Business Alert – China

Since China is planning a series of reforms at various levels, new measures will be formulated covering such areas as the establishment of investment companies by foreign enterprises, joint-venture enterprises engaged in contracting projects, and the setting up of research and development institutions by multinational firms. China will also be reviewing and revising its policies regarding taxation and foreign exchange transactions of foreign-invested enterprises (FIEs) in bank accounts opened in different localities.

Premier Zhu Rongji has said many times in public that China would take its opening-up to a new stage. At the Asia Society's annual corporate meeting held last May, Zhu pointed out that WTO membership will afford China an important opportunity to further open up. The country will speed up its opening-up process in such areas as energy, transportation, telecommunications and environmental protection. At the same time, China's doors will open wider to foreign investment in service sectors ranging from banking, insurance, to tourism, commerce and trade. Efforts will also be made to attract more foreign capital to the reorganisation and reform of state-owned enterprises (SOEs). Beijing will review and amend existing foreign-related laws and regulations in light of WTO requirements and set up an economic and trade system in line with both international practices and national conditions.

Minister of Foreign Trade and Economic Cooperation, Shi Guangsheng, also said on the same occasion that with the prospect of entering the WTO at the beginning of the new century, China will push ahead its opening-up drive in a more active manner. This move is bound to create new opportunities for foreign investors. Under the present strategy of developing the western region, China is stepping up the construction of transportation, telecommunications, energy and other infrastructure projects in the region while paying more attention to environmental protection. Priority is also given to the promotion of science, technology and education, and great efforts are made to foster talent and improve the overall quality of workers. The government is giving the necessary policy support to all these endeavours. Shi added that developing China's western region will create a favourable environment for foreign investment. China welcomes foreign companies to set up R&D centres or invest in new- and high-technology in the country. Foreign investors are also encouraged to participate in China's SOE reform and reorganisation in the form of equity holding, leasing, acquisition, and joint operation.

Standardising National Treatment Following WTO Accession

As liberalisation of investment is the global trend of development, China has to honour its commitments following its entry into the WTO.

1. Action must be taken to adjust its policy regarding foreign direct investment in accordance with the principle of national treatment. In other words, discriminatory treatment against domestic enterprises and preferential treatment for FIEs should be abandoned.
   
   
2. Services sectors such as telecommunications, banking and distribution will open further to foreign investment and geographical restrictions will be removed.
   
   
3. Existing policies and laws that are inconsistent with international practices would be adjusted and revised to ensure that China's laws do not contravene WTO rules and regulations.
   
   
4. During the transitional period, continuous efforts would be made to narrow the gap with international norms. The WTO Agreement on Trade-related Investment Measures (TRIMs) has placed higher demands on intellectual property rights (IPR) in China. If China cannot offer effective protection to the legitimate rights of IPR owners from other WTO members, it may lose the concessions and preferential treatment it enjoys, or even face retaliation. After its entry into the WTO, China must continue to improve its IPR laws to meet the requirements set in the agreement.
   
   

   Utilised Foreign Investment in China

   Unit: US$ bn

   Note: Starting from 1997, the amount of foreign bonds issued has been categorised under Other Foreign Investment instead of Foreign Loan. Source: Statistical Survey of China 2000

   
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5. China must take the initiative to adjust other policies related to foreign investment. Such adjustments should include using industrial policies to give support to its capital- and technology-intensive industries in order to offset the negative impact of trade liberalisation on these industries and promote industrial upgrading. The taxation policy should be adjusted in such a way that it could play a better role in the redistribution of income and mitigate possible social instability resulting from a widening of income gaps. Efforts should also be made to bring about a higher savings rate and to attract and sustain the inflow of foreign capital.

It is obvious that these adjustments of policies on foreign investment are aimed at gaining early WTO accession. Based on analyses from different sources, it can be expected that adjustments mainly cover the following aspects:

1. With regard to enlarging the business scope of investment companies established by foreign enterprises, the Chinese government is considering granting export rights to such companies which source domestic raw materials for export. Meanwhile, encouragement will be given to enterprises engaged in R&D, and approval will be granted to investment companies to market domestically-produced goods directly.
   
   
2. As for joint-venture enterprises engaged in contracting projects, China would consider giving support to qualified domestic companies to team up with leading international companies in establishing such enterprises. China may further expand the business scope of these enterprises this year, giving them support in contracting overseas projects. At the same time, the construction industry will be liberalised.
   
   
3. On the question of foreign exchange transactions of FIEs in bank accounts opened in different localities, the Chinese government will continue to improve measures which have already been put into force. For example, FIEs with accounts in different localities will be allowed to make foreign exchange transactions among these accounts. New regulations governing foreign exchange transactions in bonded areas will also be introduced.
   
   
4. On the establishment of R&D institutions by multinational companies, China will continue its policy of "market in exchange for technology". It may be willing to concede a larger slice of the market to projects involving a higher level of cooperation that provide systems design technology and have great market potential in China. Incentives such as tax concessions will be gradually introduced for the development of projects with international funding.
   
   
5. In processing trade, China is gradually improving the related tax system. It is clear that China encourages the development of the processing trade, especially the processing of products with a high added value, which serves as a channel for its participation in international cooperation.
   
   
6. On taxation, the following tax concessions contravening WTO rules and regulations would be adjusted accordingly:
   
   
   1. Only domestically-produced equipment in technological transformation projects is eligible for tax deduction. With effect from July 1, 1999, the purchase of domestically-produced equipment by domestic enterprises for technological transformation under the state's industrial policy can enjoy a 40% deduction on the total amount of price and tax shown on the special VAT invoice, and the amount is to be deducted from the additional amount of enterprise income tax payable a year prior to the purchase of the equipment. If the amount to be deducted is greater than the amount of tax payable, the outstanding amount may be spread out for up to five years. Domestically-produced equipment entitled to tax deduction can still be computed for depreciation at the original price. However, the fact that this preferential policy does not apply to imported equipment goes against the principle of national treatment.
      
      
   2. Instant tax rebate for self-developed products. For example, after paying VAT at the statutory 17% rate on the sale of computer software developed by themselves, ordinary Chinese taxpayers are eligible for an instant rebate on that part of actual tax burden in excess of 6%. While this regulation is intended to encourage innovation and the development of high technology, it discriminates against similar computer software from other WTO members.
      
      
   3. Higher tax burden on imported goods than on domestic goods. For example, while imported agricultural products such as grain are subject to a 13% VAT, the marketing of domestically-produced grain and agricultural products is exempt from VAT. Commercial enterprises dealing in agricultural products are allowed to withhold an amount equivalent to 10% of the purchase price as tax deduction for VAT payment.
      
      
   4. Tax deduction and exemption on the basis of export performance. FIEs engaged in exports are eligible for a 50% deduction on enterprise income tax if their export volume exceeds 70% of their output value for the current year. Although this does not constitute a violation of the principle of national treatment, it amounts to the subsidising of domestic products and is in contravention of WTO countervailing regulations.
      
      
   5. Incentives for the use of domestic raw materials. In order to encourage export-oriented processing enterprises to use domestically-produced steel, China offers tax exemption, deduction and rebate to processing enterprises purchasing steel from Baoshan, Anshan, Shoudu and 24 other steel production enterprises. Also, as a solution to the problem of the overstocking of cotton, China encourages enterprises to use domestically-produced cotton for export processing by offering them tax exemption, deduction and rebate. However, it is against WTO regulations to offer subsidies to enterprises for using import substitutes.
      

Utilised Foreign Investment in China in 1999

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Distribution of Foreign Investment in China in 1999

Unit: US$ '000

Note: The figures of national total does not only represent the summation of data from all municipalities and provinces, it also includes data from different departments. *not available Source: Statistical Survey of China 2000

Recommendations for Foreign Investors

In view of these policy changes, foreign businesses already have investments or planning to invest in the mainland must re-evaluate China's investment environment and make the necessary adjustments to their strategies.

Re-evaluation of Investment Costs

1. Costs versus preferential policies

   Following its entry into the WTO, China has to formulate its foreign investment policies in accordance with TRIMs. It must do away with all regulations that are not in line with the principle of national treatment and ensure that foreign investors enjoy the same rights as SOEs.

   In light of this, foreign investors are unlikely to receive any preferential treatment for their future ventures in China. Thus, they are advised to take all possible costs into consideration, especially hidden costs such as apportionments, taxes, and all kinds of labour costs and funds, including housing fund and social insurance (e.g. pension, medical care, work-related injuries, unemployment and maternity leave).
   
   

2. Selected industries versus selected regions

   In the past, many special zones and bonded areas were established to lure foreign investors, and foreign firms were offered various kinds of preferential treatment. Following its entry into the WTO, China must adopt unified investment policies for the whole nation and must not favour one region over another, or it will be accused of violating the principle of national treatment. In future, China will gradually shift to a policy of giving preferential treatment to selected industries rather than selected regions.
   
   

3. Tax concessions versus indirect concessions

   Before, China introduced preferential measures for different regions and different types of investors in order to lure foreign investment. In taxation, concession was offered on enterprise income tax and import tariffs. However, the principle of national treatment dictates that FIEs should neither be discriminated against nor treated favourably. Therefore, it can be expected that the Chinese government will gradually reduce and ultimately abolish all tax concessions. Indirect concessions will be offered instead. For instance, FIEs may be allowed a faster rate of depreciation, tax exemption, deduction and rebate, and transfer of losses. Special reserve fund may also be set aside as an indirect means of support to FIEs. These methods are not bound by international taxation regulations and embody the principle of fairness in taxation.

Breaking Regional Protectionism

1. China's entry into the WTO will help eliminate regional protectionism and reduce the special privileges enjoyed by regional industries. Local protectionism is a problem that has been bothering the central government for a long time. WTO accession will provide the external force that can finally eliminate local protectionism and bring about fair competition.
   
   
2. New interest groups have emerged in China in the wake of reform and opening up. These interest groups are obstructing China's further opening up. Entry into the WTO will bring in external forces to boost internal reform. This will help create a sound economic and political environment and usher in a new wave of reform and opening up.
   
   
3. China's entry into the WTO as a developing country will give it the time it badly needs for large-scale industrial restructuring. China's WTO talks with the US centered on trade in services, including telecommunications, banking, insurance, securities, retailing and wholesaling, tourism, sea, land and air transport, accounting, legal services, consultancy, advertising, education, culture, and foreign trade. As it takes time for China to adjust its industrial structure, it will only be opening its service sectors gradually and conditionally. Foreign firms seeking market access into China's service sectors must therefore have a good grasp of its tempo and timetable for opening up, and prepare themselves before it is their time to move in.

Domestic Market

After China becomes a member of the WTO, FIEs will have a freer hand in opening up its domestic market. They may combine foreign sales with domestic sales to minimise investment risks, using export sales to support their expansion of the domestic market. The following are some suggestions for FIEs:

1. Building a national logistics and distribution network

   Apart from distribution channels and the building of brand image, the biggest headache of manufacturers in their quest to open up China's domestic market is how to deliver their goods to the sales outlets. China is a vast country, which means transportation is a big problem whether by train or by truck. An important strategy for FIEs seeking a share of China's domestic market is to establish national logistics centres in major cities.

2. Franchising chain operation to domestic enterprises

   Most Chinese entrepreneurs want to build up their own business. FIEs may extend their successful chain-operated business to the Chinese mainland and charge royalties for the use of the brand or company name and the provision of equipment, materials, interior decoration, technical support, training and so on. In this way, they will not only be able to bypass the legal problems of establishing domestic trading companies, but will be able to quickly gain market access. This is a win-win approach that can minimise the investment risks of foreign firms while satisfying the urge of mainlanders to set up their own business.

China's Foreign Investment Policies that Contravene WTO Agreements

The General Agreement on Tariffs and Trade (GATT), the precursor of the WTO, reached three agreements relating to the establishment of a global investment mechanism during the Uruguay Round, which ended in 1994. These are the Agreement on Trade-Related Investment Measures (TRIMs), Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPs), and General Agreement on Trade in Services (GATS). The inclusion of investment measures in multilateral trade talks was a major breakthrough of the Uruguay Round as well as an achievement by GATT in establishing a global investment protection mechanism. This is the basis of the effects of WTO accession on China's policies on foreign investment.

GATT included investment measures in trade talks because countries and regions across the world had set their own conditions on foreign investment as prerequisites for their market access (or purchase of domestic enterprises of the host country) or as subsidies or incentives. These measures are of two types. The first type covers incentives for investment, including tax concessions, tariff concessions, investment subsidies, and acquisitions and mergers. The second type covers operational requirements, including restrictions on profit repatriation, foreign exchange control, and requirements on local equity, local content, domestic sales, trade balance, licencing, technology transfer, product specifications, exports proportion, and import substitutes. TRIMs requires that the principles of national treatment, quantitative restriction and transparency established by GATT should apply to these measures. In other words, the host government should do away with unreasonable measures that contravene the principles of national treatment and quantitative restriction, and should promptly announce trade-related investment laws and policies.

Preferential Treatment for FIEs

The three agreements mentioned above have the principle of national treatment at the core. In international direct investment, national treatment means that foreign enterprises should receive the same treatment as domestic enterprises in incorporation, ownership, control, judicial matters, legal protection, and matters relating to the investment property or investment activities.

China' existing policies on foreign investment are inconsistent with the principle of national treatment and the three WTO agreements in two main respects, namely FIEs are given both preferential and discriminatory treatments. In order to attract foreign direct investment, China implements a dual-track tax system whereby domestic and foreign enterprises are levied different income taxes. The income tax concessions extended to foreign firms are not granted to domestic enterprises, especially private operations. As for circulation-related taxes, foreign firms can enjoy rebates on their tax burden resulting from the replacement of the consolidated industrial and commercial tax and special consumption tax by VAT, consumption tax and business tax; but domestic enterprises do not have this privilege. With regard to tariffs, foreign enterprises are exempt from tariffs on the import of production equipment, parts and components as well as raw materials, auxiliary materials, components, parts and packaging materials imported for the production of goods for export in accordance with law (this measure was abolished in 1996 but reinstated in 1998). Foreign investors and technical personnel are allowed to import, tax free, a given quantity of articles for daily use. Foreign direct investment projects may apply to the government for the use of land, and the government will assign land use rights to them for a given period in the form of leasing. Special economic zones and open coastal cities often offer considerable concessions to foreign firms on land use fees. Foreign direct investment projects on education, culture, science and technology, medical and health care, and public facilities as well as export-oriented and hi-tech projects enjoy even more favourable terms. Foreign enterprises also have priority in investment approval and have the privilege of recruiting talent from other cities. They are granted import and export rights, management autonomy, a freer hand in foreign exchange management and greater flexibility in setting their wage scales.

Discriminatory Treatment for FIEs

Despite the many privileges, foreign enterprises receive discriminatory treatment in certain areas, which mainly finds expression in the fact that they face much stricter requirements than domestic enterprises in bank loan seeking, business scope, equity ratio, and application for export licences and quotas. Foreign enterprises are also subject to local content requirements, foreign exchange balancing requirements and export to domestic sales ratio. It is therefore not surprising that foreign investors often complain about unfair treatment in acquiring raw materials, applying for bank loans and obtaining guarantee for a fixed price level compared with domestic enterprises. Complaints about discriminatory treatment are particularly strong against requirements on localisation, import-export balance and credit control in the automobile, petrochemical, chemical and computer industries.

As for trade in services, foreign firms are subject to strict requirements or even denied access. On IPR, China's existing Trademark Law, Patent Law and Copyright Law also fall far short of the requirements of TRIPs.