China amends innovation tax incentives and Hainan free trade port requirements
Lewis Lu of KPMG China looks at the latest enhancements to innovation tax incentives as well as new integrity requirements for Hainan free trade port incentives.
In line with the goals of the 14th Five-Year Plan period (i.e., 2021–25), China’s policymakers have recently made several enhancements to China’s innovation tax incentives. This is with a view to moving up the value chain and strengthening technological self-sufficiency. While most are limited in duration to the final three months of 2022, they could be extended.
In parallel, efforts are being made to ensure the integrity and proper usage of existing tax incentives, including those offered by the Hainan free trade port (FTP).
Tax support for innovation and R&D activities
In September 2022, several Chinese government bodies, including the Ministry of Finance and State Taxation Administration, collectively issued Announcements No. 28 and No. 32. These provide for the following:
Eligible high-and-new technology enterprises (HNTEs) can benefit from 100% immediate tax depreciation and a bonus deduction of 100% on equipment investments. This covers expenditures incurred between October and December 2022 in purchasing or self-constructing equipment or machinery, and excludes expenditure on buildings. An existing incentive provides for 100% tax depreciation on equipment with a unit value of less than RMB 5 million ($700,000). The new treatment means that in the three months to the end of 2022, much larger-value items can also benefit. The provision on bonus depreciation is also notable. Up to now, bonus depreciation was provided for in the context of the R&D super deduction incentive. This is now taken further, and HNTEs can claim 100% bonus depreciation on equipment unrelated to R&D activities. Any unused deduction can be carried forward to subsequent years.
The R&D super deduction is enhanced for the final three months of 2022. At present, a bonus deduction of 75% is provided for R&D expenses, with a 100% rate provided to manufacturing enterprises and small and medium-sized scientific and technology-driven enterprises. Under the new provisions, the 100% bonus deduction will be provided for all eligible R&D expenditures incurred between October and December 2022. If it produces a better result, the taxpayer can instead prorate a quarter of its annual R&D spend to the October–December period.
In a significant development linked to the national drive for technological self-sufficiency, new corporate income tax (CIT) incentives for fundamental research have been introduced. This provision is intended to operate on a standing basis and is not limited to three months. Benefits are provided at contributor and recipient ends. For investors, the expense incurred on contributions to non-profit scientific research institutes, universities, and government-managed natural science funds for their fundamental research can be fully deducted for CIT purposes and is also given a 100% bonus deduction. At the level of the recipients, a CIT exemption on the contributions is granted to non-profit scientific research institutes and universities. This is retroactively applied to January 2022.
The innovation incentives provided by China could lead the effective tax rate of Chinese operations to drop below 15%, the trigger level for the GloBE minimum tax. With regard to the 2022 tax year, these incentives should not be affected by GloBE, as no country has, or intends to have, these rules in effect for the 2022 tax year. This analysis would need to be revisited as GloBE is rolled out across the world. Chinese tax policymakers are yet to provide a firm indication on whether, and when, they will adopt the GloBE rules.
Integrity provisions for Hainan FTP tax incentives
China rolled out its preferential income tax regime for the Hainan FTP in 2020, including the ‘double 15’ tax incentives. There is a reduced 15% CIT rate for enterprises registered in the Hainan FTP that are engaged in encouraged industries. There is also a maximum 15% individual income tax (IIT) rate for personnel with high-end and urgently needed skills who work in Hainan.
To ensure that these incentives are not abused, integrity provisions were included from the start.
For the CIT incentive, a Hainan registered company was required to earn at least 60% of its business income from encouraged industries and possess substantive operations in Hainan. This was designed to prevent domestic profit-shifting from highly taxed companies in, for example, Beijing or Shanghai to a Hainan entity.
For the IIT incentive, the individual was required to provide evidence of at least 183 days of residence in Hainan in a tax year. This was to prevent individuals from living and working in, for example, Beijing or Shanghai but claiming to be domiciled in Hainan and benefiting from the 15% rate.
To bolster these integrity provisions, the Hainan authorities set out the following requirements in September 2022:
In order for individuals to access the 15% Hainan IIT incentive, their employers must also meet certain requirements. Specifically, employing companies need to meet the Hainan substantive presence requirements set for CIT incentive purposes. This requirement also holds where the individuals work for a partnership. While a partnership is not subject to CIT, the same test must be met by the partnership (in Hainan) for staff to claim the IIT incentive.
The Hainan substantive presence requirements applied for CIT incentive purposes have been clarified, as follows:
Having fixed premises with the necessary equipment and facilities to carry out production and business operations in the FTP;
Having sufficient staff in the FTP;
Having accounting records retained in the FTP; and
Having assets (with ownership or use rights) situated and used in the FTP.
Two circumstances are set out where an enterprise is deemed to fail the Hainan substantive presence requirements. A company lacking production and operation functions will not qualify. This is intended to exclude companies that just book buy-sell transactions, make tax filings, and issue invoices. A company whose operations are not at its registered address will also not qualify.
More robust audit measures will be applied. Enterprises that are newly entitled to the double 15 tax incentives will be subject to follow-up review. A sample check will be applied to enterprises that already qualified for the incentives.
These measures will take effect from January 2023 to the end of 2024. From 2025, the Hainan FTP will be treated as being outside China’s customs border (referred to as being ‘sealed off’). Further implementation rules will be released in advance of that.