Revisiting Tax Incentives for R&D Activities in China

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By Dezan Shira & Associates
Editor: Tongyu Zhang

Upgrading science and technology innovation is a critical component of China’s 13th Five Year Plan covering the years 2016-2020, as the Chinese government aims to upgrade its tech capabilities. As part of this effort, on December 27, 2016, the Ministry of Finance (MOF), General Administration of Customs (GAC), and State Administration of Taxation (SAT) issued a joint notice (Cai Guan Shui [2016] No.70) to standardize the duty-free import process of scientific and technological research equipment by scientific research institutions, technology development institutions, and schools.

Meanwhile, since being published in 2015, the two notices regarding deduction of R&D expenses (Cai Shui [2015] No. 119 and SAT announcement [2015] No. 97) were implemented in 2016. Therefore, now is a particularly relevant time to consider R&D related tax incentive policies for foreign-invested enterprises (FIEs) to review for effective tax planning.

Support of duty-free imports for science and technology innovation

Regarding foreign-invested R&D institutions in China, Notice No. 70 is applicable for those approved as foreign-invested R&D centers by provincial level authorities of commerce, finance and taxation, as well as local administration of customs.

According to the Notice, the import of scientific research, sci-tech development, and teaching supplies, which domestic suppliers cannot manufacture or for which they are unable to meet performance requirements, are exempt from import duties and import VAT. In addition, teaching books, materials, and relevant scientific research imported by scientific research institutes and schools, are exempt from import VAT. Note that the list of duty-free items may be reviewed within the announcement, Cai Guan Shui [2016] No. 72.

Considerations for additional deduction policies of R&D expenses

Scope of R&D activities

R&D activities refers to systematic activities that an enterprise conducts to obtain and apply new science and technology knowledge creatively or substantially to improve its technologies, product (services), and processes.

However, as the definition of R&D activities is rather vague, Notice No. 119 uses a ‘negative list’ form to exclude activities and certain industries (as listed below) that do not apply to the pre-tax additional deduction policies.

Activities:

  • Conventional upgrades of the enterprise’s products (services);
  • Direct application of certain technological research results;
  • Technical support activities provided by the enterprise to its customers following commercialization;
  • Repetitive or simple changes to existing products, services, technologies, materials, or processes;
  • Market surveys or management studies;
  • Quality control, testing and analysis, repair and maintenance in industry (service) process; and
  • Research in social sciences, arts, or humanities.

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Industries:

  • Tobacco manufacturing;
  • Lodging and food and beverage (F&B);
  • Wholesale and retail;
  • Real estate;
  • Leasing and commercial services; and
  • Entertainment.

Deductible R&D expenses

If R&D expenses incurred by an enterprise in its R&D activities have formed intangible assets and are included in the current period’s profit or loss, 50 percent of such R&D expenses will be deducted from the taxable income amount of the current year. If intangible assets are formed, pre-tax amortization will be made based on 150 percent of the costs of the intangible assets.

The specific scope of R&D expenses include:

  • Staff and labor expenses consisting of salaries, pensions and insurance of personnel engaging in R&D activities directly, and the service fees of external R&D personnel;
  • Direct costs include materials, fuels and power expenses directly consumed by R&D activities and relevant manufacturing, purchasing or testing expenses for different stages of the R&D procedure;
  • Depreciation of instruments and equipment used for R&D activities;
  • Amortization of intangible assets used in R&D activities;
  • Design fees for new products, fees for formulation of new processes, clinical trial fees for new drugs, and onsite testing fees for exploration and development technologies;
  • Other expenses directly related to R&D activities, such as technical books and materials expenses, expenses for evaluation of R&D results and so on. Note that the total amount of these expenses shall not exceed 10 percent of the total amount of R&D expenses allowed for additional deduction.

Special matters

For expenses incurred by R&D activities carried out by an external organization or individual entrusted by the enterprise, 80 percent of the actual amount shall be included in the entrusting party’s R&D expenses and allowed for additional deduction. However, expenses of R&D activities carried out by an overseas entrusted entity are not able to apply to additional deduction.

In the case of a project with high technical requirements and large investment which requires centralized R&D by an enterprise group, such a group may, based on the principles of matching corresponding rights and obligations as well as expenses and gains, share the actually incurred R&D expenses among benefiting member enterprises to allow the related enterprises to compute their respective additional deduction.

Declaration and filing of R&D expenses deduction

Enterprises should submit a “Filing Form for Enterprise Income Tax Incentives” and the R&D project documents to complete filing with the tax authorities no later than the annual computation and settlement tax declaration, and retain the following materials for future inspection:

  • Proposal and approved resolution for the independent, entrusted, or cooperative R&D project;
  • Composition of the organization or project team for the R&D project, as well as name list of the R&D personnel;
  • Contract for the R&D project, which should be registered with the science and technology administrative authorities;
  • Explanation on distribution of expenses of staff undertaking R&D activities and instruments, as well as equipment and intangible assets used for these activities;
  • Balance sheet of R&D projects, breakdown of distribution of R&D expenses, and the actual benefit-sharing ratio;
  • Subsidiary ledger for R&D expenditure;
  • Expert opinions issued by local science and technology administrative authorities; and
  • Other materials stipulated by the provincial tax authorities.
Key takeaways

In consideration of China’s economic and political environment, it is now reasonable for FIEs to evaluate the gains and losses of relocating some advanced-technological business activities in China, such as R&D research and high-tech manufacturing. Apart from the tax incentives, FIEs can also enjoy the relatively lower labor cost for skilled workers and professional researchers.

Nevertheless, FIEs should pay attention to the implementation of the additional deduction of R&D expenses for two main reasons. First, R&D activities are complex, covering the full stages of business procedure. Secondly, identification of R&D expenditure is indistinct in practice, with taxation authorities maintaining a level of administrative discretion. Therefore, it is important for enterprises to keep in contact with local taxation authorities, as well as seek opinions from professional advisors.


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