China Tax Reform and Updates Desmond Yeung Deloitte Touche Tohmatsu March 16, 2002 Hong Kong

1. China Tax Reform and UpdatesDesmond YeungDeloitte Touche TohmatsuMarch 16, 2002 Hong Kong

2. Foreign Direct Investment over past 20 years

3. China’s Utilization of Foreign CapitalUnit: US$Billion

4. Foreign Investment in Guangdong (Actually Used)US$Billion

5. WTO’s Potential Impact Internet services Banking Dramatic Moderate Negligible Chemicals Distribution Insurance Agriculture Autos Effect of WTO membership Securities Pharmaceuticals Energy Processed foods, consumer goods Telecom services Electrical equipment Low Medium High Current degree of protectionism

6. WTO’s Impact on China’s Taxation System • Tax rules and policies that are inconsistent with WTO requirements will be abolished • Tax rules and policies that constitute “supernational treatment” will be abolished • Changes made/proposed to address these issues • Unifying corporate laws • Revised WFOE and JV laws and new import duty rates • How current preferential incentives available to FIEs will be dealt with • How “supernational treatment issues” will be addressed • Implications for FIEs • Effects of the unification of the corporate tax laws • Implications of the revised WFOE and JV laws

7. WTO’s Impact on China’s Taxation System Tax rules and policies that are inconsistent with WTO requirements: • Dual-track system • Tax consolidation rules • Income tax and other tax concessions extended to FIEs, e.g. tax holidays • Income tax rate reductions for FIEs located in special zones • Preferential treatment policies offered to FIEs • Tax rate reduction for FIEs exporting more than 70% of their sales • Incentives for technologically advanced enterprises

8. WTO’s Impact on China’s Taxation System • Tax rules and policies that are inconsistent with WTO requirements: • Incentives for service-oriented enterprises • Tax refund for re-investment • Stricter requirements for FIEs than domestic enterprises in: • Incentives for the use of domestic raw materials • VAT and income tax incentives for purchasing domestically made equipment • Seeking bank loans • Business scope • Equity ratio • Applications for export licenses and quotas • Trade in services • Deductibility of management fees • Deductibility of entertainment expenses • Deductibility of fixed asset costs

9. WTO’s Impact on China’s Taxation System • Tax rules and policies that constitute “Supernational Treatment”: • Preferential tax treatment for foreign banks • FIEs exempt from surtaxes and surcharges • Tax treatment of dividends paid by FIEs • Limitation on salary deductions for domestic enterprises • Full deductibility of donations for FIEs

10. Changes/Proposed Changes to China’s Taxation System • Unification of corporate tax laws • Dual income tax system will be repealed • Implications: • Foreign and domestic enterprises will be subject to a uniform corporate income tax rate (reported to be 25%) • Level playing field • Repeal or amendment of many of the current tax rules, regulations and policies

11. Changes/Proposed Changes to China’s Taxation System • How will current preferential incentives offered to FIEs be dealt with? • Technically do not violate WTO principles • Likely to be repealed • Preferential incentives offered to FIEs in SEZs will be repealed • Re-organization of preferential policies • Tax policy to favor infant industries • Indirect concessions may be offered to FIEs in future • Incentives offered on industry basis

12. Opportunities Available to Foreign Investors • You need to “rethink” your company’s China strategy • Points to consider in light of the general and taxation implications of WTO: • Identify the current laws, regulations and practices in China relating to your industry that are currently inconsistent with China’s WTO obligations • Gain an understanding of the changes, if any, that China will be obligated to make • Assess the impact that these changes will have on your company • Identify any transitional and implementation issues that your company should be aware of • Develop and implement a specific action plan

13. Other Regulation UpdateNew Rules for FIEs in Free Trade Zone – Gongshangqizi [2001] No. 363 • An FIE in Free Trade Zone (“FTZ”) is allowed to set up liaison offices outside of the FTZ • The liaison offices are limited to the provision of liaison services for the FIE • Such offices cannot enjoy the tax preferential treatments which are applicable for the FIE • Such offices cannot open foreign exchange account

14. Other Regulation Update • New Laws for WFOE , EJV & CJV • Major Deletions to Comply with WTO Rules • Local content requirement • Foreign exchange balancing requirement • Technology transfer requirement • Export commitment • Filing of Production Plan

15. Other Regulation Update • New Rules China Holding Company • Expansion of Business Scope • Technology training for the domestic distributors and agencies / clients • Permitted to establish company limited by shares with foreign investment in a capacity as a overseas sponsor or to hold the non-listing, non-transferable legal person stock of the company limited by shares with foreign investment • Permitted to purchase and sell products manufactured by its invested enterprises within and outside China • Permitted to import and sell on a trial basis in a small quantity inside China • Pre-Condition • Registered capital has been fully injected

16. Other Regulation Update • Rules for Joint-venture Leasing Company • Conditions for financial leasing JV • Registered Capital: not less than USD 20 million • Foreign Party’s capital ratio: from 25% to 80% • Operation period: not more than 30 years • Management: 3 years or more industry experience • Conditions for operational leasing JV • Registered Capital: not less than USD 5 million • Foreign Party’s capital ratio: from 25% to 80% • Operation period: not more than 20 years • Management: 3 years or more industry experience

17. Other Regulation Update • Rules for WFOE/JV Venture Capital Firms • Establishment Requirements for Foreign Investors • At least one investor whose net assets reaches USD100m and its investment to this company reaches USD 20m • At least one investor whose total capital in previous 3 years reaches USD100m • Establishment Requirements for PRC Investors : • At least one investor whose net assets exceeds RMB 100m or the total capital in previous 3 years reaches RMB100m, and its investment to this company reaches USD5m • Business Scope: • Allowed to invest in hi-tech or encouraged area, management and Investment consulting, etc. • Not allowed to invest in area not open to foreign investor, stock, option, future bargain, intangible assets, or invest with loans, or provide loans, etc.

18. Other Regulation Update • FIEs Can Issue A Shares • Circular Waijingmaozizi [2001] No.39 • Only foreign owned holding company limited by shares is permitted to list in A Share market • Must Comply with foreign investment industry policy • Approve by Comply with requirement of procedure for setting up a foreign owned holding company limited by shares (approval of MOFTEC) • After the company is listed, the unlisted shares must be not lower than 25% of the total; and • Other conditions required for a listed company

19. New…Revised rule on the assessment of dutiable value of import and export goods – Customs Order [2001] No. 95 issued by Customs Customs duty • The dutiable value should be based on the transaction costs. However, the Customs still has the right to assess the dutiable value by certain methods • If the Customs queries on the transaction costs declared by the importer, written notice should be issued requesting the importer to provide additional documents to prove that the transaction costs are true and fair. The importer should response within 15 days

20. New…Reduction in customs duty rates – Circular Shushuifa [2001] No. 475 Customs duty • Effective from Jan 1, 2002, the customs duty rates for certain goods are reduced. The average customs duty rate fell from 15.3% to 12%

21. New…Further push on the adoption of “Exempt, Credit , Refund” Method -- Caishui [2002] No. 7, Guoshuifa [2002] No. 11 Export Refund • Effective from Jan 1, 2002, all the manufacturing enterprises should adopt “Exempt, Credit, Refund” in respect of export of self-produced goods • The FOB price stated in an export invoice is normally adopted to calculate the export refund • The amount of export sales is no longer required to exceed 50% of total sales for export refund purpose

22. New…Tax Incentives to Software and Integrated Circuits Industry (Guofa [2000] No.18 & Caishui [2000] No.25) • 3% VAT on software and 6% for integrated circuits enterprises • On a pay-first-refund-later basis • Refund is exempted from income tax • A five-year tax holiday starting from the first profit-making year • Full deductibility of salaries and training costs • 10% income tax rate for key software enterprises • Customs Duty and Import VAT Exemption on imported equipment and related technologies for own use • Accelerated depreciation period • Software: 2 years • Integrated circuits equipment: 3 years

23. New…Preferential Tax Policy to spur Western China Development - Guofa [2000] No. 33 • 15% income tax rate for foreign and domestic enterprises established in Western region within a set period • “2-years exemption, 3-years half reduction” for newly established transportation, infrastructure , post, broadcast & television enterprises • Import VAT & Custom Duty exemption for self-use within total investment amount • Effective from 2001 to 2010

24. New … • Export Refund for FIEs -- Caishuizi [1998] No.184 • Beginning January 1, 2001, “No Levy No Refund” policy would no longer apply to “Old FIEs” • Old FIEs is defined as enterprises established before December 31, 1993 • “NLNR” is replaced by “Pay First, Refund Later” or “exempt, credit and refund” • Software Exportation- Waijingmaojifa [2000] No. 680 • Software exports are entitled to a 100% VAT refund upon export

25. Discontinued… Caishui [2000] No. 99 • 15% incentive EIT rate for Listed Companies will be abolished from Jan 1, 2002 Caishui [2001] No. 74 • 5 year Business Tax incentive for foreign & foreign invested financial institutions registered in Economic Special Zone is abolished from May 1, 2001 Caishui [2000] No. 145 • Consumption Tax on fancy soap, meridian-treaded tires and re-capped or renewed tires is exempted from Jan 1, 2001

26. Reduced… Caishui [2000] No. 125 • Taxation for individuals’ income earned from residential leasing: • Business Tax – 3% • Individual Income Tax – 10% • Real Estate Tax – 4% Caishui [2001] No.21 • BT for finance and insurance industries will be reduced by 1 percent per year from 2001 to 2003, i.e. 7% in 2001

27. Clarified… Foreign Enterprise Income Tax FEIT treatment for the FIEs engaged in real estate development -- Guoshuifa [2001] No. 142 • EIT payable = Taxable income X Applicable tax rate – EIT paid previously on the sales of properties recognized in this period + EIT paid on the accounts in advance for this period • Taxable income = Sales recognized in this period – Costs and expenses matched with the sales

28. Clarified… Guoshuihan [2001] No. 954 • If a branch of FIE purchase home-made and self-use equipments under the name of the FIE, the FIE could apply for VAT refund according to Circular Guoshuifa [1999] No. 171 Guoshuihan [2002] No. 165 • No business tax is levied on the transfer of an enterprise as a whole, including total assets, debtors and liabilities as well as labors

29. Clarified…Detailed preferential tax policy to spur Western China Development - Caishui [2001] No. 202 • Income tax rate of 15% for the foreign and domestic enterprises established in Western region and engaged in encouraged industries, for the period from 2001 to 2010 • “2-years exemption, 3-years half reduction” for newly established transportation, infrastructure, post, broadcast & television enterprises: • Starting from the commencement date of operation for a domestic company • Starting from the first profit-making year for a FIE • Exemption of Import VAT and Customs Duty for self-use equipment within total investment amount for the domestic enterprises established in Western region and engaged in encouraged industries

30. Clarified… Value-added Tax Funding for Branch is Not Rebate - Guoshuihan 2001 No.247 Working capital received by the branches from the head office (such as salaries, telephone expenses, rental expenses, etc.) are not treated as income received related to the purchases from the head office. No input VAT should be reduced

31. Clarified… Enterprise Income Tax Guoshuihan [2000] No. 945 • Bad Debt due to bankruptcy of debtor arising from transaction between associated enterprisecan be deducted before tax upon the approval of tax authorities Caiqi [2001] No. 251 • Entertainment incurred by enterprise without operation income can be deducted with a ceiling of 2% of its total income (Advertising expense for some industries can be fully deducted before tax (Circular Guoshuifa [2001] No. 89)

32. Clarified… Enterprise Income Tax Interest receivable of financial enterprises (Guoshuifa [2001] No. 69) • Interests accrued within 180 days after the due date should be recognized as income • Interests overdue more than 180 days no need to be accrued • For the interest included in the taxable income, it can be reversed off when it is overdue more than 180 days; when the interest is finally paid, it should be included into taxable income

33. Clarified… Foreign Enterprise Income Tax Guoshuihan [2002] 4 For foreign investment financial institutions, interest income should be recognized on an accrual basis for FEIT purpose. Guoshuifa [2001] No. 69 is not applicable to foreign investment financial institutions

34. Clarified… Foreign Enterprise Income Tax Caishui [2000] No. 144 • Software Use Fee earned by foreign enterprise when transferring software together with telecommunication equipment should be subject to withholding tax as royalty Guoshuian [2001] No. 289 • Tax authority cannot grant tax incentives to the JVs which foreign injected capital is less than 25% requirement within time limits

35. Clarified… Foreign Enterprise Income Tax Circular Guoshuihan [2001] No. 405 • R&D Expense incurred in joint-development or outsourcing development can qualify for a 50% additional deduction Circular Guoshuifa [2001] No.86 • No reinvestment tax refund to the additional tax paid as a result of transfer pricing audit

36. Clarified… Business Tax Transfer of technology by foreign enterprises or individuals (Caishui [2001] No. 36) • Contract signed before 1993 - exempted • Contract signed after Jan 1, 1994 and income earned before Dec 31, 1997 – no adjustment no matter whether tax has been paid • Contract signed after Jan 1, 1994 and income earned after Jan 1, 1998 – taxable • Contract signed after Jan 1, 1994 and income earned after Oct 1, 1999 – technology-transfer income can be exempted, other royalty-transfer income is taxable

37. Clarified… Individual Income Tax Traveling Allowance (Guoshuihan [2001] No.336) • Home leave benefits received by expatriates is exempted from IIT only if it is for trips between China and the location of their family (spouse or parents) with a maximum of two trips per year Severance Pay (Guoshuifa [2001] No.157) • Severance pay up to 3 times of local annual average salary of last year is exempted from IIT

38. Clarified… Deed Tax Deed Tax Exemption for Reorganization (Circular Caishui [2001] No. 161) Deed Tax is exempted for the following 4 circumstances: 1. Merger 2. Spur off or split off 3. Transfer of equity while the ownership of the real estate / building is not transferred together 4. Creditor receives real estate in bankruptcy proceeding

39. Specials…New Tax Administration & Collection Law • Enterprise tax payer is required to report its bank account number to tax bureau; (Article 17) • Late payment interest rate is reduced from 0.2%/day to 0.05%/day; (Article 32) • Statute of limitation for non reporting is reduced from 10 years to 5 years; (Article 52) • Effective from May 1, 2001

40. Specials… New Rules for FEIT Final Settlement • Extensive disclosures requirements • 14 statements and schedules • Transfer pricing information • Cost and expense analysis • Details of expenses and income • Etc. • Supporting documents for tax preferentialtreatments and incentives • Supporting documents for claming deductions: • Bad debt, losses, etc. • Changes of accounting methods • Other items

41. Local Updates (Beijing, Shanghai)

42. Beijing UpdateVAT incentive for Software & IC industries (Jingguoshui [2000] No. 187) • 3% effective tax rate for all software sales • Exceptions: Fee for training services , maintenance, and other service fees received when selling software products should be subject to 17% VAT

43. Beijing Update Choice of tax incentive policy -Jingdishuiqi [2001] No. 386 • Software production enterprises registered within Zhongguancun can choose to adopt tax incentive policy for software & IC industries ( i.e. 2 +3 from the first profit-making year) or for new technology enterprises (i.e. 3+3 from the commencement of business) • The election is irrevocable

44. Beijing Update Incentive Pay for Senior Talent of software Enterprise inBeijing (Jingkezhengfa [2001] No. 165) • Up to 80% of the individual income tax paid on salary for the preceding year by senior management and technicians will be awarded for initial purchase of residential properties, motor vehicles and for the capital injection for the investment in new high-tech enterprises in Beijing

45. Shanghai UpdateIncentives for Hi-tech Industry in Shanghai (Hucaifa [2001] No.1) • High Tech Enterprises: • 3 years of full financial support and following 2 years 50% financial support for the local contributions of Business Tax (“BT”), EIT and VAT • 90% to hi-tech enterprises and 10% as hi-tech fund • For foreign Invested Enterprises (“FIEs”) who invest in hi-tech industry, establish R&D centers and transfer hi-tech: • 5 years of full financial support and 3 years 50% financial support for the local contributions of Business Tax (“BT”), EIT and VAT • 90% to hi-tech enterprises and 10% as hi-tech fund • For technology transferred by FIEs and R&D centers • Exemption of BT

46. Shanghai UpdateIncentive for Software and Integrated Circuits Industry in Shanghai (Hucaifa [2001] No.3) • For software enterprises • Financial support for the EIT previously paid in reinvestment amount • For software enterprises located in Pudong Software Park, Shanghai Software Park, State Information Security Base and Shanghai Integrated Circuits Base • Financial support for the local contributions of EIT exceeding the rate of 10% • For integrated circuits technology transferred by foreign enterprises to enterprises located in Shanghai • Exemption of withholding tax

47. Shanghai Update“Tenth Five-Year” Financial Support in Shanghai Pudong New Area Guideline Industries Covered Financial support for targeted sectors Trading In Pudong New Area Agricultural Tourism Technology&development Real estate developers Financial support for the development Exporters of Waigaoqiao Free Trade Zone Basic service providers Real estate developers Financial support for the development Warehousing of hi-tech industry in Zhangjiang Hi-tech Processing Park Equipment rental

48. Shanghai Update“Tenth Five-Year” Financial Support in Shanghai Pudong New Area Ratio and base in “Tenth Five-Year”Ratio and base in “Ninth Five-Year Base Percentage(%) Base Percentage(%) Added value 4 VAT 23.5 3 17.6 2 11.8 Revenue 5 BT 100 2.5 50 Profit 14 EIT 93.3 10 66.7 7 46.7 5 33.3