We would like to share with you a potential tax development which if endorsed by the State Council in the next month or so, will have wide-spread impact to your investment in China.

In short, it is currently proposed that when the new Corporate Income Tax Law takes effect on 1 January 2008, dividend distributed by Foreign Invested Enterprises ("FIEs") to their foreign investors will no longer enjoy tax exemption, and will be subject to 10% withholding tax if no planning is done.

For existing investments of MNCs in China, tax planning is possible to mitigate China withholding tax to say 5% e.g. through the insertion of an appropriate treaty holding company such as Hong Kong. Proper planning needs to be in place to achieve the desirable structure and tax results. For existing investments in China, foreign investors must be able to complete all the restructuring steps properly within this year so as to ensure the restructuring itself may enjoy tax free reorganisation treatment in China. It's possiple that this restructuring safe harbour may no longer be available after 2007 when the new law takes effect. Even if this regime remains in effect, the window for a tax-free restructuring may close at any time, so foreign investors should consider whether to take advantage of the tax-free restructuring before December 31 2007. Restructuring of this nature may take several months and hence early attention is warranted to this issue.

> Dividend withholding tax

Under the present China tax system, dividends repatriated by a FIE (with at least 25% foreign equity investment) are exempted from dividend withholding tax.


Potential new rules under the new CIT law

Under the new CIT system, it now seems quite likely that such exemption may only be granted to certain high-tech enterprises encouraged or supported by the state. In other cases a withholding tax is expected to come in, underlying the applicable tax treaty limitations. A grandfathering rule does not seem to be available. It is also not certain, whether pre 2008 earnings if distributed after 2007 may be treated differently.


Potential responses

In the following please find some potential reactions for the investors to such development:

• Distribute and repatriate dividends in 2007
• Distribute and reinvest prior earnings in new projects in 2007. The minimum requirement is to have the application duly filed with the tax authorities within 2007.
• Review holding structure. Check for alternative holdings in tax efficient locations such as Hong Kong, Singapore (new tax treaty signed, expected to enter into force from 2008), Luxembourg and Mauritius (all 5% according to the relevant tax treaties).
• To the extent there is significant earning generated in 2007, an interim dividend may be considered, although this is not a straightforward matter in China and may only be done with negotiation, careful planning and timely project management.

> Tax neutral restructuring

Under the current regime, restructuring of PRC equities within a 100% group may qualify for the tax free treatment under Circular 207 (Guo Shui Han [1997] 207). Among others, the circular requires that the restructuring has business purpose. Current rules do not limit the availability of tax free treatment irrespective of whether the transferee is a PRC entity or an offshore entity.

Potential new rules under the new CIT law

It is possible that in the future, equity restructuring may be tax free only if there is a 100% ownership relation between the transferee (i.e. buyer) and the transferor (seller) and the transferee is a PRC entity. It is not clear whether the 100% relationship has to be a direct parent-subsidiary relationship.


Potential responses

There are significant uncertainties with regard to the complete carryover of cirulcar 207 tax free restructuring into the new CIT regime. We nevertheless recommend to:

• Consider dividend withholding tax planning by interposing 5% treaty location holdings (see above)
• Proceed with any equity restructuring at the earliest convenience and ensure it is completed before end of 2007

Although this information is only preliminary and there is still some internal discussion among the different authorities we are of the opinion that tax planning into China should now consider a Chinese dividend withholding tax from 2008. Considering the potential change in the restructuring rules, any restructuring planning should be initiated as soon as possible, as long as the old rules shall still be applicable.