Editor's Note: Recently, HuaShui has received a large number of consultations from traditional Chinese medicine (TCM) enterprises. Although the main products of these enterprises vary, covering products such as bezoars, small rice paper plants, and Ganoderma lucidum spores, the tax issues involved are highly consistent. Specifically, these products had previously been enjoying the corporate income tax exemption policy for primary processing of agricultural products. However, these enterprises have recently received notices from tax authorities stating that the relevant product production processes do not qualify as primary processing of agricultural products and do not meet the conditions for policy application. As a result, the enterprises are required to pay back taxes for previous years along with late payment surcharges. Among these enterprises are leading companies in the TCM industry, with the amounts of taxes and surcharges involved often reaching tens of millions or even hundreds of millions of yuan. What exactly does the scope of primary processing of agricultural products include? Can related TCM products enjoy the tax exemption policy? This article aims to explore and analyze these issues.

I. Case Introduction: TCM Decoction Piece Manufacturer Found to Have Improperly Enjoyed Tax Benefits, Owing Over RMB 100 Million in Back Taxes

Company A is a Traditional Chinese Medicine (TCM) decoction piece manufacturer. Its main business involves purchasing raw medicinal materials and various excipients, processing them into TCM decoction pieces, and selling them externally. Its processing techniques include relatively simple physical processing, such as cleaning, cutting, drying, and cooling, as well as more complex chemical reactions, such as stir-frying, roasting, calcining, and steaming/boiling. In prior years, Company A had relied on the Notice of the Ministry of Finance and the State Administration of Taxation on Issuing the Scope of Primary Processing of Agricultural Products Eligible for Corporate Income Tax Preferences (Trial) (Cai Shui [2008] No. 149) to file and register its TCM decoction pieces as "primary agricultural product processing" products, thereby enjoying the corporate income tax ("CIT") exemption. In early 2026, the tax authority issued a Notice of Tax Matters to Company A, determining that it had incorrectly applied the CIT exemption policy for primary processing of agricultural products over the preceding five years, and requiring the company to pay back taxes and late payment surcharges totaling approximately RMB 108 million.

II. Dispute Focus and Tax Authority's Position

The focus of the dispute in this case is: whether the production of TCM decoction pieces constitutes primary processing of agricultural products, and whether it qualifies for the CIT exemption policy.

The tax authority's position is as follows:

Under Item (7), "Primary Processing of Medicinal Plants," in Part I of the Appendix, Scope of Primary Processing of Agricultural Products Eligible for Corporate Income Tax Preferences (Trial), to Cai Shui [2008] No. 149, the scope of primary processing of medicinal plants eligible for the tax exemption is defined as: "the production of TCM medicinal materials in the form of slices, threads, lumps, segments, etc., through simple processing treatments such as sorting, arranging, bundling, washing, drying, chopping, steaming/boiling, and stir-frying, applied to the roots, stems, bark, leaves, flowers, fruits, and seeds of various medicinal plants." Therefore, to qualify for the CIT exemption for primary processing of agricultural products, an enterprise must satisfy the statutory conditions in terms of industry classification, processing techniques, and product attributes. Specifically:

1.Industry Classification Dimension: Article 1(1) of the Announcement of the State Administration of Taxation on Issues Concerning the Implementation of CIT Preferences for Agriculture, Forestry, Animal Husbandry, and Fishery Projects (SAT Announcement [2011] No. 48) provides that, unless otherwise specified, enterprises engaged in the agriculture, forestry, animal husbandry, and fishery projects eligible for tax preferences under Article 86 of the Regulations for the Implementation of the Enterprise Income Tax Law shall refer to the classification standards of the Industrial Classification for National Economic Activities (GB/T 4754-2017). Therefore, to qualify for the CIT exemption for agriculture, forestry, animal husbandry, and fishery under the Enterprise Income Tax Law, an enterprise must first fall within the relevant industry categories under the Industrial Classification for National Economic Activities. As a TCM decoction piece manufacturer, Company A's core business is "processing of TCM decoction pieces," which falls under "Pharmaceutical Manufacturing" within the "Manufacturing" sector, rather than "Agriculture, Forestry, Animal Husbandry, or Fishery." Thus, it does not meet the industry classification requirement.

2.Processing Technique Dimension: Cai Shui [2008] No. 149 explicitly lists the eligible techniques as "simple processing treatments such as sorting, arranging, bundling, washing, drying, chopping, steaming/boiling, and stir-frying." These are essentially basic processing steps that preserve the original characteristics of the agricultural product. In contrast, the TCM decoction piece processing techniques involved in Company A's production process, while superficially similar to the techniques listed in Cai Shui [2008] No. 149, constitute a specialized pharmaceutical technology subject to the Good Manufacturing Practice for Pharmaceutical Products (GMP). They differ from primary processing of agricultural products in terms of processing purpose, technical standards, and quality control requirements.

3.Product Attribute Dimension: The tax authority explicitly states that the tax-exempt products under Cai Shui [2008] No. 149 are "TCM medicinal materials" (zhongyaocai), not "TCM decoction pieces" (zhongyao yinpian), and that these two products differ in their attributes. From a regulatory perspective, the production of TCM medicinal materials does not require a pharmaceutical license. However, under Article 44 of the Drug Administration Law, the production of TCM decoction pieces requires a Drug Manufacturing Certificate. This stricter regulatory requirement confirms the fundamental difference in product attributes between TCM decoction pieces and TCM medicinal materials. The "TCM decoction pieces" produced by Company A, having undergone processing, meet the definition of a drug and fall within the scope of pharmaceutical regulation, rather than qualifying as "TCM medicinal materials" under Cai Shui [2008] No. 149.

In summary, the tax authority determined that the TCM decoction pieces sold by Company A do not fall within the scope of the CIT exemption for primary processing of agricultural products, and the related income should be subject to CIT in accordance with the law.

III. Tax Law Analysis: Whether TCM Products Can Enjoy Tax Exemption Cannot Be Generalized

(A) Product Classification in the TCM Industry

The Announcement of the National Medical Products Administration, the Ministry of Agriculture and Rural Affairs, the National Forestry and Grassland Administration, and the National Administration of Traditional Chinese Medicine on Issuing the Good Agricultural Practice for Chinese Medicinal Materials (Announcement [2022] No. 22) provides that "Chinese medicinal materials refer to medicinal raw materials derived from medicinal plants, medicinal animals, and other resources, which are used for the production of TCM decoction pieces and TCM preparations after standardized cultivation (including ecological cultivation, wild tending, and imitated wild cultivation), breeding, harvesting, and primary processing." The General Provisions of the 2025 Edition of the Chinese Pharmacopoeia clarify that "decoction pieces refer to drugs that are directly used in TCM clinical practice or preparation production after processing... Where the processing of decoction pieces involves cleaning and cutting, unless otherwise specified, the name and related items of the decoction pieces shall be the same as those of the medicinal materials... The medicinal ingredients in the prescription refer to decoction pieces; those requiring stir-frying, steaming, boiling, or processing with auxiliary materials shall use the processed product name in the prescription." The Notice on Issuing the Rural Drug Distribution Network Publicity and Training Outlines (Guo Shi Yao Jian Shi [2006] No. 201) clarifies that Chinese patent medicines have two concepts. The narrow concept refers mainly to ready-made medicines prepared from Chinese medicinal materials according to certain therapeutic principles, which can be taken at any time, such as various pills, powders, granules, etc. — this is what people commonly refer to as Chinese patent medicines. The broad concept includes not only the narrow concept but also all Chinese herbal medicines that have undergone processing.

In summary, within the TCM industry, Chinese medicinal materials, TCM decoction pieces, and Chinese patent medicines each have relatively clear definitions. They are interrelated but distinct, constituting three different product categories. Through primary processing at the production site, medicinal plants and animals can yield Chinese medicinal materials, which serve as the raw materials for TCM decoction pieces. After processing, Chinese medicinal materials can produce TCM decoction pieces. The processing methods include physical processing such as cleaning and cutting, as well as chemical reactions such as stir-frying, steaming, boiling, or processing with auxiliary materials. In other words, the processing techniques in the TCM industry themselves vary in complexity. For example, the Chinese Pharmacopoeia lists the processing method for "Solidago decoction pieces" as removing impurities, spraying with clean water, cutting into segments, and drying. The processing method for "Croton tiglium powder" includes the "frosting method" to reduce the toxicity of croton seeds. The processing method for "processed Arisaema" includes adding alum and boiling. Ready-made medicines in the form of pills, powders, and granules prepared from Chinese medicinal materials according to specific formulas constitute Chinese patent medicines, whose processing techniques are more complex than those of TCM decoction pieces. Thus, TCM decoction pieces represent an intermediate product category between Chinese medicinal materials and Chinese patent medicines.

(B) Tax Rules Related to TCM Products Under the CIT Exemption Policy

According to Cai Shui [2008] No. 149 and its Appendix, Scope of Primary Processing of Agricultural Products Eligible for Corporate Income Tax Preferences (Trial), Item (7), "Primary Processing of Medicinal Plants," it is provided that "the production of Chinese medicinal materials in the form of slices, threads, lumps, segments, etc., through simple processing treatments such as sorting, arranging, bundling, washing, drying, chopping, steaming/boiling, and stir-frying, applied to the roots, stems, bark, leaves, flowers, fruits, and seeds of various medicinal plants, falls within the scope of primary processing of agricultural products, and the income therefrom is exempt from CIT." The same provision also contains a negative exclusion, stating that "the processing of various Chinese patent medicines does not fall within the scope of primary processing." Thus, the tax law clearly designates the exempt object as "primary processing of agricultural products (medicinal plants)." On this basis, it first positively lists that Chinese medicinal materials produced through simple processing of various parts of medicinal plants constitute primary processing of agricultural products, and then negatively excludes the processing of Chinese patent medicines from the scope of primary processing. Through this legislative model combining positive enumeration and negative exclusion, the tax law delineates the scope of primary processing of agricultural products. However, with respect to the processing of TCM decoction pieces, neither this document nor subsequent supplementary notices have clarified whether it falls within the scope of primary processing, resulting in a degree of ambiguity and contradiction.

(C) Ambiguities and Contradictions in the CIT Exemption Policy

1. Legislative Ambiguity

From a legal interpretation perspective, the object of the CIT exemption policy is "primary processing of agricultural products," while "primary processing" and "deep processing" represent a classification of the complexity of processing techniques. The processing of Chinese medicinal materials, TCM decoction pieces, and Chinese patent medicines involves a progression from simple to complex techniques. The tax law explicitly states that the simpler processing of Chinese medicinal materials constitutes primary processing, but it does not provide a basis for determining whether the more complex processing of TCM decoction pieces qualifies as primary processing. The tax law explicitly states that the more complex processing of Chinese patent medicines does not constitute primary processing, which allows for the conclusion that even more complex processing should clearly be considered deep processing, but it does not provide a basis for determining whether the simpler processing of TCM decoction pieces — which is less complex than the processing of Chinese patent medicines — qualifies as primary processing. The tax law regulates the more complex processing of Chinese patent medicines but remains silent on the simpler processing of TCM decoction pieces, which clearly constitutes legislative ambiguity.

2. Legislative Contradiction

The CIT law also lists "stir-frying" as a primary processing technique within the scope of primary processing of medicinal plants. However, from the perspective of the TCM industry's production process, once medicinal plants or animals undergo stir-frying, it becomes difficult to classify them as "Chinese medicinal materials." As previously mentioned, Chinese medicinal materials refer to products obtained from medicinal plants and animals after cultivation, breeding, harvesting, and primary processing. Primary processing generally includes techniques such as cutting and drying, but does not include the more complex technique of "stir-frying." The Reply of the General Office of the National Medical Products Administration on Issues Concerning TCM Decoction Piece Manufacturers' Procurement of Medicinal Materials Undergoing Primary Processing (Fresh Cutting) (Yao Jian Zong Yao Guan Han [2021] No. 367) defines "fresh cutting" as a method of primary processing, stating that "fresh cutting is one of the methods of primary processing. It involves cutting freshly harvested Chinese medicinal materials into slices, blocks, segments, or pieces according to traditional processing methods. Although it changes the form of the Chinese medicinal materials, it does not alter their nature, and it reduces the processing steps of drying, moistening, cutting, and re-drying." This indicates that primary processing should be limited to processing techniques that change the form but not the nature of the product. The CIT law's inclusion of "stir-frying" within the scope of "primary processing" while simultaneously limiting the processed product to "Chinese medicinal materials" clearly presents an internal contradiction.

The root cause of the ambiguity and contradiction in the CIT policy regarding the applicability of "TCM decoction pieces" lies in the fact that TCM decoction pieces are a specialized concept unique to the TCM industry. However, under the current CIT policy framework, the primary processing of agricultural products preferential policy is formulated by the Ministry of Finance and the State Administration of Taxation, while agricultural departments and drug regulatory authorities are not among the issuing entities. Although the tax law has borrowed certain specialized concepts from the TCM industry, inconsistencies are inevitable.

(D) Returning to the Original Intent of the Tax Law to Discuss the Policy Applicability of TCM Products

In the context of this case, we believe that the TCM decoction pieces processed by Company A are not automatically excluded from the scope of "primary processing" under the tax law. The concepts of "TCM decoction pieces" and "Chinese medicinal materials" are not mutually exclusive within the tax law framework; rather, they overlap and intersect. Therefore, the determination of whether a product falls within the scope of primary processing should not be based solely on its product name but should involve a return to the original intent of the tax law to discuss the policy applicability of TCM products.

Conclusion One: Returning to the original intent of Cai Shui [2008] No. 149, the object of the tax exemption is "primary processing of agricultural products," not limited by product names. Regardless of the product name, if the production process constitutes primary processing, the income should be eligible for tax exemption; otherwise, it should be taxable. The core criterion for determining whether Company A can enjoy the CIT exemption should focus on the substance of the activity — "primary processing of agricultural products" — rather than on whether the product name is "Chinese medicinal materials" or "TCM decoction pieces." In other words, the tax law focuses on the complexity of the production process, not on the classification of the final product under the drug regulatory system.

This logic is also supported by the legislative approach in the VAT field. According to SAT Announcement [2026] No. 9, TCM decoction pieces in the form of slices, threads, blocks, and segments made from medicinal plants fall within the scope of agricultural products and are subject to a 9% VAT rate. This means that, within the tax law system, TCM decoction pieces produced through simple processing are not fundamentally different from Chinese medicinal materials in terms of their "primary agricultural product" attributes, as both are included in the category of agricultural products. This interpretive logic in the VAT field also provides important reference significance for CIT purposes.

Conclusion Two: The understanding of "primary processing" should revert to the independent definition under the CIT law. The relationship between the tax law and the Industrial Classification for National Economic Activities is not one of simple equivalence but rather a relationship of "reference" rather than "adherence." According to Article 1 of SAT Announcement [2011] No. 48, enterprises engaged in the agriculture, forestry, animal husbandry, and fishery projects eligible for tax preferences under Article 86 of the Implementation Regulations shall, unless otherwise specified, refer to the standards of the Industrial Classification for National Economic Activities. The term "reference" (rather than "adherence" or "in accordance with") indicates that the tax law retains independent judgment on industry classification issues and may make exceptions or redefine terms based on its own policy objectives. In practice, the determination of industry classification is often guided by the principle of substance over form, rather than the rigid application of industry codes.

For example, grain milling is classified under Manufacturing (Category C) in the Industrial Classification for National Economic Activities, but Cai Shui [2008] No. 149 includes it within the scope of primary processing of grain, granting it tax-exempt treatment. This exemplifies the tax law's redefinition of basic concepts based on its own value orientation. In accordance with the principle of tax legality, the application of tax law should be based on the explicit provisions of the tax law itself. The Industrial Classification for National Economic Activities serves only as an auxiliary reference and cannot replace or restrict the substantive criteria stipulated by the tax law. Therefore, in the case of TCM enterprises, the key to determining whether Company A can enjoy the primary processing exemption lies in whether its processing techniques fall within the scope of simple processing enumerated in Cai Shui [2008] No. 149, rather than whether its industry registration is "Manufacturing" or whether the product name is "Chinese medicinal materials" or "TCM decoction pieces." The independent definition of the tax law should take precedence in application — this is an inherent requirement of the principle of tax legality.

Conclusion Three: From the perspective of tax law provisions, the occurrence of chemical reactions or changes to the chemical properties of raw materials does not necessarily mean that the processing falls outside the scope of primary processing. For example, techniques such as steaming, boiling, stir-frying, and fermentation are all included within the scope of primary processing under the tax law. According to Cai Shui [2008] No. 149, the tax law's criterion is not based on "whether a chemical reaction occurs" or "whether chemical properties are altered" but rather on the benchmark concept of "simple processing treatments" as positively enumerated.

Conclusion Four: Processing (paozhi) does not necessarily mean that the activity falls outside the scope of primary processing. From the perspective of TCM industry practice, "paozhi" (processing) is a broad concept encompassing a wide range of techniques. It is an overarching category that includes "physical processing" (e.g., cutting, drying) and "chemical reactions" (e.g., stir-frying, calcining). "Paozhi" should not be equated with "deep processing" and categorically excluded from the scope of primary processing. In particular, many medicinal plants and animals only require simple cutting and drying to produce TCM decoction pieces. Cutting and drying can be covered by both "primary processing" and "paozhi." Further classifying whether the technique constitutes "primary processing" or "paozhi" lacks practical significance.

Conclusion Five: The fact that a product is subject to drug regulatory oversight and requires a Drug Manufacturing Certificate does not necessarily mean that its processing falls outside the scope of primary processing. The Drug Manufacturing Certificate is a regulatory requirement for drug quality, not a criterion for determining the complexity of the production process. According to Article 41 of the Drug Administration Law, engaging in drug production activities requires approval from the drug regulatory authority of the relevant province, autonomous region, or municipality directly under the Central Government and the obtaining of a Drug Manufacturing Certificate. Article 44 further provides that TCM decoction pieces must be processed in accordance with national drug standards; those that do not meet national drug standards or are not processed in accordance with the processing specifications formulated by the drug regulatory authorities of the relevant province, autonomous region, or municipality directly under the Central Government may not be released for sale or distributed. These provisions indicate that the legislative purpose of the Drug Manufacturing Certificate system is to ensure drug quality and safety, not to assess the complexity of the production process. Whether a product qualifies for the CIT exemption for primary processing of agricultural products should be determined by applying the substantive criterion of whether the processing techniques fall within the scope of simple processing enumerated in Cai Shui [2008] No. 149. The fact that a product has obtained a Drug Manufacturing Certificate cannot serve as a basis for denying that its processing constitutes primary processing. These two matters fall under different legal systems with different regulatory purposes and should not be conflated.

IV. Tax Compliance Recommendations for Traditional Chinese Medicine Enterprises

1. Engage Professional Tax Lawyers to Conduct Thorough Review and Evidence Collection of Production Processes

It is recommended to engage a legal team with experience in the tax affairs of the TCM industry to systematically review and document the production processes for all product categories. The core task is to conduct a point-by-point comparative analysis between the simple processing treatments enumerated in the appendix of Cai Shui [2008] No. 149 and the enterprise's actual production process system, clearly distinguishing which processes qualify as "simple processing" recognized by tax law and which fall beyond the enumerated scope as "deep processing."

2. Actively Seek Interpretations from Competent Authorities and Strive for Clear Policy Determination

Within the framework of the principle of tax legality, enterprises should proactively submit written inquiries to competent authorities, requesting a clear interpretation on the applicability of tax preferences for the "primary processing of TCM decoction pieces." Cai Shui [2008] No. 149 neither explicitly includes "TCM decoction pieces" within the scope of tax exemption nor directly excludes them. This "not explicitly listed" status itself requires clarification from the competent authorities.