This year marks the 11th consecutive year in which the Central Committee of the Communist Party of China has focused on rural issues in its most important policy statement of the year, the No. 1 Central Document. This repeated emphasis on supporting and protecting agriculture, rural areas, and farmers has led to tax incentives and other measures that make the food and agribusiness industry in China one of the more attractive areas for foreign investment from a tax perspective.
Tax exemptions for agribusiness
In 2008, China leveled the playing field for all enterprises—both foreign and domestic—by eliminating most of the preferential tax rates and holidays for foreign-invested enterprises (FIEs) through the Enterprise Income Tax Law (EITL). But the measure kept tax incentives for FIEs and domestic companies investing in the agriculture, forestry, animal husbandry and fishing industries. Specifically, the EITL Implementing Regulations exempt companies from paying enterprise income tax (EIT) on profits earned from the following activities:
- Growing vegetables, grains, potatoes, oil plants, beans, cotton, ramie, sugar crops, fruits and nuts;
- Breeding new varieties of agricultural products;
- Growing Chinese medicinal herbs;
- Cultivating and growing trees;
- Raising livestock and poultry;
- Harvesting forestry products;
- Providing services related to agriculture, forestry, animal husbandry, and fisheries, such as irrigation services, preliminary processing of agricultural products, veterinary services, agricultural technology promotion, agricultural machinery servicing, and repair; and
- High seas fishing.
In addition to the EIT exemption, China offers various value-added tax (VAT) exemptions and reductions from its standard rate of 17 percent to FIEs and domestic companies investing in crop production, breeding, forestry, animal husbandry and aquaculture industries. For example, the sale of self-produced, “qualified” agricultural products is exempt from VAT. “Qualified” products include “primary” vegetable and animal commodities from the crop production, breeding, forestry, animal husbandry, and aquaculture industries. The sale of non-self-produced agricultural products is subject to a reduced VAT rate of 13 percent. Taxpayers who engage in the wholesale and retail of vegetables, raw meat, and egg products are also exempt from VAT.
Taxpayers should pay attention, however, as the range of products that qualifies for these incentives is not always intuitive. For example, baby formula—viewed as an attractive investment area for foreign companies after contaminated domestic milk killed six babies and sickened thousands in 2008—does not qualify. Processed products can only qualify for the tax incentives if they are used in the preliminary processing of agricultural products. Preliminary processing for milk products includes purification, homogenization, disinfection, sterilization, canning, and other processes that result in pasteurized milk and ultra-high temperature processed milk. In other words, baby formula, which is milk powder and not fresh milk, would not fall within this scope and therefore does not qualify for the tax incentives.
Engaging the “company plus farmers” business model
From a commercial perspective, a foreign investor with an established FIE may still benefit from the tax incentives outlined above even if farming activities are not part of the FIE’s core expertise. The FIE can outsource the farming activities and carry out operational activities such as marketing, management, procurement, and sales. This arrangement is called the “company plus farmers” business model. Under the model, the FIE outsourcing company will assume most of the business risks so that the FIE can retain most of the profits.
The State Administration of Taxation (SAT) permits companies using the Model to qualify for EIT and VAT exemptions that would otherwise be available only to the entity conducting the outsourced farming activities. We are aware of a number of companies that use the Model to process and manufacture milk products.
Special incentives for western China
To develop China’s western regions, policymakers have prioritized agribusiness by establishing major production districts, promoting modern agriculture, and opening up more agribusiness categories to foreign investment. In addition, China provides tax incentives to enterprises that have existing operations or locate new operations in western China. From January 1, 2011 to December 31, 2020, any enterprise with operations located in western China can enjoy a reduced 15 percent EIT rate if its main business (i) is in an “encouraged industry” like food and agribusiness and (ii) generates more than 70 percent of the enterprise’s total revenue. However, only the revenue sourced from headquarters and branch offices that are located or established in western China—not the rest of China—is counted toward the 70 percent requirement.
Shifting from M&A to investment
During the last few years, most foreign investment in China’s food and agribusiness industry has been through acquisitions and not organic growth. As such, a foreign investor looking to make a food and agribusiness acquisition in China should conduct the same thorough tax due diligence that it would for any other acquisition in China. For example, the foreign investor should be on the lookout for indications that the target company keeps two sets of books—one of which understates income and overstates expenses in order to evade taxes. Although the issues may vary in degree of severity, foreign investors almost always must deal with some form of tax non-compliance in the target’s past.
A foreign investor must therefore weigh its desire to secure the deal against risk tolerance for the target’s pre-acquisition liabilities. Requiring the tax structure to be “cleaned up” as a condition for closing is one approach to dealing with these issues, but this approach has its limitations and may create further issues such as raising the acquisition price. Dealing with tax issues post-closing also requires careful planning to avoid unearthing past practices that may lead to tax audits. In many cases, buyers may prefer an asset deal rather than a share deal to avoid exposure to such liabilities.
The bottom line
Although most preferential tax rates and tax holidays for FIEs were eliminated in 2008, China’s focus on rural issues has allowed tax incentives to survive in the food and agribusiness industry. Controlling for other factors, this tax incentive policy makes the food and agribusiness industry more attractive to foreign investors than others.
[author] Amy Ling ([email protected]) is a Special Counsel in the Tax Group at Baker & McKenzie based in Shanghai. She assists multinational companies on a range of issues relating to PRC tax and legal implications of investments in China, including cross-border structuring, tax efficient holding structures, exit strategies, corporate reorganizations and repatriation concerns. She also has a special focus on tax implications on employee remuneration structures. Hardy Zhou ([email protected]) is a professional services lawyer in the Tax Group at Baker & McKenzie based in Shanghai. His practice focuses on general tax planning and tax advisory work in China. He is a current member of the Chinese Institute of Certified Public Accountants (CICPA), a member of the International Fiscal Association (IFA), a Chinese correspondent at the International Bureau of Fiscal Documentation (IBFD), and a researcher at Center for International Tax Law of East China University of Political Science and Law. [/author]