The growing cost of investing in China: a shift in strategy

by RitaZhao on February 23, 2011

in Diaz Reus News

by Vincent Li

Beginning December 1, 2010, foreign enterprises in China were required to pay “municipal maintenance and development taxes” and “educational taxes,” eliminating the last two tax exemptions that were previously accorded to foreign-invested companies. As a result, foreign invested companies enjoy no more tax benefits and bear the same tax burdens and obligations as their Chinese counterparts. This ends the two-decade long preferential status that the Chinese government had extended to foreign companies.    

Foreign investors have long enjoyed tax incentives and benefits on profits made in China. For example, prior to 2007, wholly foreign enterprises paid corporate income tax at a preferential rate of 15-17% (15% for wholly foreign owned enterprises and 17% for joint venture foreign enterprises), while the income tax rate applicable to domestic enterprises is 33%. This ended in March 2007 when the new Business Income Tax Law was enacted, applying a uniform rate of 25% to all enterprises and reserving preferential rates to only those businesses designated as high tech companies (15%) or small businesses (20%). Thereafter, China has been taking steps to remove the residual tax benefits previously accorded to foreign investment. In 2008, foreign enterprises were required to pay “agrarian land occupation taxes.” In 2009, foreign individuals and entities were required to pay the same percentage of property tax as Chinese citizens. Then, in December 2010, the last remaining exemptions – exemptions from “municipal maintenance and development taxes” and “educational taxes,” were removed. Foreign-invested enterprises are now treated like domestic businesses for tax purposes.

The removal of tax benefits has caused some to complain that doing business in China is becoming excessively expensive. But that is not the only cause for concern. Other factors also increase the costs of doing business in China, including:

  1. Currency

As China is under more pressure to revalue its currency, foreign investors must pay higher manufacturing costs in China. The exchange rate between the Chinese Yuan and U.S. dollar rose 0.3% in October 2010, then 0.1% the following month. It is estimated that by the end of 2011, the RMB/USD exchange rate will have risen from 6.63:1 to 6.2:1. This is indeed bad news for businesses like Walmart, which have long benefited from cheap manufacturing costs in China. With a stronger RMB, paying their costs in RMB and selling products in USD, companies will see their profit margin shrink.

  1. Labor Costs  

It was once believed that with a population of 1.3 billion, China has an inexhaustible reservoir for cheap labor. Labor costs still remain cheap in the country’s interior, but have risen significantly in the more developed Guangdong and Southern Jiangsu coastal regions where there is a shortage of young, skilled laborers. Moreover, steep inflation is pressing workers to ask for increased wages and benefits. As a result, average labor costs have at least doubled over the past three years. This trend continues.

  1. Shipping Costs

Adding to the hike is shipping costs for goods transported from China to the U.S. For example, in the first half of 2010, shipping prices rose 21% over a five-month period. The rise was steeper for the latter half of the year. Some companies reported a 35% expense increase for shipping goods from China to the U.S. in September 2010 alone.

So how do companies cope with the prospect of spending more for doing business in China? Some will move their businesses elsewhere, such as India, the Philippines, Vietnam, or Indonesia. However, China still has its obvious advantages: excellent infrastructure, skilled labor, stable governance, and proximity to a massively expanding and maturing consumer market.

Many investors unwilling to give up on China have chosen to shift their operations to interior provinces – labor is cheaper and infrastructure, though not comparable with more developed coastal regions, is improving. Among them is Foxconn Technology, which makes Apple iPhones. Foxconn was forced to increase salaries at its Shenzhen manufacturing plant in response to a notorious labor dispute early last year.

As more foreign corporations are moving inland, new challenges are emerging. For example, government agencies in the interior provinces are sometimes more bureaucratically minded, less knowledgeable about Western-styled property or contract rules, and more protective of local interests. How do companies confront this situation? The first step is to obtain knowledgeable and experienced counsel to assist during the transfer and sale process. Diaz Reus has handled negotiations for several American clients in places like Chongqing municipality and Sichuan province. In general, we found that there is a huge disconnect between Western business minds and the bureaucratic business culture in China’s inland provinces. Without informed guidance by professionals familiar with Chinese law and practices, these negotiations definitely would have risked impasse, and likely would have broken down.

Is China, like Korea, Taiwan, and Japan three decades ago, shifting from its labor-intensive economic development model to a more technology-based or service-based model? The government’s decision to abolish preferential tax treatment for foreign enterprises is a telling sign of the times. It is a bold gesture of confidence, signaling that China is no longer relying on foreign investment for its economic well-being.  

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