The PRC is putting policies in place to foster private investment into targeted technology areas
Inside China, written by FenXun Partners’ Xusheng Yang and Sue Liu, is an insight into aspects of the China market that often elude the naked eye. |
On June 18, the US Senate voted to reinstate a crippling sanction on ZTE Corporation, one of the largest telecommunication equipment manufacturers in the world. This rebuked an earlier agreement by the Trump administration to suspend and modify an order of denial of export privileges that had been imposed by the US Department of Commerce on ZTE in April 2018 for violation of US export sanctions. The denial order, which effects a ban on US firms to supply ZTE with components and technology without special licence for seven years, was so wide-ranging that ZTE had to suspend its major operations in May. To avoid the collapse of a Chinese state-owned enterprise that is listed on both the Shenzhen and Hong Kong stock exchanges, state power came to the rescue. In early June, as part of a trade deal between the US and China, ZTE was granted a reprieve in exchange for paying a $1 billion fine and accepting close monitoring by US regulators. Thinking it had overcome an existential crisis, the company's stock resumed trading on June 13 after a two-month suspension. But all of a sudden, ZTE's survival has been thrown back into doubt.
ZTE's final fate aside, the chokehold that the US has on Chinese telecom giants appears to have touched a nerve. Few, if any, sympathise with ZTE, but the twists and turns it experienced repeatedly brought into sharp focus Chinese manufacturers' debilitating dependence on foreign technologies and high-tech components. To avoid a squeeze between competition from lower labour cost regions in other parts of the world and deep-rooted reliance on technology controlled by developed countries, the Chinese government has been working on reforming the manufacturing sector. In May 2015, it announced a comprehensive state-led initiative to upgrade China's manufacturing sector in targeted areas. A key component of the initiative is the promotion of innovation and technology development by Chinese companies. On top of the deployment of state funding into identified industries and companies, utilising incentive policies to energise private capital and to direct private investment into targeted areas is a vital part of the implementation of such an initiative.
Venture capital's appetite for long-term high growth in early-stage and small enterprises has put it on the forefront of technology innovation. Some of the most popular investment areas for venture capital include artificial intelligence, biomedicine, green energy and automation, which match well with the upgrade of made in China. Although a late starter, China's venture capital industry has experienced exponential growth since the late 1990s, with its largest telecommunication, media and technology companies leading the charge. According to reports released by KPMG, the size of venture capital investment in China reached $35 billion in 2016 and $40 billion in 2017. Effectively channelling venture capital investments into target industry segments would be a win-win strategy for all. To tilt the balance, a set of rules on tax deduction for venture capital and angel investment into early-stage technology companies were put in place. Following a test run in nine municipalities and districts, the application of these tax incentives was expanded to the entire Chinese mainland in 2018. The tax incentives are provided in the Circular on Tax Policies for Venture Capital Enterprises and Individual Angel Investors (Circular 55), promulgated on May 14 2018 by the Ministry of Finance (MoF) and the State Administration of Taxation (SAT).
Main provisions
In accordance with Circular 55, qualified investors may deduct up to 70% of the qualified investment amounts from their taxable incomes. Although there have been various versions of similar tax incentives for venture capital investments, Circular 55 appears to offer the most accessible and inclusive terms so far. For instance, as a welcome deviation from previous comparable tax incentives, both enterprise investors and individual investors may benefit from such tax incentives.
Qualified venture capital investment enterprises may claim the prescribed tax deductions if they are established in mainland China as tax resident enterprises (eg companies but not partnerships). Only partnerships that are tax resident enterprises are subject to audit collection (as opposed to verification collection) for enterprise income tax purposes, and they are not owned by founders of the invested tech start-ups in question.
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In accordance with Circular 55, qualified investors may deduct up to 70% of the qualified investment amounts from their taxable incomes |
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In addition, such venture capital investment enterprises should have filed with the National Development and Reform Commission (NDRC) as venture capital investment enterprises in accordance with the Interim Measures on Administration of Venture Capital Investment Enterprises, promulgated by the NDRC on November 15 2005. They also need to have complied with article 8 (Special Provisions in respect of Venture Capital Investment Funds) of the Interim Measures on Supervision and Administration of Private Investment Funds, promulgated by the China Securities Regulatory Commission on August 21 2014. Further, a qualified venture capital investment enterprise may not hold, together with its affiliates, 50% or more of the equities in the invested tech start-up two years after its investment.
In addition, individual angel investors may claim such a deduction if they (i) are not founders or employees of the tech start-up in question or the founders' or employees' respective relatives, and do not have labour dispatch relationships with the invested tech startup; and (ii) hold, together with relatives, less than 50% of the equities in the invested tech start-up two years after the investment. The term relatives covers spouses, parents, children, grandparents, grandchildren and siblings.
Qualified investment targets under Circular 55 are described as seed period and start-up period technology companies. A qualified tech start-up should also be a tax resident enterprise that:
is established in mainland China and is subject to audit collection for tax purposes;
has, at the time of investment, no more than 200 employees (at least 30% of which are college educated);
whose total assets or annual revenue don't exceed RMB30 million ($4.63 million);
has been, as of the time of investment, in existence for no more than five years (60 months);
is not, at the time of investment, and for the two years thereafter, listed in any domestic or foreign stock exchanges; and
has, in the concurrent and subsequent tax years of the investment, R&D expenses of no less than 20% of its total costs and expenses.
Circular 55 does not provide a definition of technology company, nor does it cite other laws and regulations for reference. However, in May 3 2017, the SAT, together with the Ministry of Science and Technology and the MoF issued Evaluation Measures for Small and Medium-Sized Technology Companies which may offer some indication as to what a technology company is in the eyes of the SAT.
What is a technology company
The Evaluation Measures set up three evaluation categories – technology personnel, R&D input and technology achievements. The technology personnel category evaluates the percentage of employees (including full-time, part-time and temporary employees) that directly manage, conduct or service R&D and technology innovation activities. The R&D input category refers to the percentage of costs and expenses incurred for R&D activities against either revenue or overall costs and expenses of a company. The technology achievements category evaluates the quality and quantity of intellectual property owned by the company that is relevant to the company's main products or services.
Obviously, the tech start-ups under Circular 55 can be distinguished from the technology companies referred to in the Evaluation Measures. Still, the latter offer some guidance on identifying technology companies, even though the measures provided therein may not be directly applicable.
Identifying qualified investments
A qualified investment should be made through the subscription of equity shares (as opposed to bonds or convertible bonds) directly from, and payment of cash consideration (as opposed to other assets) to, the target company (as opposed to acquisition of existing shares from other shareholders). A qualified investor may start to claim applicable tax deduction after a holding period of two years (24 months).
Starting from the tax year in which the two-year holding period is fulfilled, a qualified investor may claim deduction from its taxable income of up to 70% of the qualified investment amount.
Applying deductions
Such a deduction may be applied to offset (i) the taxable income of a qualified investor that is a tax resident enterprise; (ii) where the qualified investor is not a tax resident enterprise (such a limited partnership), the taxable income of its resident enterprise investors or individual investors that is derived from such qualified investor; or (iii) the taxable income of an individual angel investor that is derived from a transfer of shares (dividends and other types of income do not qualify) of such tech start-up.
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The fact that Circular 55 provides for the passing of deductions through the qualified investor itself makes this omission rather peculiar |
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In the event that the taxable income for the applicable tax year is insufficient to fully apply the deductible amount, the excess deductible amount may be carried forward into subsequent tax years. No limit has been provided on the number of tax years such a deduction carry forward may apply for venture capital investment enterprises. Given that the main resource of income for a venture capital investment enterprise is presumably portfolio venture capital investments, a deduction attributable to one qualified start-up may be applied against all tax income of an enterprise investor. On the other hand, an individual's income may derive from various other resources, eg salaries, or investments in financial products or real estate etc. As such, Circular 55 made it clear that deductions attributable to an individual investor's investment in a qualified tech start-up may only be made again taxable income derived therefrom.
Where an individual angel investor invests in multiple qualified start-ups, unused deductions derived from one qualified tech start-up may, following the dissolution of the tech start-up, be applied against income derived from transfer of shares of other qualified tech- start-up within a 36-month period following dissolution. Any unused deduction after the 36-month period will expire. As a result, individual angel investors have comparatively more restricted income categories to offset against, need to wait longer (ie until the exit) to utilise applicable deductions, and are more restricted on deduction carry forwards. It appears that, solely from a tax perspective, individuals may suffer less favourable deduction terms by investing directly, rather than investing through a qualified venture capital investment enterprise.
Circular 55, however, does not expressly provide a scenario where the qualified investor is a partnership, and one or more investors in the qualified investor are also partnerships. Partnerships are treated as pass-through entities in Chinese tax regulations and are popular in the private funds sector. It is quite normal for a venture capital fund formed as a limited partnership to have fund investors that are partnerships. And, such fund investors may, in turn, be partnerships. The fact that Circular 55 has provided for the passing of deductions through the qualified investor itself makes this omission rather peculiar. Whether a deduction can be passed through multiple layers of non-resident enterprises remains subject to further SAT clarification or interpretation by local tax authorities processing such claims.
Looking forward
Circular 55 becomes effective on July 1 2018, but the provisions applicable to qualified venture capital investment enterprises will be deemed to have been in place since January 1 2018. As provided in Circular 55, deductions apply retrospectively to qualified investments made in the two-year period preceding its entry into force, which means that qualified investments made by venture capital investment enterprises after January 1 2016 or by individual angel investors after July 1 2016 will be able to benefit from Circular 55.
Procedurally, a qualified investor will need to jump through a few hoops to realise a potential deduction. While venture capital investment enterprises may find some guidance in the Application Measure for Enterprise Income Tax Preferential Treatment issued by the SAT on April 25 2018, individual angel investor may need to reference the relevant enterprise income tax application requirements and confirm with local tax authorities to the correct application, filing and record keeping practice. Due to the two-year holding period, the first batch deductions may become available in 2019 in the nine pilot areas. It is expected that some wrinkles will need to be ironed out.