Zhou Qigang is a staff member of the planning and accounting department of the China Pacific Insurance (Group) Co. Ltd. According to Zhou, his company is now paying income tax at 33 percent; while foreign-funded insurance companies like the Allianz Dazhong Life Insurance Co. Ltd. enjoy a preferential rate of 15 percent.

"But the situation will change soon as the new round of tax reform has started, which will lead to unified income tax rates for both domestic and foreign-funded companies," Zhou said.

It is widely believed that the new, unified business income tax rate would be 25 percent, though the State Administration of Taxation has not yet confirmed anything. In line with the country's 10th Five-Year Plan (2001-05), a new unified tax law will soon be put into practice.

Unfair play

Different tax laws have created a major problem for China's current business income taxation system. At present, domestic enterprises pay income taxes according to the Provisional Regulations of the People's Republic of China on Enterprise Income Tax, while foreign-funded companies follow the Income Tax Law of the People's Republic of China for Enterprises With Foreign Investment and Foreign Enterprises. As a result of the different taxation systems and tax rates, the tax burden borne by domestic enterprises almost doubles that of foreign-funded companies.

Giving preferential treatment to foreign-funded companies has been a common practice in many regions of China. Take Hefei Ancor Optoelectronic Machinery Co. Ltd. in Anhui Province for example. A foreign-funded hi-tech enterprise, Hefei Ancor was established in 1994, with initial registered capital of 3.14 million (US$379,227), of which foreign capital accounted for 62 percent.

Located in the national-level Hefei New and High Technology Development Zone, Ancor enjoys various favorable taxation terms. Although its nominal tax rate stands at 24 percent, it actually pays a mere 12 percent. In addition, the local government also exempted the company from the 3 percent local tax.

Professor Liu Heng from the Central University of Finance and Economics pointed out that preferential tax terms helped attracting foreign capital in the early period of the country's reform and opening up. "But today's economic situation is much different from those days, and different tax rates are very likely to result in the success or failure of an enterprise in market competition," he said. Especially after China's accession to the World Trade Organization (WTO), such tax system violates the principle of tax neutrality, as well as WTO principles of free trade and fair competition, said Professor Liu.

Professor Hu Yijian from the Shanghai University of Finance and Economics maintained that time is now ripe for China to unify its tax laws and tax rates.

Effects on domestic and foreign firms

A source close to the top management of Ancor revealed that preferential tax terms are the primary reason for the rapid development of the company. According to this source, Ancor's profits stood at 1.55 million yuan (US$187,198) in 1997, increased to 6.75 million yuan (US$815,217) in 2000 and soared to 11.21 million yuan (US$1.35 million) in 2001.

However, the company has no intention to withdraw capital from China even if the country unifies its tax rates at 25 percent, according to the source.

There are two reasons: One is that Ancor invests in China because of its good investment environment rather than merely the favorable taxation terms. Second, the company has already transferred a considerable amount of capital over the past years of operation in China, by means of transfer pricing.

Pan Yingli, dean of the Department of Finance of the East China Normal University, believed the second reason might be a key factor for whether a foreign-funded company will withdraw its capital or not. She cited U.S. investment in China for example.

Generally speaking, the cost of foreign investment in China is no higher than 5 percent, she noted, while American companies annually enjoy around 10 percent of returns on investment. Based on the 5-percentage-point difference, American investors had already transferred billions of dollars of profits out of China by February 2003 when their actual investment reached US$41 billion.

According to an insider in the tax profession, through transfer pricing, foreign businesses' taxable amount of income has been greatly reduced, therefore, their performance may not be so sensitive to the raised tax rate after unification.

On the contrary, domestic enterprises, which have been paying higher tax rates, are looking forward to the tax reform.

Professor Ping Xinqiao from the China Center for Economic Research of Peking University said the reduction of tax rates after unification will bring more opportunities to domestic enterprises. He indicates that there are more than 870 million yuan (US$105.07 million) of private savings in banks, part of which is likely to be invested in businesses after the unification of tax rates.

According to participants in the drafting of the new tax law, in future, private enterprises will only need to pay personal income tax and no business income tax.

The new tax law will also replace the former region-oriented preferential policies with industry-oriented preferential policies and the preferential tax terms will materialize in multiple, flexible forms, such as direct reduction and exemption, accelerated depreciation and pre-tax deduction. 

(Beijing Review February 11, 2004 )