In the last two years, the Chinese government implemented various measures to encourage companies to engage in R&D activities. Among these measures, the Pre-Tax Additional Deduction for Research and Development Expenses Policy is the most important.
What is the pre-tax additional deduction for research and development expenses policy?
The Pre-tax additional deduction for research and development expenses policy is a policy that allows an enterprise to deduct additional R&D expenses on top of the actual expenses incurred when calculating taxable profits. Currently, the additional deduction rate is 75% (the said expenses are not converted into intangible assets) and 175% (the said expenses have been converted into intangible assets) for most companies. The rates for manufacturing enterprises and small and medium sci-tech enterprises are as high as 100% and 200%, respectively.
What is required to be qualified for the deductions?
For companies with research and development costs, this could help significantly to reduce their tax burden. However, to be qualified for the deductions, many conditions are required to be met. Firstly, it is crucial to define the R&D activities to be carried out correctly. For the additional deduction, the R&D activities refer to the systematic activities with specific goals constantly carried out by enterprises to gain and creatively apply new knowledge of science and technology or materially improve technologies, products (services) and techniques. On the contrary, for the conventional upgrade of products or directly applying certain R&D achievements, these activities are not allowed to be counted as qualified R&D activities for the additional deductions, and the costs spent on them are not subject to the additional deduction.
In addition to stipulating the scope of R&D activities, the tax authority also has requirements for accounting and management of R&D expenses. The R&D expenses should be integrated by different projects and recorded correctly in ancillary accounts, other than just recorded in regular accounts, i.e. clearly differentiated. The ancillary accounts should be set up in the prescribed format, especially for incurred R&D expenses. It is also required that R&D expenses should be accounted separately from routine production and management expenses.
To comply with the accounting requirements, it is also essential for the enterprises to organise and maintain proper supporting documents, indexed and clearly defined as linked to the R&D, in case the authorities conduct a review or question the expenses. The documents include the project plan and purpose or hoped conclusion, personnel list, commissioned contract, expenses allocation statement, etc.
Since manufacturing and small and medium sci-tech enterprises are eligible to enjoy higher additional deductions, they must meet additional criteria. Manufacturing enterprises must mainly engage in the manufacturing business and gather more than 50% of their total income from the manufacturing business.
The qualifying criteria for small and medium sci-tech enterprises are even stricter – they will be evaluated and graded based on the proportion of R&D expenses against the total sales revenues, the total costs and expenses and based on the types and quantity of intellectual property rights they own. Only when the score hits the threshold can the enterprise qualify as a small and medium sci-tech enterprise unless this enterprise already has certification of high-tech enterprise or other specified rewards or certificates.
According to the current policy, enterprises shall adopt the handling methods “based on actual R&D expenses, making an independent judgment, declaring for enjoyment and retaining the relevant materials for future reference” when enjoying extra deductions. It is efficient and time-saving for taxpayers since they do not have to wait for the tax bureau’s approval.
However, it is more challenging because the taxpayers must accurately assess what would be included. Under the circumstance where the authorities assess that the taxpayer wrongly enjoys the extra deduction, the taxpayer will not only be required to repay the saved tax but also be liable for interest and penalties.
How we can help
Due to the complexity of R&D expense issues and the potential risks, taxpayers should seek professional advice before implementing extra deductions in R&D accounting. Acclime China has been involved in many cases, helping companies set up their R&D internal accounting and tracking and assisting them when they are being checked and reviewed by the authorities.