The Chinese government has introduced a range of VC tax incentives, including a rule which allows 70% of the VC investment to be offset against the taxable income of the investing VC enterprise or angel investor.
This incentive can be used where the seed or start-up capital investment is made in 'science and technology' enterprises, as defined in the rules. The latest iteration of this incentive, set out in Circular 55 (issued 2018), applies on a national basis from January 1 2018 for corporate income tax (CIT) purposes, and from July 1 2018 for individual income tax (IIT) purposes.
Building on this, China's Ministry of Finance (MOF) and State Administration of Taxation (SAT) issued Circular 8 on January 10 2019, setting out the IIT rules for individual partners of VC enterprises taking limited partnership form.
This addresses longstanding issues with lack of clarity in the application of partnership tax rules to VC enterprises. These recent changes to VC tax rules are being made in parallel to announcements of further CIT and VAT reductions for small domestic businesses, the lowering of tax burdens under the new IIT law, as well as major, across-the-board, VAT rate reductions announced in the context of the National People's Congress meetings in early March.
Circular 8 offers two tax calculation options for VC partnership enterprises (through which investment funds are operated) when determining the IIT liabilities of their individual partners:
In situations where a VC partnership elects to tax account for its investment returns on a fund-by-fund basis, the capital gains and dividend income of the enterprise are attributed through to the individual partners.
The annual gains/losses of all projects invested by the specific VC enterprise are aggregated, with some allowance for transfer expenses. Tax is withheld on behalf of the partner in respect of his share of the net gains.
Where applicable, the individual partner may utilise against these gains the special VC investment incentive to obtain a deduction of 70% of the amount invested in the transferred project (which is solely applicable for gains arising from transfer of equity, with no carry forward of the balance unused).
Dividend income is similarly (separately) aggregated, and tax is withheld from the portion attributable to each partner. Other VC enterprise operating expenses are not deducted from the income attributed through to the partners. The flat 20% rate, which is the standard IIT rate for investment income, is applied.
Annual enterprise income basis
There are two approaches for income and loss offsets:
1) In situations where a VC partnership elects to tax account for its investments gains/losses on an annual enterprise income basis, income derived by an individual partner through the VC enterprise is calculated as a proportion of the VC enterprise's total aggregate income.
The total aggregate income is determined by deducting (from gross income and gains) the allowable costs, expenses and losses related of the business, allowing for aggregation and offset of all the different income streams arising to the VC enterprise.
2) Where the 70% deduction, special VC investment incentive is applicable, the individual partner may utilise against their share of the total aggregate income, and carry forward any unused balance. The taxable net income will then be subject to IIT at a progressive rate from 5% to 35%.
Venture capital taxation
As can be seen, the second approach allows for a better use of income and loss offsets. Under the first approach, not only is there no set-off regarding dividend income and equity losses, but also regarding where a net loss arises from gains and losses on equity disposals. The individual partner simply recognises its equity transfer income as zero, and the loss cannot be carried forward.
The second approach also allows for better use of VC enterprise expense deductions, as well as better utilisation of the 70% deduction and standard IIT deductions. The trade-off is a potentially higher IIT rate. A record filing must be made with relevant in-charge tax authorities on the treatment chosen (the default approach is the annual enterprise income method). Once the election is made, it may not be changed within three years. Circular 8 applies from January 1 2019 to December 31 2023.
Inbound investment landscape
Against the backdrop of China-US trade issues and a slowing pace of economic growth, the Chinese government has been actively making efforts to retain and attract more foreign investment to China.
These efforts include accelerating the introduction of the Foreign Investment Law and making revisions to two industry catalogues that govern sectoral limitations on foreign investment:
- new Foreign Investment Law: The draft bill passed in December, with reviews in January by China's National People Congress (NPC), and a final review in early March. Once it is finalised, it will replace the existing legislation governing foreign investment in China. Highlights include harmonisation of the rules governing foreign and domestically invested enterprises, new rules to prohibit 'forced' technology transfers, and institution in law of the rules governing sectoral limitations on foreign investment in China (the national treatment + 'negative list' approach); and
- Amendment to industry catalogues: These catalogues designate whether economic sectors are open or closed to foreign investment, and whether the latter is encouraged. The latest (February) draft revisions to the Catalogue of Encouraged Industries for Foreign Investments (and Catalogue of Priority Industries for Foreign Investments in Central and Western China) additionally list 53 and 43 encouraged sectors, respectively. The goal of the revision is to encourage more foreign investments in fields such as modern agriculture, advanced manufacturing, hi-tech, and modern service sectors.