In a move toward a market economy, China recently approved a bill creating a unified enterprise income tax of 25% for companies, thereby ending nearly three decades of preferential tax treatment for foreign companies. [1] This new enterprise income tax (EIT) law will become effective on January 1, 2008. [2] Under the new EIT law, foreign companies in China, currently benefiting from the present preferential tax regime, are expected to experience a significant increase in their tax costs while domestic companies in China will see a noticeable reduction in their tax burdens. [3]
Currently, domestic companies in China pay more income taxes than their foreign counterparts. Although China’s present corporate income tax law imposes a statutory income tax rate of 33%, this rate applies mainly to domestic firms and very few foreign companies that do not qualify for preferential tax treatment e.g., foreign services companies. [4] Foreign companies that invest in certain areas, such as economic and technological development zones, foreign infrastructure and high-tech industries, enjoy a preferential income tax rate of 15% or 24%. [5] In addition, most foreign companies in China are entitled to a tax holiday whereby they are exempted from income tax for the first two profitable years in China and are only required to pay half of the set income tax for the following three years. [6] Notably, the new EIT law will eliminate these preferential tax treatments, with two major exceptions: (1) high-tech and other high priority foreign industries will still be entitled to a preferential tax treatment of 15%; and (2) foreign companies with small profits with be entitled to a preferential tax treatment of 20%. [7]
China’s new EIT law has been viewed as a response to the World Trade Organization’s requirement of non discriminatory treatment between domestic and foreign firms. [8] While the policy of preferential taxation is regarded as a necessity for enticing foreign investments, it is often criticized because of its harmful effect on fair market competition. [9] The preferential treatment of foreign companies creates an unequal playing field where domestic companies would have to pay a higher tax than their foreign rivals. [10] Thus, the preferential tax treatment in China discriminates against the domestic companies and places them at a disadvantage.
Many economists refute the argument that the increase in corporate income tax for foreign firms will dampen the influx of foreign investment in China. [11] According to Liang Hong, chief China economist from Goldman Sachs Asia, foreign investment will continue to flow into the Chinese market, regardless of the 10% increase in income tax, because China’s rapid economic development and higher returns as compared to other countries are major appeals to foreign investors.” [12] Likewise, Patrick Horgan, head of the Beijing office of multinational communications and investment consultancy APCO, stated that “most foreign investors these days are not in China solely for preferential tax treatment. The domestic market and cheap skilled labor are just as important.” [13] China’s Finance Minister Jin Renquig said that the average corporate income tax in China’s 18 neighboring countries and regions is 26.7%. [14] Further, the full impact of the increase in enterprise income tax on foreign companies in China will be offset by a five-year transitional period. [15]
Regardless of the opinions of economists like Liang Hong and Jin Renquig, the availability of favorable tax exemptions and cheap skilled labor in China’s neighboring countries may draw certain foreign investors from China. In comparison to China’s new EIT rate of 25%, foreign companies investing in special manufacturing zones in Vietnam are entitled to a 10% enterprise income tax rate along with an eight-year exemption. [16] Similarly, Thailand offers foreign companies, investing in special zones around Bangkok an eight-year exemption from enterprise income tax and five additional years at half of the set tax rate. [17] Although these two neighboring countries do not boast domestic markets comparable to that of China, they both provide cheap skilled labor which attracts foreign investments. [18] India, whose domestic market is comparable, imposes a higher enterprise income tax on foreign companies than does China. [19]
Although the impact of China’s new EIT law on the influx of foreign investment is debatable, a unified corporate income tax rate for both domestic and foreign companies is a necessary step towards achieving a market economy. This author believes that the new EIT law will dampen the flow of foreign investment at some rate but the effect may be minimal due to China’s considerable domestic market and maturing economy.
Sources:
[1] China Passes New Law on Property, BBC NEWS, Mar. 16, 2007, http://news.bbc.co.uk/go/pr/fr/-/2/hi/asia-pacific/6456959.stm.
[2] Id.
[3] Kerstin Heidrich & Rainer Hausmann, Tax Alert: China’s New Corporate Income Tax Law- Changes and Recommendations, ERNST & YOUNG, Mar. 2007, available at http://www2.eycom.ch/publications/items/tax_news/20070320_taxalert/200703_EY_TaxAlert_e.pdf.
[4] Chi Hung Kwan, China in Transition: The Need for a Unification of Income Tax Rates for Foreign and Domestic Firms, Research Institute of Economy, Trade and Industry, May 29, 2006, http://www.rieti.go.jp/en/china/06052901.html.
[5] Id.
[6] Id.
[7] Heidrich & Hausmann, supra note 3.
[8] Time to Pay Dues, BUSINESS CHINA, Mar. 26, 2007, available at 2007 WLNR 5473053.
[9] Don Lee, China to End Tax Breaks for Foreign Firms, LOS ANGELES TIMES, Mar. 17, 2007, available at http://www.latimes.com/business/la-fi-chinatax17mar17,0,7354978.story?coll=la-home-business.
[10] Kwan, supra note 4.
[11] PEOPLE’S DAILY ONLINE, New Enterprise Tax Rate not to Affect Foreign Investment in China, Mar. 8, 2007, http://english.people.com.cn/200703/08/eng20070308_355646.html.
[12] Id.
[13] Mark Godfrey, Will They or Won’t They?, EUROBIZ MAGAZINE, Sept. 2006, available at http://www.sinomedia.net/eurobiz/v200609/story0609.html.
[14] See, New Enterprise Tax Rate not to Affect Foreign Investment in China, supra note 11.
[15] Id.
[16] Godfrey, supra note 13.
[17] Id.
[18] Id.
[19] Id.