Background: A New Era for Foreign Investment in China

The Foreign Investment Law of the People’s Republic of China (the “FIL”) came into force on 1 January 2020, which is the first comprehensive and systematic law in the field of foreign investment. It ushered in a new era of foreign investment in China. 

In accordance with Article 31 of the FIL, the organisation form, structure and operating rules of foreign-invested enterprises (the “FIEs”) that were established after 1 January 2020 (the “New FIEs”) are subject to the provisions of the Company Law of the People’s Republic of China (the “Company Law”) and the Partnership Law of the People’s Republic of China (the “Partnership Law”) and other applicable laws. 

For FIEs established before 1 January 2020 (the “Existing FIEs”), the FIL and the  Implementation Regulations for the Foreign Investment Law of the People’s Republic of China (the “FIL Regulation”) set a transition period of five years. 

During the transition period, existing FIEs may adjust or retain their original organisational structures. From 1 January 2025, however, the market regulatory authorities shall not process the application(s) for any other registration matter(s). They shall publicly announce the relevant information if the FIE has not adjusted its organisation form or structure and complete the change registration pursuant to the FIL and the FIL Regulation. In other words, FIEs must adjust their organisational structures as required by the FIL by 31 December 2024. 

The sixth revision of the Company Law of the People’s Republic of China (The “New PRC Company Law”) will become effective on 1 July 2024. It might be the most extensive amendment in its history, but the changes introduced in the New PRC Company Law have far-reaching implications for business, including FIEs entering and operating in China. 

Therefore, both the New FIEs and the Existing FIEs that have already adjusted to the Company Law are required to adhere to the provisions of the New Company Law effective from 1 July 2024. For existing FIEs that have not yet adjusted to the Company Law, the five-year transition period will conclude on 31 December 2024, necessitating their alignment with the provisions of the New PRC Company Law from 1 January 2025.

Given that the Limited Liability Company (LLC) is the predominant organisational structure being adopted by FIEs in China, this article will discuss tax impact on the entire process from establishment to deregistration of an LLC in China by demonstrating major changes of the New PRC Company Law such as Capital contribution rules and the relevant tax impacts alongside the revisions to provide reference for foreign investors who considering doing business in China. 

Part I Overview of Major Changes in the New PRC Company Law 

The New PRC Company Law addressed various aspects of company governance such as company registration, capital contribution and reduction, organizational structure, transfer of equities, rights and liabilities of shareholders and senior management, and deregistration etc. 

For this article, we will mainly discuss tax matters related to registration, capital contribution, capital reduction, profit distribution, and deregistration as per the New PRC Company Law. The major relevant changes have been outlined below:

I.  Registration 

•  Detailed company registration items, including the name, domicile, registered capital, business scope, legal representative name, and LLC shareholders' names. 

•  Added that if the detailed registration items are not registered or not updated, they shall not be used against bona fide counterparty(s).

•  There are legal consequences (e.g., being rescinded by a competent authority) for making a false declaration of their registered capital and submitting false materials during the registration process, etc.

II.  Capital Contribution

•  Limits the maximum period of capital contributions to five years. 

•  Expands forms (stock and creditor’s rights) of capital contributions. 

•  Failure to make capital contributions may result in shareholders bearing joint and several liability and ultimately losing the equity of the unpaid capital contributions. 

III.  Capital Reduction 

•  Unless otherwise stipulated in legal provisions or agreed upon by all the shareholders of an LLC, the proportional reduction applies by default in capital reduction. 

•  Under certain conditions, companies may be allowed to offset losses by reducing their registered capital.

•  There are legal consequences (e.g., refund received funds or compensate losses if any to the company) should there be any violation of the provisions of Capital Reduction. 

IV.  Profits Distribution 

•  Clarify that unless all the shareholders have agreed not to distribute the profits in accordance with the proportion of the capital contribution, the default is that the profits shall be distributed by the LLC in proportion to the capital contributions. 

•  In the event of a breach of the provisions governing profits distribution, there will be legal ramifications. Specifically, shareholders will be required to reimburse the distributed profits, and the responsible directors, supervisors, and senior executives will be subject to liability for any losses incurred by the company.

•  The board of directors is required to distribute profits within six months after the passing of a resolution at a shareholder’s meeting to distribute profits.

V.  Deregistration

•  Deregistration is required where a company needs to be terminated due to dissolution, bankruptcy, or other statutory cause.

•  Deregistration is required upon completion of the liquidation of the company. 

•  The company may be deregistered under summary procedures. However, untrue commitments may result in its shareholders bearing jointly and severally liability for the debts incurred before the deregistration.

Part II Tax Implications 

In this section, we will discuss the tax implications on the establishment, operation, and deregistration of a company in relation to the changes in the New PRC Company Law above. Please keep in mind that this is not a comprehensive analysis of the relevant tax implications. The purpose of this discussion is to highlight a few key points regarding the tax impacts on matters involved throughout the entire lifecycle of a company.

I.  Establishment Stage 

a.  Non-Monetary Capital Contributions 

Article 48 of the New PRC Company Law states that among other capital contributions (such as in currency or in kind, intellectual property, and land use rights), shareholders may also make capital contributions in stock rights and creditor’s rights. 

Both equity and debt investments fall under the category of non-monetary contributions, which often involve complex tax implications. For instance, making capital contributions in stock rights may qualify for certain preferential tax treatment. According to Cai Shui [2014] No.116 and Cai Shui [2015] No.41, Enterprise and individual shareholders who contribute with non-monetary assets may enjoy deferred tax benefits for five years. 

In addition, the non-monetary assets as capital contributions shall be assessed and verified. Therefore, it is important for companies and individuals to assess potential tax burdens beforehand when making non-monetary contributions. 

b.  Five-Year Subscribed Capital Contribution Term 

LLC shareholders might be liable for tax losses due to their unpaid capital contribution within the stipulated period. 

According to Article 47 of the New PRC Company Law, the amount of capital contributions subscribed for by all the shareholders shall, per the articles of association, be fully contributed by the shareholders within five years of the date of establishment. 

Article 38 of the Implementation Regulations for the Enterprises Income Tax Law of the People’s Republic of China (“EIT”) (Revised in 2019) states that interest expenditure incurred by an enterprise in production and business activities shall be deductible. This means that the interest expenses related to a company’s external loans are eligible for pre-tax deduction with certain limitations. 

According to the Reply of State Administration of Taxation on EIT Issues Relating to Pre-tax Deduction of Interest Expenditure Incurred on Unpaid Investments of Enterprise Investors [Guo Shui Han (2009) No. 312]，if investor(s) fail to pay the payable capital amount within the “stipulated period” (generally referring to the capital contribution timeframe specified in the company’s articles of association ), the interest incurred by the enterprise's external borrowings, equivalent to the interest payable on the difference between the actual paid-up capital and the capital amount due within the stipulated period, shall not be considered a reasonable expenditure of the enterprise. Therefore, it cannot be deducted when calculating the taxable income of the enterprise. 

According to Article 49 of the New PRC Company Law, if shareholder(s) fail to timely make their capital contributions in full, they shall not only make the full amount of capital contributions to the company but also be liable for compensation for the losses they caused to the company. 

Therefore, the company may be entitled to request shareholder(s) to bear its tax losses if the corresponding interest cannot be deducted before tax due to the shareholder’s unpaid capital contribution. 

II.  During Operation Period 

a.  Reduce the Registered Capital  

Due to the five-year capital contributions limitation under the New PRC Company Law, many companies may opt to reduce their registered capital to lower the required paid-in capital to minimise the risk of non-compliance. However, reducing the registered capital may trigger income tax liabilities.

According to the Public Announcement of State Administration of Taxation on Several Corporate Income Tax Issues [Announcement (2011) No.34], in the event of divestment or reduced investment in an investee enterprise, the assets obtained by the investor enterprise can be divided into three categories: (i) investment cost recovery, (ii) dividend income, and (iii) income derived from the transfer of investment assets. 

Among the three categories, the portion related to income derived from the transfer of investment assets might be subject to EIT in China. 

b.  Profits Distribution 

Under Article 3 of EIT, if a non-resident enterprise does not have any institutions or premises established in China, or if the income derived or accrued is not related to those institutions or premises, the enterprise must pay income tax on the income earned in or derived from China. In general, non-resident enterprises are subject to a 10% withholding tax. A lower withholding tax rate may apply under certain tax treaties. 

To encourage overseas investors to invest in China, according to Cai Shui [2018] No. 102 and the State Taxation Administration Announcement [2018] No.53, overseas investors’ direct investment in China with the profits distributed from resident enterprises (within the applicable scope of the policy pertaining to encouraged and non-prohibited foreign investment projects and fields) may be eligible for the exemption of temporarily not levying withholding income tax, subject to certain conditions. 

For instance, if an overseas investor uses distributed profits to make retrospective payments for registered capital, to increase paid-up capital, or to contribute to the capital reserve of a domestic resident enterprise, they may be eligible for the said preferential tax treatment.

III.  Deregistration Stage 

Overall, the company deregistration process might involve multiple government authorities such as the Ministry of Commerce of the People’s Republic of China (“MOFCOM”), the State Administration for Market Regulation (“SAMR”) and the State Taxation Administration (“STA”). The whole process of deregistration depends upon the forms of FIEs and their preparedness, level of compliance etc. The process may extend for a period of up to one year or potentially even longer.

 

According to Article 240 of the New PRC Company Law, an enterprise that has not incurred any debts or has paid off all debts can be deregistered under the summary procedures, subject to the agreement of all the shareholders.

 

However, an untrue commitment may result in its shareholders bearing jointly and severally liability for the debts incurred before the deregistration. In other words, the shareholder shall be jointly and severally liable for unpaid taxes even if the deregistration procedure has been completed.

Takeaways

•  Take Tax Consideration as a Whole

As the effective date of implementation of the New PRC Company Law approaches, FIEs must consider not only the various company structure and governance changes introduced by the new law but also the potential tax implications.

 

The tax implications associated with these changes to the New PRC Company Law extend to all stages of a company’s life cycle. Tax consideration is crucial for every transaction encountered by foreign investors doing business in China.

•  Make an Appropriate Decision on the Initial Registered Capital 

For new FIEs, foreign investors need to proceed cautiously to make an appropriate decision on their initial registered capital. The amount of registered capital should balance adequate reserve capital to meet ongoing operational requirements and avoid setting an excessive amount of registered capital to mitigate the risk of being unable to fulfil their capital contribution obligations in time.

•  Reduction Capital Scheme Needs to be Analyzed on a Case-By-Case Basis 

To attract foreign investment, China has extended and issued multiple tax incentives both at the national and local levels. While operating a business in China, foreign investors should consider that they might be able to apply for multiple tax preferential treatments. To foster innovation, certain tax incentives may be applied to specific sectors, such as a 15% reduction in the EIT for companies that meet or have qualified for the high-tech criterion.

•  Tax Compliance is Essential 

Ceasing a business can be achieved by deregistration procedures. However, it is imperative to recognise that such procedures do not serve to evade the ramifications of non-compliance. Even following the completion of the deregistration process, shareholders may remain jointly and severally liable for any outstanding tax liabilities. Consequently, strict adherence to tax obligations/compliance is paramount for FIEs.

* Special thanks to Bianca-Maria Durac for proofreading this article. Bianca is an aspiring solicitor and a current LLM student at University College London (UCL, UK), specialising in International Banking and Financial Law. 

Please note that this article is not intended and cannot be constituted as a comprehensive analysis of the related Chinese law or under any circumstances as legal advice from the author and Tsinglaw Partners.