New developments affect China, India.

• Author: Hryck, David
• Position: INTERNATIONAL TAX

China and India are two of the fastest developing economies in the world, and special tax incentives and tax holidays have been significant contributors to the growth in these markets. Recent tax developments should be considered in connection with new and existing investments in these countries.

Effective generally as of January 1, China and Hong Kong have entered into a favorable income tax treaty that should allow increased tax efficiency on funds coming out of China into Hong Kong. In general, the treaty simplifies the current tax regime and should open up the use of Hong Kong as a base for their mainland operations. For example, among other favorable provisions, the treaty reduces the withholding tax rate from 10 percent to 7 percent on both interest and royalty payments. As a result, a Hong Kong holding company may be a favorable vehicle for moving taxable profits out of China through royalty and interest deductions.

A Hong Kong holding company may also be an effective structure for Chinese manufacturing operations to minimize their profit in China. For example, it should be possible to have a Hong Kong company take title to raw materials and hire its Chinese subsidiary to manufacture the product. The Hong Kong company would sell the product and pay tax on approximately 50 percent of the profit under the special Hong Kong sourcing rules (i.e., an effective tax rate of approximately 8.75 percent, or one half of the statutory rate of 17.5 percent), and only the arm's-length service fee would be taxable in China. The remaining profit would be untaxed.

The foregoing strategies may become increasingly important for multinationals to consider if and when the Chinese government approves the proposed new corporate income tax law. Its proposals, if adopted, would eliminate certain preferential tax rates currently available to foreign invested enterprises (FIEs) and unify the corporate tax rate at 25 percent for both FIEs and domestic investment.

Currently, many FIEs are...