1、Summary
We review newly introduced regulations supporting pre-tax deductions for enterprise innovation in science and technology in China including recommended action to take to take advantage of these new tax preferential policies. The key points are highlighted as below.
HNTEs are entitled to enjoy a 100% super deduction of the purchase amount of the equipment and appliance newly acquired during the period from October 1, 2022 to December 31, 2022 before EIT.
Enterprises entitled to the current additional pre-tax deduction ratio of 75% for R&D expenses, can apply a ratio of 100% during the period from October 1, 2022 to December 31, 2022.
- Where the R&D expenses do not form intangible assets and are included in the current profits and losses, on the basis of actual amount or proportional amount calculated, an additional 100% of such R&D expenses could be deducted from the taxable income amount. Where intangible assets are formed, amortization will be based on 200% of the costs of the intangible assets before EIT.
2、Background
On September 7, 2022, in an executive meeting of the State Council, Premier Li Keqiang made a series of strategic proposals to stimulate consumption and encourage enterprise innovation, in order to support employment and entrepreneurship. Among these proposals, the introduction of phased pre-tax reduction policies, as a method to encourage and support enterprise innovation, has attracted the attention of qualified enterprises from a tax perspective. The Ministry of Finance ("MOF"), the State Taxation Administration ("STA") and the Ministry of Science and Technology, jointly announced on September 22, 2022, the Announcement on Increasing Pre-Tax Deduction to Support Innovation in Science and Technology ("Circular No. 28") (关于加大支持科技创新税前扣除力度的公告) to support innovative development of high and new technology enterprises ("HNTE") and enterprises with research and development ("R&D") functions.
3、Overview
Circular No.28 provides two parallel phased pre-tax reduction policies:
（1）a 100% super deduction of equipment and appliance purchase amount before enterprise income tax (EIT) for HNTEs; and
（2）an increase of the super deduction rate of eligible R&D expenses from 75% to 100% for certain qualified enterprises.
The effective period for the above phased pre-tax reduction policies is from October 1, 2022 to December 31, 2022, i.e., the fourth quarter of 2022 ("Q4 2022").
（a）Deduction of equipment and appliances purchase amount before EIT
According to Circular No. 28, HNTEs may deduct the full amount of equipment and appliances (i.e., fixed assets exclusive of houses and buildings, similarly hereinafter) that are newly purchased during the period from October 1, 2022 to December 31, 2022 from the taxable income amount on a one-off basis in the current year before EIT. This policy applies to all enterprises that have been qualified or will become qualified as HNTEs in Q4 2022.
Current laws and regulations in China also prescribe the one-off deduction rule for equipment and appliances purchased by an enterprise. Specifically, equipment and appliances newly-purchased by an enterprise during the period from January 1, 2018 to December 31, 2023 with a unit value not exceeding RMB 5 million may be included in the costs and expenses of the current period, and be deducted when calculating the taxable income amount, and are not required to be depreciated over the years. The table below provides a comparison of the current rules and Circular No. 28.
It is apparent that the EIT incentives offered by Circular No.28 to HNTEs in relation to equipment and appliances purchase expenses is significant. HNTEs that will be in a profitable position in 2022 will benefit directly from the tax savings derived from the 100% super deduction before EIT, and the tax savings will be equal to the equipment and appliances purchase expenses incurred in Q4 2022 multiplied by the preferential tax rate of HNTEs which is generally 15%.
In addition, it is worth noting that the shortfall amount for deduction in the current year to which Circular No. 28 applies may be regarded as a tax loss and carried forward to subsequent year(s) of up to 10 for HNTEs.
In light of the above, HNTEs are encouraged to accelerate the acquisition of fixed assets and increase R&D investment.
（b）Increased super pre-tax deduction rate from 75% to 100%
Circular No. 28 provides further tax incentives on the basis of existing pre-tax deduction of R&D expenses for qualified enterprises.
Applicable enterprises
For enterprises entitled to the current super pre-tax deduction ratio of 75% for R&D expenses, this ratio has been raised to 100% in Q4 2022 including enterprises other than the followings:
Enterprises in industries on the "negative list", including tobacco manufacturing, lodging and food and beverages, wholesale and retail, real estate, leasing and commercial services, entertainment and any other industries stipulated by the MOF and STA.
- Enterprises where a super pre-tax deduction ratio has been increased from 75% to 100% including manufacturing enterprises, and small- and medium-sized tech enterprises.
A super pre-tax deduction is applicable to an enterprise's R&D expenses incurred and included in the enterprise's profit or loss where intangible assets have not been formed. Where intangible assets have been formed, amortization will be based on 200% of the costs of the intangible assets before EIT. This provision is not clearly stated in Circular No. 28, but is mentioned in its subsequent operational guidelines, the Operational Guidelines for the Policy of Increasing the Super-Deduction Percentage of Other Research and Development Expenses of Enterprises to 100% (the "Operational Guidelines"), (其他企业研发费用加计扣除比例提高到100％政策操作指南) issued by the STA.
In-scope R&D expenses for super pre-tax deduction
The scope of R&D expenses for super pre-tax deduction in Circular No. 28 does not change when compared to the existing laws and regulations in China. Briefly summarized, the in-scope R&D expenses include:
Staff and labor expenses including wages and salaries and social security of employed and dispatched researchers, technicians and auxiliary personnel.
Direct costs including: (a) materials, fuels and power expenses directly consumed by R&D activities; (b) development and manufacturing expenses for moulding and technology and equipment used for intermediate testing and product trial, acquisition costs of samples, prototypes and general testing methods that do not constitute fixed assets, and inspection expenses for trial products; and (c) operation and maintenance, regulation, inspection, maintenance expenses for instruments and equipment used in R&D activities, as well as lease expenses for instruments and equipment rented in the form of operating lease and used in R&D activities.
Depreciation of instruments and equipment used for R&D activities.
Amortization of intangible assets used for 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 relevant expenses such as technical books and materials expenses, material translation expenses, expert fees, etc. which do not exceed 10% of the total amount of R&D expenses allowed for super pre-tax deduction.
Specifically, all above expenses shall be clearly separated between R&D activities and non-R&D activities, otherwise the super pre-tax deduction will not be applicable for those cannot be clearly separated.
In addition, several special matters stated in the existing tax rules and regulations in China are also applicable to Circular No. 28 although these are not specified in Circular No. 28, which include:
Entrusted R&D expenses. For expenses incurred by R&D activities carried out by an external organization or individual entrusted by the enterprise, 80% of the actual amount shall be included in the entrusting party's R&D expenses and allowed for additional deduction. For expenses incurred for R&D activities carried out by entrusted overseas parties, 80% of the actual amount of such expenses may be itemized as the principal's entrusted overseas R&D expenses. The entrusted overseas R&D expenses, to the extent of two-thirds of the domestic R&D expenses that meet the given conditions, may be eligible for a super pre-tax deduction before EIT.
Joint development. In the case of a cooperative jointly developed project, cooperation parties shall calculate additional deductions respectively for R&D expenses borne by them.
Calculation of Q4 2022 R&D expenses
According to Circular No. 28, an enterprise may opt to calculate R&D expenses in Q4 2022 based on the following two methods:
（1）on the basis of the actual amount incurred ("actual amount method"); or
（2）on the basis of proportion ("proportional method") subject to the formula below:
Q4 2022 R&D expenses = Total amount of R&D expenses actually incurred in 2022 * [the number of months of business operation after October 1, 2022 / the actual number of months of business operation in 2022]
Circular No. 28 proposes the above two alternative calculation methods of Q4 2022 R&D expenses with the aim to reduce the accounting burden of enterprises and to enable enterprises to enjoy maximum tax incentives.
Declaration procedure
To simplify the procedure, enterprises are not required to apply to Chinese tax authorities to enjoy the tax incentive upon approval. With respect to Q4 2022 R&D expenses, enterprises may enjoy the super pre-tax deduction at the time of the 2022 EIT annual filing by adopting the handling method of "self-determination, declaration of entitlement, retention of the relevant materials for future inspection". However, it is unclear whether enterprises are allowed to super deduct the R&D expenses in advance at the time of the prepayment and declaration for Q4 2022 (in case of quarterly filing of EIT) or for each month from October to December, 2022 (in case of monthly filing of EIT).
4、Implementation issues to be further clarified
The provisions of Circular No. 28 are relatively straightforward and simply set out, however, the following issues may be encountered by enterprises in its implementation, which may need to be further clarified.
The definition of equipment and appliances "purchased"
Generally, an enterprise may acquire fixed assets through multiple ways including outsourcing purchase, self-construction, financing lease, donation, investment, exchange of non-monetary assets, debt restructuring, etc. However, there is no clear definition of equipment and appliances "purchased" in Circular No. 28 and its operational guidelines. Pursuant to the interpretation of Notice of the Ministry of Finance and the State Administration of Taxation on Enterprise Income Tax Deduction Policies Relating to Equipment and Instruments ("Circular No. 54") (财政部、国家税务总局关于设备、器具扣除有关企业所得税政策的通知) issued by the STA, it is technically assumed that the "purchase" will include outsourcing purchase and self-construction. Whether this definition and interpretation is applicable to Circular No. 28 will be subject to the further clarification made by relevant authorities. Similarly, the value of fixed assets and the timing of the purchase are also yet to be clarified.
Timing of super pre-tax deduction in EIT filing
Shortly before the release of Circular No. 28, the STA announced a new regulation, the Announcement of the State Taxation Administration on Matters Relating to Enterprises' Prepayment and Declaration of Entitlement to Preferential Policies on Weighted Deduction of Research and Development Expenses (i.e., Circular No. 10) (国家税务总局关于企业预缴申报享受研发费用加计扣除优惠政策有关事项的公告) in May 2022 relating to the super deduction of R&D expenses in prepayment and declaration. Circular No. 10 provides that "an enterprise may, at the time of prepayment and filing EIT returns for the third quarter (in case of quarterly filing) or September (in case of monthly filing), choose at its discretion to enjoy the preferential policies on super deduction of its R&D expenses for the first three quarters of the current year". This means an enterprise may enjoy the super pre-tax deduction of R&D expenses policy and advance the super deduction timing for its R&D expenses for the first three quarters of 2022 to quarterly or monthly EIT filing and prepayment, instead of at the point of annual EIT filing, which is to be completed by the end of May 2023. As such, an enterprise may take advantage of cash flow savings.
Due to the lack of an explicit provision, it remains unknown whether an enterprise may save its cash flow by making an advanced super deduction of R&D expenses in Q4 2022 EIT quarterly filing/monthly filing.
5、Recommended actions
For HNETs that have fixed assets purchase needs, on the premise of maintaining an enterprise's sufficient cash flow, advance the timing of fixed assets purchase to Q4 2022 as far as possible.
Re-evaluate the progress of R&D activities and make a forecast for Q4 2022 R&D expenses. Compare the benefits with the actual amount method and the proportional method, and choose the method that can better benefit an enterprise.
For procedural items, an enterprise is not required to obtain a pre-approval from tax authorities to enjoy the aforesaid tax incentives. However, tax authorities reserve the right to conduct a post-tax inspection. This change puts forward higher requirements for the personnel responsible for tax.
In fact, tax authorities will pay more attention to enterprises enjoying preferential tax policies. When it comes to a post-tax inspection, tax authorities may generally examine materials including but not limited to:
(a)a proposal for the independent, entrusted or cooperative R&D project;
(b)a composition of the project team and a name list of R&D personnel;
(c)a contract for the entrusted R&D project;
(d)records on work of R&D personnel and usage of relevant equipment;
the distribution of personnel, equipment and intangible assets that are used for R&D projects and non-R&D projects (only the expenses incurred by personnel, equipment and intangible assets that are related to R&D activities can be factored into the basis of super pre-tax deduction; however, all expenses incurred by personnel, equipment and intangible assets cannot be super pre-tax deducted without clear distribution);
(e)an auxiliary ledger for R&D expenditure.
Where the actually incurred amounts of R&D expenses of the respective projects of an enterprise are not accurately recorded or the calculation of the total amount is inaccurate, tax authorities will have the right to make reasonable adjustments to its pre-tax deduction amount or additional deduction amount. As a consequence, an enterprise is required to remit EIT within a specified time with the imposition of late payment interest or even a penalty in certain circumstances.
6、Reference
（1）Notice of the Ministry of Science and Technology, the MOF and the STA on Revision and Promulgation of the Administrative Measures for the Identification of High-tech Enterprises (高新技术企业认定管理办法(2016年修订)).
（2）Notice of the MOF and the STA on Enterprise Income Tax Deduction Policies Relating to Equipment and Instruments ("Circular No.54") and the Announcement on Extension of the Implementation Period of Certain Preferential Tax Policies (关于延长部分税收优惠政策执行期限的公告).
（3）Notice on Extension of Carry-forward Period for Losses of High-tech Enterprises and High-tech Small and Medium Enterprises (关于延长高新技术企业和科技型中小企业亏损结转年限的通知).
（4）Notice on Improvements to Policies of Super Pre-tax Deduction of Research and Development Expenses (关于完善研究开发费用税前加计扣除政策的通知).
（5）Announcement on Further Improvements to the Policy of Super Pre-tax Deduction for Research and Development Expenses (关于进一步完善研发费用税前加计扣除政策的公告).
（6）Announcement on Further Increasing the Proportion of Super Pre-tax Deduction of R&D Expenses of Small- and Medium-sized Tech Enterprises (关于进一步提高科技型中小企业研发费用税前加计扣除比例的公告).
（7）Operational Guidelines for the Policy of Increasing the Super-Deduction Percentage of Other Research and Development Expenses of Enterprises to 100% issued by the STA.
（8）Notice on Relevant Policies for the Pre-tax Super Deduction of Expenses for Overseas Research and Development Commissioned by Enterprises (关于企业委托境外研究开发费用税前加计扣除有关政策问题的通知).
（9）Announcement of the State Taxation Administration on Matters Relating to Enterprises' Prepayment and Declaration of Entitlement to Preferential Policies on Super Deduction of Research and Development Expenses ("Circular No.10").
（10）Announcement of the State Administration of Taxation on Issues Relating to Additional Deduction of Research and Development Expenses of Enterprises (国家税务总局关于企业研究开发费用税前加计扣除政策有关问题的公告).
This article was first published in ALM.
(https://www.chinalawandpractice.com/2022/11/11/new-pre-tax-reduction-policies-supporting-enterprise-innovation/)
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