HOW BIG A BITE?
The big changes in China’s tax code reflect a shift in economic priorities. But much about the law remains a mystery.
By Tom Leander

William Dong, the China CFO of Brussels-based imaging company Agfa-Gevaert, has mixed emotions about the recent changes to China’s tax code. He feels relief that the long-awaited reform of an outdated system has been enacted. But he’s still in the dark about the choices he must make now – and in a hurry. “We’re waiting for more information and guidance,” says Dong. “There’s still a lot that’s unclear.”

This might seem a strange reaction to a law that has been promoted as simplification of a complex and unfair tax system. The dramatic changes are simple enough. The new enterprise income tax – passed by the legislature March 16 and effective January 1, 2008 – revises tax rates for foreign and domestic companies to a uniform 25%. Foreign companies no longer will enjoy an effective rate of 15% in special economic zones (SEZs). Domestic companies, which were socked with a 33% tax rate, will see a big drop in tax liability. (For highlights of China’s new tax law and a comparison to other Asian tax regimes, see the chart beginning page 38 prepared by PricewaterhouseCoopers.)

Moreover, the new system provides for tax incentives, but these will not be based on where in China a company is doing business, but instead on what kind of business the company is doing. There will be incentives that target industries the government wants to grow under China’s new five-year plan: they include high-tech and businesses needed to clean up China’s pollution problem, including environmental engineering, ethanol manufacturing, and water conservation.

All of this is clear. But for CFOs like Dong, who is anxious to start planning for the change, there is a problem: the law itself provides few details about the new incentives (the entire document is only ten pages long) and China’s authorities haven’t yet issued guidance or interpretation of the new law.

Be Careful What You Wish For

The new tax code has been a long time coming. The former code was outdated, designed to encourage manufacturing for export and technology transfer from foreign companies. The purpose was to improve economic conditions by creating an incentive to build export businesses. China’s accession to the World Trade Organization opened up many sectors to foreign competition, and over the years a huge and attractive consumer market developed on the mainland. Western companies now also look to China to develop their R&D centers, so successful has the PRC been in elevating its production base and talent pool up the ‘value chain’. Meanwhile, executives of Chinese companies that struggled under a levy of 33% lodged the reasonable complaint that higher taxes for local firms held back the expansion of Chinese businesses.

The simplification to 25% under the new law is a bow to this complaint. Why was such an obvious reform held back so long? “To encourage manufacturing through fiscal policy certainly seems anachronistic today,” says Tony Fay, Beijing counselor and tax specialist for White & Case, the US law firm. Perhaps, but the approach had many friends. Foreign trade groups like the American Chamber of Commerce in Shanghai and its European counterparts maintained that the preferential tax treatment of foreign companies was necessary because so many Chinese companies evaded taxes. They claimed that the higher rate for local firms hardly mattered.

The Chinese tax authority’s answer was to promise stronger enforcement and tougher penalties for tax evasion across the board. The new law devotes an entire chapter under the subject of “Stringent Administration”, and introduces new measures to combat tax avoidance, codifying techniques used in OECD countries.

Other elements seem aimed to put to rest the charge that foreign companies get a free ride in China. The tax law includes a “resident enterprise” concept for the first time. If an enterprise is established under PRC laws, or if it is a foreign company whose place of “effective management” is in China, then it will be taxed on worldwide income (non-resident companies will be taxed only on money earned from sources in China). But it’s not yet clear what degree of local management will put a company in the resident category. Another big change: Companies must pay a withholding tax on profits paid by a China enterprise back to a foreign company headquarters. Guidelines on this rule have not been published either.

No Worries

Danny Po, M&A and tax specialist at PricewaterhouseCoopers, says the underlying significance of the law is that “China has adjusted its preference of foreign investments, and the areas in which it prefers foreign investors to invest.” To Po, the changes reflect a growing confidence in China’s global standing, not only for lower cost manufacturing, but as a consumer market with its own draw. He says that the State Council, China’s highest executive body, “anticipates an insignificant impact on inflow of foreign investments, after the [new tax] regime is in place.” This comes despite what PricewaterhouseCoopers estimates will be an increased tax bill of approximately US$5 bn for foreign firms (although this could be lower because of grandfathering treatments). Two recent announcements in response to the law suggest he may be right: US technology firm Motorola declared that it had no plans to alter its investment strategy in China. Similarly, US-based GE said it will respond to the incentives for clean technologies by investing US$50m to build a Shanghai technology center for environmentally friendly products.

But Francis Hu, China CFO for US chemical firm 3M, is more circumspect. “Our concern is that the government does not have a full set of rules for foreign companies to play by,” says Hu. The immediate effect for 3M will be “not too much of a change,” he says, because the company has operated in China for many years, and is eligible for grandfathering under current tax terms for five more years.

Hu wonders, however, how the tax law will affect 3M’s investment decisions as it considers expanding in China. To decide on the best structure for a new investment, Hu will need to look carefully at the government’s clarifications on incentives. Whatever benefits emerge from the fine print will help 3M decide whether to invest in China or elsewhere. The government promised to issue guidelines before the law takes effect – hardly reassuring to CFOs needing to make long-term decisions today.

Hu suspects that when the guidance does come out, the effect could weaken the government’s move away from geographical incentives. China has established 147 national economic development zones since 1984 and many of these have created jobs and prosperity in their regions. Local politicians, always a force to be reckoned with, will inevitably seek out loopholes in the new tax law to retain businesses that might otherwise depart for lower cost manufacturing centers like Vietnam.

They may try, but some China watchers believe the influence of SEZs has been dying for some time. James Feldkamp, who heads the Asian operations of BBK, a US consultancy to manufacturing companies, says many export-focused commodity producers have already moved to lower-cost manufacturing locales, as pay levels in China have crept up. Increasingly, though, foreign manufacturers are making products for sale in China, seizing on its fast growing consumer market. Under this strategy, it makes sense to stay, despite the end of tax breaks. “Most of our clients that are looking to produce goods here in China see the country as a source for sales,” says Feldkamp. Using car makers as an example, he adds: “If you have excess capacity elsewhere, you’re not looking to China to export vehicles.”

Tax Limbo

Agfa-Gevaert is also committed to China as a market for its goods. But Dong says until the clarification on incentives emerges, it will be impossible to determine how and where to invest. Meanwhile, Agfa is undergoing a major change worldwide, breaking its businesses into three publicly traded companies. The new structure will require each national division to become decentralized and independent. Dong is under pressure to make this new organizational scheme work for China. Depending on the details of the tax incentives, the best approach might be to create a new company in a favored industry or perhaps move to a different location. But he won’t be able to see the best choices on legal structure until he’s out of taxation limbo.