China: China Further Clarifies Customs Duty And Value-Added Tax Exemptions For Foreign Investment Enterprises

In March of this year, China dealt a strong blow to the international investment community by abolishing certain tax holidays and exemptions. Since then, the General Administration of Customs ("GAC"), National Development and Reform Commission ("NDRC"), Ministry of Finance ("MOF"), and Ministry of Commerce ("MOFCOM") jointly issued a circular to clarify and broaden the scope of foreign investment enterprise ("FIE") qualifiers for import tax preferences. In this article, we will cover these changes and advise on their expected outcomes.

In 1979, when China opened its doors to foreign investment, it offered companies tax holidays and import tax preferences to encourage investment. In addition to a "two-year exemption and three-year half reduction" tax holiday,¹ the government exempted machinery and equipment purchases from customs duties and value-added taxes ("Exemptions"). Then in 1997, the government withdrew the Exemptions and restricted eligibility for the Exemptions to those FIEs established after April 1, 1996. In addition, the government restricted eligibility to FIEs in the following categories:²

• Business within either the Category of Encouraged Industries ("Encouraged Category") or Category B of the Restricted Industries in the Foreign Investment Industry Catalogue ("Category B");

• FIE foreign investor transfers technology to the FIE; and

• Imported equipment not within the List of Commodities Which Cannot Be Imported Free of Taxes for Foreign Investment Projects ("Commodity List for Domestic Investment").

For years, the above rules failed to meet the demands of the developing business climate and left open many questions concerning eligibility. Recently, however, GAC, NDRC, MOF and MOFCOM jointly clarified these questions in the Announcement Concerning Issues on the Customs' Implementation of the Application of Relevant Preferential Policies on Import Duties ("Announcement 35"). Announcement 35 was issued on July 13, 2007, and came into effect on July 20, 2007.

Reiteration of Exemptions for Normal FIEs

In China, a wholly foreign owned enterprise or a joint venture with foreign ownership of 25% or more is an FIE. An FIE whose business falls within the Encouraged Category or is covered by the industrial items identified in the Catalogue of Priority Industries for Foreign Investment in the Central-Western Region ("Priority Catalogue") is generally eligible for the Exemptions.

In addition, Announcement 35 grandfathered import tax preferences for certain FIEs: (1) pre-April 1, 2002 approved FIEs whose businesses falls within Category B, or (2) FIEs established prior to April 1, 1996. Those enterprises are eligible for the Exemptions, however, they must fulfill certain confirmation and approval procedures to qualify: (1) they must submit their project confirmation certificates and other required documents to Customs before December 31, 2007, and (2) they must complete the approval procedures for the Exemptions before December 31, 2010. Failure to file prior to the statutory deadlines will disqualify the entity from Exemption eligibility.

In the past, all foreign investment joint stock companies ("FIJSCs"), regardless of their capital sources, qualified for the Exemptions just like FIEs. Announcement 35, however, differentiates FIJSCs according to their origins. An FIJSC that was initially established with foreign investment qualifies for the same treatment as an FIE. But an FIJSC that was established by domestic funds is generally not eligible for the Exemptions ("ineligible FIJSC").

Despite this restriction, Announcement 35 provides opportunities for ineligible FIJSCs to qualify for the Exemptions. Although an ineligible FIJSC does not qualify an Exemption for the equipment it imported within the original investment, it can be exempt from customs duty and VAT if it uses new capital to purchase equipment.

Likewise, in the case of an FIJSC resulting from a domestic enterprise's issue of B Shares or overseas shares,³ projects invested by the original domestic enterprise are not eligible for the Exemptions. But projects invested by such FIJSC are nonetheless entitled to the Exemptions. The invested project, however, must be in the Encouraged Category or Priority Catalogue and the equipment imported for its own use and outside of the Commodity List for Domestic Investment. Because more and more Chinese companies are seeking money offshore, the Chinese government wants to encourage them to repatriate the proceeds raised internationally by all means.

Traditionally, an enterprise with foreign investment of less than 25% does not qualify as an FIE. Announcement 35, however, changes that. So long as the foreign investment project falls within the Encouraged Category or Priority Catalogue and is outside the Commodity List for Domestic Investment, the FIE, regardless of the proportion of foreign ownership, still qualifies for the Exemptions for imported equipment. The exception to this advantage is a listed FIJSC whose foreign ownership is less than 25% due to dilution pursuant to a split of share structure. Such FIJSC is not entitled to the Exemptions even if the foreign ownership will go back to 25% or more in the future.

An company invested by an FIE ("FIE's Investee") in China used to be disqualified from enjoying the preferential treatment applicable to FIEs, including the Exemptions. Like the relaxation of the rules pertaining to FIEs with foreign investment of less than 25%, Announcement 35 now permits an FIE's Investee to qualify for the Exemptions. If an existing FIE makes an investment to establish a new company or control a company in the Central-Western Region of China, the equipment it imports for its own use within the total investment is eligible for the Exemptions, so long as the foreign ownership is not less than 25% and the project is in the Encouraged Category or Priority Catalogue.

An FIE's Investee outside the Central-Western Region or in the Central-Western Region but whose foreign investment is less than 25% also qualifies for the Exemptions for equipment imported for it own use within the total investment, provided that the project falls within the Encouraged Category or Priority Industrial Catalogue and outside of the Commodity List for Domestic Investment.

Early this year, after the new corporate law canceled the tax holidays, foreign companies that wanted to develop their businesses in China seemed to have fewer advantages regarding their investments in China. The preferential policies identified in this article, however, might provide opportunities for foreign investors' strategies in China as well as additional options for continued investment in the region.

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