Guidance issued on tax measures for development of the Hainan Free Trade Port
On 30 June 2020, China’s Ministry of Finance and State Taxation Administration issued guidance (Circulars 31 and 32) implementing several tax measures to support the development of the Hainan Free Trade Port (HFTP), which measures were announced by the State Council on 1 June 2020. The measures are effective retroactively as from 1 January 2020 and will expire on 31 December 2024, and include:
- A 15% enterprise income tax (EIT) rate (reduced from the statutory 25% rate) for taxpayers engaged in “encouraged” business activities in the HFTP;
- A tax exemption for certain foreign-source income from newly formed foreign branches and new foreign direct investment of taxpayers established in the HFTP in the sectors of tourism, modern services, and high and new technologies;
- Accelerated tax deductions for eligible capital expenditures by taxpayers established in the HFTP; and
- A 15% effective individual income tax (IIT) rate for qualified talent working in the HFTP.
The guidance addresses various aspects of the tax measures and is summarized below.
Reduced income tax rate for encouraged business activities
A reduced 15% EIT rate is available for a taxpayer that meets the following tests:
- Its primary business activity is an encouraged business (as set forth in specific industry catalogues);
- The revenue from such primary business activity accounts for 60% or more of gross revenue; and
- It carries out substantial business operations in the HFTP.
This reduced rate only applies to income attributable to a company’s head office and branches established in the HFTP. For example, if a company's head office is established in the HFTP, the reduced rate may not be applied to income attributable to branches established outside the HFTP. Similarly, if a company's head office is established outside the HFTP, the reduced rate only applies to income attributable to the company's branches established in the HFTP. In addition, when determining whether the encouraged businesses and 60% revenue tests have been met, a company’s head office or branches established outside the HFTP will not be considered.
Encouraged businesses test
Taxpayers must have as their primary business activity an “encouraged” business as set forth in any of the following industry catalogues:
- The Guiding Catalogue for Industrial Structure Adjustments. The National Development and Reform Commission (NDRC) publishes this catalogue, with the most recent version issued in 2019. There are 821 encouraged businesses listed.
- The Catalogue of Encouraged Industries for Foreign Investments. The NDRC and the Ministry of Commerce publishes this catalogue, with the most recent version issued in 2019. The catalogue is comprised of two parts: Part I applies nationally and has listed 415 encouraged businesses; and Part II applies in mid- and western China and has varied encouraged businesses depending on the province. For the Hainan province, 40 encouraged businesses are listed.
- The Catalogue of Newly added Encouraged Industries in the Hainan Free Trade Port (HFTP catalogue). This catalogue has not been released yet.
Based on the two existing catalogues, a pure holding company may not be able to meet the encouraged businesses test unless it adds functions such as providing various business and management services (e.g., research and development, IT outsourcing, supply chain, accounting, tax, legal) to group affiliates.
Financial services likely will be a key industry considered in the development of the HFTP catalogue in order to encourage foreign investors in the financial sector to invest in the Hainan province.
Sixty percent revenue test
The taxpayer’s revenue from the encouraged business must account for 60% or more of gross revenue.
There is no clear guidance on the type of revenue that must be included in order to determine whether the 60% threshold has been met. "Gross revenue" could include a broad range of items including passive income from dividends and interest, as well as capital gains from the sale of shares. As such, a taxpayer may find it difficult to meet the test in a year in which, for example, it disposed of a significant number of shares in certain investments.
Substantial business operations test
A taxpayer also must carry out substantial business operations in the HFTP. This test was introduced in order to avoid granting the tax incentive to companies that have no (or nominal) operations or assets in the HFTP.
In determining whether a taxpayer carries out substantial business operations in the HFTP, Circular 31 refers to the place of effective management, which is a concept introduced in the EIT Law to determine whether a company is tax resident in China. The considerations commonly used in determining a company's place of effective management for EIT purposes may include but are not limited to:
- The place where a company's shareholder meetings, board meetings, or other management meetings are held; and
- The place where a company maintains its books and records.
Supplementary guidance issued by the Hainan Tax Bureau on 31 July 2020 suggests that certain information (such as total assets, gross revenue, salary expenditure, and number of employees) of companies or branches established in the HFTP will be needed in order for the tax authorities to determine whether the test has been met.
Tax exemption on new foreign-source income
A tax exemption applies to certain foreign-source income earned by taxpayers established in the HFTP that are engaged in the tourism, modern services, and high- and new-technologies sectors. The HFTP catalogue will contain guidance as to whether a taxpayer’s business falls within the scope of these sectors.
The exemption applies to income from operating profits derived from 1 January 2020 through 31 December 2024 from branches established in foreign jurisdictions during this same period.
The exemption also applies to dividend income derived from 1 January 2020 through 31 December 2024 from a foreign company in which the taxpayer holds a 20% or more equity interest and that is a result of a direct investment in such company during this same period. The investment may be acquired through capital contributions to a new or existing foreign company or purchased from a foreign company’s existing shareholders. Gains from the disposal of such direct investments do not fall within the scope of income eligible for the tax exemption.
In addition, the foreign jurisdiction in which the branch is located or investment is made must impose a minimum statutory income tax of 5%. No guidance currently exists as to how this requirement will be applied within indirect shareholding structures, such as when a foreign investment is made through a holding company established in a jurisdiction that imposes a statutory income tax of 5% or higher.
Accelerated deduction of certain capital expenditures
For fixed assets (excluding buildings) or intangible assets that are acquired between 1 January 2020 through 31 December 2024, taxpayers established in the HFTP may accelerate the deduction of the cost of such assets as follows:
- For assets valued at RMB 5 million or less, an immediate tax deduction is allowed; and
- For assets valued at more than RMB 5 million, an accelerated depreciation or amortization schedule is allowed.
To qualify for the accelerated deductions, the assets must be purchased, constructed, or developed by the taxpayer.
This treatment is similar to that provided in Circular 54 (issued in 2018 and applicable nationally through 2020); however, Circular 54 does not cover intangible assets and contains more restrictions on fixed assets valued at more than RMB 5 million.
15% effective tax rate for qualified talent
A partial IIT exemption is available to qualified talent working in the HFTP during 2020 through 2024 in order to achieve a 15% effective tax rate on the individual's taxable income in the following categories: comprehensive income, business income, and subsidies recognized by the Hainan government.
The requirements to qualify for this exemption (e.g., high-end and urgently needed talent) and other relevant measures will be determined and issued by the provincial governments (with involvement from the Ministry of Finance and State Tax Administration).
This measure is similar to those currently implemented in the nine mainland China cities of the Greater Bay Area (GBA). However, unlike the measures in the GBA where the government collects the tax first and then grants a tax-free subsidy to qualified taxpayers, the HFTP measure provides a more streamlined process so that the relevant income is exempt immediately from tax when the annual tax return is filed without the need for granting a subsequent subsidy.
Future plan to reduce IIT on comprehensive and business income
Although not addressed in the guidance, the State Council also announced on 1 June 2020 a planned measure that would limit the IIT brackets on comprehensive income and business income to 3%, 10%, and 15% (the normal IIT brackets are: 3%, 10%, 20%, 25%, 30%, 35%, and 45% for comprehensive income; 5%, 10%, 20%, 30%, and 35% for business income) for certain individuals residing in the HFTP. Comprehensive income includes salaries and wages, income from provision of independent services, author’s remuneration, and royalties. In order to qualify, the income must be derived by an individual in a given calendar year from 2025 through 2035, if the individual resides in the Hainan province for 183 days or more in that year.