CHINA'S TAXMAN COMETH
In Asia’s most challenging jurisdiction, CFOs should get ready for higher taxes and more aggressive enforcement.
By Niles Lo

A Malaysian by birth, Ng Wai Lun, CFO of AstraZeneca China, has spent 15 years in Shanghai, yet still speaks in the casual tone of his native country. For years, he’s experienced double-digit growth and cutthroat competition, and has struggled mightily to impose controls on his unwieldy business. But his smile vanishes and hauteur fails when he talks about tax planning. “It’s been a case of any day now, for three years,” he says of imminent tax reform in China. Ng expects the proposed reforms to reduce profits enormously. Still, he says, “What can we do anyway? We still have to be in China, even with higher taxes.”

Ng’s mixed sense of frustration, anticipation, and opportunity is echoed by tax-planning units in foreign companies operating in the People’s Republic. For years, these firms have benefited from tax breaks associated with China’s economic development zones. Like Ng, they know that China is a major part of their company’s ten-year plan. They know that their tax liability will rise, but they also know that there will be, inevitably, ways to mitigate the impact of tax increases. Since 2002, when China’s State Tax Authority announced plans to ‘harmonize’ tax structures for local companies and foreign-invested enterprises into a unified tax code, CFOs have waited for the definitive sign that this will be the year to plan for the change. Has that day arrived?

The answer is an unqualified maybe. Tax harmonization looks to be finally on the way. Press reports have quoted Ministry of Finance officials as saying that a unified tax will finally be implemented in 2006. This so-called ‘national treatment’ will eliminate the distinction between foreign and domestic investors in the interest of providing a level playing field for everyone. This means that tax holidays and preferentially low tax rates for foreign-invested enterprises and for firms investing in special economic zones and other open-trade zones will be abolished. But the government is also likely to allow established foreign-invested enterprises some form of tax break for a limited time. It’s also expected that local governments will be permitted to provide incentives for new entrants – both domestic and foreign – to invest in China’s economically lagging western regions and in key sectors such as high technology and environmental protection. According to business information provider Economist Intelligence Unit (EIU), a sister company of CFO Asia, incentives may also be provided to ventures that agree to employ workers laid off from state-owned enterprises.

How far these breaks will allow company tax strategists to edge their tax liability below the 25 to 28 percent level under the harmonization plan is open to question. Some CFOs, Ng included, see the government’s confusion over two conflicting drivers of tax policy – that of attracting foreign investment and protecting local businesses from foreign competition – as deep enough to cause further delays. “If you ask me, it’s not going to happen anytime soon,” says Ng. “The government doesn’t want to rock the boat. From what I hear the government has decided to postpone it.” Still, he concludes that to do business in China, you have to accept that higher taxes are part of the bargain – and could come quickly. “Really, there’s no risk management,” he says. “If they shift the tax rate tomorrow, we have to stay in China.”

Tough Jurisdiction

The sense of China as a problematic market for tax planning is echoed in a recent study by PricewaterhouseCoopers (PwC) of 90 companies with operations throughout Asia. [For tax developments across Asia see ‘2005 Regional Tax Update’ compiled by PwC and beginning on page 45]. Forty percent of the tax planners cited China as the clear number one in the list of countries that provide the greatest tax challenges in the region. By contrast, India placed second in this dubious sweepstakes, cited by only 14 percent of the respondents as being the market with the greatest tax challenges.

Speaking of China, PwC’s Rod Houng-Lee, tax leader for China and Hong Kong, says: “Regions of high growth and expansion invariably present tax challenges. Yet,” he argues, “while the situation is changing, it can be managed well if managed carefully, and the advantage of China as a center of production and as a growing domestic market for sales is unlikely to be affected by expected changes in tax policy.”

One of these challenges is that some foreign businesses have made, or are making, the transition from seeing China as a manufacturing hub for export to a market for profitable sales. Domestic taxes on local products will now have to be taken into account. Another challenge is the withering away of the joint-venture structure now that limitations on foreign investments in certain industries such as cars are being lifted. Companies will be free to look at the best ways to locate production and distribution, and the policies of local tax regimes will necessarily be part of the planning.

These elements, outward signs of China’s extraordinary growth, present opportunities as well as risks. But a persistent challenge emerges in China’s struggle to field a tax code that allows leeway for local concerns as well as for revenue building to bolster central government coffers. According to Paul Cavey, chief China economist for the EIU, the complexity has intensified as China’s growth calls for greater government action on programs designed to address the social divide between rich and poor. Feeling the pressure for increased spending, central officials have sought to fund shortfalls by taking revenue from local authorities, thereby spreading revenue gaps to other levels of the bureaucracy.

In response to all these concerns, tax policy in China can have a start-again, stop-again quality, as well as a confusing complexity, that frequently nettles company tax planners. One respondent to the PwC study noted: “Customs and tax rules and actual practices in China pose a challenge due to different interpretations.”

So in what way is this ‘manageable’, in Lee’s sense? For one, the tax system in China can hardly be dubbed punitive to growth. “China’s tax system is in fact remarkably strategic,” says Glenn Desouza, Shanghai-based national leader for transfer pricing of China at PwC. “It rewards what’s beneficial for society. Bringing in patented technology that’s advanced is considered beneficial, for example. But a trademark royalty doesn’t get a business tax exemption. Frankly, a good deal of the credit for China’s growth should be given to its ‘tailor-made’ or ‘bespoke’ approach to taxation.”

Tax policy is also recognized as a driver of economic growth, and local tax authorities are concerned with business development and enforcement in equal measure. Says Desouza: “Tax enforcement in local Chinese bureaus has been fairly pragmatic. In the Yangtze River delta, for instance, the local governments are by nature very pro-business. And now the western regions are anxious to get in on the game. The idea is that the bigger the pie, the more we all benefit. There’s a moderating effect when you have the local ministry of commerce attracting investment.” Desouza adds: “The reason companies find it easier to set up in China is because there’s less bureaucracy than elsewhere, particularly South Asia. The Chinese want to do business and are willing to work with the company.”

That said, enforcement in the PRC is becoming increasingly fierce. Both Lee of PwC and Cavey of the EIU say there’s a growing reaction to perceived tax evasion by foreign-invested enterprises on the part of both the central and local governments. These enterprises face suspicions that they engage in widespread tax fraud by transferring their profits overseas or by over-reporting their losses. State Tax Authority officials estimate that state coffers lose 30 billion renminbi (US$3.6 billion) every year because of tax evasion by multinational companies.

Lee says the risk will grow as the tax bill grows. “If you look at the sophistication in transfer pricing in China,” he says, “it’s relatively low compared to Japan, South Korea, or Australia. But as the tax rates for foreign companies increase, the use of transfer pricing strategies will become more common.”

There will be pressures on CFOs and tax planners for increased vigilance. Lee and Desouza note that greater care in documenting and storing evidence of inter-company transactions should be part of foreign companies’ internal controls processes. The reason: companies may be called upon to demonstrate that the ‘materiality’ of profitable production – and therefore its potential to be taxed – resides outside of China. In other words, many companies have established factories in China as part of their global supply chain, but full assembly might be completed elsewhere. Tax planners will have to retain documents that prove that the China side of the production is not material to the profits.

The government even provides an opportunity to end-run the possibility of a transfer-pricing audit. Foreign company tax planners who recognize such a risk can approach the government for an advance pricing agreement (APA). This agreement involves presenting the case that a transfer-pricing scheme is within legal bounds, and results in a ‘comfort letter’ from the tax authorities indicating that the transaction is transparent and legal. Lee, however, notes that this process can be time consuming. CFOs, he suggests, should weigh the risks of not entering into such an agreement – and possibly being hit by an audit – against the costly but reassuring process of obtaining an APA.

“The APAs aren’t easy,” says Lee. “Before pursuing one, you have to weigh the pros and cons carefully.”