The PRC Enterprise Income Tax Law (the “New EIT Law”) was promulgated by the National People’s Congress on March 16, 2007 and will come into effect January 1, 2008. The New EIT Law aims to unify the dual enterprise income tax system and will replace both of the PRC Income Tax Law for Foreign-funded Enterprise and Foreign Enterprise that is applicable to foreign invested enterprises (“FIEs”) and foreign enterprises and the PRC Interim Regulations on Enterprise Income Tax that is applicable to domestic enterprises (“DEs”), respectively.

The major changes of the New EIT Law compared with the currently effective EIT laws are as follows:

1. Definition and Scope of Taxpayer

The New EIT Law introduces the term “legal person” instead of the current criteria for DEs, “independent economic accounting” when defining the taxpayer. Therefore, in accordance with the New EIT Law, the enterprise income tax consolidated with those of business establishments without legal person status shall be paid collectively by their legal person entities. The scope of the taxpayer is the enterprises and other organizations that derive revenue. However, the New EIT Law is not applicable to the sole individual proprietorship enterprises and partnership enterprises.

The New EIT Law introduces the concepts of “resident enterprise” and “non-resident enterprise” in conformity with the international practice. A “resident enterprise”refers to an enterprise established in China under PRC law or an enterprise incorporated under foreign laws but maintains its actual management office in China. A “non-resident enterprise” refers to an enterprise incorporated under foreign laws and actual management office is located outside China but that has an entity or premises in China or which does not have an entity or premises in China but derives income from sources within China. A resident enterprise shall pay the enterprise income tax on worldwide incomes while a non-resident enterprise shall generally undertake a limited obligation of tax payment only on the incomes derived from sources within China.

2. Unified Tax Rate

The current enterprise income tax rate is 33% for DEs and FIEs but with exception in some special regions where FIEs may be levied at a preferential rate of 24% or 15% and exception for low-profit DEs at a special rate of 27% and 18%, respectively. Various kinds of exceptions broaden the gap between the nominal tax rate and the tax burden actually bore by the enterprises engaged in different industries. The New EIT Law has adopted a unified standard tax rate of 25% applicable to both DEs and FIEs and the tax rate of 20% for non-resident enterprises.

The unification of tax rate is expected to play a positive role in providing a fair competition environment for DEs and FIEs and may effectively control tax avoidance of the “fake foreign-funded enterprise” at the same time.

3. Preferential Tax Treatments and Transitional Measures

The new preferential tax regime that is mainly based on industrial preferences and location-based preferences as the supplement under the New EIT Law will replace the current location-based preferences. In addition, the New EIT Law no longer provides for a tax refund to foreign investors for the purpose of reinvestment in China.

The major preferential tax treatments under the New EIT Law are as follows:

（1） The tax rate applicable to an eligible small-scale low-profit enterprise is reduced to 20%;
（2） The preferential tax treatment currently enjoyed by the high-tech enterprises located in National High-tech Industrial Development Zones will be implemented nationwide, the tax rate applicable to the high-tech enterprises with priority support from the State is reduced to 15%;
（3） Venture capital enterprises that invest in the projects with priority support from the State and encouraged industries are able to obtain certain tax credits;
（4） The enterprise income tax on income derived from engaging in agriculture, forestry, husbandry or fishery projects, infrastructure projects with priority support from the State, environmental protection projects, energy or water conservation projects, and income from the qualified technical transfers is reduced or exempted;
（5） The income derived from engaging in utilizing resources extensively in the manufacture of products in compliance with the national industrial policy is able to be deducted for calculation of the taxable income; and
（6） The research and development expenses for the development of new technologies, new products and new techniques are able to be additionally deducted for calculation of the taxable income.

To ease the increased tax burden impacted by the New EIT Law, the existing enterprises established prior to March 16, 2007 which are enjoying the tax reduction and exemption treatment are subject to the following transitional measures: (1) For those enterprises that are eligible for a preferential tax rate of 15% and 24% or other kinds of reduced tax rate at present, their applicable tax rate will be gradually increased to 25% over the 5-year transitional period after the implementation of the New EIT Law; and (2) Enterprises currently enjoying a tax holiday may continue to enjoy the benefit of such tax holiday until the date of expiration of the respective tax holiday. However, if the tax holiday has not yet begun as of January 1, 2008 because the FIE has not yet had its first profit-making year, under the New EIT Law the tax holiday period will automatically begin on January 1, 2008. The cutoff date does not apply to high-tech enterprises newly established after March 16, 2007 in one of the five special zones or in the Shanghai Pudong New Area. These enterprises are still able to enjoy transition-period treatment. Relevant detailed measures for implementation of this transition are to be formulated by the State Council. In addition, the preferential tax treatment for the enterprises engaged in the encouraged industries in the Development of the Western Region is till retained in the New EIT Law.

4. Unified Deduction Policy

FIEs and DEs adopt different systems to deduct costs and expenditures from the income under the existing enterprise income tax system. For example, FIEs may deduct the expenses actually incurred in connection with salary while DEs are subject to certain limitations on such expenses. The New EIT Law unifies deduction policy and provides adequate compensation for the expenses actually incurred in connection with salary and lowers the tax basis for DEs. Furthermore, the New EIT Law provides a super deduction rate for charity donation up to 12% of pre-tax income compared with the current rate of 3%.

5. New Regulations for Anti-Tax Avoidance

Avoiding the income tax through transfer pricing between affiliated enterprises is a prevailing practice in the transnational economic activities. The New EIT Law introduces the arm’s-length principle as the key principle for preventing transfer pricing. Therefore, any related-party transaction not conducted on an arm’s-length basis could be subject to a transfer pricing review and adjustment by the tax authority. However, the New EIT Law does not provide penalty provisions on transfer pricing. The costs of an enterprise and its affiliates for jointly development, assignment of intangible assets, or jointly providing or accepting labor services shall, according to the arm’s-length principle, be allocated when calculating the taxable income.

In addition, the New EIT Law introduces the concept of “advance pricing” to allow the enterprises to negotiate with tax authorities the pricing principle and calculation methods for the related party transaction in advance.