New developments affect China, India.

China and India are two of the fastest developing economies in the world, and special tax incentives and tax holidays have been significant contributors to the growth in these markets. Recent tax developments should be considered in connection with new and existing investments in these countries.

Effective generally as of January 1, China and Hong Kong have entered into a favorable income tax treaty that should allow increased tax efficiency on funds coming out of China into Hong Kong. In general, the treaty simplifies the current tax regime and should open up the use of Hong Kong as a base for their mainland operations. For example, among other favorable provisions, the treaty reduces the withholding tax rate from 10 percent to 7 percent on both interest and royalty payments. As a result, a Hong Kong holding company may be a favorable vehicle for moving taxable profits out of China through royalty and interest deductions.

A Hong Kong holding company may also be an effective structure for Chinese manufacturing operations to minimize their profit in China. For example, it should be possible to have a Hong Kong company take title to raw materials and hire its Chinese subsidiary to manufacture the product. The Hong Kong company would sell the product and pay tax on approximately 50 percent of the profit under the special Hong Kong sourcing rules (i.e., an effective tax rate of approximately 8.75 percent, or one half of the statutory rate of 17.5 percent), and only the arm's-length service fee would be taxable in China. The remaining profit would be untaxed.

The foregoing strategies may become increasingly important for multinationals to consider if and when the Chinese government approves the proposed new corporate income tax law. Its proposals, if adopted, would eliminate certain preferential tax rates currently available to foreign invested enterprises (FIEs) and unify the corporate tax rate at 25 percent for both FIEs and domestic investment.

Currently, many FIEs are taxed at a 15 percent rate, so these proposals could meaningfully increase operating costs in China. While the proposals do contain transitional and grandfathering rules that would continue the 15 percent rate in some cases, serious thought should nevertheless be given to planning for new investments into China.

In addition to the legislative changes, China has begun to focus on inter-company transfer pricing; the Chinese tax authorities are aware that transfer pricing has been used to shift profits out of China and avoid Chinese taxes. Thus, it has become increasingly important to analyze and document inter-company transactions and pricing arrangements in China.

The most significant and favorable tax change in India over the last year or so has been the creation of special economic zones that allow for special tax incentives to stimulate investment. On the negative side, however, changes are being seriously considered to the Indian-Mauritius tax treaty.

Mauritius has historically been used as a base for setting up a holding company for Indian investment because the current tax treaty provides an exemption from the Indian non-resident capital gains tax. As in the case with other Indian tax treaties with tax-friendly jurisdictions, the Indian Ministry of Finance is contemplating changes that would essentially disallow tax treaty benefits to a company with few or no business operations. Thus, care should be taken to ensure that a Mauritius holding company, or a company in another tax jurisdiction, has substance in order to claim the tax treaty's benefits.

--Contributed by David Hryck, an international tax partner in the New York office of DLA Piper U.S. LLP.