China in Transition
The Need for a Unification of Income Tax Rates for Foreign and Domestic Firms
Chi Hung KWAN
Consulting Fellow, RIETI
In an effort to accelerate economic development through the introduction of foreign capital, China has implemented various preferential measures for foreign firms, including in the area of taxes. However, due to changes in the environment both at home and abroad, the time has become ripe for a unification of the income tax rates that applied to domestic and foreign companies.
In China, domestic firms pay taxes based on the Provisional Regulations on Enterprise Income Tax, while their foreign counterparts follow the Income Tax Law on Enterprises with Foreign Investment and Foreign Enterprises. The tax rate set under both these laws is 33%, but the actual applicable rate differs due to the preferential measures applied to domestic and foreign companies. While the tax rate is 33% across the board for domestic companies, in the case of foreign enterprises that invest in certain areas (such as the coastal open economic zones, special economic zones and economic and technological development zones specified by the state) or industries (such as infrastructure and high-tech), a reduced rate of 15% or 24% is applied. In addition, so long as certain conditions are met, foreign enterprises are also entitled to a tax holiday (where they are exempt from paying the tax for two years from the year they first log a profit, and only need to pay half the tax for the next three years). In fact, most foreign companies in China are in one way or another benefiting from the preferential tax system.
Such a policy of preferential taxation was an inevitable choice to woo foreign investment in the early days of China's market-opening reforms, when the investment environment was not that good. However, with the progress made in the shift toward a market economy, the harmful effects of this policy are also becoming clear.
First, giving preferential tax treatment to foreign enterprises means that domestic firms are being discriminated against, and this contradicts the principle of fair market competition. Domestic companies that have to pay a higher tax than their foreign rivals are placed at a disadvantageous position, and their potential to grow is restricted. Discontent is especially on the rise among domestic firms because the preferential tax measures have remained in place despite the fact that other traditional discriminatory practices against foreign firms, including restrictions on entering services industries such as finance, export obligations, minimum local procurement ratios and requirements to balance their own foreign currency holdings were abolished after China's entry into the World Trade Organization.
Also, the inflow of a massive amount of foreign investment and the accompanying surge in exports has led to an increase in China's balance-of-payment surplus and brought about trade friction with other countries and upward pressure on the Chinese currency. The aim of introducing foreign investment in the early years of market-opening reforms in the first place was to make up for the lack of domestic funds. However, China has now become the world's largest holder of foreign exchange reserves, and the objective of accepting foreign investment has shifted to gaining advanced technology and management know-how. In line with this, the emphasis of foreign investment policies, including taxation, is shifting from "quantity" to "quality."
Furthermore, in order to reap the benefits of the preferential tax treatment given to foreign enterprises, many Chinese firms have set up dummy companies overseas, such as in Hong Kong, and invest in China posing as foreign companies. In fact, it is believed that such "round-tripping investment" makes up a large portion of total direct foreign investment in China. Thus the preferential tax treatment given to foreign enterprises has not only led to inequalities between foreign and domestic firms, but among domestic enterprises themselves.
After nearly 30 years of market-opening policies, China’s investment environment has improved, including in the area of infrastructure development, such as roads, telecommunications and electricity, and has also come to gain attention as a massive market. Given this situation, the stage is set for a unification of the income tax rates applied to foreign and domestic enterprises. While there is still stiff opposition from the Ministry of Commerce and local governments, which fear that this would lead to a sharp drop in direct investment, the Ministry of Finance is spearheading moves to revise relevant laws.
At the present stage, the proposal most likely to be realized is the abolition of the preferential tax rates that apply to foreign firms and the unification of the income tax rate at around 25%. The revision is expected to be deliberated at the National People's Congress of 2007 and take effect in 2008. Transitional measures are being considered, such as giving foreign enterprises already in China a five-year grace period and returning the amount of additional tax they paid during this time as a result of the tax hike.
Even after income tax rates for domestic and foreign enterprises are unified, it does not mean that preferential taxation itself will be abolished. However, out of consideration of more balanced development among regions and further industrial upgrading, the focus of such preferential treatment will shift from the traditional coastal areas and foreign enterprises to inland regions and high-tech industries. When formulating their business strategies in China, Japanese companies will need to take such changes in the tax system into account.
May 29, 2006
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