In the first half of 2017 China rolled out a range of new tax reduction measures to facilitate the development of the Chinese economy. In particular, Premier Li Keqiang set out, in the April 2017 Report on the Work of the Government to the State Council, plans for VAT rate bracket consolidation, enhanced research and development (R&D) expense super deductions for certain small and medium enterprises (SMEs), personal income tax deductions for private health insurance, and new venture capital (VC) tax incentives.
Focusing on the latter, effective from 1 January 2017 a new tax incentive is provided to VC enterprises investing in science and technology enterprises at seed capital or start-up stage (referred to here as “technology start-ups”). The incentive had already been flagged as early as September 2016 in State Council Circular 53. The details are provided in Circular 38, issued by MOF and SAT on 28 April 2017.
Under the incentive, 70% of the investment amount can be offset against the taxable income of the VC enterprise for Corporate Income Tax (CIT) purposes. Furthermore, from 1 July 2017 equivalent Individual Income Tax (IIT) treatment will be provided for individuals investing through VC partnerships, as well as in an individual capacity as ‘business angels’. The new rules will initially be piloted in eight designated locations, including Beijing-Tianjin-Hebei, Shanghai, Guangdong, Anhui, Sichuan, Wuhan, Xian, Shenyang, as well as Suzhou Industrial Park. The details of the incentives are set out in this Alert.
The new incentive treatment applies in the following circumstances.
The tax incentive treatment only applies to equity investments are made in technology start-ups by way direct cash subscription for new equity. It does not apply where an investment is made in existing equity transferred from other existing shareholders of the technology start-ups.
Where an investment is made within the two years prior to the implementation of the new rules (i.e. January and July 2017), and where the investment is held for at least two years after the implementation date, the incentive treatment can also be applied to this investment.
In recent years, the Chinese VC industry has undergone rapid development. The emergence of new channels for financing “mass entrepreneurship and innovation” is supportive of the Chinese government’s wider initiatives to foster innovation and upgrade the Chinese economy to avoid the ‘middle income trap”. However, to-date, VC investment, particularly where it used a corporate vehicle, faced double taxation. CIT at 25% applies at entity level on dividends and gains and IIT at 20% applies to dividends received by the investors in the VC entity, as well as to gains on disposals of interests in the VC entity.
Already, for close to a decade, the 2008 CIT law and the subsequent Guo Shui Fa  No.87 provided that VC enterprises investing in non-listed small and medium high and new technology enterprises (HNTE) by way of equity investment could obtain a tax incentive. This was, as with the new VC incentive, a 70% tax deduction based on the value of the investments. The incentive had also been expanded to cover corporate investors in VC partnerships from 1 October 2015, with the issuance of Cai Shui  No.116 and SAT Announcement  No. 81.
However, the usefulness of these incentives was limited by the fact that the threshold for investee enterprises to obtain HNTE status is relatively high. In fact such threshold may be hard to reach for most technology start-ups. In addition, the existing incentives did not cover investments by individual, whether investing through a VC partnership or in their own right.
Circular 38 exhibits the following key aspects:
1. Lower investee threshold to access incentive:
The new tax incentive treatment expands the scope of eligible investees insofar as no HNTE status is required. It is noted though that the criteria for an investee to be regarded as a technology start-up map fairly closely to those for enterprises looking to access the small and medium HNTE enterprise incentives. Variations from these criteria for technology start-ups are noted here:
It might also be noted that while the earlier VC incentives simply applied the tax incentive treatment to equity investment in HNTEs, not saying in what form this investment should be made (e.g. in cash, in kind, etc.) the new incentive demands a cash investment for newly subscribed equity.
2. Greater number of potential incentive beneficiaries:
The new incentive is more expansive than the prior VC incentives, as it also applies to individual investors for IIT purposes, whether investing through VC partnerships or in an individual capacity as ‘business angel’ investors.
This being said, and as noted above, the utility of the business angel incentive is more limited that the other variants of the incentive. With the exception of cases where one of the investees undergoes de-registration/ liquidation, the tax deductible 70% of the investment in a given start-up may be solely offset against the taxable gains arising from the disposal of equity in the same start-up. It can also not be offset against dividend income derived from the technology start-up. This is different from the treatment of individuals and enterprises investing through VC partnerships, who may offset the 70% deduction against all taxable income amount allocated to them through the partnership. It also differs from the treatment of a VC corporate enterprise which is similarly unrestricted. It also differs from the earlier incentive covering VC investment in HNTEs.
3. Geographic restrictiveness:
The new incentive treatment is initially only being piloted in eight designated areas. As seen from the above, either the investee or the VC enterprise itself must be in one of the areas for the incentive to apply. However, it can be foreseen that this incentive treatment is likely to be expanded nationwide in due course.