Letter from... China

An overhaul of the tax rates foreign companies pay in China is adding to mounting costs for international investors there, reports Alexandra Harney

The new Enterprise Income Tax Law, which came into effect on 1 January, has eliminated many of the blanket tax incentives foreign companies have enjoyed for years. Until this year, foreign groups paid an effective tax rate of 15%, while domestic companies paid 33% of their income to the Government. Now, both groups will pay 25%.

The move, which replaces preferential tax treatment for foreign companies with specific incentives for investors in high-tech and environmentally friendly industries, as well as infrastructure, is part of Beijing’s efforts to wean the economy off a dependency on exports and level the playing field for local and international companies.

‘Foreign investors and domestic players are on equal grounds right now,’ said Calvin Lam, Hong Kong-based partner at Deloitte Touche Tohmatsu.

The law, which was passed in March 2007 by China’s legislature, the National People’s Congress, after years of debate and consultation, came as little surprise to foreign companies with operations in the country. In 2006, the Government began rolling back export tax rebates on polluting, energy-intensive goods. But the passage of the Enterprise Income Tax Law still marks a turning point in China’s economic policies towards foreign investors.

When China first began opening its economy to the outside world in the 1980s, it established special economic zones and offered generous incentives, including tax holidays, preferential tax rates and rebates, to lure foreign investors to its shores. These days, few foreign companies need convincing that China is a land of opportunity: in 2006, the country attracted US$69.5bn worth of foreign direct investment, according to the United Nations Conference on Trade and Development.

What Chinese officials want now is to nudge their economy up the value chain, out of the labour and energy-intensive export processing sectors that are draining the country’s resources, causing labour disputes and polluting the air and water. The new law sets tax rates for high technology investors at 15%. Research and development expenses can be deducted at favourable rates, and infrastructure, agricultural and environmental projects will also enjoy beneficial tax rates.

While precisely which companies will qualify for these reduced rates is not yet clear, Lam expects Beijing to issue guidelines to supplement the legislation.

Another significant change that the law brings is that it moves China away from geographic incentives, which local governments have generously applied in a vicious competition for investment, towards industry-specific inducements. Provided this is evenly enforced, this could hint towards a more rational competition among municipalities.

For some companies in southern China, an export manufacturing hub since the 1980s, the tax equalisation policy could not have come at a less convenient time. The prices of everything from plastic to steel are rising, even as the Government introduces tougher labour laws that add to companies’ costs. At the same time, labour shortage is driving up wages. In the span of two decades, parts of southern China have experienced an entire industrial revolution, from making trinkets to telecommunications equipment, from wooing all foreign investors to choosing them more selectively.

As a result, foreign companies that are only interested in manufacturing for export and not in selling into the domestic Chinese market are now looking to countries like Vietnam and India, as well as less developed parts of China, said Alberto Vettoretti, regional partner at Dezan Shira & Associates, a China business advisory and tax practice.

Vietnam, for example, offers tax incentives that China scrapped last month, he said. Dezan Shira, which advises multinationals on setting up in China, is opening an office in Vietnam. Clients are now looking to set up research and development centres rather than factories in Shenzhen, the city bordering Hong Kong that was one of the first to be opened to foreign investment in the 1980s.

In some ways, the corporate tax rate adjustments bring China more closely in line with other countries - not a bad thing, most accountants and executives agree. Lam, for one, hopes this is not the end of China’s efforts to align its tax policies with international norms. Individual income tax, now taxed at a maximum of 45%, should be lowered to around 35%. ‘If the Chinese Government wants to attract talent, [this rate] should be reduced,’ said Lam.

Alexandra Harney is the author of the forthcoming book, The China Price: The True Cost of Chinese Competitive Advantage (Penguin, March 2008).