At the start of the third millennium, China marked the 21st century as the "China Century." In recent years, China acts unceasingly on every plane and in every sector to place itself as the leader, or at least as an equal, relative to the world's superpower - the United States. This momentum commenced with the decision of the Olympic Committee that the 2008 Olympic Games will be held in China, while China decided that, as the Games' host, it would update its internal infrastructure; "show" the world its strength and power (in a variety of aspects); and present "the real, modern China, the China of the next centuryâ€¦" China advanced in significant sectors in most economic and life sciences sectors in order to adapt itself to the Western world. The country changed the exchange rate (mainly under pressure from the US). In order to reduce the cost margin and to simplify imports into the US and Europe. China "retook" Hong Kong and Macao from the British and the Portuguese, and slowly (during the next 50 years) will transfer their management and administration to the "Chinese system," including conversion of the Chinese language to the second language. China opened its domestic economy to private enterprises, enabling a material increase in the socioeconomic level and equal opportunity for the Chinese population within China (still, clearly with certain limitations and restrictions). Extensive changes are also evident in the sectors of technology and industry, and most of the world's population, especially in the US and in other Western countries, are affected directly by every change in China and its economy. The material improvement in the quality of its industrial production has resulted in many Western countries transferring their manufacturing facilities to China, thereby reducing drastically the prices of their products. Concurrent with the personal development of much of China's population, its technological development and exposure to the West, negative factors also affect China and its people. In recent years, as a result of increased industrial activity, rivers became contaminated, mountains were quarried for raw materials, lakes were dried up, roads and infrastructure were constructed that change the natural surroundings, with associated destruction in many locations. Recently, as a result of understanding of the cumulative damage to China's land and image, the country began to change its consideration in this regard, and various laws regarding environmental protection, restrictions on industrial pollution and on air pollution, are in the process of enactment. Also on the personal level, China is undergoing a revolution, with both positive and negative implications, mainly in large commercial cities. Some Chinese earn between $1 and $3 per day, while others now earn substantial salaries (also in Western terms). Today, Chinese who are employed in the medium-level management or in the tourism and hotel sectors earn more than $1,500 per month. As a result of social pressure and the freedom to change one's place of work, many "migrate" between places of work that offer them better salary or preferential conditions. This situation has resulted in pressure on companies and in economic entities to offer more and more and to remunerate their employees in excess of accepted Western standards - only in order to retain these employees. Chinese tax reform During the 5th Session of the 10th National People's Congress (NPC), which was concluded on March 16, 2007, the Corporate Income Tax Law (New Tax Law) was approved and will become effective on January 1, 2008. The new law aims to level the playing field for all companies in China and adopt more streamlined tax incentives, since China is in hot demand and no longer needs to use tax incentives to entice foreign investors. The new tax law establishes a unified 25% tax rate. With an exception for certain enterprises with small profits, both domestic companies and Foreign Invested Enterprises (FIEs - for example, Israeli-owned) in China will generally be subject to the 25% rate. Under the current tax law, the 33% statutory income tax rate applies to domestic companies; while certain FIEs may enjoy an exemption or preferential tax rate of 24% or 15% as well as a tax refund on reinvestment of after tax profits. The unified tax rate significantly reduces domestic companies' nominal tax burdens, but for many FIEs currently under the preferential tax regime, their tax costs are expected to increase. Certain existing tax benefits, especially for hi-tech enterprises located in National Hi-Tech Industrial Development Zones, will now be implemented nationwide. It is expected that the definition of hi-tech enterprises will be updated. Income derived from qualified environment protection, energy and water-saving projects and technology transfer may enjoy tax reduction or exemption under the new tax law. The new law provides grandfather (transitional) provisions for existing FIEs owned by Israelis and others. For FIEs that are currently enjoying the preferential tax rate of 15% or 24%, their applicable tax rate increase will gradually be phased in to the new 25% tax rate during a five-year transitional period. For example, the 15% tax rate will increase by 2% per year until it reaches 25% by the end of the five-year transition period. Entities that are currently benefiting under the fixed-term tax holiday regime will retain the remaining tax holiday until it is exhausted. If the tax holiday has not yet commenced due to accumulated losses, the tax holiday will be deemed to begin in 2008. Transition relief will also be available to some qualified hi-tech enterprises that are newly established in specific areas, such as Shanghai Pudong New Area and the current five Special Economic Zones. They may be able to avail themselves of the 2+3 tax holiday (2 years exempt, 3 years 50% exempt). The new tax law provides that withholding taxes of 20% will apply to passive income. Passive income is defined to include dividends, interest, royalties and capital gains. It is expected that further guidance on this subject will be provided in the detailed implementing regulations. What does all this mean for an Israeli business? Israeli businesses and consumers already enjoy cheap Chinese products and strong demand for Israeli technology, products and services. Nevertheless, Israeli investors and businesses should consider the Chinese tax changes that will occur at the beginning of 2008. There is a tax treaty in force between Israel and China - it does not cover Hong Kong. Among the things to check out are the following: 1) In Israel, the regular corporate tax rate is 29% in 2007, 27% in 2008, 26% in 2009 and 25% (like in China) commencing in 2010. But productive plants in Israel will continue to enjoy exemption or lower rates (10% to 20%) under the Israeli "privileged enterprise" and "approved enterprise" regimes. 2) How can you combine Israeli tax breaks with low Chinese labor costs? Sometimes technological products developed, owned and supervised in Israel may be granted privileged enterprise tax breaks even if subcontractors outside Israel are used. This is sometimes referred to as the "fabless fab" (fab is short for a fabrication plant). Specialist advice should be obtained in specific proposed cases. 3) The Chinese tax authority will be on the look-out for anyone doing business via a "permanent establishment" (fixed place of business, branch) in China to pay Chinese corporate tax on profits attributable to China. An Israeli company with a branch in China can credit the Chinese tax against Israeli company tax. 4) Check that inter-company transactions are on "arm's length" terms according to the requirements of the tax laws of each country. 5) Consider arranging for a Chinese subsidiary or joint venture company with accumulated profits to pay dividends before the end of 2007 without Chinese dividend withholding tax. In 2008, China will impose a 20% withholding tax, although this should decrease to 10% under the China-Israel tax treaty. This may be especially worthwhile if Chinese tax incentives were obtained. 6) Consider the new Chinese tax residency rules so that one is not inadvertently deemed to be a Chinese resident, e.g. by having management level meetings in China. 7) Check the Chinese VAT situation especially the partial VAT penalty on Chinese exports which incorporate raw materials imported into China. Consider an appropriate business model that may mitigate this problem. In conclusion, the changes in China are amazing, and are taking much less time than would be needed in other countries. The changes are so comprehensive and far-reaching that even the Chinese do not always believe their own eyes, especially during the last two years. As always, consult with legal, commercial and tax specialists in each country. Leon.firstname.lastname@example.org email@example.com Leon Harris is an International Tax Partner at Ernst & Young Israel. Ziv Rotem-Bar is an expert on business and procurement in China and author of "Sourcing-China and Hong Kong."