foreign country, and should be in the nature of an enterprise income tax. A clear definition of the term "in the nature of an enterprise income tax" is required to take into account potential differences in various countries' tax regimes. For example, a "tax" rather than a government charge should be involved and income tax should normally be imposed on a net rather than gross revenue basis, etc. In practice, some taxpayers may find themselves in the difficult situation of having to determine whether a capital gains tax or a tax similar to the PRC land appreciation tax (which is a tax imposed on appreciation value when the real estate is sold) could be regarded as "in the nature of an enterprise income tax" to decide whether the tax is creditable for FTC purposes. 2) Determination of the creditable tax The foreign tax to be credited should be the tax which is to be paid and has actually been paid; in other words, only tax that has actually been paid is creditable. This is different from certain countries where accrued tax also may be creditable and may give rise to a number of practical problems: for example, where the parent company and the foreign subsidiaries have different tax years or where the overseas subsidiaries distribute dividends based on accounting profits without a corresponding tax certificate, it is likely that income sourced from overseas would be subject to PRC tax without being able to simultaneously take an FTC. Where a tax sparing clause is available, it is not entirely clear how to calculate the foreign-source taxable income and to implement the FTC rules. In addition, some countries have a federal income tax as well as state/province local income tax, and sometimes local income

taxes can be deductible for federal income tax purposes. Whether both the federal and local income tax could be used as an FTC would need to be considered. Other practical problems, such as whether a pre-paid tax could be regarded as tax actually paid and creditable also need to be resolved. 3) Tiers of foreign companies qualifying for FTC The EIT Law and its implementation rules provide that PRC companies are entitled to take an FTC for foreign tax paid by overseas companies where the PRC shareholder holds directly or indirectly at least 20% of the shares of the overseas company. However, no clarification is provided as to whether there are limitations on the tiers of foreign companies or how the 20% ownership threshold is to be determined. Meanwhile, based on our discussions with the State Administration of Taxation, it is possible that the FTC would be limited to the third tier of foreign companies invested in by a PRC company. We understand that the tax department is still considering and evaluating the relevant impact of the proposed policies. For example, if due to operational needs or as a result of overseas acquisitions, there may be more than three tiers of foreign subsidiaries and the foreign tax paid by foreign subsidiaries beyond the third tier would not be creditable by the parent company in China. In addition, it appears that tiers of companies for FTC purposes need to be considered in conjunction with the CFC rules to avoid the situation where taxpayers are caught by the CFC rules but not able to take credit on the other hand. 4) Calculation of indirect tax credit Article 24 of the EIT Law provides that, when a PRC tax resident company receives dividends or other equity investment income from its directly or indirectly controlled foreign companies, the foreign tax paid by the foreign companies attributable to such income would be creditable against the PRC tax, subject to the FTC limit. Currently, there is no specific guidance to calculate the foreign tax attributable to the dividends under the multi-tier situation. We understand that the following formula has been considered for calculation purposes: The foreign tax paid by the foreign company in the current tier but attributable to dividends received by the above tier = (Foreign tax paid on profits in this tier + Foreign tax paid by the foreign company of the tier(s) below, but attributable to the dividend income received by the current tier) Dividends repatriated to the above tier After-tax profit in this tier If this formula is used to calculate the FTC limit in a multi-tier situation, the timing of taxes and the repatriation of after-tax profits accumulated in each level and ultimately passed to China's holding company could be different. Thus, it is necessary to have a mechanism to track the tax and after-tax profits by entity and by year (such as a pooling system, FIFO principle, etc.). 3. FTC limitation

1) Per country computation Article 78 of the Implementation Rules generally provides that the FTC limit is to be computed on a per country basis rather than on the category of income. That is, in calculating the FTC limitation, all taxable income derived from the same country is taken into account, with active and passive income blended to constitute the taxable income. However, it is not clear whether a look through principle will be used in this determination. Two options are available: (1) If intermediary holding company could be looked through and the income is regarded as sourced from the country in the lowest tier; or (2) if there is no look through with respect to the intermediary holding company, the income should be regarded as sourced from the first tier. The second option would provide more tax planning opportunities for taxpayers. 2) Offset of gains and losses between domestic headquarters and foreign branches Article 17 of the EIT Law provides that, when calculating the EIT, losses incurred by an enterprise from its overseas operating branch may not be offset against domestic profits. However, the concept of overseas operating branch" is not precisely defined. We understand that it generally refers to an establishment engaged in operating activities outside China, excluding an independent legal entity such as a subsidiary. Article 5 of the Implementation Rules also lists an "operating branch" as one of the "establishments." Without further guidance, it is likely that taxpayers will presume that losses incurred by overseas establishments other than an operating branch may be offset against domestic profits.

4.

FTC administration

Other than article 81 of the Implementation Rules (which provides that the taxpayer must submit relevant tax payment documents issued by the foreign tax authorities to claim FTC benefits), there are no other specific requirements on tax compliance of FTC. The reporting requirements on FTCs in the existing annual income tax return also appear very limited. A detailed reporting requirement in the tax returns would help the tax authorities adequately collect taxpayer information on foreign-source income and tax liabilities, and provide detailed guidance for taxpayers to correctly calculate the FTC and track each years FTC and the application of the FTC limit. The authorities also should consider developing alternatives for taxpayers, such as a tentative fixed-rate deduction followed by future adjustment, etc. when taxpayers are not able to obtain the tax clearance documents from the foreign tax authorities in a timely manner. Summary Although the EIT Law has introduced the concept of an indirect FTC and established the principle to calculate the FTC limit, the implementation regulations need further development. While the issues discussed above need to be considered in any FTC analysis, they are not exhaustive. We hope that the upcoming guidance will address some of the issues; nevertheless, considering the general complexity of FTC mechanisms, the regime likely will be developed on a progressive basis.

Tax Analysis is published for the clients and professionals of the Hong Kong and Chinese Mainland offices of Deloitte Touche Tohmatsu. The contents are of a general nature only. Readers are advised to consult their tax advisors before acting on any information contained in this newsletter. For more information or advice on the above subject or analysis of other tax issues, please contact: Beijing Kevin Ng Partner Tel: +86 10 8520 7501 Fax: +86 10 8518 7501 Email: kevng@deloitte.com.cn Hangzhou Frank Xu Partner Tel: +86 571 2811 1901 Fax: +86 571 2811 1904 Email: frakxu@deloitte.com.cn Shanghai Vivian Jiang Partner Tel: +86 21 6141 1098 Fax: +86 21 6335 0003 Email: vivjiang@deloitte.com.cn

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About the Deloitte China National Tax Technical Centre The Deloitte China National Tax Technical Centre (NTC) was established in 2006 to continuously improve the quality of Deloitte Chinas tax services, to better serve the clients, and to help Deloitte Chinas tax team excel. The Deloitte China NTC prepares and publishes Tax Analysis, Tax News, etc. These publications include introduction and commentaries on newly issued tax legislations, regulations and circulars from technical perspectives. The Deloitte China NTC also conducts research studies and analysis and provides professional opinions on ambiguous and complex issues. For more information, please contact: National Tax Technical Centre E-mail: ntc@deloitte.com.cn Eastern Region Zhang Li Guo National Director & Partner Tel: +86 21 6141 1038 Fax: +86 21 6335 0003 Email: ligzhang@deloitte.com.cn Southern Region (Chinese Mainland) Miao Zhi Cheng Director Tel: +86 755 3331 0993 Fax: +86 755 8246 3222 Email: zmiao@deloitte.com.cn Northern Region Angela Zhang Partner Tel: +86 10 8520 7526 Fax: +86 10 8518 1326 Email: angelazhang@deloitte.com.cn Southern Region (Hong Kong SAR) Davy Yun Director Tel: +852 2852 6538 Fax: +852 2520 6205 Email: dyun@deloitte.com.hk

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