China to end tax breaks for foreign investors

Chinese government officials now see the country as having reached the status of an ideal locale for foreign direct investors (i.e. those who build plants in-country) and have decided to end the tax breaks that lured them in despite China's many negatives from a foreign investor's standpoint. Will foreign investors continue flocking to China, given its pervasive corruption and onerous requirements* for foreign investors? Or will they divert their investments to China's regional (and out of region) competitors?

China appears close to ending tax breaks long enjoyed by foreign companies, a sign the government believes such incentives are no longer necessary to boost investment and growth.

Since the 1980s, China has offered reduced tax rates to woo foreign investors. These days it is having little trouble persuading them to set up shop or expand, thanks to the country's powerful export-manufacturing base and its robust economic growth -- which officials on Thursday said registered at 10.7% for 2006, surpassing 10% for the fourth straight year. Last year alone, Beijing says foreign companies poured $69.5 billion into Chinese operations.

Indeed, officials now worry that the rapid expansion of foreign-owned manufacturing businesses is using up scarce land and straining supplies of key raw materials. China is also focusing on developing its own domestic champions that can compete with multinationals. In a strategy document issued last year, the government said it will be more selective in foreign investment, and aim for quality, not quantity.

As a result, the government appears increasingly likely to pass a long-discussed tax law during China's annual legislative session in March that would, among other things, equalize tax rates for local and foreign companies. China's current official rate is generally higher than Hong Kong's and Singapore's, but lower than those of many European countries, and roughly in line with those of other developing nations.

According to a draft of the proposed "Enterprise Income Tax Law" that has been circulating among businesses in recent weeks, the tax rate for foreign and domestic companies will be set at 25%, and most existing tax holidays will be phased out over five years. Currently, the corporate-income tax rate is 33%, but local governments and development zones have often offered foreign companies rates as low as 15% to set up in their jurisdictions.

"Where I think the law has got its greatest impact is on the brand new investor," said Brendan Kelly, a tax partner in the Shanghai office of Baker & McKenzie LLP. Most foreign companies now operating in China are aware that they will have to deal with higher taxes in the future, he said. But "someone new to the marketplace may have been expecting a lot of tax holidays, and they may find it surprising how heavily this will impact them."

Compared with the wealth of incentives that are offered now, the draft law allows for only a few exceptions. Small companies with minimal profits would qualify for a 20% tax rate, while high-technology companies considered to be of national importance would still be granted a 15% rate. The new law would also permit areas with large ethnic-minority populations to offer income-tax breaks.

Wang Li, deputy commissioner of the State Administration of Taxation, said Wednesday that the law will be submitted to the National People's Congress, China's legislature, when it meets starting March 5. If passed, as now seems likely, the law could take effect in 2008. Mr. Wang, speaking at a news briefing, didn't comment on the contents of the draft law, which hasn't been officially released by the government, and which could still change before being adopted.

"In the past, having different tax policies for foreign and domestic companies was necessary, and played an important role in attracting foreign investment and stimulating economic growth," Mr. Wang said. However, he said, problems with the current system have since become apparent, such as the way it permits domestic companies to lower their taxes by setting up offshore, and the need for change has become more apparent.

Tax authorities first proposed a unified 25% income-tax rate in mid-2001. Domestic companies, more of which have been paying the statutory 33% rate, were eager supporters. But local governments, worried that the loss of tax breaks would hurt their economic-development programs, resisted.

* Among other things, foreign investors are required to hand over their technology to Chinese companies via joint-venture requirements. They are also not allowed to take their machinery with them if they decide to move their factory to some other country.