On 25 December 2009 the State Administration for Taxation and the Ministry of Finance issued the “Notice on Foreign Tax Credit Issues for Enterprise Income Tax” (Caishui  No. 125) (“Circular 125”), outlining more detailed rules in respect of claiming foreign tax credit relief under the Enterprise Income Tax Law (“EITL”). Under Article 23 of the EITL is tax credit is provided in respect of income for which foreign tax has already paid by the resident taxpayer (“direct FTC”). Article 24 of the EITL extends the credit to where the resident taxpayer has received dividends and similar proceeds from shares in a foreign enterprise and that foreign enterprise has already paid tax on its profits in the original jurisdiction (“indirect FTC”). Articles 80 and 81 of Implementing Regulations of the Enterprise Income Tax Law (“IREITL”) limit the availability of this indirect tax credit to where the resident enterprise holds more than 20% of the equity in the foreign enterprise.
It is important to note that under the EITL, tax resident enterprises are subject to tax on their worldwide income. Where foreign sourced income is taxed in the country of source (which will usually be the case) the potential for double taxation arises. Accordingly, the FTC rules aim to prevent such double taxation. However, at the same time, the rules need to be designed to avoid potential abuse of the FTC. One manner in which the EITL prevents abuse is to limit the FTC to the tax amount that is payable under the EITL (the “FTC Limit”). Under Article 78 of the IREITL, this limit is to be calculated on a jurisdiction by jurisdiction basis in accordance with the formulabelow：
FTC Limit： Enterprise’s Total China Tax Liability on Worldwide Income x Taxable Amount of Specific Foreign Sourced Income) / total taxable worldwide income
EXAMPLE: An example can best illustrate the operation of the FTC. China Co has $1000 ($700 sourced from China and $300 sourced from the United States) of taxable income worldwide. This gives rise to a tax liability of $250 in China. Accordingly, the FTC Limit is calculated as follows – $250 x $300 / $1000 = $75. $75 is therefore the allowable FTC Limit in respect of China Co’s US tax liability.
Under Article 77 of the IREITL, only taxes which are “in the nature of income taxes” are entitled to an FTC. Unfortunately, Circular 125 does not clarify what is meant by “in the nature of income taxes”. This is highly unlikely to include transactional taxes, such as VAT or GST, but would most likely include withholding tax. It is anticipated that clarification will be given in this area in the future. Circular 125 then lists certain specific payments that will not qualify for the FTC, including (inter alia):
- Foreign income taxes that, although they have been paid, should not have under foreign jurisdiction’s income tax laws and regulations;
- Interest or penalties incurred because of the non-payment or late payment of foreign taxes; and
- Foreign income taxes that will not be paid because of the operation of a double tax agreement;
Indirect FTC and interposed entities
Circular 125 permits tax resident enterprises to “look-through” interposed entities for the purpose of the Indirect FTC In other words, where dividends or similar payments, on which tax in the nature of income tax has already been, are made by a foreign enterprise to an intermediate holding company, the tax resident enterprise will be entitled to a FTC in respect of the tax paid by the original enterprise. However, this look-through ability is limited to three tiers. Further, in order to qualify to “look-through” there must be a 20% holding at each level of the chain and, the tax resident enterprise must hold, directly or indirectly, hold 20% in the relevant foreign enterprise. The diagram below illustrates these holding requirements in respect of two-tiers:
Simplified Calculation of FTC Limit
In certain circumstances Circular 125 allows a simplified calculation to be used for the FTC Limit. For the purposes of the Indirect FTC, where the tax resident enterprise is unable, because of reasons outside its control, to establish the income tax liability for the foreign country, the FTC Limit will be 12.5% of foreign source income, except where the tax rate of the respective source jurisdiction is lower than 12.5%. Where source jurisdiction’s tax rate is “significantly higher” than China’s tax rate, China’s 25% corporate tax rate will be the relevant multiplier. Circular 125 lists the following countries as having a significant higher tax rate than China: Argentina, Bangladesh, Burundi, Cameroon, Cuba, France, Japan, Jordan, Kuwait, Laos, Morocco, Pakistan, Syria, the U.S. and Zambia. It should be noted that the simplified approach does not negate the need for the tax resident enterprise to produce the relevant tax certificates or other proof of payment of some tax.
Inability to calculate FTC accurately
Apart from where the conditions exist to use the simplified approach, if the tax resident enterprise is unable to accurately calculate the FTC Limit in respect of a particular country, then they will not be entitled to claim the FTC in China.
Tax Treatment of Income from Foreign Branches
Tax treatment of “foreign branches without separate taxable status” is explained under the Circular. This entity is basically a foreign branch of a resident taxpayer that is not a legal person under the relevant foreign laws or is not a tax resident in accordance with a double tax agreement. Circular 125 confirms, this simply restates the general operation of the EITL in respect of worldwide income, that the foreign sourced income of such entities must be included in the taxable income of the resident taxpayer. Similar to the position generally with foreign branches under Article 17 of the EITL, resident taxpayers are not entitled to deduct foreign losses relating to their “foreign branches without separate taxable status” from domestic profits.
Circular 125 also notes that, in respect of a branch which is a taxable entity in the foreign jurisdiction, expenses which are common to both the foreign operations and the China operations should be allocated on a reasonable basis. No guidance is given as to what will constitute a “reasonable allocation”.
Circular 125 applies retrospectively from 1 January 2008.