China is set to increase taxes on foreign companies Dec. 1 by doing away with an exemption to maintenance/construction and education taxes that has been in place since the nation’s sweeping 1994 tax reform. China’s State Council announced Oct. 18 that it would unify the City Maintenance and Construction Tax and the Education Surcharge for Domestic Enterprises, Foreign Invested Enterprises and Foreign Individuals.
The policy change will bring tax rates for foreign companies in line with the tax rates for domestic companies, and Chinese state media claim it marks the end of the period of special treatment for foreign business. While the tax will not drive foreigners away, it will add to the growing costs of operating in China, and the trend of ever-rising costs combined with political dangers will likely pose major challenges to foreign businesses in the not-so-distant future.
China’s Gradual Tax Reform
The maintenance and construction tax and the education tax will be calculated based on the amount that companies, organisations or individuals currently pay in taxes for turnover or sales (namely, value-added tax, consumption tax or business tax). The construction and maintenance tax level will be 7 per cent in cities, 5 per cent in towns and townships, and 1 per cent in other administrative levels, while the education tax will be a flat 3 per cent. Thus, the new tax on a company operating in a city would be an additional 10 per cent of their current turnover tax. Previously, neither the maintenance/construction tax nor the education surcharge applied to foreign companies or individuals. The exemption for foreigners began when the taxes were first levied in 1985-86 and was maintained despite removing some foreign privileges in the major 1994 tax reform. This exemption was in keeping with China’s policy of offering special tax treatment for foreign firms in order to attract foreign investment and technology after its 1978 economic opening up.
Though the tax hike has arrived somewhat suddenly — with little more than a month for businesses and individuals to prepare — and is by no means negligible, it is nevertheless unsurprising and follows other tax reforms under way for several years in China, particularly before the global financial crisis interrupted. At the beginning of 2007, China imposed a levy on urban land use for foreign enterprises and made the land use tax uniform for domestic and foreign companies. Most important, in early 2008 China began the process of unifying the corporate tax rate at 25 per cent for foreign companies and domestic companies, to be completed by 2012, with foreign companies moving gradually up from 15 per cent and domestic companies moving gradually down from 33 per cent. And at the beginning of 2009 China began to levy an urban real estate tax on foreign firms that previously had been exempt.
The unification of domestic and foreign tax rates is meant to simplify the tax code, do away with the long-held privileges for foreign firms and boost domestic firms. The move is also meant to encourage the reshaping of the manufacturing sector and broader economy by discouraging areas with overcapacity — especially foreign-invested, low-value-added manufacturing or inefficient foreign firms that can only profit with special tax breaks — and encouraging the development of private (and, less significantly, state-owned) domestic manufacturing and services.
Fiscal reform is a critical element of China’s attempt to wean its economy from export-led growth serving foreign demand so that it can become a more self-propelled consumer economy. With the global economic crisis ebbing, Beijing has renewed this effort. The reform will also support local government finances and improve social services. The construction/maintenance tax and education tax fit into this scheme, although some ambiguities about how they will be implemented remain and their effect will not be drastic. The higher tax revenues will go to improve rural and urban public services, thus boosting local governments’ financial positions and providing common people with more support, enabling them to spend more of their income rather than save it. Higher revenues for education outlays will also be necessary to expand education programs to the rural and urban poor and improve the skills of the workforce.
Rising Costs of Operating In China
Needless to say, foreign-invested businesses and foreigners living in China are not eager to pay any new tax. First, the tax itself will damage their bottom line; Chinese media quoted a source at a beer company as saying the tax would amount to about 29 per cent of the company’s profits from January through September 2010. But on a deeper level, foreign companies are becoming more sensitive to ever-rising costs in China. Rising labour costs are perhaps the most widespread concern, but prices are also rising for raw materials, land, energy and other utilities. A recent report by the U.S.-China Business Council showed that higher taxes ranked second, after labour costs, as the top causes of rising costs.
China assumes that the benefits it offers to foreigners, namely the rapid growth of its economy and its growing and potentially gigantic consumer market, will outweigh the costs of higher taxes. It has emphasised that it is pursuing still deeper market reforms, opening more sectors to foreign investment and participation, despite rising taxes. However, foreign companies’ greatest concerns relate to the Communist Party’s policies, the growing risk of protectionism and preferential policies for domestic firms, plus forced technology transfers, ineffective intellectual property rights enforcement and a number of hidden costs, including massive corruption. All of this has amounted to growing complaints about China’s business environment and a broader rethinking of strategies going forward, including diversifying to other countries that offer low-cost manufacturing options.
Of course, these complaints still make up a minority, and foreign businesses are seeing enough profitability in China to continue expanding their investments for the time being. But the bigger challenges to foreign business in China are not yet visible, as they are most likely to emerge in the next few years, after the country experiences the economic slowdown that it appears to be facing and that has struck every other export-model economy after decades of rapid growth. At that time, the Chinese state will be focused entirely on preserving stability and less concerned about appeasing foreign interests, and the uneasy relationship between foreign businesses and the political-regulatory regime will likely become much more grim.
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