Calculating the Taxable Income for a Business in China
Under China’s corporate tax rate laws, the standard profit tax rate is 25% unless a company pursues regional promotions or industry’s strategic programs. The corporate tax rate, also referred to as ‘Enterprise Income Tax’, is based on a simple calculation of profits, capital growth, and passive income. While evaluating the profits and capital gains is relatively straightforward – the calculation of passive income requires including all the various resources that add up as a revenue generator. Some of these passive income generators for a business could be rents, interests, and royalties.
The Formula for Calculating the Taxable Income in China
A business’s taxable income amounts to the gross income that remains after debiting the expenses, losses, and depreciation costs. Hence, the formula for calculating the taxable income is:
Taxable Income = Total Income – (Non-taxable income + Exempted Income + Expenses + Depreciation costs + Losses)
Here’s how you calculate each of the values stated in the above formula, to derive a final taxable income according to the China corporation tax rate.
1- Total Income
As per the China corporation tax rate rules for businesses, a net income comprises of all the revenues that add up to the business’s profitability. These factors include financial gains, growth in capital amount, dividends from a foreign company, and passive income resources.
This tax law equally applies to both the domestic and foreign-owned companies and is imperative in evaluating corporate tax on revenue or profit in China.
The tax rules, however, are a bit divergent for TREs and Non-TREs.
a) Tax Resident Enterprises (TRE):
A company that is registered and/or managed in China is defined as a TRE and the global income of such a company is subjected to EIT (Enterprise Income Tax).
b) Non-Tax Resident Enterprises (Non-TRE):
Under the Corporate Income Tax law, a company is termed as a Non-TRE if it:
– Is incorporated under a law of foreign region or,
– Is managed from abroad or,
– Has an establishment in mainland China or has generated profit from Chinese resources without having an establishment in the country.
Such companies are subjected to WHT (withholding tax) on the assets like Interests, Dividends, Royalties, and Rents, as per the rules defined for the China tax calculator.
A foreign currency income should be calculated in RMB to establish the total net income.
2- Deduct Non-Taxable Income
On the basis of the nature of a Business; it may or may not have a non-taxable income. As a matter of fact, the recent China corporation tax rate law has fairly eliminated the income that falls under this group.
3- Debit Exempt Income
Normally, there are not many occurrences where exempt income needs to be subtracted, but if there is a case, it needs to be accounted for calculating the taxable income.
4- Subtract Business Expenses
This one is pretty obvious. The costs associated with running a business need to be deducted as per the China tax calculator, for evaluating a final taxable income.
Hence, the best business practices strongly suggest documenting each and every expense that contributes to the business’s running cost. These running expenditures include, but are not limited to:
– Rent paid for the office building or other facilities
– Salary, insurance and pension expenses
– Maintenance costs for machinery and other equipment
– IP registration costs
– Fixed assets capital expenditure
– Borrowed cash expense
– Expenses associated with intangible assets acquisition e.g. trademarks, copyrights, and patents.
Some other business expenses that need to be accounted for calculating the taxable income include:
- R&D Expenses – New Technology and Products – 150 percent of the expenses incurred in this category are ‘super-deductible’.
- Salaries for Handicapped team members – The salary expenses for these employees super-deductible by 200%.
- Cost Sharing Expense – Cost-sharing is allowed for intangible assets and common services (like company advising strategy and group procurement) amongst the related parties.
Limitations on Expense Deduction:
There are certain restrictions on expense deduction on the following categories, as per the rules defined for China’s profit tax rate.
- Advertising – These expenses are deductible up to 15 percent of the enterprise’s sales income.
- Entertainment – The expense in this category is limited to up to 5 percent of income and is deductible by 60 percent only.
- Donations – 12 percent of accounting profit is deductible under the donations category.
Evaluation of Inventory:
Below are the three standard methods for inventory valuation and any one of these can be adapted to evaluate the inventory, which subsequently accounts in calculating the taxable income for the businesses in China.
- Specific Identification
- First in – First out
- Weighted Average.
Limitations on Interest Payments in lieu of Thin Capitalization Rule
As per this rule, the deductions are limited for payments related to the financing from the related parties. For financial institutions, this rule fixes the debt-to-equity ratio of 5:1 while for other businesses the ratio is 2:1. Interest payments to the related parties beyond this set threshold are not permissible. A deviation to this rule, however, allows the financing beyond the threshold, if the company can present documental proof that funding is conducted at an arm’s length or the tax rate of leading entity is now less than China’s borrowing entity.
Cases of Non-deduction:
- Below is the list of scenarios where a deduction is not applicable as per the China corporation tax rate rules, for calculating the taxable income.
- Management fees are generally non-deductible. However, if charged at arm’s length, the services fees paid to affiliates residing in China or abroad are subject to deduction.
- Income tax paid on earned income and all subsequent charges (e.g., late payment surcharge).
- Losses and fines imposed on unlawful business operations
- Payments like dividends that are related to equity interests to investors. However, the payments in this category are deductible if they are paid to affiliates in China or overseas.
5- Subtract Assets Depreciation:
For calculating the taxable income of a business, the depreciation of asset is calculated using the straight-line method. This is typically done for the assets like machinery or any other equipment that is used to generate income.
Furthermore, the below aspects are taken into account while calculating the asset’s depreciation.
Accelerated Depreciation: When already proved and well documented; the recording of reduced depreciation is permitted in the below cases:
- Sudden technology changes or any significant change in technological standards which reduces the value of the asset or limits its chances of generating income in coming days
- Continuous erosion of vibration in machinery.
Intangible Assets: As per the rules on corporate tax on revenue or profit in China, the intangible assets are amortized using the straight-line method and are either done over a term of 10 (or more) years or by using the time span specified in the contract that governs the use of the asset.
Purchased goodwill: Purchased goodwill is non-deductible unless the business is transferred or liquidated. It is calculated as below:
Purchase goodwill = Value paid by the business as going concerned – (Sum of Assets – Liabilities)
6- Debit Losses
At the end of each year, the losses, including the assets losses and bad debt losses, are deducted from the total income, for calculating the taxable income. However, the tax losses may be carried over for up to 5 years under the provision known as ‘tax loss carryover.’