China Cracks Down on Foreign Business Tax Breaks

 
 

China’s slowing economy and fiscal readjustment have led central and local governments to begin a crackdown on foreign corporate tax breaks in a search of higher revenue. The central government has become increasingly vigilant against tax evasion among multinationals, while local governments are beginning to refuse corporate tax breaks to foreign firms.

Tax breaks in China take several forms. Preferential tax breaks are usually available to firms in the encouraged sectors, which in recent years has been the high-technology, R&D, and some additional industries (including agriculture and major infrastructure projects). Enforcement of tax rules on multinationals has conventionally not been stringent. Local governments have also provided tax breaks to some foreign businesses, but these are now under threat of elimination as localities struggle to fund themselves in a revenue crunch. Case in point: the Wall Street Journal recently reported that Foxconn is in the process of negotiating with the city of Zhengzhou to build a 35 billion RMB ($5.6 billion) plant with tax breaks intact, as promised subsidies may be taken away.

Some multinational corporations in China have used tax loopholes, including transfer pricing, to curb the amount of taxes paid to the Chinese government. Now, the government is cracking down to obtain revenue and comply with international standards. An example was set last November when a large, unnamed multinational (believed to be Microsoft) was fined 840 million RMB for tax evasion. As China’s growth slows, these revenues are increasingly important in generating government funds. The effort is also a product of a foreign diplomatic agreement, as China has endorsed efforts by G20 leaders to curb multinational tax evasion and to strengthen global tax cooperation.

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China’s fiscal reform process has unsettled enterprises as well as local governments. For background: Normal taxes include the enterprise income tax, value-added tax, business tax, consumption tax, and customs duties. The tax system is currently being revamped to move service-sector enterprises away from the business tax and toward the value-added tax. A new regulation was put in place on February 1 to prevent tax evasion among multinationals, although the rule provides authorities with a measure of discretion in determining whether multinationals indeed have substantial business operations in the country. The service sector firm change will redistribute revenue away from local governments and toward the central government, reinforcing the revenue crunch already underway.

Moreover, the multinational tax crackdown and the removal of some local government tax breaks for foreign firms have increased uncertainty in an operating environment that is already becoming more expensive. Tax breaks were increased in the nineties and 2000s to accelerate growth and attract multinational corporations, and as wages and business regulation enforcement remained low, China became an ideal location for foreign direct investment. Now, as wages rise, and businesses are fined for price-fixing and other violations, China poses new challenges for foreign enterprises wishing to set up shop abroad. An effective increase in tax payments does not help the situation.

It is unclear what the future will hold for foreign firms in the way of preferential tax breaks. Currently, the picture is somewhat alarming for these firms, who may choose to move elsewhere in the long run, taking their beneficial employment impacts with them. China’s move to enforce international best tax practices for multinationals makes sense in terms of positioning the nation as a “team player” on the world stage, but it may discourage growth going forward. This controversial issue will play out in the next year as China’s growth continues to slow.

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