New Regulations on Withholding Income Tax for Overseas Investors in China
To promote the growth of foreign investment in China, the Ministry of Finance (MOF), State Administration of Taxation (SAT), National Development and Reform Commission (NDRC), and Ministry of Commerce (MOC) of the People’s Republic of China (PRC) jointly issued the “Notice on Policies concerning Temporarily Not Levying Withholding Tax on Distributed Profit used for Direct Investment by Overseas Investors” (Cai Shui  No.88) (Circular 88) on December 21, 2017. The issuance of Circular 88 is in compliance with the purpose of the “Notice of State Council on Several Measures for Promoting the Growth of Foreign Investment” (Guo Fa  No. 39). Under Circular 88, the profits that are obtained by overseas investors from resident enterprises in the PRC and are directly reinvested in encouraged investment projects will be entitled to the tax deferral policy and withholding tax will currently not be levied on those profits when certain conditions are met.
To coordinate with the enforcement of Circular 88, the SAT issued the “Announcement of the State Administration of Taxation on Issues Relating to Implementation of Temporary Waiver for Withholding Income Tax for Overseas Investors Using Distributed Profits for Direct Investments” (State Administration of Taxation Announcement  No. 3) (Announcement 3) on January 2, 2018, which contributes to the realization of such tax benefits.
1. Historical Continuity
The tax benefit prescribed by Circular 88 is not particularly innovative. In 1991, the “Income Tax Law for Enterprises with Foreign Investment and Foreign Enterprises [Repealed]”stipulated that where any overseas investor of a resident enterprise that reinvests its share of profit obtained from such enterprise directly into that enterprise by increasing its registered capital, or uses the profit as capital investment to establish other enterprises, and that the operation period thereof is not less than five years, should, upon approval by the tax authorities, be refunded 40 percent of the income tax already paid on the reinvested amount. However, the “Enterprise Income Tax Law” of 2008 repealed that tax benefit.
Recently, faced with tax competition from a variety of countries and regions, Circular 88 and Announcement 3 explicitly show that the Chinese government is moving to attract and retain overseas investors.
2. Key Notes of Circular 88
To be entitled to the deferred taxation of withholding income tax, overseas investors and the investment thereof should meet a string of conditions including (i) the form of direct investment, (ii) the profits are obtained from the resident enterprises, (iii) the profits are directly reinvested into encouraged projects and (iv) the profits must be transferred directly into the invested enterprises. Please note that the withholding income tax is deferred for the time being rather than being exempted.
The qualifying forms of direct investment include (i) increasing the paid-in capital or capital reserve of resident enterprises, (ii) investing in newly-established resident enterprises, (iii) acquiring the equity interests of resident enterprises from non-related parties and (iv) other forms prescribed by the MOF and SAT. This tax benefit is not available under Circular 88 where the overseas investors increase or acquire the shares of a listed company (except that constituting strategic investment) or acquire the equity interests of resident enterprises from related parties.
To enjoy the tax benefits, the profits obtained by the overseas investors should be directly reinvested into encouraged projects. Whether a project is encouraged or not depends on the list of encouraged industries contained in “Catalogue of Industries for Guiding Foreign Investment and Catalogue of Priority Industries for Foreign Investment in Central and Western China.”The invested enterprises should conduct specified business activities, including (i) manufacturing of products or provision of services, (ii) research and development activities, (iii) investment in construction projects or procurement of machinery equipment or (iv) other business activities. The invested enterprise conducting at least one of these activities would be considered eligible.
The overseas investors under Circular 88 only refer to overseas non-resident enterprises, excluding overseas natural persons.
Circular 88 applies to qualifying profits obtained by the overseas investors on and after January 1, 2017. For those overseas investors who are entitled to but have not received the benefit, they may apply for the tax refunds within three years after the actual payment of tax. Thus, it appears that overseas investors could receive these tax preferences for activities dating back to 2014. Applying tax refunds is usually a lengthy and painful process. It is to be seen how that retrospective application of Circular 88 would work in practice.
3.1 Tax Related
The chart below illustrates the procedures for overseas investors and profit distribution enterprises to apply for the tax benefits under Circular 88:
Where the overseas investors recover the investment (whether directly or through other methods, including equity transfer, buy-back or liquidation), the overseas investors should declare to the tax authority and make the tax payments within seven days after the withdrawal of the investment. Meanwhile, the overseas investors should submit materials related to the encouraged business activities that are conducted by the invested enterprise, such as financial accounting data.
3.2 Foreign Exchange Matters
Given that the profits must be transferred directly into invested enterprises, the overseas investors may go through the following foreign exchange formalities with the foreign exchange banks. The detailed information of the procedures is found in the “Operating Guidelines for Foreign Exchange Services under Direct Investment” promulgated by State Administration of Foreign Exchange (SAFE).
4. Questions and Answers
When profit distribution enterprises actually pay profits to the invested enterprises, what materials should be submitted for the foreign exchange banks to prove that the capital is the distributed profits obtained by the foreign investors?
In accordance with the “Authenticity Review” principle (Notice of the State Administration of Foreign Exchange on Further Promoting Trade and Investment Facilitation and Improving Authenticity Review” [Hui Fa (2016) No.7]), the profit distribution enterprises may submit a Board Resolution, financial statements and tax returns in relation to the profit distribution to prove the nature of the capital.
Which government departments have authority to evaluate whether the business operations conducted by the invested enterprises are encouraged projects?
The “Catalogue of Industries for Guiding Foreign Investment and Catalogue of Priority Industries for Foreign Investment in Central and Western China” are both promulgated by the NDRC and MOC. Thus, where the competent tax authorities have any doubt as to whether the business activities carried out by the invested enterprises constitute “encouraged projects,” they may request advice from municipal level tax authorities; the municipal level tax authorities may request further advice from the NDRC or MOC at the same level.
As exhibited in the chart above, the overseas investors should provide specific materials for the profit distribution enterprises for review, such as the “Information Report on Deferred Payment of Withholding Income Tax by Non-resident Enterprise.” Other than those materials, could the profit distribution enterprises ask for additional materials?
It is possible. Announcement 3 expressly requests that overseas investors provide the “Information Report on Deferred Payment of Withholding Income Tax by Non-resident Enterprise” (Report Form) for the review of the profit distribution enterprises (Article 3, Announcement 3). The blank “Attachments List” of the Report Form shows that, given the legal liabilities imposed on the profit distribution enterprises by Announcement 3, the profit distribution enterprises may request additional evidence beyond the evidence voluntarily provided by the overseas investors to prove the information’s authenticity.
When the overseas investors actually recover the investment, what procedures should be required to allow for the lower dividend tax rates under the tax treaties?
When the overseas investors actually recover their investment, they can still utilize tax treaty benefits pursuant to the relevant provisions. However, generally they only apply for the effective tax treaty benefits when the profits have been paid, rather than when the taxes have been paid, except as otherwise stipulated by the tax treaties. When making tax declarations, the overseas investors should submit the reports, statements, and materials prescribed by the “Administrative Measures on Entitlement of Non-residents to Treatment under Tax Treaties” (State Administration of Taxation Announcement  No. 60).
Assume that the overseas investors reinvested the profits obtained from the resident enterprise into the enterprise, and did not withhold tax at that time; subsequently, the overseas investors partially transferred shares of that enterprise. How will the equity transfer be treated?
According to Announcement 3, the reinvested amount will be the first amount to be recaptured through an equity transfer. Announcement 3 expressly provides that “where the investment held by an overseas investor in a Chinese resident enterprise includes part investment for which an overseas investor is entitled to temporary waiver and part investment for which an overseas investor is not entitled to temporary waiver, if the overseas investor disposes part of the investment, the overseas investor should be deemed as disposing the investment for which it has enjoyed temporary waiver.” Thus, the reinvested amounts would be prioritized for the equity transfer and the overseas investor should make the retrospective tax payment accordingly.
The promulgation of Circular 88 and Announcement 3 has illustrated the Chinese government’s emphasis on attracting foreign investment. Circular 88 mainly provides the substantive conditions for overseas investors to temporarily not withhold income tax. Announcement 3 mainly describes the applicable processes. Based on these new regulations, it may be advisable for overseas investors to review their plans related to their dividends and reinvestment, as well as to review recent dividends/reinvestments to determine whether they may retroactively take advantage of the policy.