To counter the recent slowdown of foreign direct investment in China and the decision of some multinationals to move their manufacturing operations to South Eastern Asia countries, the Chinese government has been pushing for greater investment incentives to attract and keep foreign direct investment in China.
As a part of this drive, four key government agencies, on December 21, 2017, introduced a new scheme for deferring withholding tax which would otherwise be imposed on dividends distributed to foreign investors if the dividends are reinvested in China.
The agencies – the PRC Ministry of Finance, the State Administration of Taxation, the National Development, and the Reform Commission and Ministry of Commerce — jointly issued the Circular on Policy Issues Concerning Deferral of Withholding Tax Where Foreign Investors Directly Invest in China After-tax Profits Distributed to Them, Caishuizi  No. 88, (Circular 88).
Circular 88 grants a temporary non-imposition of withholding tax vis-à-vis dividends foreign investors receive from their Chinese subsidiaries if they reinvest such dividends in China in projects which fall within the Encouraged Category of China’s Catalogue for the Guidance of Foreign Investment Industries and its equivalent for China’ Midwestern Regions.
Typical Encouraged industries are: water conservation; environmental protection; scientific research and technological services; lightweight and eco-friendly metals for aviation and auto industries; and batteries for electric cars, which are key components for new-energy cars.
The new dividend withholding tax deferral scheme is applicable only if the re-investment is made to increase the registered capital of an existing company, contribute to the registered capital of a newly-established company, or acquire an equity interest of an existing company from its current shareholder(s) excluding contributions to the newly-increased registered capital, conversion of its share of the capital surplus into registered capital, and acquisition of shares of companies listed in the PRC, but including such reinvestment in PRC-listed companies where the foreign investor qualifies as a “strategic investor” under China’s Administrative Measures for Strategic Investment by Foreign Investors in Listed Companies.
Transfer of reinvested funds
Also, the new rules do not allow the reinvested funds to be routed through any other bank accounts in or outside China.
Circular 88 provides that if reinvestment is made in cash, the funds for such reinvestment shall be remitted by the dividend-distributing company directly into the bank account of (i) the company in which the reinvestment will be made (re-investee company) in the case of the establishment of a new company or by making a contribution to the existing or increased amount of registered capital of a re-investee company, or (ii) the transferor which transfers the equity interest of an existing company to the foreign investor in the case of an equity acquisition.
Further, the circular states that where reinvestment is made in kind, such as in securities or other non-cash forms, the legal ownership of such non-cash assets shall be passed directly to the reinvestee company or transferor of the equity interest.
As such, before the reinvestment is made, these non-cash assets shall not be held by any other enterprise or individual in trust or on a temporary basis.
Moreover, to avoid withholding tax leakage, Circular 88 requires that when and if a foreign investor recovers such re-invested capital through an equity transfer, buy-back, or liquidation, the foreign investor shall report to the competent tax authority and pay withholding tax deferred under Circular 88 within 7 days of recovering such capital.
This tax claw-back does not apply if the disposition of such reinvestment is resulted from a tax-free re-organization and tax-free treatment was actually granted.
Retroactive tax incentive
Last, but not least, Circular 88 takes effect retroactively from January 1, 2017.
Foreign investors who have already paid withholding tax on dividends received on or after January 1, 2017, before re-investing in China, may apply for tax deferral treatment under Circular 88, and claim a tax refund within three years after the actual payment of the withholding tax, provided that such re-investments meet all conditions mentioned above.
—David Dingfa Liu is a Partner, FuJae Partners, Shanghai, China, where his practice is focused on FDI-related corporate, M&A, international arbitration and tax matters. He can be reached at email@example.com or +86 21 22859818.