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Takeaways from China's tax reforms
April, 28th 2007
A lot of thought has gone into making the Chinese income-tax system taxpayer-friendly. India is attempting to do the same through a new and simplified direct tax code that is on the anvil.

India's direct taxes code is undergoing a metamorphosis. A new and simplified code, which promises to be simple and taxpayer-friendly, is on the way . It is increasingly becoming clear that tax competition among nations is driving countries towards more attractive tax provisions sought to be administered in an assessee-friendly manner and, thus, carve out an essential differentiator to attract increased investment flows.

In this context, a look at the recent tax reform in China will be instructive. A March 16 decree reduces Chinese corporate tax rates from 33 per cent to 25 per cent and also contains certain provisions and policies which India should pay heed to. (These provisions are expected to come into force effective January 1, 2008).

Tax Rates

China has reduced income-tax rates for both domestic and foreign companies to 25 per cent. This is significantly lower than India's nominal tax rates of 30 per cent (as proposed in the Finance Bill, 2007) for domestic companies and 40 per cent for foreign companies. And this is not all as far as an Indian corporate income-tax is concerned. If one looks closely, it becomes evident that the effective rate of income-tax paid by companies goes beyond the nominal rate. A surcharge of 10 per cent of the income-tax and an education cess of 2 per cent of the income-tax (proposed to be increased to 3 per cent by the Finance Bill, 2007) make the effective tax rate 33.66 percent (33.99 per cent if one considers the proposed increase in education cess).

If Fringe Benefit Tax (FBT) and Dividend Distribution Tax (DDT) are taken into account, which companies have to pay in addition to the income-tax, they actually end up paying much more than 30 per cent. Foreign companies pay a lower surcharge of 2.5 per cent, plus education cess of 2 per cent (proposed to be increased to 3 per cent).

Moderate rates of income-tax not only result in better tax compliance but also help in attracting Foreign Direct Investment (FDI). China's step to reduce the corporate tax rates is an attempt at that.

Small-scale enterprises with low profitability and meeting certain conditions are subject to a lower tax of 20 per cent. This is a good measure which India should consider.

Also, dividend distributed by domestic companies in China is neither subject to distribution tax nor taxed in the hands of a shareholder irrespective of the shareholder's residential status. This helps eliminate double taxation of income of Chinese companies. In India, unfortunately, rather than doing away with dividend distribution tax, the tax is proposed to be raised from an effective rate of 14.025 per cent to 16.995 per cent.

Tax Incentives

Coming to income-tax incentives, India has a number of tax holidays and concessions primarily given with the objective of facilitating economic growth. These are either location specific for example, to new industrial units in backward areas and to new undertakings set up in specific States where the need for growth is more acute or industry specific; for example, tax incentives for power, housing, production of mineral oil, etc.

Some of these have already seen a sunset for example, tax holiday for setting up convention centres, multiplexes, cold chain facilities for agricultural produce, telecom services etc. And for some others, the sunset provisions have already been prescribed. Another tax holiday which has a sunset and which is currently talked about is that for the IT/ITES sector which is available to new undertakings registered with Software Technology Parks of India or Export Oriented Units and which commence manufacture/production or render specified services before April 1, 2009.

The Chinese model for granting tax incentives is interesting. Broadly, the model looks to grant complete exemption to taxpayers in agriculture, animal husbandry, forestry, environmental protection, etc. Another key area where complete tax exemption is provided is for investment in or operation of public infrastructure projects. So, like India, China also being an economy which is growing, realises the need to incentivise investment in key growth areas and is willing to provide tax exemption/incentive for investment in and operation of public infrastructure facilities.

In this context, the proposed amendment to Section 80-IA of the Income-Tax Act, 1961 by the Finance Bill, 2007, where tax holiday for infrastructure development is proposed to be denied to contractors and to reorganisation of companies engaged in development operation and maintenance of notified infrastructure facilities assumes significance.

Looking at the huge funding requirement of $320 billion for infrastructure in the next five years and in view of the Finance Minister's statement that public-private partnership should be encouraged in this area, the proposed amendment could certainly act as a dampener.

Another important policy that the Chinese tax law has is the grand-fathering of the tax incentives and a phase-out of certain tax concessions. China, which had area based tax concessions hitherto, has announced a gradual step-up in tax rates for enterprises located in certain areas that hitherto enjoyed a concessional tax treatment (being taxed at 15 per cent).

These enterprises would slowly move to a `normal' tax regime, of being taxed at 25 per cent only, in the fifth year from the current year. The tax rate would gradually move up from 15 to 25 per cent over this five-year period. India too has seen staggered withdrawal of tax concessions, particularly for export profits (Section 80HHC of the I-T Act). Perhaps, for exemptions sought to be abolished/withdrawn in the new tax code, a gradual step-up in the tax rates could be considered so as to enable taxpayers enjoying complete tax holiday swallow t.

There are other provisions such anti-abuse, thin capitalisation and controlled foreign company provisions that China has introduced. These, it appears, may also find a place in the new direct taxes code.

Foreign tax credit

Another provision in China's corporate tax code which India would do well to include in the proposed direct tax code, is the carry forward of foreign tax credit for a period of five years.

Suppose a Chinese resident enterprise or a foreign enterprise having income from sources outside China that is effectively connected with the place of business or establishment of such a foreign enterprise within China, pays foreign income-tax which is in excess of the Chinese income-tax payable in respect of such income. It can then carry forward such excess to be set off against Chinese income-tax payable in any of the subsequent five years, to the extent that in each of those years, there remains unused credit limit for that year after utilisation of foreign tax credit arising in that year. In other words, just as Minimum Alternative Tax (MAT) paid in India is allowed to be carried forward and set-off over a 10-year period in India, China allows a similar carry forward and set-off of foreign taxes paid by a Chinese resident enterprise over a five-year period.

From the above, one can see that a lot of thought has gone into making the Chinese income-tax system taxpayer-friendly. India is attempting to do the same through the introduction of a new and simplified new direct tax code.

As this code has not yet been placed before Parliament, policymakers should keep a few of the taxpayer-friendly measures adopted by China in mind so as to not make income-tax as a significant differentiator for foreign investors intending to choose between the two countries.

Sudhir H. Kapadia
(The author is Executive Director, KPMG.)

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