When China first welcomed foreign investment in the 1980s, the government offered an irresistible bonus: lower income taxes for foreign companies than for domestic companies. In the past two decades, foreign-invested enterprises (FIEs) in China have enjoyed a de facto tax rate of 13%-17%, compared with 23%-33% for local entities. To sweeten the deal, FIEs were also granted tax cuts in special economic zones and selected industries, such as IT, as well as a two-year tax exemption. Boasting low taxes, weak local competition and a huge market, China became the uncontested haven for FDI.

But bonuses do not last forever, the Chinese government cautions. Blessed with an impressive stockpile of FDI, policy-makers in Beijing are rethinking: why continue to hand out carrots cheaply?

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Tax unification

The terms of taxation are set to change by as early as January 1, 2008, if the draft for a new Enterprise Income Tax Law is passed by the Chinese legislature this March. Although plans to unify the enterprise income tax between local and foreign firms have been milling around for years, the formal proposal did not reach the National People’s Congress until Christmas Eve last year.

The Chinese media reports that the revised tax rate would be 25%, with a transition period of five years for foreign companies that are currently operating in China. Companies that earn lower profit margins fall into a lower tax bracket of 20%, subject to certain criteria.

In short, the proposed revision signals a landmark shift in the way FDI is received in China vis-à-vis domestic businesses. In the near future, foreigners and locals would pay income tax at the same rate. Tax incentives would come under more centralised control and standardisation.

For local business groups and economic nationalists, the proposal is certainly good news. Proponents have long found creative ammunition in China’s accession to the World Trade Organization, singing the liberal-trade jingle in their chorus for ‘a level playing field’. ‘Super national treatment’ enjoyed by foreign firms in terms of tax came under an increasingly awkward spotlight as Chinese leaders did not like to be seen as selling out national interest for foreign investment.

Vocal dissent

Foreign investors were unimpressed. When plans to unify taxes by 2006 were announced two years ago, a group of multi-national corporations in China, including General Electric, BP and Siemens, launched a lobbying campaign. They urged the Chinese government to “not fix what isn’t broken”.

The MNCs had local supporters. Some experts in China argued for unequal taxes, viewing them as compensation for a host of implicit benefits enjoyed by domestic firms, such as market access.

But perhaps the strongest voice of concern against the dampening effects of standardised taxes came from local governments. Although the tax revision may increase fiscal revenue, more important to local bureaucrats are capital and jobs that FDI would bring to local economies. FDI is widely seen as the surest and fastest engine of gross domestic product – the key to career advancement in a country where “economics take command”.

Even within the central bureaucracy, opinions are said to diverge between ‘hawks’ and ‘doves’. Finance offices pushed hard for tax unification, seeing it as part of their mission to rationalise China’s tax structure. Commerce bureaux, whose performance is premised upon FDI figures, were more inclined towards the status quo.

Lobbying efforts paid off for a while. A draft of the bill was supposed to be sent for legislative review in August 2006 but was delayed. “We have to wait until the time is ripe,” said Yu Guangyuan, chairman of the budget committee, following news of the delay. “But change is inevitable.”

Business response

For what seems like a close deadline and intense political fuss among major figures, there is a surreal calm on daily corporate ground. Bob Poole, who heads the US-China Business Council (USCBC) in Beijing, says: “Many companies still see [the revision] as some time away.”

And other issues are a bigger worry for foreign companies operating in China. At government business promotion agency IE Singapore’s office in Beijing, for example, client companies are said to be more concerned with real estate laws and new business opportunities than with taxes.

Companies are not entirely complacent, however. Business associations such as the USCBC keep a close watch on the latest policy developments. FIEs have also taken steps to prepare for impending changes, whenever they may come.

A hot issue is whether and how current tax incentives may be retained if the proposed revision is passed into law. Legal advisers from WilmerHale’s Beijing office recommend that companies “obtain ‘grandfathering clause’ commitments” from authorities of the localities in which their businesses are based. This may not be easy, however.

The chief finance officer of a multinational company, who chose to remain anonymous, revealed in a local press report that the local tax administration had not been able to grant his company a “certificate” to guarantee current tax privileges. He said he was told that such certificates had never been issued before. Local authorities lack the mandate to make legal promises if the tax policy remains in limbo.

Others are prepared to take a tax hike in their stride. The USCBC’s Mr Poole says that some companies would welcome standardised taxes if there was more transparency in tax administration henceforth.

Beyond taxes

Most FIEs seem unconcerned about unified taxes. That does not mean that taxes do not matter. They do. The key is that taxes alone are unlikely to make or break investment decisions.

Foreign companies in China are there for the long haul. Standardised taxes may raise costs for FIEs. Yet, from the broader perspective, China continues to boast a fast-expanding market and abundant labour. Therefore, for China to maintain its leading position in FDI, without providing preferential taxes to foreign companies, it is imperative to improve basic conditions for business development.

In the USCBC’s 2006 Annual Survey, taxation was not on the list of the top 10 concerns facing its member companies, including prominent names such as Exxon Mobil, Hewlett-Packard and Microsoft. Top of the list in descending order were talent recruitment and training, administrative licensing and business approval, and intellectual property rights enforcement.

That the overriding business concern has nothing to do with state regulation but with the lack of (right) human capital is surprising. After all, the one resource that China boasts the most of is people. Last year, 34 million university graduates entered the job market. About one-third of college-aged adults in China receive higher education, an enviable statistic among developing economies.

A 2006 survey by Mercer Consulting of 114 companies in China echoes concerns about staff retention. Employees in the prime group of 25-35 years old left their jobs within one-to-two years in 2005, compared with three-to-four years in 2004. According to Guo Xin, managing director at Mercer Consulting in China, the greatest shortage of professionals is in the second-tier cities outside of Beijing and Shanghai, and in the sales and engineering sectors.

Yet, despite a hunger for talent among companies, job-hunters in China report an increasing hard time. Average wages for a fresh graduate stood at Rmb1550 ($199) in 2003, a steep fall from previous years. Anxious to calm disappointment, higher education authorities urged graduates to “drop their expectations”.

A mismatch of demand and supply explains the ironies of China’s labour market. It also portends the bottlenecks of advanced industralisation in what is still a transitional economy. Structural weaknesses such as human resource constraints pose a greater challenge for Chinese policymakers and foreign enterprises than getting past the politics of tax adjustment.

FDI strategy

China’s FDI strategy is fast evolving. In earlier years, foreign companies were drawn to the country by tax breaks and cheap labour. From there, China became ‘the factory of the world’. But today it has bigger aspirations. Taxes are being renegotiated to restructure the incentives for investment.

First and foremost, China wants to move up the value chain and away from rudimentary production. The phasing out of export tax rebates is a case in point. Export rebates have been abolished or slashed for low-end and environmentally unfriendly products like timber and alloys; and raised for high-technology products.

China also wants foreign companies to help develop local industrial capacity. As part of the state’s plan to promote machinery manufacturing, FIEs will be granted tax refunds for the purchase of heavy equipment from Chinese companies from July last year.

However, whether China can attract FDI towards high-end manufacturing and services, and ultimately develop its own brand of manufacturing, goes beyond changing taxes. Supplying critical resources, including human capital and energy, and improving business certainty are the prerequisites. In this regard, the unification of enterprise taxes is just one step in what is a far more complex challenge of restrategising FDI.