By He Qinglian

   A series of revisions to China’s foreign investment policy took place in October 2006. The most significant changes include: First, on October 8, 2006, the State Council passed a draft resolution merging the domestic corporate tax and foreign corporate tax systems. It is expected to become law—Corporate Tax Law¹—at next year’s “Two Conferences.” Secondly, a number of the official research institutions reported that, in the future, as part of a long-term plan, various policies highly favorable to foreign investors would be discontinued.²

     Such a directional change in government policy signals that the golden era of foreign investors acquiring large profits without paying taxes is coming to an end. Although in the past 20 years, only one third of those investors actually realized their gold-mining dreams in China, the dream itself motivated them to keep pouring money into China.

China’s economic environment has experienced tremendous changes

   As China’s policies on foreign investments have tightened up, the infusion of foreign investments into China has been shrinking. This is echoed by the recent official figure—the actual foreign investments in China dropped by 1.52 percent³ in the first nine months of this year. Such a drop is well within the expectations of the Chinese government. It is the result of the policy changes on foreign investment. The policy shift comes from changes in China’s domestic economic environment.

    First of all, the thirst for foreign capital has decreased. By the end of September, China’s foreign currency reserves had jumped to US$987.9 billion, higher than any other country in the world, according to the latest data from China’s central bank.⁴ In the past, China’s policy provided foreign investors with tax advantages over domestic corporations in order to stimulate more foreign investments in China. Since capital is no longer the bottleneck for China’s economic development, the foreign investment policies naturally changed to favor hi-tech investments.

    Secondly, the problem of China’s limited resources is becoming increasingly severe. In particular, many resources, including energy, mineral resources, land, and low-cost labor, all lean toward the export-related industries. There are hardly any rules on environmental violations and labor rights. The boom in China’s exports has developed at a huge expense to the country’s resources, environmental damage, and energy consumption. On the other hand, the social benefits have not increased in proportion to the profit, despite all the development. Therefore, there is no significant increase in demand in the domestic market; “sustainable development” has become a pipe dream.

    These two factors have determined that China must revise its foreign investment policies.

    What changes have been made to the foreign investment policies?

    The current changes to the foreign investment policies are based on two criteria. One is to check if the foreign investment policy in the relevant areas will conflict with China’s economic interests. The second is to examine whether the current degree of openness will cause any economic security issues—although “economic security” is not a clearly defined topic in China. Despite the standard list of sectors established by the Chinese government to exclude the involvement of foreign investors, some attempted takeovers by foreign investors in sectors and industries that do not fall in the prohibited list did not eventually go through because of “national economic security” concerns.

    The recent revisions to the foreign investment policies fall into the following two major categories.

  1. Consolidation of the two tax systems 

   The so-called “consolidation of two tax systems” is to implement the same tax standards for both domestic and foreign corporations. In the past, due to the two different taxation systems for the two different types of entities, domestic corporations had to shoulder heavier tax burdens, while foreign companies enjoyed lower tax rates. According to publicly available data in China, the actual tax rate that China’s domestic corporations paid averaged 25 percent, while their foreign counterparts paid a tax rate of only 12 percent, a difference of 13 percent. The tax advantages used to be the main incentive for foreigners to invest in China. In the past three years, however, as the amount of foreign investment has surged, a viewpoint unfavorable to foreign investments has gradually come to dominate mainstream thought. Such a viewpoint holds that the foreign investments in China have reached the saturation point, and China’s domestic enterprises are in a disadvantageous position due to the heavy corporate taxes. Thus the voices calling for the consolidation of the two tax systems became ever louder. In the end, the State Administration of Taxation, the Ministry of Finance, and the National Development and Reform Commission, all of whom are proponents of a single tax system for both, won the battle within the circle of decision makers, leading to the present adjustments and changes in China’s foreign investment policies. It appears that the motion of the “Corporate Tax Consolidation” will likely be passed at the People’s Congress in March, 2007, and it will be implemented in 2008 at the latest.⁵

    The Ministry of Finance has pre-announced the consolidated tax rate to be 25 percent. The Research Institute of Finance under the Ministry has finished an evaluation of the impact of the merged tax rate on fiscal revenues, based on a range of 25 percent to 28 percent. To please the local governments, the central government promised a transitional period of one to two years, with a larger degree of freedom for regions in the West.

    The tax consolidation will have a significant impact on foreign investors, who enjoy many tax advantages in China, including the “Two Waivers and Three Halves.” (Presently, foreign corporation enjoy tax benefits for five years, starting from the first year of having profit. The first two years are free of tax. In the following three years, they pay half of the tax.) Local governments usually take the approach of taxing them first and giving them a refund later. Many foreign corporations, especially those from Hong Kong and Taiwan, have been relying on the tax advantages and export tax reimbursements as their main vehicle for profits. Once the new tax system is in place, many of these companies will likely pull their investments out of China. For multinational corporations, however, the situation could be different. Since China is merely the production base or the host country for their subsidiaries, the multinational corporations can sell their China-produced products to the parent companies and therefore use the internal price to transfer the profits to countries with lower tax rates. As a result, they can avoid the potential disadvantages caused by the new tax policies. There are also multinational corporations whose markets are in China. For them, the only choice is to hold on to the business until they no longer make a profit.

     The argument that domestic corporations are the biggest beneficiaries of the “corporate tax consolidation” is not true either, as they will pay the same tax rate as before and will not enjoy lower taxes. The benefits to them, if any, are indirect at best. For example, compared to the same products made by the foreign corporations in China, the products made by the domestic corporations are usually of lower quality, albeit with comparable prices. However, in the past, the foreigner companies enjoyed lower tax rates; thus they could set lower prices to expand their market share. Now, with the consolidated tax rates, the domestically made products can use a lower pricing approach to take the market shares from their foreign competitors.

     It is the Chinese government that will benefit the most, as it will be able to collect significantly more taxes as a result of the new policy.

   2. Policies on takeovers by foreign investors

   Another major policy change concerns the takeovers by foreign investors. In the last two years, the investment strategy of the Ministry of Commerce has been to encourage foreign investors to acquire Chinese firms. Take the 2004 data as an example. In 2004, the foreign investments in the form of acquisitions consisted of 10 percent of the overall foreign direct investments (FDI). In the recent couple of years, the pace of foreign takeovers has been accelerating. The most noticeable include the takeover of Xugong Construction Machinery by the Carlyle Group of the United States, and the purchases of Sichuan Shuangma Cement Co. Ltd by the Lafarge Group, Shenzhen Development Bank Co. by the New-bridge Capital Group of the United States, Qingdao Beer by Anheuser-Busch, and the Lanwu Steel Corporation by Arcelor. Among the acquisition attempts, some succeeded, and some failed. The main reason for the failures, according to the Chinese media, was the concern for “China’s national economic security.” ⁶ After three years of continuous media exposure, the list of sectors and companies that may affect the national economic security has greatly expanded.

   With the alleviation of the thirst for capital and the ever-rising nationalism, the door opening for foreign mergers and acquisitions has become even narrower. “Provisions on the Takeover of Domestic Enterprises by Foreign Investors,” announced on August 8, 2006, and effective on September 8, is the indicative official document on the policy changes for foreign takeovers. In addition, there are a few other noticeable trends, including:

   1. The State Council is discussing the formation of an inter-ministry commission similar to the foreign investment investigation committees in other countries. Led by the National Development and Reform Commission and involving the Ministry of Commerce and the Ministry of Finance, this new organization will collaboratively investigate all of the major foreign takeovers in the machinery and manufacturing industries. 

    2. Restrictions on takeovers or stock ownership by foreign investors will be placed in the seven key manufacturing sectors, including nuclear power plant equipment, power plant equipment, electric power transmission and distribution equipment, shipbuilding, gears, petrochemical equipment, and the steel industry. 20 to 40 key enterprises have reportedly been added to the list that is under the State Council’s direct protection.⁷ The criteria for the status of “key” enterprises are based on the market shares, asset amounts, production scales, and revenues of the corporations.

    While the Ministry of Commerce has long been a proponent of providing favorable terms to foreign investors, it made a sharp turn this year by issuing the “Report on the Control of China’s Industries by Foreign Investors,” and by reexamining the effectiveness of attracting foreign investments to China over the past few years. Full of national economic security concerns, the report has the tone that foreign investors have already taken control of China’s industrial sectors.

    As far as how to properly decide on a policy for foreign takeovers, China’s press widely believes that two red lines must be drawn. One is to ensure that foreign investors do not disturb China’s economic order. The other is to check on whether the foreign investors have threatened the security of the industries. Any foreign acquisition within these two red lines will likely be the target of protectionism, while the foreign investments that are beneficial to the transformation of the industrial structure or means of economic growth will be encouraged.

    Who is influencing the foreign takeover policies?

    Before asking the question, one may first ask who is actually most concerned about industrial security.

     Widely quoted as the supporting evidence that China’s industrial security is being compromised, a report distributed by the Research and Development Center of the State Council indicates that in each of the industries open to foreign investors, foreign investors almost exclusively control the top five enterprises. In particular, foreign investors own the majority rights of asset control in 21 out of 25 of China’s industries; they control the majority of the shares of the largest five elevator manufactures, which produce 80 percent of China’s market shares. In the home appliances industry, 11 out of 18 national level enterprises are joint ventures with foreign investors, while in the cosmetic industry, foreign investors control 150 Chinese companies. In addition, 20 percent of the medical industry is under foreign investors’ control, and 90 percent of the sales in the auto industry come from foreign brands.⁸

    The aforementioned industries were not previously on the list of strategic industries for national economic security. Nor do Beijing authorities believe they are related to economic security. It is no exaggeration that the fact that these industries are now related to national economic security is the result of the widespread media coverage in the past two years. Then who is concerned about the economic security of these companies?

    There are only two groups of people that have a vested interest in these industries: the domestic competitors and the consumers. From the perspective of protecting consumer rights, Chinese consumers get much better quality from the merchandise and services from foreign companies in China. Moreover, the Chinese consumers are forced to tolerate the monopoly prices and the inferior products and services in the industries that are not threatened by foreign investors’ control or subject to economic security. These industries include Telecommunications, oil and energy industries, and the financial systems. The extent that the public interest is harmed by these state-owned monopolies is demonstrated in the following incident. On October 4, during the 16^th Party Congress this year, to crack down on the overly powerful ministries and government departments, the central government published an article in the name of the Xinhua News Agency, “Take Measures to Suppress and Prevent the ‘Special Interest Groups’ from Growing,” publicly acknowledging that the state-owned monopolies infringe upon the public’s interest and damage social harmony.

    It is fair to conclude that the media coverage linking these non-crucial industries with the national economic security must come from the domestic companies that compete with their foreign counterparts doing business in China. The major players in these industries are all state-owned enterprises, not the domestic private companies.

    We should not overlook the power of these “special interest groups” in influencing state policies and legislation. To maintain their monopoly positions, these groups have been utilizing various means, including hiring scholars to appeal for them in the name of protecting the national industries. The outcome is the directional adjustments of the foreign investment policies. As a matter of the fact, it is more appropriate to call it these special interest groups protecting their monopoly interests than the protection of national economic security. If these examples are still insufficient, the new regulations China is currently pushing forward to restrict the expansion of the large international chain stores in China, including Wal-Mart Stores, and the Carrefour Group, are surely unrelated to national economic security.

    The Chinese companies are cleverer now because they know how to protect their own interests by waving the nationalism flag. Many industrial associations are involved in the foreign takeover debates. For example, the Bearing Industry Association of China publicly expressed its opposition to the preliminary acquisition agreement between the Schaeffler Group of Germany and the Luoyang Bearing Group. The China Cement Association is also demanding that the government investigate the M&A activities of foreign investors in the domestic cement industry.

   Should the domestic companies demand the protection of their industries in order to gain more time to renovate and improve the quality of their merchandise and services, their actions would not deserve criticism. On the other hand, if the purpose of their demand is to protect their monopoly interests by compromising the interests of consumers, the protectionism under the disguise of the nationalism flag needs to be questioned.

     Blocking the road for Chinese firms to become “fake” foreign investors

     Another indicative change of the foreign investment policies is that it blocks the road for many Chinese firms to enjoy the favorable terms by disguising themselves as “foreign investors.”

   Among the foreign investments in China, 1/3 of them are actually from native Chinese who have transferred their assets abroad and then infused them back to China in the name of foreign companies. According to a conclusive study by the Chinese government, there are three forms of “fake” foreign investments. The first scenario is that the Chinese companies in Hong Kong, Macau, or other countries, out of their strategic needs, come back to China to form foreign investment companies. The second scenario is that to raise capital, the domestic corporations register some shell corporations overseas, then return to China to acquire their former domestic corporations, and finally bring them to IPO. The last form is that the formerly domestic corporations register some shell companies with offshore financial centers and then become foreign corporations in China.

    It is estimated that the third form of “fake” foreign investments is very common in China. As of today, not only Hong Kong, with its single tax system, remains the best place for China’s domestic companies to register their shell companies, but the Virgin Islands, the Cayman Islands, and the Samoa Islands have become the 2^nd, 7^th, and 9^th most popular regions for Chinese companies to register their offshore entities. With regard to the ratio of “fake” foreign investments in China to total FDI, the World Bank estimated that, in 1992, it was as high as 25 percent. Some experts say that today that number is over 33 percent.⁹

     “Provisions on the Takeover of Domestic Enterprises by Foreign Investors” presented by the Chinese authorities in August introduced the regulations on “actual control.” Provision 11 and 15 require the applicants to disclose to the investigation authority their administrative relationship and their actual holders. Under these rules, the takeovers actually controlled by domestic corporations must be subject to approval by the Ministry of Commerce. Provision 9 provides that the acquisitions of domestic companies by overseas corporations that are actually controlled by domestic entities will not, in principle, enjoy the advantageous treatments. In addition, provision 59 provides that when the natural stockholders of domestic corporations change their nationalities, the nature of the corporations they own cannot be changed (to a foreign investors’ venture)^.10

    These provisions make it improbable for “fake” foreign investments to profit from their outflanking tactics. Nevertheless such a change indeed conforms to the Chinese government’s political principle of consistently treating overseas Chinese as citizens of China.

(Originally published in Finance and Culture Weekly of Taiwan News, November 8, 2006, Issue 263)

References:

1. Accounting Times, October 16, 2006, “liangshui hebing maichu shizhixing bufa, (A Substantial Step Taken on Consolidation of the Two Tax Systems)” vol 90 http://www.atimes.com.cn

2. Xinhua News Agency, October 20, 2006, “weilai zhongguo de waizizhence jiang zubu xiangzhongxingwaizi zhuanbian, (China’s Future Foreign Investment Policy will Gradually Change to a Neutral Policy)”

3. See note 2 above.

4. Website of People’s Daily, November 8, 2006, “waihuichubei tupo yiwanyi meiyuan, ju’e waihui ruhe shiyong, (Foreign Currency Reserves exceed 1000 billion US dollar; How to Make Use of Foreign Currency reserves)”  http://finance.people.com.cn/GB/1045/5011992.html

5. See note 1 above.

6. Xin Caijing (New Finance Magazine), January 5, 2006, “2005 niandu ‘zhongguo shida binggou shijian’ dianping, (Comments on the 2005 ‘Top 10 M&A’s in China’)” by Li Bing

7. Sichuan jingji xinxiwang (Sichuan Economics Information Network), June 28, 2006, “liubuwei yu lianxi bufang, waizibinggou congyan shencha, (Six Ministries and Commissions Work together to Seriously Investigate M&A’s by Foreign Investors)” http://www.sc.cei.gov.cn

8. Global M&A Research Center, China’s Map of Industries, 2004 – 2005, April, 2005, published by People’s Post & Telecom Press

9. 21 shiji jingji baodao (21st Century Economic Report), June 19, 2006, “waizi shuishou loudong, (Loopholes of Taxation on Foreign Investment)”

10. Website of People’s Daily, August 10, 2006, “guanyu waiguo touzizhe binggou jingneiqiye de guiding, (About Regulations on M&A’s of Domestic Enterprises by Foreign Investors)” www.finance.people.com.cn/GB/1037/4685010.html

Chinascope, December,2006