Charges to change with the times
Companies with mainland links should look out for shifts in the tax system, writes Robert Hanson
RENOWNED ECONOMIST Adam Smith viewed taxation as an art learned by government to drain money from the pockets of people and business. If alive today, he would no doubt hold similar opinions and would be observing with interest the significant changes being planned by the mainland government to its methods of tax collection.
Peter Kung, China tax partner for accountancy firm KPMG, said companies with mainland-related business should keep a close eye on several forthcoming changes. These primarily concerned transfer pricing, the unification of domestic and foreign tax codes, and refunds of value added tax (VAT), which Mr Kung sees as an important issue that has received surprisingly little attention.
Although the international financial press has largely focused on exchange rate policies and the possible revaluation of the yuan when discussing ways to reduce China's trade surplus with the rest of the world, Mr Kung sees other options.
'Reducing the VAT export refund rate is an alternative to currency appreciation. This would increase the cost of exports, reduce demand for them and cut the balance of payments surplus in a way similar to allowing the yuan to appreciate in value,' Mr Kung said.
This method had the advantage of generating extra tax revenue.
'The government is thinking about implementing it this year, but no decision has been made yet,' he said.
The issue of transfer pricing comes into play when one company owns and operates businesses in more than one tax jurisdiction. Transferring profits and reporting them in a jurisdiction where lower rates are applied can reduce the tax bill. Suspecting that many companies understate their profits in China, with the result that the mainland is missing out on a substantial slice of revenue, the government is ready to act.
'For the past four years, China has been attracting between US$50 billion and US$60 billion of foreign investment annually,' Mr Kung said. 'At the same time, statistics have shown that nearly two thirds of foreign investment enterprises are loss making or just about breaking even. This doesn't make sense; companies would not invest so much in China if so many were making a loss.'
Therefore, the tax authorities have started to devote more resources to examining the transfer pricing policies of multinationals. It is believed that this year about 100 of the largest overseas corporations will be asked to explain where they reported the profits of their China operations and why.
Investigations are likely to focus on three areas: companies which have made consistent losses or just broken even but continue to expand rapidly, those which report profits during tax holiday periods and losses at other times, and those with many transactions generating profits in locations such as the British Virgin Islands.
Officials will carry out the investigation at a regional level under the supervision of Beijing authorities to ensure the programme is carried out in line with recognised international practices.
'The authorities will benchmark against similar companies in the same industry to get an idea of expected levels of profit. With a little fine tuning, it should be possible to get a fairly clear indication by using data provided by the industry and the government,' Mr Kung said.
Because the transfer pricing review will be based on rational calculation and objective criteria, Mr Kung expects companies will have few complaints about its conclusions.
However, Michael To Tat-wang, tax director at Grant Thornton, anticipates possible differences of opinion.
'Where our clients' figures and the government's differ, we may need to look for reasons. These might include the use of advanced technology to reduce production costs,' he said.
Whatever changes there are to the tax system, Mr Kung is confident they will not deter foreign investment.
'China has a large and efficient labour force and is competitive in terms of taxation,' he said.
'The government may be clamping down on transfer pricing, but it is taking a professional approach so that companies understand why, and have no reason to feel hard done by.'
Accession to the World Trade Organisation meant that China had to move towards creating a unified tax code applicable to local and international companies, Mr To said. 'Domestic companies pay 33 per cent tax, whereas foreign investment companies enjoy a two-year tax break and then an additional three years of paying half tax,' he said. He expects full harmonisation by 2007 and 2008.
'Going forward, the new tax rate is likely to be around 25 per cent for all companies,' Mr Kung said. 'Tax incentives are more likely to be focused on specific industries and geographical regions which are economically less well off.'
Possible reduction in VAT refunds as a means of dealing with the mainland's trade surplus
Investigation of transfer pricing policies to see where companies are reporting profits
Harmonisation of taxation rates for mainland and overseas enterprises. A standard rate of about 25 per cent is expected to be in place by 2008