The downside of China's
level playing field
By Stephen Wong
SHANGHAI - As part of its commitment to World Trade Organization (WTO)
accession, China must grant the so-called "national treatment" to
foreign-invested businesses in the country, which means overseas and domestic
enterprises will enjoy the same benefits and have the same responsibilities.
Granting "national treatment" for foreign companies means full access to the
Chinese market like their domestic rivals. But that
also means paying as much tax as their domestic counterparts.
China began to levy a 33% corporate income tax on both local and foreign
businesses from 1994. But to lure foreign investment, the Corporate Income Tax
Law, which applies only to foreign-invested companies, cuts their tax rate to
15% or less. Domestic companies, however, are governed by the Provisional
Ordinance on Corporate Income Tax for Local Firms and have to pay the tax in
full.
Since China's WTO entry in late 2001, Beijing has been gradually opening the
market to foreign investors while preparing a reform to unify the two-tier
corporate income taxes, paving the way for granting them "national treatment".
Now the five-year transitional period for WTO accession is almost over, during
which foreign firms have been given greater access to the Chinese market but,
to the disappointment of domestic enterprises, the income-tax regime has still
not been reformed to make it more fair for domestic enterprises.
Before the Standing Committee of the National People's Congress (NPC) convened
to consider new legislation last month, China's official media claimed that
legislation unifying income tax for foreign and domestic firms would be on the
agenda.
But domestic business people were disappointed and angry once again as no draft
legislation on tax reform was tabled. This means the reform will be postponed
for at least another year, as there will be insufficient time to submit it for
the legislature's annual session in March. So the earliest tax reform can be
approved is early 2008.
"Various departments involved in tax unification [have] yet to reach an
agreement on some key points," Hong Kong-based Ta Kung Pao newspaper quoted an
unnamed NPC source as saying. "But decision-makers still plan to pass the
reform plan within the term of this legislature" (which ends in March 2008.
Analysts believe Beijing may want to delay the reform to continue luring
foreign capital into the country. But the delay is unfair to domestic
businesses, they say. While foreign firms gain greater and greater market
access, domestic firms have to pay as much as twice as much tax as their
foreign rivals.
It has been widely reported that the unified corporate income tax would be
between 24% and 27%. This means that tax paid by foreign firms' would rise by
up to 12 percentage points, while the rate for domestic companies would drop by
up to 9 points. It is also widely expected that foreign firms would be given a
period of grace of three to five years.
China's preparation for tax unification started years ago. In August 2004, the
Ministry of Finance and the State Administration of Taxation submitted a draft
on tax unification to the State Council, with the hope of getting it endorsed
by the legislature in 2005 to become effective from the beginning of this year.
But the reform did not go as smoothly as expected. Because of objections from
foreign investors and growing concerns about a drastic decline in
foreign-capital inflow, the reform initiative has been shelved from time to
time.
Anxious domestic companies
The story of China's two dairy giants Yili and Mengniu, both based in Inner
Mongolia, shows why domestic companies want the unified corporate income tax so
badly.
In the first half of this year, Yili achieved revenue of 7.93 billion yuan
(US$1 billion), about 380 million yuan more than its major rival Mengniu, a
mainland-Hong Kong joint venture. But Yili's post-tax interim profit stood at
202 million yuan, only two-thirds of Mengniu's.
Pan Gang, Yili's board chairman, attributed the disparity to the different tax
rates. While Yili paid 31% corporate income tax, Mengniu paid only 10%. "As a
result, the profits of Yili are lower than its competitor's," said Pan.
The discriminative tax rates for domestic and foreign-funded companies may be
disastrous for China's domestic banks, which will soon face fierce competition
from foreign lenders as China is scheduled to open its banking sector fully by
the end of this year.
Currently, China levies about 15% corporate income tax on most foreign-invested
banks and about 33% on domestic banks, not to mention other incentives for
foreign lenders. Already with a poorer performance than foreign-invested
companies, the Chinese banks will be in an even weaker position against their
foreign competitors if their tax rates are not reduced, Dr Li Hong from the
Shanghai University of Finance and Economics told the media.
As China completes its transitional period for WTO accession this year and is
expected to open its market further, many industries are facing the same
problem as the banking sector.
While domestic businesses are anxiously awaiting tax unification, many local
governments in China are not very happy with the reform, fearing China may lose
its appeal to foreign investors. Foreign companies have also voiced their
disagreement with the reform plan.
Soon after financial officials openly spoke in support of the unified tax in
January 2005, 54 Fortune 500 multinationals with investment in China voiced
objections.
The bigger obstacles come from the local governments, however, which are
competing with one another to offer tax incentives to attract foreign
investment, with the aim of creating more job opportunities and raising gross
domestic product figures within their jurisdiction.
Most Chinese cities now waive the first two years' corporate income tax for
foreign ventures and cut the tax by half for the next three years. Some cities
offer more incentives. Take the southern Chinese municipality of Chongqing for
example. According to a nine-year-old local policy, for a foreign-invested
manufacturing enterprise planning to operate in Chongqing for over 10 years,
the corporate income tax will be waived for the first six years and cut by half
in the seventh to 10th years.
Local-government officials certainly have reasons to worry that abolishing such
preferences would push the foreign investors to other areas or even to other
countries with lower costs, especially as China's official tax rates are higher
than most countries'.
China's tax rates are among the highest in the world. It levies a personal
income tax of up to 45%, corporate income tax up to 33%, and a 17% value-added
tax, although in practice many companies and individuals find ways to evade the
taxes. In a "tax misery" score published in Forbes magazine last year, Beijing
came second.
Fake foreign investment
The discriminative corporate tax system has also created other problems. One of
them is to encourage local governments and domestic enterprises to introduce
"fake" foreign investment in order to pay less tax.
Many local governments and domestic firms have set up shell companies in Hong
Kong or other "tax paradises" and then use the shell companies to make
investments back home.
It is difficult to tell how much of the foreign direct investment China
receives each year comes from such "fake" sources.
According to figures from China's Ministry of Commerce, investment from the
United States, Japan, and the European Union accounted for less than a quarter
of the total foreign investment in China as of June.
In 2005, Hong Kong remained the No 1 foreign investor in mainland China,
followed by the British Virgin Islands, a well-known tax paradise in the
Caribbean.
The official newspaper China Business News quoted Mei Yuxin, a researcher with
the Ministry of Commerce, as saying that at least one-third of the "foreign
investment" in China was in fact made by overseas shell companies held by
Chinese companies.
The rampant "fake foreign investment" has prompted the Chinese government to
restrict Chinese citizens from setting up companies abroad, demanding that all
such overseas-registered companies be reported to the relevant authorities. But
it is doubtful whether this will be taken seriously.
Since treating foreign firms the same as domestic ones is part of China's
commitment to its WTO accession, unification of the corporate-income-tax system
is necessary and inevitable. Despite all the obstacles and opposition, it now
appears to be just a matter of time before the reforms are implemented.
Stephen Wong is a Shanghai-based freelance writer.
