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This article provides an overview of how China taxes banks and their banking operations in China. This topic is increasingly important in China today, given the opening up of the banking sector to investment by foreign banks. While China has special tax rules that apply only to foreign funded financial institutions, the majority of bank taxation rules in China apply to all banks, whether foreign or Chinese invested. This is in contrast to the taxation of foreign investment in other sectors, where tax legislation is more developed and robust.
Regardless of industry, the dichotomy in enterprise income tax treatment between foreign investors and their Chinese counterparts will soon end. Along with China¡¯s World Trade Organization (¡°WTO¡±) commitments to open up the banking sector, China has also pledged to end the discriminatory enterprise income tax treatment between foreign and Chinese invested enterprises across all sectors. China promulgated a new tax law that unifies these two tax regimes in March. This new unified tax regime changes many aspect of how foreign enterprises and foreign invested enterprises are taxed, and as such, this article will highlight areas that are affected by the new law.
I. INTRODUCTION
Foreign banks seeking access to the Chinese banking sector are faced with two principal strategies: organic growth or strategic equity investments in Chinese banks. With respect to organic growth, 2006 marked a milestone for foreign banks with the release of the People¡¯s Republic of China, Regulations on the Administration of Foreign Funded Banks on November 11, 2006 (the ¡°Foreign Bank Regulations¡±). China issued the Foreign Bank Regulations to take effect on December 11, 2006, which is the fifth anniversary of China¡¯s accession to the WTO and also the deadline for China to open up its banking sector to foreign banks pursuant to its WTO obligations.
The Foreign Bank Regulations require, among others, that a foreign bank establish a locally incorporated bank, either wholly foreign owned or a Sino-foreign joint venture, before it can engage in the long sought-after retail Renminbi (¡°RMB¡±) business with Chinese individual customers. Foreign banks can also operate in branch form, although the permitted business scope of foreign bank branches is limited and do not include the ability to conduct RMB business with Chinese individual customers. For foreign banks that are currently operating in China in branch form, they will be required to incorporate their branches before they can engage in the full scope of RMB banking activities with Chinese customers. Bank branch incorporation creates a number of China tax issues that need to be resolved, as more fully discussed later in this article.
The minimum investments required to establish a locally incorporated bank, as well as branches of the bank, can be significant. The Foreign Bank Regulations require that the minimum registered capital of a wholly foreign-funded bank or a Sino-foreign joint venture bank be RMB 1 billion. Moreover, each branch must have a working capital injection of no less than RMB 100 million. In addition, the total amount of working capital allocated from a wholly foreign-funded bank or a Sino-foreign joint venture bank to all its branches cannot be more than 60% of the head office¡¯s aggregate capital.
Alternatively, foreign banks can seek to acquire strategic minority stakes in large Chinese banks to gain exposure to the Chinese banking sector. The China Banking Regulatory Commission (¡°CBRC¡±) issued the Administrative Measures on Equity Investment by Foreign Financial Institutions in Domestic-funded Financial Institutions on December 8, 2003 (the ¡°Investment Measures¡±) to regulate foreign investment in Chinese banks. The CBRC oversees the enforcement of China¡¯s banking regulations, which was previously assumed by China¡¯s central bank, the People¡¯s Bank of China.
Under the Investment Measures, foreign banks are allowed to invest in Chinese commercial banks, urban credit unions, rural credit unions, trust and investment corporations, enterprise group financial companies, financial lease companies and other Chinese financial institutions established with the approval of the CBRC provided they meet prescribed conditions. Foreign banks must, among others, have total assets of no less than US$10 billion at the end of the year prior to the year of application in most circumstances and have a capital adequacy ratio of not less than 8%, in the case of commercial banks.
The Investment Measures limit a single foreign bank to purchase up to 20% of the shares of a Chinese financial institution. A non-listed Chinese financial institution converts to a foreign funded financial institution (¡°FFI¡±) if the total foreign equity investment in the bank reaches or exceeds 25%. Listed Chinese financial institutions, on the other hand, will remain classified as a domestic financial institution (¡°DFI¡±) regardless of the percentage of foreign equity holding (whether 25% or even higher). The classification of a bank as an FFI or DFI has important China tax implications as discussed in this article.
II. CHINA BANK TAXATION RULES
A. Enterprise Income Tax and Business Tax
Banks in China are subject to the Chinese Enterprise Income Tax (¡°EIT¡±) and the Business Tax.
EIT is a tax on net income. The prevailing basic tax statutes governing the EIT liability of FFIs are the Income Tax Law of the People¡¯s Republic of China Concerning Foreign Investment Enterprises and Foreign Enterprises (¡°FEITL¡±) and its implementing rules (¡°FEITR¡±), both effective as of July 1, 1991. Beginning from January 1, 2008, the FEITL and FEITR will be replaced by a new tax law ¡°Enterprise Income Tax Law of the People¡¯s Republic of China (¡°EITL¡±)¡± and its implementing rules. The implementing rules are expected to be promulgated later this year. Foreign bank branches are subject to EIT at a rate of 25% (the prevailing tax rate under FEITL is a combined national and local tax rate of 33%) with respect to their business income derived from within China and those derived from outside China having actual relationship with foreign bank branches.[1] Incorporated FFIs are similarly taxed but their taxable base consists of income from all sources.[2] However, incorporated FFIs as well as foreign bank branches, enjoy preferential tax treatment with respect to profits from foreign currency transactions. DFIs do not generally enjoy such preferential tax treatment. When the EITL and its implementing rules take effect, such differential treatment might be eliminated, although detailed rules regarding this have not yet been issued.
Business Tax is a tax on turnover derived from specified activities conducted within China, including financial services. China¡¯s Business Tax laws, which apply equally to FFIs and DFIs, are embodied in two basic statutes: Provisional Rules of the People''s Republic of China on Business Tax (¡°BTL¡±), effective as of January 1, 1994, and the implementing rules thereunder (¡°BTR¡±), effective as of January 1, 1994. Business Tax is calculated from a simple formula based on a bank¡¯s turnover times the applicable Business Tax rate, which is currently 5% for financial institutions. In general, turnover consists of a bank¡¯s total consideration and all other charges. However, with respect to certain financial transactions, special rules can apply in determining the amount of turnover subject to Business Tax.
B. Preferential Tax Treatment for Foreign Currency Transactions
China currently grants preferential EIT treatment with respect to revenue derived by an FFI from foreign currency transactions. This special treatment is not available to DFIs.
With respect to EIT, Article 75(5) of the FEITR grants incorporated FFIs and foreign bank branches a one year tax holiday beginning from their first profit-making tax year and a 50% reduction in the prevailing EIT rate during the second and third years provided the following conditions are met:
¡¤ The FFI has a term of operation of 10 years or more,
¡¤ The FFI is established in a Special Economic Zone or in other zones approved by the State Council, and
¡¤ The FFI¡¯s invested capital, or working capital in the case of a branch, exceeds US$10 million.
If the above requirements are met, an FFI also enjoys a reduction in the normal EIT rate from 33% to 15%.[3] The State Administration of Taxation (¡°SAT¡±) clarified in a 1995 circular that the location requirement in ii. above is met as long as the FFI is established in a location in which the State Council permits an FFI to be established. Because FFIs can only be established in locations permitted by the State Council, practically speaking, all FFIs will meet this location requirement. Under the new EITL, preferential treatment for FFIs including tax holidays and reduced rates is eliminated; however, a grandfather period for up to five years is granted to existing FFIs, which will generally be allowed to continue to enjoy their existing tax incentives.
Pursuant to Caishuizi (1997) No. 52 (¡°Circular 52¡±), the above preferential tax treatment does not apply to profits derived by FFIs from RMBtransactions. Circular 52 requires FFIs conducting both foreign currency and RMB business operations to separate account management, accounting, and tax management for its foreign currency and RMB business operations. Profits attributable to RMB transactions are taxed at the normal EIT rate of 33%.
As mentioned earlier, the forthcoming tax reform will scale back a broad range of tax incentives for foreign investors and treat FFIs and DFIs equally. Because the implementation rules to the new tax law have not been issued yet, it is unclear at this time whether the foreign currency transactions of FFIs will continue to enjoy this preferential tax treatment.
C. Tax Compliance Rules
FFIs and DFIs must file monthly or quarterly provisional returns and annual returns to report and pay EIT.
Monthly or quarterly provisional filings and tax payments are due within 15 days from the end of each month or quarter (i.e., by April 15th, July 15th, October 15th and January 15th). Monthly or quarterly payments are calculated based on the actual profits during the period, or 1/4 or 1/12 of annual taxed profit of last year.
Annual returns must be filed within five months from the end of the tax year. Annual taxable income and liability are reported and determined on the annual return. The monthly or quarterly provisional payments are credited against the calculated annual tax liability. Refunds are payable if the amount of the provisional tax payments exceed the calculated annual tax liability. If there is tax due, it must be paid within five months of the tax year-end.
Banks, finance companies, trust and investment companies must file Business Tax returns on a quarterly basis, while other types of financial institutions file Business Tax returns on a monthly basis.[4] Business Tax returns and payments are due within 10 days from the end of each quarter or month.[5]
III. TAXATION OF INTEREST INCOME
A. General Rules
A bank¡¯s interest income is subject to EIT and Business Tax. Chinese tax laws do not offer a technical definition of interest and a payment is generally considered as interest if it is derived as such from traditional financial instruments such as deposits, loans, bonds, and other advances.[6]
B. Characterization of Debt
Chinese tax laws do not contain rules regarding how hybrid debt instruments that have the characteristics of debt and equity should be characterized for Chinese tax purposes. In practice, the Chinese tax authorities can be expected to be influenced by a number of factors in determining the character of hybrid debt for Chinese tax purposes.
First, the legal characterization of an instrument is important. For instance, in the case of debt financing from a foreign source, the registration of such instrument with the State Administration of Foreign Exchange as foreign debt would be a persuasive factor in favour of debt treatment.
Another factor influencing debt versus equity characterization is compliance with minimum registered capital requirements. Although Chinese tax laws do not currently contain thin capitalization rules, commercial regulations governing foreign invested enterprises impose minimum registered capital requirements that effectively cap the amount of debt (whether from related or unrelated parties) the enterprise can carry.[7] In contrast, Chinese invested enterprises are not subject to such regulatory debt-equity limitations. However, Guoshuifa (2000) No. 84 limits a domestic invested enterprise from deducting the portion of interest paid on loans from related parties that exceed 50% of the enterprise¡¯s registered capital. The implementation rules to the EITL is reported to contain thin capitalization rules, although, if it does, interesting issues arise as to how those rules would work together with the regulatory minimum registered capital requirements for foreign invested enterprises. The general minimum registered capital ratios for foreign invested enterprises are set forth below, although some differences apply in certain cases such as for foreign invested real estate enterprises:
|
Total Investment
(Registered Capital + Debt) |
Percentage of Registered Capital to
Total Investment |
|
Less than or equal to US$3 million |
At least 70% of the total investment must be registered capital |
|
More than US$3 million and less than or equal to US$10 million |
At least 50% of the total investment must be registered capital
(Minimum US$2.1 million registered capital if total investment is less than US$4.2 million) |
|
More than US$10 million and less than or equal to US$30 million |
At least 40% of the total investment must be registered capital
(Minimum US$5 million registered capital if total investment is less than US$12.5 million) |
|
More than US$30 million |
At least 33.33% of the total investment must be registered capital
(Minimum US$12 million registered capital if total investment is less than US$36 million) |
Accordingly, if a purported debt instrument causes a foreign invested enterprise to exceed the above debt-equity ratios, the Chinese tax authorities may deny a deduction for the portion of interest that is attributable to the excess debt.
The Chinese tax authorities may also deny a deduction for interest paid under a purported debt instrument if the interest is considered to exceed arm¡¯s length standards. Chinese tax laws limit the amount of interest that can be deducted on a loan between related parties to normal commercial lending rates (that is, the interest rate that a commercial bank in China would charge on a similar loan). Accordingly, to the extent that interest paid under a hybrid debt instrument is not considered arm¡¯s length, a deduction for the non-arm¡¯s length portion of the interest may be denied.
C. Interest Income from Re-Lending Transactions
Special rules apply in determining the amount of interest income subject to Business Tax in re-lending transactions involving the lending of borrowed funds (normally from offshore parties) to third party customers in China. For qualified re-lending transactions (defined below), a bank¡¯s interest income is offset by the interest paid on the corresponding borrowing.[8] Guoshuifa (2000) No. 135 (¡°Circular 135¡±) limits this special treatment to foreign currency re-lending. The re-lending of funds in RMB is treated as general lending so no deduction is allowed for interest paid on the funds borrowed.
Article 20 of the Business Tax Regulations defines a qualified re-lending transaction as the business of lending borrowed funds to another party for use where the source of the borrowed funds does not include deposits received from units or individuals or from the lender¡¯s own operative capital. If the funds re-lent come from either of these two sources, then the loan is treated as general lending where Business Tax is levied on the total amount of interest received, without any deduction for interest paid on borrowings. For FFIs, Circular 135 automatically disqualifies a loan as re-lending under the following circumstances: (i) where the FFI funds the loan with amounts borrowed from an offshore affiliate with which it deposits its operative capital, and (ii) the amount borrowed from the offshore affiliate equals the amount of the FFI¡¯s operative capital deposited with such affiliate.
Moreover, Guoshuihanfa (1994) No. 607 requires FFIs to segregate clearly qualified re-lending transactions from non-qualified re-lending transactions; otherwise Business Tax will be levied on the aggregate lending amount and a deduction for the interest on the inbound borrowing will be denied.
D. Tax Exempt Interest Income
Caishuizi (1995) 79 currently exempts Business Tax on interest income derived from loans made to other financial institutions. However, such loans are still subject to EIT.
IV. TAXATION OF FEE AND OTHER INCOME
Besides interest, banks can also earn service fee income as well as other types of income such as guarantee fees, prepayment fees, credit card fees, mortgage servicing fees, commitment fees, termination fees, penalties as well as other fees. In general, these items constitute taxable income of the bank and are generally subject to EIT at 25% (the prevailing rate under the FEITL is a combined national and local tax rate of 33%) and Business Tax at 5%.
Preferential Business Tax treatment is available to FFIs established in Special Economic Zones (including the Pudong New Area in Shanghai) with respect to service fees derived from enterprises and individuals resident therein within five years of an FFI¡¯s incorporation date. Income from such qualified persons must be clearly segregated in order to be entitled to the Business Tax exemption. The changes to preferential EIT treatment under the EITL is not expected to affect Business Tax preferences.
V. NON-PERFORMING LOAN TAXATION ISSUES
A. Treatment of Delinquent Loans
As a general rule, FFIs and DFIs must report interest income for EIT purposes in accordance with the accrual principle. For DFIs, however, interest no longer needs to be accrued and taxed if the borrower is delinquent in making interest payments for a prescribed period of time. Under Guoshuihan (2002) No. 960, in the event a loan is delinquent for more than 90 days, a DFI can discontinue accruing interest on such loan. However, if the delinquent interest is repaid in the future, the interest repayment is recaptured as taxable income during the period of recovery. Whether such treatment is still available or applicable to FFIs after the EITL and implementing rules take effect remains uncertain.
B. Bad Debt Deductions
FFIs engaged in credit, leasing or other such undertakings are permitted to deduct a certain percentage of bad debt per year. The annual allocation to bad debt reserves cannot exceed 3% of an FFI¡¯s year-end balance of loan receivables (not including inter-bank loans) or accounts receivable, notes receivable and other receivables. The amount allocated can be deducted from taxable income for that year. However, Guoshuifa (1997) No. 123 (¡°Circular 123¡±) clarifies that an FFI cannot claim such a bad debt reserve deduction with respect to loans secured by properties. DFIs are also allowed to deduct an allocation to a bad debt reserves but only up to 1% of its year-end asset balance on which bad debt reserves is made.
If the amount of debt that is considered ¡°uncollectible¡± exceeds a bank¡¯s bad debt reserves, the balance can generally be booked as a loss. In the case of FFIs, for instance, bad debt is considered ¡°uncollectible¡± in the following cases:
¡¤ The debtor is bankrupt and the debt due is uncollectible even after the debtor¡¯s liquidation;
¡¤ The debtor has died and the debtor¡¯s estate is insufficient to repay the debt in full; and
¡¤ The debt is delinquent for over two years and remains uncollectible.
If the debt is collected in a later period, the recovered loss shall be recaptured in the year of recovery.
The EITL does not disallow the deduction of bad debt actually incurred. However, it disallows a deduction for any un-assessed reserves. Detailed rules regarding the deducibility of expenses are expected to be contained in the forthcoming implementation rules to the EITL.
VI. TAX TREATMENT OF BANK BUSINESS EXPENSES
A. General Rules
FFIs are generally permitted to deduct all expenses that are related to their business operations to the extent such expenses are not specifically disallowed. In contrast, DFIs are subject to caps on the deductibility of a number of expenses, including salary expenses, donations, and entertainment, advertising and promotional expenses. The EITL unifies the expense deduction rules for FFIs and DFIs. It is expected that the new tax law and its implementation rules will retain deduction caps for certain expenses, such as advertising expense, but will lift caps on other expenses, such as salary expense.
Certain expenses cannot be deducted, including expenses that are not business related, capital expenses (which must be depreciated/amortized over time), income taxes, and fines. The FEITR also prohibits the deduction of management fees paid to related companies.[9] However, Chinese tax laws generally permit a deduction for payment of administrative expenses allocated from the head office, although special rules apply with respect to the allocation and deduction of head office administrative expenses to foreign bank branches which are explained below. The EITL does not contain any prohibitions on the deduction of management fees; however, it is not certain whether the EITL¡¯s implementing rules might contain restrictions.
B. Special Deduction Rules Applicable to Foreign Bank Branch
A foreign bank branch is entitled to deduct expenses related to its business operations in China; in contrast, an incorporated FFI can deduct expenses related to its business operations both inside and outside of China. Special rules limit the amount of head office administrative expenses and interest expenses a foreign bank branch can deduct, as discussed below. It should be noted that the EITL does not provide such special deduction rules and that there are no implementation rules yet addressing these issues.
1. Head Office Administrative Expenses
Article 20 of the FEITR allows a foreign enterprise¡¯ branch in China to pays its foreign head office reasonable administrative expenses that are attributable to the branch¡¯s production and business operations in China. The head office is required to document, among others, the amount of the administrative expenses charged and the allocation methodology used to apportion the expenses and attach a verification report by a certified public accountant.
Guoshuihan (2002) No. 11 (¡°Circular 11¡±) provides specific guidance regarding the allocation and deduction of head office administrative expenses by foreign bank branches. Circular 11 confirms that foreign bank branches are allowed to deduct a reasonable amount of administrative expenses incurred by their foreign head office to the extent that the expenses were incurred by the head office for and in connection with the management of the business operations of the China branch. Circular 11 permits the allocation of head office administrative expenses to a foreign bank branch using one of the following methodologies:
¡¤ Ratio of business revenue of the foreign bank branch to the total business revenue of the foreign bank;
¡¤ Ratio of assets of the foreign bank branch to the total assets of the foreign bank;
¡¤ Ratio of the profits of the foreign bank branch to the total profits of the foreign bank;
¡¤ Ratio of the number of employees or payroll of the foreign bank branch to the number of employees or payroll of the foreign bank;
¡¤ Ratio based on the average of any two or more of the above ratios; or
¡¤ Any other method approved by the competent tax authority.
If the foreign bank has multiple branches in China, the allocation methodology applied to each branch should be consistent.
Circular 11 also imposes documentation requirements which are consistent with those provided under Article 20 of the FEITR. Namely, the foreign bank branch is required to submit the following to its in-charge tax bureau: (i) documents supporting the scope of the administrative expenses; (ii) the total amount of administrative expenses; (iii) the methodology used to allocate the administrative expenses; and (iv) a report issued by a certified public accountant verifying items (i) through (iii). Circular 11 grants tax bureaus discretion to deem the amount of administrative expenses deductible if the required documentation cannot be furnished. In such case, the competent tax authority may use industry averages as a benchmark.
Circular 11 imposes the following ceiling on the amount of head office administrative expenses that can be allocated to and deducted by a foreign bank branch: (i) for the first three years after the branch¡¯s establishment, 5% of the annual revenue of the foreign bank branch; and (ii) from the fourth year onwards, 3% of the annual revenue of the foreign bank branch.
2. Interest
A foreign bank branch is generally entitled to deduct interest on loans used for its business operations in China. However, Circular 123 denies the branch an interest deduction if:
¡¤ The loan is used to raise funds because working capital payable by the branch¡¯s head office was not fully allocated within the stipulated time limit;
¡¤ The interest falls within the amount incurred during the period when the branch¡¯s head office failed to fully allocate the working capital; and
¡¤ The interest is payable in respect of that portion of working capital not allocated by the branch¡¯s head office.
VII. TAXATION OF BANK BRANCH RESTRUCTURING
Banks that seek to restructure their operations from branch form to incorporated form in order to take advantage of the full scope of permissible RMB business activities will need to consider the various China tax implications of doing so. On March 26, 2007, the Ministry of Finance and SAT jointly issued Circular (2007) No. 4 to address tax issues on the restructuring of foreign bank branches to wholly foreign owned subsidiaries. This circular sets forth the following principles:
- Turnover tax. The transfer of property and equity from a foreign bank branch to a wholly foreign owned subsidiary as part of a restructuring is not subject to business tax and value added tax.
- Enterprise income tax. The assets of a foreign bank branch can be transferred at their book values to a wholly foreign owned subsidiary as part of a restructuring so that there are no enterprise income tax consequences on the transfer.
Foreign bank branch losses can be carried forward to offset the profits of the wholly foreign owned subsidiary as part of the restructuring within five years starting from the year the loss was incurred. A foreign bank branch¡¯s tax holiday remaining as of the date of the restructuring can carry over to the wholly foreign owned subsidiary as part of the restructuring.
- Stamp Duty. Dutiable agreements and accounting books on which stamp duty has already been settled in the name of the foreign bank branch are not again subject to stamp duty after they are transferred to the subsidiary as part of the restructuring.
- Deed tax. Deed tax is not applicable on the transfer of property from the foreign bank branch to the wholly foreign owned subsidiary as part of the restructuring.
VIII. CONCLUSION
China¡¯s banking sector continues to draw interest from international investors. Whether acquiring a strategic equity stake in a Chinese bank or establishing independent retail RMB operations, it is important to understand the China tax implications of banking operations in China. The growth, diversification and liberalization of the banking sector will put pressure on the Chinese tax authorities to keep tax laws in pace with regulatory changes. This comes at a time when China is about to implement a significant tax reform that is expected to equalize the tax treatment between foreign and Chinese invested enterprises and scale back the decade and a half-old tax preferences granted to foreign investors. These changes will keep not only the Ministry of Finance and the SAT busy, but also tax managers in the banking sector who must address China tax issues in a heavily regulated banking environment that is growing increasingly sophisticated and complex. |