China plans to enact a bill that would eventually unify income tax rates for domestic and foreign companies at 25 percent after years of criticism that the tax policies are unfair to domestic entities.

The Standing Committee of the National People's Congress (NPC),or China's top legislature, has initiated the lawmaking process to discuss a bill on corporate income tax on Sunday.

China's current dual income-tax structures have long been the subject of intense debate. Many Chinese economists, government officials and business leaders have openly criticized the tax policies as being unfair to domestic businesses, while offering advantages to foreign-invested enterprises (FIEs).

Chinese companies currently pay income tax at a nominal rate of33 percent, while their foreign counterparts, which benefit from tax waivers and incentives, pay an average of 15 percent.

Although the actual income-tax gap of the two types of businesses is less wide -- domestic companies pay around 24 percent and overseas-funded businesses 14 percent, many people believe that it handicaps domestic players who have been facing tougher competition since China joined the World Trade Organization in 2001.

Local companies have called forcefully for the same privileges, but foreign investors counterattack that local competitors are able to obtain preferential loans and other special treatment.

In fact, many local governments offer various tax incentives to investors, domestic or foreign, such as very low land rent or locally defined tax waivers.

The generous tax incentives have fueled foreign capital inflows. China has been one of the world top destinations for FDI, hitting 53.5 billion dollars in 2003, 60.6 billion dollars in 2004,and 60.3 billion dollars in 2006 in terms of the amount actually used.

But the WTO entry has forced China to consider revising the dual income-tax structure ranging from 24 to 28 percent to put all market players on an equal footing.

The process has, however, not been progressing smoothly. Within the government, opinion divides. While some government departments call for a fair tax system, others fear a unified tax structure would cause FDI losses.

The Ministry of Finance, major drafter of the bill, has been actively promoting the move. Finance Minister Jin Renqing openly accused the current tax regimes of being "too complicated", saying "a unified tax code will create a taxation environment that favors fair competition among all ventures registered in China."

New rate in line with international averages

The draft bill suggests a 25-percent income-tax rate for both domestic and foreign-funded businesses, which compares favorably with other countries and regions and with international rates.

There are 159 countries and regions that levy corporate income tax at an average 28.6 percent.

According to the draft law, income tax for small businesses with low profits will be limited to 20 percent. Depending on what region and what industry they are active in, small businesses now pay either 18 percent or 27 percent.

To put domestic businesses on an equal footing with their foreign counterparts, the bill authorizes domestic companies to deduct employees' full salaries from taxable income as foreign companies do. Up until now, domestic companies could only deduct a maximum of 1,600 yuan (200 U.S. dollars) per person.

The two-year full tax exemption and three-year partial tax exemption for foreign manufacturers will be rescinded and export-oriented foreign-funded businesses will no longer enjoy a special 50-percent tax break.

According to official calculation, as the new tax rate for domestic companies, which constitutes the majority of the tax base, will substantially drop, income tax collected from domestic companies will shrink by 134 billion yuan (16.8 billion dollars).

Despite an income tax increase of foreign companies of 41 billion yuan (5.1 billion dollars), the state coffer will still face a reduction of 93 billion yuan (11.6 billion dollars) in income taxation.

In 2005, China's tax revenue, excluding tariffs and agricultural tax, rose to a record high of 3.0866 trillion yuan (381 billion dollars).

Still, China's fast growing economy, improved competitiveness of businesses and growth momentum of fiscal revenue have convinced tax and financial officials that the country can afford the loss.

We push corporate income tax reform under such circumstances. It's a time favorable for reform as state finance and businesses have strong capacity to face the reform," said Jin.

Transitional measures for FIEs

To offset the impact on FIEs, the bill proposes a number of transitional measures in implementing the unified income-tax structure.

Among others, the bill allows FIEs to continue to enjoy tax incentives in five years after the new rate is effected and gradually increase income taxes.

A 10-percent tax increase for foreign businesses is not a drawback in terms of investment. For businesses, it's important to be in China," said German businessman Uwe Schmitt who works for a lining company in China.

Analysts believe that China's vast market potential and operational cost advantages will continue to make China a favorable investment option for many foreign investors.

By the end of August this year, 579,000 FIEs had been set up in China, with actually used foreign capital of 659.6 billion dollars.

The bill also extends some preferential tax policies to more businesses, such as all hi-tech companies will enjoy a 15-percent rate to boost innovation. At present, only those in state hi-tech zones enjoy the privilege.

Investment in equipment for environmental protection and water conservancy purposes and for production safety will be used to offset tax payable in the bill.

In China's legislative process, three rounds of deliberation will be conducted at the NPC Standing Committee after the draft bill is submitted.

The new income tax rate is expected to take effect in 2008 if the bill is adopted by the NPC plenary session in March 2007.

The State Council will also work on a set of detailed regulations to implement the draft bill.