China Tax/Business News Flash 

• The enterprise annuity plan referred to in Circular 694 is a supplementary pension scheme for employees established by employers pursuant to Circular [2004] No. 20 Trial Measures on Enterprise Annuity ("Circular 20") issued by the PRC Ministry of Labour and Social Security.  It is funded by contributions made by employers and employees as well as income and gains from investments with the annuity funding.  Circular 20 stipulates that the employer's contributions are normally capped at 1/12 of an employee's total remuneration of the preceding year and the combined contributions from employer and employee are normally capped at 1/6 of the employee's total remuneration of the preceding year.
     
• Employee's contributions to an enterprise annuity plan are not deductible in calculating the employee's taxable income for IIT purposes; whereas, employer's contributions to an enterprise annuity plan should be taxable as employment income in the hands of the employee in the month when the contributions are made.  The amount is taxed separately from the monthly salary but no additional deduction of the monthly statutory deduction would be allowed.  This concessional tax treatment however applies only to qualified plans as set up in accordance with Circular 20.  For non-qualified plans, the employer's contributions should be added to the employee's monthly regular salary in the month when the contributions are made.  Accordingly, such contributions to non-qualified plans would generally be subject to higher marginal IIT rates than contributions made to qualified plans.
     
• Circular 694 also makes it clear that the employer should be responsible for managing the withholding of the IIT in respect of its contributions made to an enterprise annuity plan.
    
• Where the employer's contributions are not subsequently vested in an employee due to the failure to satisfy certain prescribed conditions (such as, the number of service years), a refund can be claimed for the IIT overpaid in respect of the contributions he / she has forfeited.  Circular 694 also sets out the requirements for the employee to apply for the IIT refund.
     
• Circular 694 took effect from 10 December 2009.  It provides rectification measures for employers who have not withheld any IIT on the employer's contributions to an enterprise annuity plan to withhold and report the IIT underpaid using a special retro-calculation method as specified in Circular 694.

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Enterprise annuity plans are considered as long-term reward schemes and have been implemented by many companies in China, including domestic enterprises and foreign investment enterprises.  It is also common for employers to prescribe certain vesting conditions (such as, the number of service years) on the employer's contributions to an enterprise annuity plan for long-term employee retention purpose.
   
What is good
  
Previously, the IIT treatment of contributions to an enterprise annuity plan was not clear.  We noted that there were different IIT treatments on the contributions which were mainly based on discussions with the relevant local-level tax bureaus on a case by case basis.  Circular 694 now removes this uncertainty and provides guidelines on ongoing IIT treatment and rectification measures and introduces a concessionary treatment for calculating the IIT on the employer's contributions.
   
It is clear from Circular 694 that the taxing point of employer's contributions is at the time of the contributions and the tax authorities will no longer allow an employer to defer the taxing point of unvested employer's contributions until a later time when the contributions are fully vested.  The introduction of the IIT refund mechanism in respect of the forfeited employer's contributions provides a relief for the employees who are being taxed upfront on the benefits they are not otherwise entitled.
   
Companies may be encouraged to establish an enterprise annuity plan in China due to the concessionary IIT treatment on employer's contributions allowed by Circular 694.  Companies which have implemented an enterprise annuity plan should revisit their plans to ensure that it qualifies for the concessionary IIT treatment.
   
What is challenging
   
Circular 694 imposes an extra burden on employers.  It makes clear that employers have the responsibility to withhold and report the IIT on the employer's contributions made to an enterprise annuity plan.  In addition, although IIT refunds on forfeited employer's contributions can be claimed by an employee, employers will still have to provide documentation, such as IIT withholding reports and receipts and annuity contributions details, etc, to support the employee's application.  This will increase the administrative burden to HR and finance departments, especially in those industries which have relatively high staff turnover rate.
   
Further, employees may no longer find enterprise annuity plans to be attractive as they have to pay IIT upfront even on the unvested employer's contributions (bearing in mind that no cash is received by the employees and they have to dig into their own pockets to pay the IIT) despite they can have some IIT savings due to the concessionary IIT treatment under Circular 694.  Companies which have implemented an enterprise annuity plan may have to revisit their plans to ensure that it can continuously meet their reward target.
   
From the employer's perspective, it is still harsh to see that Circular 27 only allows deduction of employers' contributions to enterprise annuity plans to be capped at 5% of total salary cost for CIT purposes.  In other words, the employer would be unable to claim the CIT deduction in respect of the excess contributions and, at the same time, the employee would need to pay IIT in respect of the employer's contributions - this would result in a lose-lose situation.
   
What is uncertain
   
Pension plans are generally classified into "defined benefit plans" and "defined contribution plans".  The former plan normally guarantees a certain payout at retirement, according to a fixed formula which usually depends on the member's salary and the number of years' membership in the plan.  The latter plan provides a payout at retirement that is dependent upon the amount of money contributed and the investment performance of the fund in the plan.  It appears that Circular 20, Circular 27 and Circular 694 have only covered the regulatory and tax issues of defined contribution plans.  It is uncertain how the accrued benefits under defined benefit plans should be accounted for both IIT and CIT purposes.  It leaves a vacuum to be filled up.
    
According to Circular 694, an employee can claim IIT refunds on forfeited employer's contributions with supporting documents provided by the employer.  However, it remains to be seen how simple and fast the IIT refund process would be.
   
Circular 694 is silent on the tax treatment of the investment income and gains of an enterprise annuity plan.  There are a few fundamental issues that have to be addressed.  For example, do the investment income and gains belong to the employers or employees and consequently what type of tax (i.e. CIT or IIT) should be triggered, if any?  If such income belongs to the employees, is it taxable (bearing in mind that gains derived by Chinese individuals from the buying and selling of shares listed in the Chinese stock exchanges and unit of funds are currently exempt from IIT)?  If it is taxable, what is the timing of taxation (at the time the income is earned or at the time of withdrawal upon retirement?).  It is likely that the SAT needs more time to analyse these issues before clarifying the relevant treatments.
   
Employers which have implemented an enterprise annuity plan but have not reported any IIT on employer's contributions should take immediate action to settle the underpayment of IIT in order to minimize potential late filing interests and penalties.

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