Dodging the draft (tax): how China's draft inheritance tax law turns a blind eye to the rich, a good eye to the masses, and how a reorientation can be realized.

• Published date: 01 January 2013
• Author: Brown, Justin T.
• Date: 01 January 2013

I. INTRODUCTION

The Chinese economy has undergone unprecedented growth over the last three decades after Deng Xiaoping's system of opening and reform. (1) This growth has lifted millions of Chinese out of poverty, (2) helped drive the expansion of the global economy, (3) and made China a more formidable force in global politics. (4) The people of China, however, have not shared equally in the benefits of this growth. Income and wealth distribution in China have become increasingly unequal both geographically (5) and by social class, (6) leading to increasing social unrest and discontent. (7)

With a Chinese Communist Party preoccupied with maintaining its monopoly on power, the government has considered and implemented a number of measures to ameliorate, or at least improve the public perception of, this economic disparity. (8) Among the measures that have been considered is the imposition of a wealth transfer tax, specifically an estate or inheritance tax. (9)

Although no such tax has yet been passed, a wealth transfer tax holds a number of benefits and could be an important tool in combating unequal wealth distribution and promoting equal opportunity in China. Many officials and scholars have recognized the potential benefits of a wealth transfer tax in the context of modern China, (10) and in 2004, the Draft Inheritance Tax Law was proposed but never passed. (11)

This topic is also of particular relevance for U.S. readers since the U.S. Estate Tax was temporarily repealed in 2010, but reinstituted in 2011. (12) Moreover, income distribution, as measured by the Gini Index using 2007 numbers, places the U.S. 45th on the world list of income inequality, signifying a more equal distribution of income than China, which ranks 27th but still shows considerable room for improvement. (13)

This Note will examine the 2004 Draft Inheritance Tax Law and provide suggestions for improving the law. Part II provides a background of the social and political context leading up to the Draft Law and of the developments since 2004. Part III examines the Draft Law itself and comments on its shortcomings, omissions, and areas needing improvement. Finally, Part IV summarizes the arguments for and against the tax examined in Part III and concludes that a wealth transfer tax could be a useful tool to achieve China's numerous social objectives. The Draft Law of 2004, however, requires many serious revisions before implementation.

II. BACKGROUND ON WEALTH TRANSFER TAXES IN CHINA

Since the founding of the People's Republic of China in 1949, wealth transfer taxes have been passed twice, but neither was actually enforced and collected. (14) Currently, the most significant source of Chinese tax revenues is the value-added tax ("VAT"). (15) In addition to the VAT, there are roughly twenty other forms of tax currently levied in China, including personal income tax, corporate income tax, real-estate tax, stamp duty, resource tax, and sales tax. (16) The personal income tax has been repeatedly revised, most recently in September 2011. (17) The State Administration of Tax ("SAT") has become more professional and skilled at administering various taxes over the years, and today it boasts an impressive collection rate. (18)

A. History of the Draft Inheritance Tax Regulations

As a result of social forces and a perceived need for measures to increase wealth equality, (19) the National People's Congress produced the Interim Draft Regulations of the People's Republic of China on Inheritance Tax ("Interim Draft Regulations") in 2004. (20) Although not enacted at that time, the question of imposing a wealth transfer tax remains a topic of debate within China. (21) The general consensus, especially among tax officials, (22) is that some form of wealth transfer tax should be collected in China, but not until "necessary systems" are employed to allow for the effective enforcement of this tax. (23) Since 2010, there has been a major resurgence in the push for a wealth transfer tax. (24) The social factors creating demand for a wealth transfer tax have only expanded in recent years, making the passage of this tax more likely than ever. (25)

III. THE 2004 DRAFT

A. General Overview

In 2004, the Chinese government promulgated the Interim Draft Regulations. (26) Although the regulation is called an "Inheritance Tax," it would be more appropriately labeled an estate tax. (27) The tax is levied based on the entire value of the assets in the decedent's estate, rather than on the amounts received by individual heirs or devisees. (28)

The regulations levy a tax on all assets located within the national borders of China that are transferred at death by Chinese nationals residing abroad, as well as assets belonging to foreign nationals which are located in China at the time of death. (29) The tax also imposes on all assets, both domestic and foreign, owned by Chinese nationals residing in China at their time of death. (30)

B. Specific Provisions

There are a number of troubling provisions within the Draft Inheritance Tax Regulations. Part III.B will discuss the provisions that create potential problems. It will then provide suggestions for improvement.

1. Tax Exempt Status of Insurance Proceeds

The first major issue with the regulations is the exclusion of insurance proceeds from the taxable amount of the estate. (31) This provision creates a large loophole for wealthy individuals looking to avoid the inheritance tax. By including such a provision in the regulations, China provides an incentive for individuals to purchase life insurance plans with high benefit levels, since the proceeds would not be included in the taxable estate. (32)

In order to prevent avoidance of the tax via the purchase of high-benefit insurance policies, most wealth transfer tax regimes worldwide include insurance proceeds as part of the taxable estate. (33) Excluding full life insurance benefits would undoubtedly lead to over-insurance on the part of Chinese nationals and greatly undermine the purpose of the tax. (34) Thus, the Draft Regulations should be amended before passage to close this loophole.

There are many ways to modify the regulations to close this loophole without placing an undue burden on future heirs. (35) One solution would be to make benefits paid to certain classes of individuals tax exempt or subject to a lower rate of taxation. (36) The regulations could provide, for example, that life insurance benefits payable to the decedent's spouse or minor children be excluded from the taxable estate, but that all other insurance benefits arising from policies held by the decedent and payable upon death should be subject to the tax. This modification alone, however, would not eliminate the ability to buy large-benefit life insurance policies in order to pass large amounts of wealth to one's children, so long as the policyholder dies when the child-beneficiary is still a minor. (37) Moreover, the regulations could include a cap on the insurance proceeds that qualify for tax-free status. A cap on the tax-free amounts would allow decedents to provide for their families while also preventing the extremely wealthy from using insurance policies as a mechanism for tax-flee transfer upon death. (38)

2. The Threshold Value for Estates Subject to the Tax

A second major issue relates to Article 7 of the draft regulations. Article 7 establishes a basic exemption of 200,000 renminbi, effectively rendering estates with a total asset value below this threshold amount exempt from the tax. (39) A threshold of 200,000 renminbi, the equivalent of about 31,900 USD, (40) is quite low compared to other wealth transfer tax systems worldwide. (41) It should be noted, however, that the exemption provided in Article 6, Clause 7, which provides for an exclusion from the tax of up to 500,000 renminbi for housing shared with certain family members, reduces the impact of the low threshold to some extent. (42)

Even assuming that an individual estate is able to take full advantage of the 500,000 renminbi housing exclusion afforded by Article 6, Clause 7, the total amount excluded comes to a mere 700,000 renminbi, or 111,600 USD. (43) With average home prices in major urban areas easily exceeding the 500,000 renminbi exclusion for housing, (44) the 200,000 renminbi basic exemption will frequently be surpassed. Consequently, a very large number of estates will owe some tax under the draft regulations. This is in stark contrast to the United States estate tax, which in 2009 imposed tax liability on only 1 in 166 deaths. (45) Given the level of attention afforded to the United States estate tax, one can only imagine the potential for public discontent that could result from levying such a broad tax on Chinese citizens.

Raising the basic exemption from 200,000 renminbi to 800,000 or 1,000,000 renminbi, (46) as many scholars have proposed, would make administration of the tax much easier, (47) as significantly fewer estates would be subject to the tax in any given year. According to a 2012 report by Boston Consulting Group and China Construction Bank, there were 1.74 million households with a net worth of 6,000,000 RMB or more that year. (48) This number is on the rise, with a 17 percent growth rate from the previous year. (49) Moreover, raising the basic exemption would help ensure that the tax achieves the goal of reducing wealth inequality, while not overly burdening citizens of average means. (50)

3. Restrictions on Transfer of Assets until Tax is Paid and Approved by the Tax Authorities

Under the draft regulations, an heir or devisee would have to wait approximately four months after the decedent's death before obtaining title to any property left to them. (51) Generally, Article 15 provides that the estate cannot be divided up, and no inheritances may be distributed, until tax is paid on the entire estate. (52) Articles 19 and 20 provide that the estate tax return must be filed within two months of death, and the...