Written by: Wei Cui

Posted on December 5, 2019

In the very first weeks of 2019, the Chinese State Council announced a panoply of “inclusive” tax cuts intended to deliver benefits to over 95% of all Chinese businesses. The appeal to “inclusivity” (普惠性) is uncommon in tax policy anywhere. But this unusual terminology does appropriately mark a new phase in the development of Chinese public finance, which I believe deserves scholarly attention. I plan to probe this topic in the coming months. In this first post, I use the State Council’s announcement to illustrate a pervasive feature of Chinese tax law and its relation to tax politics.

One of the State Council’s tax cuts announced in January is to extend temporarily (for 2019-2021) a corporate income tax preference to a larger range of firms. Prior to 2019, firms that had fewer than 80 employees (or 100 in the case of manufacturing firms) and RMB 10 million of assets (RMB 30 million for manufacturing firms) enjoyed effectively a 10% rate on their taxable income, if their taxable income as normally computed is less than RMB 1 million. The nominal tax rate is supposed to be 20%, but qualified firms only need to include half of their income as normally computed. The 2019 “inclusive tax cut” extends this 10% tax rate to all firms (regardless of sector) that have fewer than 300 employees, RMB 50 million in assets, and less than RMB 3 million in taxable income. The Ministry of Finance (MOF) calls such firms “small and micro-profit enterprises” (小型微利企业). Moreover, for such firms that earned less than RMB 1 million of taxable income a year, they only have to include a quarter of the income when computing tax liability, and can therefore enjoy a 5% tax rate.

This is pretty generous tax policy. A 5% or even 10% corporate tax rate is lower than the corporate tax rates in tax havens like Ireland, Hong Kong or Singapore, as well as the combined federal and provincial business income tax rates in any Canadian province. Readers living in countries less populous than China will probably be struck by the idea that a firm with up to 300 employees is still regarded as “small”. Those financially-oriented may also take note that firms with 3 million yuan of profit (representing a minimum return-on-assets of 6%, given the asset cap at 5 million yuan) are still regarded as “micro-profit”. In comparison, a “small business” in Canada that enjoys a low tax rate must have fewer than 100 employees and under $500,000 in annual income.

But the MOF’s use of the term “small and micro-profit enterprises” (SMPE) is odd in another, legal sense. This is because the very same words represent a defined term in China’s Enterprise Income Tax Law (EITL). Article 28 of the EITL provides that “the enterprise income tax on a small micro-profit enterprise that meets the prescribed conditions shall be levied at a reduced tax rate of 20%.” (The regular tax rate is 25%.) “SMPE” therefore must be defined to specify the scope of application of the preferential 20% rate under the statute. And sure enough, Article 92 of the 2008 State Council Enterprise Income Tax Law Implementation Regulations (EITLIR) states:

The term “qualifying small micro-profit enterprises” as used in Article 28 (1) of the EITL are enterprises that meet the following conditions…:

(1) an industrial enterprise shall have an annual taxable amount not exceeding 300,000 yuan, have not more than 100 employees, and a total asset of not more than 30 million yuan;

(2) any other enterprise shall have an annual taxable amount of not more than 300,000 yuan, have not more than 80 employees, and a total asset of not more than 10 million yuan.

In short, the SMPE concept has a specific definition under a formal legislative instrument: the EITLIR is what is called an “administrative statute” (行政法规), similar to secondary federal legislation in Canada.

Before 2017, the MOF and China’s State Administration of Taxation (SAT) appeared to take the view that any policy adopted under the corporate income tax must at least nominally be consistent with the EITL and EITLIR. After all, the EITL, enacted in 2008, was one of only two substantive tax statutes China had until 2011, and, by being an exception, represented the idea of “taxation according to law”. This is why the 10% business income tax rate was introduced in 2009 (at that time for firms earning less than 30,000 yuan in annual income) through the device of half income inclusion: there is no 10% statutory tax rate, after all.

The Chinese government continued to lower the tax rate for SMPEs through the legal device of half-income inclusion between 2010 and 2016. By 2016, all businesses described in Article 92 of the EITL were entitled to include only half of their taxable income. Effectively, no firm at that point was paying at the 20% rate.  But the government could still describe the 10% tax rate as a policy applied to SMPEs.

In 2017, however, the State Council wanted to extend the 10% tax rate to more firms. It apparently had no appetite for doing so through amended legislation. Instead, the MOF and SAT announced, in an informal policy circular, that “SMPEs” with annual income up to 500,000 yuan could claim a 20% tax rate and half income inclusion. This seemed sloppy, to say the least, since by definition (per Article 92 of the EITLIR), a firm with more than 300,000 yuan of annual income cannot be an SMPE. Consequently, the SAT, in providing further guidance under this new policy, stated that “SMPE” meant either firms defined under Article 92 of the EITLIR or the 2017 informal circular.

One charitable explanation for why the government adopted this sloppy drafting is that in 2017, only the taxable income threshold increased, while the employee and asset thresholds remained the same as under Article 92 of the EITL. So a firm earning half a million of annual income can still be recognized as an SMPE for meeting the other EITLIR requirements. The advantage of this sloppiness, presumably, is that the policy still can refer to the 20% statutory tax rate, so the break from the EITL is not total.

As though emboldened by the fact that no one in China seemed to be bothered by this legal inconsistency, the MOF and SAT, acting at the direction of the State Council, increased the “SMPE” income threshold to 1 million yuan in July 2018. Even this was not sufficient economic stimulus, so the State Council, in January 2019, lifted both the employee and asset thresholds for applying the low business tax rates. This means that the SMPE term is now completely unanchored from its definition in the EITLIR. The very same words have both a statutory and a extra-statutory meaning.

Do the State Council, MOF and SAT have any authority to bypass the EITL and EITLIR this way? Chinese government lawyers often point to the following two provisions of the EITL as relevant:

“Article 35 The specific measures for the preferential tax treatments as mentioned in this Law shall be formulated by the State Council.

“Article 36 Where the national economic and social development so requires, or the business operations of enterprises have been seriously affected by emergencies and other factors, the State Council may formulate special preferential policies concerning the enterprise income tax and submitted them to the Standing Committee of the National People’s Congress for archival purposes.”

In other words, the State Council and its agents can interpret or change corporate income tax law as much as it wants without the constraint of statute. The use of the SMPE concept in policies since 2017 seems to imply that Article 36 may even be taken as authorization to the executive branch to re-write the EIT law altogether, using the very same terms as the original statute. Why, one wonders, should the executive branch even feel hindered by the 20% statutory rate?

All this may seem mere legal quibble. From the perspective of whether the tax cut will be implemented in China, perhaps it is. But dismissing the significance of this and other similar incidents would be wrong, as it would ignore how much the slogan of “taxation according to law” has dominated both government and academic discourse in China in the last decade. The blatant disregard for the letters of the statute illustrated by the story of the SMPE term shows to me that the entire discussion of “taxation according to law” in China is a hoax. The politics of this hoax forms an important subject of my book.

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