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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