BY Duan Tao (Daisy) Cao Linlin King & Wood Mallesons’ Commercial & Regulatory group
This article was firstly published by China Law and Practice, Q1 2018.
On December 21, 2017, the Ministry of Finance, the State Administration of Taxation (SAT), the National Development and Reform Commission and the Ministry of Commerce jointly issued tax circular Cai Shui [2017] No. 88, Circular on Policy Issues Concerning Provisionally Not Levying Withholding Income Tax on Direct Investments by Foreign Investors Made Using Distributed Profits (关于境外投资者以分配利润直接投资暂不征收预提所得税政策问题的通知, Circular 88), which provides a temporary waiver of enterprise income tax (EIT, usually at 10%, unless a preferential tax rate applies under a double tax treaty or arrangement) for non-tax-resident enterprises (i.e. overseas investors) that make direct investments in an encouraged industry with profits distributed by a tax-resident enterprise in the PRC (Tax Deferral), if certain conditions are met. Subsequently, on January 2, 2018, the SAT issued the SAT Announcement [2018] No.3, Announcement on Issues Relevant to the Implementation of the Policy of Provisionally Not Levying Withholding Income Tax on Direct Investments Made by Foreign Investors Using Distributed Profits (关于境外投资者以分配利润直接投资暂不征收预提所得税政策有关执行问题的公告, Announcement 3) in order to provide further guidance in this regard.Both Circular 88 and Announcement 3 have a retrospective effect from January 1, 2017, which means that the Tax Deferral applies to dividends or profit distributions derived by overseas investors from their equity investments in the PRC on and after January 1, 2017. 

1.Why did China release this Tax Deferral policy?
Capital plays an important and positive role in driving economic growth, industry upgrade and technology development. Therefore, a number of jurisdictions have introduced tax incentives or reformed their tax regime in order to attract more capital, including the recent US tax reform which took effect from December 22, 2017. In this tax reform, America lowered its corporate tax rates to make itself a more appealing destination for foreign capital and provides tax exemptions for qualified foreign sourced dividends to encourage repatriation of US capital, among other tax measures.In this global context, back on August 8, 2017, the State Council issued a Circular [2017] No. 39, Circular on Several Measures for the Promotion of the Growth of Foreign Investment (国务院关于促进外资增长若干措施的通知) introduced a comprehensive series of measures, aimed at promoting the growth of foreign investment, further actively utilise foreign capital and improve the quality of foreign investment. These new measures explicitly contain tax policies to temporarily exempt the withholding income tax on profit distributions derived by overseas investors from China and used to make direct investment in China in encouraged industries. The release of Circular 88 and Announcement 3 is for the purpose of providing guidance and implementation rules for such policy. 
2.Is this Tax Deferral something new?
Before January 1, 2008, i.e. the effective date of current Enterprise Income Tax Law of the PRC (EIT Law), the accumulative undistributed profits of a foreign invested enterprise (FIE) are exempt from EIT upon distribution to its overseas investors; however, since 2008, under the EIT Law, an overseas investor is subject to a 10% EIT in the PRC on the dividends distributed from the FIE, which is levied on a withholding basis, unless a preferential tax rate applies under an applicable double tax treaty or arrangement.The Tax Deferral provided by Circular 88 only temporarily defers the aforesaid EIT applicable as of 2008 upon the fulfillment of certain requirements, which is different from the tax exemption available for overseas investors with respect to dividends distributions from FIEs before 2008.
3.How to qualify for the Tax Deferral?
An overseas investor shall satisfy all the following requirements to enjoy the Tax Deferral:
4.What steps shall be followed in order to enjoy the Tax Deferral?
When an overseas investor satisfies all the above requirements, it shall provide materials to the profit distributing enterprise to demonstrate its entitlement to the Tax Deferral. Subsequently, if the profit-distributing enterprise takes the position that the overseas investor is eligible for the Tax Deferral after proper verification, it may not withhold EIT on the distributed profits and shall conduct filing formalities with its in-charge tax authority.To be specific, the steps below shall be followed for the application of the Tax Deferral:
It is also worth noting that, according to Announcement 3, the in-charge tax authority is empowered to require the overseas investor, the profit distributing enterprise, the invested enterprise, the equity transferor and any other relevant entities or individuals to provide, within a specified time limit, materials and information in connection with the overseas investor’s entitlement to the Tax Deferral. Without any explicit limitation being set out on such rule, technically speaking, the tax authority may require the relevant parties to provide information related to the Tax Deferral at any time.
5.Can an overseas investor claim the Tax Deferral treatment after actual payment of taxes?
Yes, with respect to profits distributed on and after January 1, 2017, given an overseas investor is entitled to but fails to enjoy the Tax Deferral, it may apply to claim the said entitlement retrospectively within a three-year period after actual payment of the relevant taxes and thus obtain a tax refund provided that the requirements mentioned above can be satisfied.For such purpose, the overseas investor itself shall submit certain required materials to the tax authority in charge of the profit distributing enterprise, including the Reporting Form, the relevant contract and payment vouchers, the materials in connection with conducting business activities within the scope of Encouraged Industries, etc.
6.Under what circumstances would the Tax Deferral be denied? And what is the potential liability?
Generally speaking, the overseas investor’s entitlement to the Tax Deferral would be denied under the following circumstances:

  1. The overseas investor enjoys the Tax Deferral without meeting all the stipulated requirements, due to its failure to report correct information or the profit distributing enterprise’s failure to verify the information that it provides.
  2. The overseas investor withdraws or disposes its investment in the PRC that enjoyed the Tax Deferral, unless such withdrawal or disposal is conducted by virtue of an internal restructuring and the invested enterprise enjoys the special tax treatment upon the restructuring.

In case the Tax Deferral is denied, the potential liabilities are summarized in the following table:

7.When the Tax Deferral is denied, is the overseas investor still entitled to the benefits of an applicable tax treaty or arrangement?
Yes, the overseas investor is entitled to the treaty benefit that is valid at the time when the profits were distributed, instead of the one valid at the time of tax settlement, unless the treaty stipulates otherwise. In this regard, the overseas investor shall submit the relevant reporting form and other required materials upon the settlement of the unpaid / underpaid taxes, in accordance with the SAT Announcement [2015] No.60, Measures for the Administration of the Eligibility of Non-tax-resident Taxpayers for Tax Agreement Benefits (非居民纳税人享受税收协定待遇管理办法).For instance, in case the overseas investor was subject to a 10% EIT on the dividends according to the tax treaty concluded between its residence state and the PRC when the dividends were distributed, but didn’t pay such tax due to the Tax Deferral treatment, it should pay the EIT at the rate of 10% once the Tax Deferral is denied subsequently, even if the 10% EIT has been reduced to 5% due to the treaty revision upon the time when it pays the tax.
8.Observation and Recommendation
The issuance of the rules in relation to the Tax Deferral is definitely a positive signal for overseas investors with investment in China, especially for the ones which have intention to expand their Chinese investment. Also, it shows the Chinese government’s resolution to attract more foreign capital flows and it is reasonably anticipated that more foreign capital will be retained in China for further investment. With all that said, overseas investors have become more mature when making investments in China and may have realized that while tax is an important factor, it’s not the decisive one affecting investment. As a consequence, overseas investors may also take into account other factors, such as labor costs and quality, exchange rate stability and infrastructure, before making a final decision to expand their investment into China.The application of the Tax Deferral also shows a clear inclination of the PRC government towards certain industries or sectors by limiting the qualified investment within the scope of Encouraged Industries. Based upon the current version of the Categories, the Encouraged Industries mainly focus on manufacturing sectors, especially the ones with high added value, for example, the production of new medicines with biotechnology, manufacturing and R&D of automotive electronic equipment, etc. Therefore, we believe that the Tax Deferral Treatment will steer more foreign capital to flow into certain industries or sectors with advanced technologies which will obviously produce significant stimulating effects on the Chinese economy.For those overseas investors that have decided to make further investment in China and thus enjoy the Tax Deferral treatment, they are suggested to proactively and comprehensively review their current business plan and investment strategies as a whole and make adjustment if necessary, so that the benefits of the Tax Deferral can be enjoyed to the largest extent and in a strictly compliant manner. For such purpose, local practice and detailed guidance for the filing procedures in relation to the Tax Deferral shall be closely observed.Meanwhile, given the relevant liability of the profit distributing enterprise cannot be waived after the change of its investor, in order to avoid any potential risk in this regard, it is suggested that both the transferor and the transferee conduct a thorough due diligence before transferring the shares in a FIE and take this into account when drafting and negotiating the share purchase agreement.