China Tax/Business News Flash 

Jan 2010, Issue 1

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New chapter of China's foreign tax credit mechanism
   
China's Corporate Income Tax ("CIT") regime assesses resident corporate taxpayers to CIT in respect of their worldwide income.  Those resident corporate taxpayers who derive foreign sourced income could also be subject to corporate income tax in the foreign jurisdictions on the foreign sourced income.  In order to avoid double taxation, the Chinese CIT Law and its Detailed Implementation Rules ("DIR") have introduced the concept of foreign tax credit ("FTC") mechanism to allow these taxpayers to claim a tax credit for such foreign taxes paid.
  
However, the CIT Law and its DIR did not provide practical guidance and implementation details on the FTC mechanism.  With the increasing number of Chinese enterprises investing overseas, the FTC mechanism is becoming a very important and imminent issue.  Consequently, both taxpayers and Chinese tax authorities are eagerly expecting to see the detailed FTC rules to be issued to provide clear guidance for the implementation.
  
On 25 December 2009, the Ministry of Finance and the State Administration of Taxation ("SAT") have jointly issued the long-awaited circular Caishui [2009] No. 125, titled "Notice regarding relevant issues on tax credits for foreign income derived by enterprises" ("Circular 125"), to set forth detailed guidance on the implementation of FTC mechanism under the new CIT regime.  Circular 125 took effective retrospectively from 1 January 2008.
  
In this issue of News Flash, we would like to highlight the key features of Circular 125 and share our observations and comments.
  
Key features of Circular 125
  
As mentioned above, the basic provisions on FTC have been provided in Chapter 3 of the CIT Law and its DIRs respectively.  Circular 125 contains 16 articles to further clarify and elaborate the features of the Chinese FTC mechanism as follows:

• Scope of application
  
  
  FTC is not only applicable to China's tax resident enterprises ("TREs"), but also to non-tax resident enterprises having establishments and sites in China which derive foreign sourced income effectively connected with those establishments and sites in China (collectively called "Enterprises" hereinafter).  FTC is available to the above Enterprises with the following limitations:
    
  

  • FTC is allowed for foreign sourced income on the basis of "a country (region)-basket limitation without an item-basket limitation" ("One country / region limitation"); and
     
  • Where the Enterprises cannot accurately determine the foreign income tax in accordance with the above basis, they would not be eligible for FTC.  Consequently, they could face double taxation situation.

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• Determination of taxable foreign-sourced income
  
  
  

  • Circular 125 states that the source of income, whether China foreign sourced or China sourced, shall be determined in accordance with the relevant article of the DIRs to the CIT Law.
     
  • Direct expenses attributable to the earning of foreign sourced passive income, investment income as well as foreign sourced income derived by the TRE's overseas branches or permanent establishments which do not have a "separate tax filing status" have to be deducted in calculating the taxable foreign sourced income.  In addition, common expenses incurred for both foreign sourced and China sourced income have to be reasonably allocated between the two sources and also deducted in calculating the taxable foreign sourced income.  Effectively, such deduction requirement would reduce the FTC limit - please refer to the following for details.
     
  • Foreign loss incurred by overseas branches of a TRE which do not have a "separate tax filing status" cannot be used to set off against the TRE's domestic profits; but such loss is allowed to offset against other foreign profits derived by the TRE from the same foreign country / region for the year or to be carried forward for future utilization.

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• Creditable foreign income taxes
  
  
  

  • The creditable foreign taxes should be those in the nature of corporate income tax and which should be paid and has actually been paid in a foreign tax jurisdiction on the foreign sourced income.
     
  • Circular 125 does not allow FTC in respect of those foreign taxes which are wrongly paid as well as interest or penalties paid due to under-payment or late payment of foreign taxes.  FTC is also not allowed for foreign tax which has either been refunded or compensated by a foreign tax jurisdiction or on foreign sourced income which are exempted in accordance with China tax regulations.
     
  • It is a break-through to see that the China's FTC mechanism not only allows direct foreign tax (e.g., withholding tax) to be creditable, but also indirect foreign tax (foreign income tax paid by qualified foreign investee companies) for TREs.  However, indirect foreign tax will only be creditable where at least 20% of the shares of the qualified foreign investee companies are held directly or indirectly by the TRE and the qualified foreign investee companies are limited to the first 3 tiers of foreign investee companies underneath the TRE.  This would be a concern to TREs which have more than 3 tiers of foreign investee companies in their overseas investment structure.
     
  • Circular 125 also allows the claiming of tax sparing credit if it is available under the double tax agreement ("DTA") concluded between China and the other foreign tax jurisdictions.

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• Calculation of FTC limit
  
  
  FTC is allowed on an annual basis.  The FTC limit is the CIT liability on the taxable foreign sourced income as calculated in accordance with the CIT Law.  The allowable foreign tax credit on income sourced from a same country / region in a year is the lesser of the foreign tax paid and the FTC limit for that country / region for that year.  Any amount of foreign tax paid in excess of the FTC limit for the year may be carried for 5 years for future utilization.

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• Administration
  
  
  

  • Circular 125 allows two simplified FTC methods: (1) New fixed rate credit method; and (2) Exemption method.  Enterprises can apply to their in-charge tax bureaus to use these methods, if applicable.  However, there are harsh prerequisites which make them not as attractive as they appear.
     
  • It is not surprising that Circular 125 is made effective retrospectively from 1 January 2008, the same as the effective date of the CIT Law and its DIRs.  However, it causes uncertainty as to whether the Enterprises would be required to re-open the 2008 CIT filings to recalculate the FTC in accordance with Circular 125.

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• Uncertainty
  
  
  However, we note that Circular 125 still leaves some unanswered questions, uncertainties and unreasonable treatments which are important from a technical or practical perspective, such as:
   
  

  • Circular 125 has not provided clear guidelines in respect of the allocation of common expenses between foreign sourced income and China sourced income.
     
  • It does not clarify whether foreign income is allowable to set off against domestic losses.
     
  • Is there a possibility of expanding the creditable indirect foreign tax to more than 3 tiers of qualified foreign investee companies?
     
  • Is it necessary to gross-up the after-tax income in calculating FTC; and where is the "source" of dividend income under the "One country / region limitation" if the 3 tiers of qualified foreign investee companies are not in the same foreign jurisdiction?
     
  • Circular 125 has not addressed the applicability of FTC in respect of the China taxes arising from the corporate structures of some state owned enterprises who are listed overseas via so-called red-chip vehicle.
     
  • Will the enterprises be required to re-open the 2008 CIT filings and re-calculate the FTC in accordance with Circular 125? We are aware that recently some local-level tax bureaus, e.g. Shenzhen, have already required those enterprises who have claimed FTC in 2008 to re-assess their claims in accordance with Circular 125.
     
  • It is not uncommon to see a difference in the timing of recognition of income and payment of income tax liabilities in foreign tax regimes.  Circular 125 stipulates clearly the timing of recognition of foreign sourced income, but not on the foreign tax liabilities.  This would cause a mismatch of foreign sourced income and FTC.
     
  • How to revise the FTC calculation if there are adjustments in the foreign sourced income and foreign tax by the foreign tax jurisdictions after the relevant CIT return has been filed?
     
  • How does Circular 125 interact with the Controlled Foreign Corporation Rules in China?

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• Impact
  
  
  China's FTC mechanism is very important to Chinese enterprises which have invested or are planning to invest overseas, because:
   
  

  • It will help these Chinese enterprises resolve the double taxation problems.  Effectively, it is a "dollar to dollar" credit system.  With a good compliance on FTC, the after-tax returns on the foreign investments would be free of double taxation.
     
  • In view of the complexity of FTC mechanism, it commands the Chinese enterprises to have a good knowledge about the foreign tax legislations, systems, and practice of the overseas jurisdictions where they have investments; a good tax management system globally to capture and collect accurately and timely the relevant information and supporting documentation of the foreign taxes; and of course, full understanding of China's FTC mechanism.  Perhaps at the early stage, they may need to seek assistance from international tax consultants who have international tax knowledge as well as clear concept about FTC;
     
  • Chinese enterprises will need to observe the requirements of Circular 125 by the time of the 2009 CIT filing to be due in May 2010.  Some of them may even need to re-open the 2008 CIT filing as and when their local-level tax bureaus adopt such practice.  Time is running short;
     
  • Where the outbound investment structure comprises of more than 3-tier of foreign investee companies, the Chinese enterprises may need to consider restructuring to enable them to satisfy the prescribed requirement under Circular 125 so as to claim FTC on the foreign income tax paid by the foreign operating company;
     
  • Apart from tax implications, there could be accounting considerations arising from FTC, e.g. deferred tax, which are also very complicated technically.
     

  So it is highly advisable for these Chinese enterprises to pay attention to Circular 125 to ensure that the foreign taxes paid can be creditable and the foreign tax credit is calculated correctly, appropriately and timely.
    
  In summary, China's FTC mechanism is no doubt a new and complex mechanism.  Circular 125 is a "new chapter" of FTC mechanism which is significantly different than the simple and arbitrary "Fixed rate credit method" that Chinese companies generally adopted prior to 2008.  On the other hand, we wish to see more detailed administrative measures to be issued by the SAT at a later stage to clarify the uncertainties.  We will be closely monitoring the situation and will keep you updated of any significant development in this area accordingly.

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