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					China Introduces Tax Incentives for Venture Capital
Investments in High-Tech Sector
by Qingsong (Kevin) Wang, Orrick, Herrington & Sutcliffe LLP, Beijing

March 22, 2007


The P.R.C. government recently announced a new policy that allows venture
capital firms that provide equity capital to new high-tech companies to receive a
bonus corporate tax deduction of 70 percent of their qualified investment.


In line with China's ambition to become a global technology powerhouse and a leader in
innovation, the P.R.C. government recently introduced tax incentives for venture capital
investments in the emerging high-tech sector. The new policy allows venture capital firms that
provide equity capital to qualifying emerging high-tech companies to receive a bonus deduction
from their P.R.C. taxable income.

Background
China taxes capital gains as normal income at a flat rate of 33 percent under the current tax law.
That rate will be reduced to 25 percent under the new Unified Enterprise Income Tax Law, which
will take effect in early 2008.

China's tax incentives traditionally have been given to production-oriented enterprises.
Companies dedicated to investment activities, such as venture capital firms, investment funds,
and Chinese holding companies, have not been given tax incentives, which has created a heavy
tax burden for them. Consequently, most foreign investment firms make their P.R.C. investments
through offshore holding vehicles, even though China has created a framework for foreign
investors to establish onshore venture capital investment enterprises.

Even domestic investment funds have been establishing offshore special purpose vehicles to
conduct round-trip investments into China. Those offshore vehicles, if taxed at all, generally pay
withholding income tax of 10 percent on capital gains, which are classified as China-source
passive income of a foreign enterprise without an establishment in China. That compares
favorably to pure onshore venture capital enterprises, which pay corporate income tax at the full
rate of 33 percent.

Against that background, and as a response to long-term lobbying efforts by the investment
community, the Ministry of Finance and the State Administration of Taxation on February 7 jointly
issued Cai Shui (tax notice) [2007] 31. The notice grants onshore venture capital enterprises a
bonus deduction of 70 percent of their qualified investment in emerging high-tech companies. The
bonus deduction serves as an incentive for channeling more funds into start-up companies in
China's high-tech sector and seeks to reduce the abuse of offshore vehicles for investment in
China.
General Introduction of the Incentive
An onshore venture capital firm can apply for the 70 percent bonus deduction if it has made an
equity investment in an unlisted medium- or small-scale high-tech enterprise (hereafter referred to
as a qualified investee or investee) and has held the equity for at least two years. The bonus
deduction, which can be granted before the investor exits its investment in the investee, is similar
to a venture capital investment tax credit in Western countries. It is equivalent to a 23.1 percent
investment tax credit under the current tax law, and will be equivalent to a 17.5 percent tax credit
after the new tax law comes into effect in 2008.

Eligible Investors
To be eligible for the bonus deduction, an investor should be a venture capital investment
enterprise established in China, and must meet the following requirements:
    · it must be a dedicated venture capital investment enterprise, established in accordance
        with the provisional measures for the administration of venture capital enterprises
        (National Development and Reform Commission Order 39, hereafter referred to as the
        domestic VC measures), or have a dedicated business scope of venture capital
        investment and related services if established before the promulgation of the domestic
        VC measures; and
    ·   the venture capital firm must have duly completed filing procedures in accordance with
        the domestic VC measures, and the filing administrative authority must have verified that
        it has conducted its investment operations in accordance with the relevant provisions of
        the domestic VC measures.
It is unclear whether the tax notice applies to foreign-invested venture capital investment
enterprises (FIVCIEs). FIVCIEs are established by foreign investors (or jointly with domestic
investors) in accordance with the Administrative Measures of Foreign Invested Venture Capital
Investment Enterprises (the FIVCIE measures), issued in 2003. Although the domestic VC
measures clearly state that a FIVCIE can also enjoy relevant incentive policies if it meets the
relevant requirements, the tax notice does not explicitly grant tax incentives to FIVCIEs. Judging
from its reference to Guo Shui Fa [2000] 118 (discussed below), which governs domestic
enterprises, it appears that the tax notice applies only to domestic venture capital firms.

However, that issue is expected to be clarified soon. Under the new Unified Enterprise Income
Tax Law, both FIVCIEs and domestic venture capital firms will be eligible for tax incentives for
qualifying investments in high-tech companies. The incentives prescribed in the new income tax
law are actually very similar to those of the tax notice, granting venture capital investment
enterprises engaging in start-up investments a bonus deduction with reference to the size of their
investment. It can be reasonably assumed that the tax notice eventually will apply to both
domestic venture capital firms and FIVCIEs, although some adjustments may be made to
accommodate different types of investors.

Another question is whether the bonus deduction will be granted to passthrough entities. A
FIVCIE can be established as a non-legal-entity cooperative joint venture and can choose to be
taxed at the shareholder level, which, in effect, would make it a passthrough entity. A foreign
shareholder of a FIVCIE is taxed as a foreign company without an establishment in China if all
the venture capital investment activities of the FIVCIE are conducted by a separate fund manager.
The applicable tax rate on the capital gains of such a foreign shareholder would be 20 percent,
which could be reduced to 10 percent under some tax treaties. If that type of investor could
additionally claim a bonus deduction, its effective tax rate would be dramatically lowered, to below
10 percent, which may not be the actual intention of the P.R.C. government.


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Investee Requirements
In addition to the two-year holding period, the tax notice imposes additional requirements on
investees:

Size Requirements
The investee must have fewer than 500 employees. Further, neither its gross assets nor its
annual gross revenue can exceed CNY 200 million (approximately US $25.8 million). It is
apparent that the purpose of the size requirements is to encourage investment in early-stage
companies. It is not clear, however, whether the size requirements will be applied at the time of
investment, the time of application for the bonus deduction, the time of exit, or during the entire
holding period. Given that most venture capital investors would only exit their investment when
the investee has grown large enough (sometimes even waiting until after an investee has listed
on a stock exchange), it would not make sense for the size requirements to hold at any point
beyond the initial investment or the application for the bonus deduction. It is therefore likely that
one of those two timing points will apply to the size requirements.

High-Tech Requirements
When a venture capital enterprise applies for a bonus deduction, when calculating taxable
income, 5 percent or more of the investee's gross revenue for the year of application must be
allocated to research and development expenses used for new technology and product
development, and the total amount of technology-related income and sales income of high-tech
products must account for 60 percent or more of its gross revenue for the same year.

Carryforward of Bonus Deduction
If the venture capital firm qualifies for a bonus deduction but its taxable income (not discounted by
the bonus deduction) for the current year is less than the bonus deduction, causing the bonus
deduction to not be fully used in the current year, the unused amount can be carried forward and
deducted in the following tax years.

Other Income Tax Policies
The tax notice also clarifies some other income tax policy issues. It prescribes that equity
investment by venture capital firms shall be governed by the relevant regulations provided in the
Notice on Several Issues Regarding Income Tax Over the Equity Investment (Guo Shui Fa [2000]
118) (Circular 118). However, that leaves unanswered whether supplemental notices to Circular
118 will also apply to equity investment by venture capital firms.

Circular 118 governs domestic enterprises (as opposed to foreign investment enterprises). It
stipulates that dividends from equity investments will be subject to income tax only when there is
a tax rate differential between the investor and investee; therefore, the dividend will be exempted
from income tax if there is no such tax rate differential. Capital gains, however, will be taxed as
normal income. The key question is whether the investee's retained earnings, when transferred
by the investor along with the equity transfer, should be classified as dividend income or capital
gains. Originally, Circular 118 allowed retained earnings to be classified as a dividend, thereby
excluding them from capital gains, regardless of the percentage of equity holding.

However, a later circular issued in 2004 (Guo Shui Han [2004] 390) denies that treatment if the
investor holds less than 95 percent equity in the investee, in which case the relevant retained
earnings of the investee will be classified as capital gains for the investor, causing that portion of
retained earnings to be taxed twice for corporate income tax. If Circular 390 is applied to venture



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capital investments and exit transactions, the investor's tax liability is likely to increase
substantially, particularly given that investees are generally fast-growing emerging companies
with potentially large profits accumulated as retained earnings when the investor exits.

Documentation Requirements and Approval Procedures
Venture capital enterprises that apply for the bonus deduction must submit the following
documents to the local competent tax authority:
   · evidential documents regarding the investment operation of the venture capital enterprise,
       which have been verified by the filing administration authority;
    ·   a copy of the investment contract of the investee and evidential documents regarding
        verification of the paid-up capital; and
    ·   basic information about the investee and a copy of the high-tech enterprise certificate and
        high-tech project certificate issued by the relevant provincial science and technology
        authority.
The local competent tax authority shall, after examining and commenting on the application
documents, report to its superior authority according to the level of the filing administration
authority.

Authorities will publish a detailed list of the venture capital enterprises that are entitled to the tax
preference prescribed in the tax notice.

Effective Date
The tax notice retroactively entered into effect on January 1, 2006, the first day of the year the VC
measures became effective.

Observations
Although quite a few questions remain unclear, the new incentive measures will significantly
affect venture capital investment in China. More funds likely will be raised by onshore venture
capital firms, which will be attracted by the tax incentives and the prospects of a booming
technology sector. Foreign fund managers also may consider establishing onshore vehicles to tap
into China's bullish stock market while enjoying the new tax incentives.




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