China Removes Some Incentives For Manufacturers In Order To Reduce Trade Frictions And Satisfy Domestic Critics

Saturday, December 1, 2007 - 01:00

China's trade surplus with the world increased more than 20 percent in the twelve-month period between October 2006 and 2007, continuing a long march upward. Some economists have predicted that the trade surplus with the United States alone will grow to as much as $400 million in the near term - amounting to more than ten percent of China's Gross Domestic Product. Although not as large, China's trade surplus with Europe is still substantial and growing at an even faster rate.

As a consequence of these year-on-year increases in trade surpluses with no apparent end in sight, China faces increasing pressure from its trade partners around the world to bring bilateral trade flows in to balance. Most often, this pressure comes in the form of bilateral discussions with the Chinese government conducted behind closed doors.

For example, Chinese government officials met with European leaders toward the end of November to discuss trade issues. The same Chinese officials are scheduled to conduct trade discussions with the United States in December through both the Strategic Economic Dialog, a Treasury Department project, and the Joint Commission on Commerce and Trade, a joint effort of the U.S. Department of Commerce and the Office of the United States Trade Representative.Trade imbalances, as well as government policies that that may influence them, are sure to be a topic of conversation at all of these meetings.

In addition, the United States and European Union have also recently begun to work together through multilateral institutions such as the International Monetary Fund to address relevant issues such as currency valuation.

The pressure on China to adjust its trade policies can come from foreign industries as well as governments. In some situations, foreign industry pressure can be just as effective as pressure from foreign governments, if not more so.

A number of U.S. and European industries have had on-going discussions with their Chinese counterparts for many years. In some circumstances, these discussions have helped to resolve problems quickly.In others cases, the talks have not resolved the issues.

Some companies and industries have decided to take a more direct approach. For example, in late 2006 a U.S. papermaker filed a countervailing duty petition in the United States asking the government to conduct an investigation into whether subsidies to Chinese paper companies had caused injury to the corresponding industry in the United States. This request and subsequent investigation followed on the heels of a number of similar proceedings in Canada.

After a year-long process, the Department of Commerce found that China had indeed subsidized exports of glossy paper through a number of programs providing, among other things, grants for technological renovation to paper production facilities and preferential loans from government-owned financial institutions to the paper industry, which the Government of China deems "encouraged" and thus eligible for special benefits.

The Department of Commerce also found that the Chinese government offered certain tax holidays to foreign companies that located their production facilities in China. This program is particularly significant because, as the Chinese press likes to point out, substantial volumes of the goods shipped to the United States from China are exported by multinational companies.

A number of industries filed similar subsidy complaints with the U.S. government during the course of the glossy paper investigation. Those industries include makers of steel pipe, woven sacks, tires, thermal paper, and magnets, and their investigations are ongoing. In addition, the United States government also filed its own challenge of certain Chinese subsidies programs available exclusively to exporters at the World Trade Organization in Geneva. Mexico quickly joined the suit.

All indications are that increasing numbers of U.S. and Canadian industries will begin to file their own challenges to Chinese subsidies programs, including specifically tax breaks for foreign manufacturers that relocate their production to China.

It is important to note that pressure to reform some of China's subsidies programs, especially tax benefits for foreign companies, has come from within China. For example, there was increasing resentment in China of perks provided to enterprises with foreign investment that domestic enterprises did not enjoy. One of these programs was called the "Two Free, Three Half" program (the name is a lot catchier in Mandarin, where it rhymes). In essence, this program provided that companies with at least 25 percent foreign investment do not pay the standard 30 percent income tax rate during the first two years of profitability and then pay income tax at only half the normal rate, 15 percent, during the next three years. As a practical matter, there were any number of ways in which this 15 percent preferential rate could be extended almost indefinitely, such as if the company is located in any one of a number of special economic zones or produced high-technology or knowledge-intensive products. As a result of these programs, foreign-funded manufacturing concerns in China rarely paid income tax at the same rate as their domestic competitors.

Bowing to both domestic pressure to treat all companies in China evenly and the threat of additional subsidies investigations abroad, the National People's Congress passed a new tax law in March 2007. The new tax law purports to apply the same tax rate to all companies in China (not including partnerships and the like). The new law is not, however, effective until 2008, and even then it contains a number of provisions that appear to allow foreign companies currently enjoying tax breaks under programs like those challenged in the paper subsidy investigation to continue to enjoy those tax breaks indefinitely. Thus, while it appears that companies relocating their production to China after the law becomes effective in 2008 will not get the tax breaks their predecessors received, Chinese tax law will continue to treat existing companies unevenly depending on whether they have the requisite amount of foreign investment.

Moreover, China's new tax law provides unspecified breaks for income derived from "industries and projects whose development is supported and encouraged and supported by the state" as well as exemptions for income earned in agriculture and forestry, among others. The Chinese Government has published a number of catalogues of "encouraged" industries and products, which include steel, building materials, automobiles, textiles, and other items. Thus, although the Government of China has addressed the discriminatory treatment of some companies based on whether they have foreign ownership, subsidies to encouraged industries and products continue. Consequently, while the repeal of the special tax breaks for foreign companies may have some effect on trade flows, it appears that the Government of China has no intention of ceasing to provide tax breaks to a potentially wide swathe of manufacturers.

In addition to revising its income tax policy, the Government of China also in July 2007 adjusted the rebates of the Value Added Tax (VAT) for exported goods. The adjustment included the removal of VAT rebates for more than 500 types of goods, many of which were the subject of complaints from trading partners. The Government of China also reduced the VAT rebate for more than 2,000 types of additional products, including such items as bags, clothing, furniture, watches, clocks, and toys. Although explained as an attempt to discourage the export of energy-consuming products the manufacture of which may harm the environment, it seems equally likely that the motivation for the measure was a desire to decrease trade tensions.

Although VAT rebate programs for exports are allowed under World Trade Organization rules, they cannot be excessive (that is, they cannot exceed the amount of VAT actually paid). A number of China's trade partners and industries have argued that the rebates act, in effect, as an export subsidy. The European Union, for example, has noted in submissions to the World Trade Organization that the Chinese VAT system is not transparent and that refunds appear to be given in a discriminatory manner. The United States has voiced similar concerns.

China's July 2007 VAT rebate adjustments will undoubtedly affect trade flows for those products enumerated. The Chinese VAT rate for most products is 17 percent, and while many products did not receive a full 17 percent VAT rebate (rebates for some products could be 13, 11 or 5 percent, for example), any reduction in the rebate amount will be serious. For many Chinese exporters, the VAT rebate has been the profit margin. With this incentive removed, some companies could go out of business, or decide to produce other merchandise.

There should not, however, be any change in the flow of goods that did not have their VAT rebate rate adjusted. Moreover, Chinese government policies affecting currency valuation will not be affected, so there will still be an incentive to export in due to the undervaluation of the Renminbi (yuan).

Further, it is unlikely that these recent changes to China's income tax and VAT rebate program will discourage companies that want to from locating production in China. On the whole, the Government of China still offers a number of incentives to locate there, including free land for companies operating in encouraged industries. Moreover, it is not at all clear that all provincial tax authorities will comply with the new provisions, at least not immediately.

Christopher T. Cloutier practices law in the international trade group of King & Spalding in Washington, DC. He was previously a diplomat attached to the Commercial Section of the United States Embassy in Beijing, where he focused on trade policy. The opinions expressed in this article are the author's alone and do not necessarily represent the views of King & Spalding or any of its clients. Please contact the author regarding this article at (202) 626-5410.

Please email the author at ccloutier@kslaw.com with questions about this article.