Prior to 2008, foreign investors were generally exempt from withholding income tax on dividend income derived from their investment in China under the prior PRC Enterprise Income Tax Law for Foreign Invested Enterprises and Foreign Enterprises (the Prior Foreign EIT Law). From 2008 onwards, the new PRC Enterprise Income Tax Law cancelled this preferential treatment and generally subjects foreign investors to 10 percent withholding income tax on their dividend income.
In mid-2017, China's premier Li Keqiang announced during the State Council's executive meeting that China will roll out a series of new policies and incentives to further boost foreign investments. Among these is the nationwide application of the Advanced Technology Service Enterprise (ATSE) incentive (see our alert on ATSE here) and the grant of withholding tax deferral for dividend income received by foreign investors, if such dividend income is reinvested in certain encouraged industries and certain conditions are met.
Circular 88 details key guidance
Subsequent to the State Council's executive meeting, a number of implementation rules have been issued by the government departments. On December 21, 2017, the Ministry of Finance (MOF), the State Administration of Taxation (SAT), the National Development and Reform Committee (NDRC) and the Ministry of Commerce (MOFCOM) jointly issued a new circular (Caishui  No. 88, or Circular 88), formally setting out detailed guidance on the withholding tax deferral incentive for foreign investors, which applies to qualified reinvestment occurring after January 1, 2017.
In general, after January 1, 2017, if foreign investors directly reinvest their profits distributed by China resident enterprises to some Encouraged Industries and meet certain prescribed conditions, then the 10 percent withholding income tax on the distributed profits may be deferred until the foreign investors' disposal of such reinvestment in China.
Profit distributed by China-resident enterprises
Profit distributed by China-resident enterprises generally refer to equity investment return, mainly dividends and corporate bonuses that have been declared and distributed to the foreign investors by a China-resident enterprise based on their retained earnings on book.
Qualified direct reinvestments
Foreign investors are required to "directly reinvest" their dividend income in order to qualify for the deferral treatment. Qualified direct reinvestments include:
- increase in or conversion to paid-in-capital or capital reserve of domestic resident enterprises
- set-up of new residential enterprises in China
- acquisition of equity in Chinese domestic resident enterprises from unrelated parties and
- investment in other ways stipulated by the MOF and SAT.
Investment in newly issued or converted shares of listed enterprises or acquisition of publicly listed enterprises' shares, however, would not be treated as qualified direct reinvestment, unless such investment is "strategic investment" as defined in the Administrative Measures for Strategic Investment by Foreign Investors in Listed Companies.
Form of reinvestment contribution
Where cash dividends are directly reinvested by the foreign investors, such cash dividends should be directly transferred from the account of the Chinese enterprise distributing the dividend to the account of the investee Chinese enterprise or to the account of the equity transferor. Such cash dividends shall not be routed through any other bank accounts before the intended direct reinvestment.
Where the dividends to be reinvested are in-kind contributions, such as tangible assets and securities, the ownership of such in-kind contributions should be directly transferred from the Chinese enterprise distributing the dividend to the investee Chinese enterprise or the equity transferor. The ownership of the in-kind shall not be held on behalf by or temporarily passed on to another enterprise or individual before the intended direct reinvestment.
The Encouraged Industries
"Encouraged Industries" are industries listed as encouraged for foreign investment under the Catalogue for the Guidance of Foreign Investment Industries and the Catalogue of Priority Industries for Foreign Investment in the Central-Western Region. Each of these catalogues was updated in 2017.
Tax records and follow-up inspection
To secure the deferral treatment for qualified direct reinvestment, foreign investors are required to provide supporting documents and information to the profit distributing enterprise. The profit distributing enterprise shall undertake to properly review the supporting documents and file corresponding records with the relevant tax authority. On this basis, the profit distributing enterprise may release profits without withholding income tax. On the other hand, if somehow a withholding tax has been imposed on a foreign investor who should enjoy tax deferral treatment for a qualified direct reinvestment, a retroactive application for a refund may be filed within three years after payment of the withholding income taxes.
The relevant tax authorities will conduct follow-up inspection on any tax deferral enjoyed by foreign investors. When, following an inspection, a direct reinvestment is identified as not qualified, the tax authority may demand payment of the withholding income tax, together with late payment interest, from the foreign investor, unless the tax deferral enjoyed is a mistake attributable to the profit-distributing enterprise.
Tax payment upon disposal of reinvestment
If a foreign investor disposes its direct reinvestment that has enjoyed the withholding income tax deferral, either through equity transfer, share repurchase, liquidation or other means, the deferred withholding income tax shall be paid within seven days after the foreign investor's receipt of income from the disposal.
As an exception, if the disposal of the reinvestment is part of a restructuring transaction that qualifies for special tax deferral treatment available for corporate restructuring, then the foreign investor may continue to enjoy the tax deferral treatment.
Promoting multinationals' foreign investment in key areas
The issuance of Circular 88 represents the Chinese government's strong fiscal support to encourage and promote foreign investment in the encouraged industries and Central-Western China by creating a more convenient and competitive tax environment for foreign investors. Although this dividend withholding tax deferral incentive does not match the preferential treatment under the Prior Foreign EIT Law, it is nonetheless a great tax planning opportunity for multinational companies that would like to further invest and expand their business operation in China.
This incentive may also be viewed as an effort by the central government to retain tax revenue within China. In light of the recent US tax reform, which aims to attract multinational corporations and foreign capital to invest in the US economy, the reintroduction of the dividend income tax deferral incentive to encourage reinvestment within China will more or less help maintain China's economic growth and reduce capital outflow.
That said, Circular 88 has yet to clarify all the details and answer some practical questions on tax deferral treatment. For example:
- Does the tax deferral treatment apply to dividends declared after January 1, 2017, but based on retained earnings generated by the profit distributing enterprise before January 1, 2017?
- What is the liability of the profit-distributing enterprise, if the relevant tax authority finds a direct reinvestment does not qualify for tax deferral treatment?
- Shall the deferred tax still be paid if the disposal of the reinvestment turns out to be a loss to the foreign investor; if the deferred tax shall still be paid, will the withholding income tax be paid based on the original profit distributed or on the income resulting from disposal of the reinvestment?
- If a foreign investor also invests in an investee enterprise that does not enjoy a tax deferral under Circular 88, how will it be determined which portion of reinvestment being disposed is the portion entitled to the tax deferral?
- Upon disposal of the reinvestment, how does the reversal of the withholding tax exemption fit with an applicable tax treaty?
As far as we see, in spite of the ambiguity in the above details, foreign investors with future reinvestment plan in China should proactively review their plan again based on this tax planning opportunity under Circular 88. When it is appropriate, they should consider communicating with the relevant tax authorities to seek better certainty regarding the preferential treatment.
10 percent is the standard domestic withholding income tax rate on dividend income of foreign investors, but lower rates may be provided under applicable China tax treaties.