(AsiaTimes, Apr 11, 2007) Since China opened its doors in the late 1970s, foreign investment has kept flowing in. Thousands of foreign-invested companies are set up across the country each year. But are foreign enterprises making profits or losses in China?

According to official statistics, as of the end of 2005, there were about 500,000 companies with foreign investment registered in China. Of those, about 330,000 had started operating. About 55% of the foreign companies operating reported losses between 2001 and 2004. In 2005, the figure dropped to 42.96%.

It seems strange that while Chinese enterprises, including state-owned, joint-stock and private companies, have been making profits in recent years, nearly half of all foreign-invested businesses have been losing money. Yet while so many foreign enterprises claim to be losing money, China witnesses a continual rise in its foreign direct investment (FDI).

FDI in China in 2006 totaled US$63 billion, higher than the $60 billion in the United States. China became the largest FDI recipient in the world in 2003, receiving $53.5 billion.

According to a research report by the National Bureau of Statistics on foreign companies claiming to be making losses in China, two-thirds of them have "extraordinary losses". Chinese officials believe many of these foreign companies are in fact using transfer pricing and other ways to reduce taxable income.

Chinese officials earlier said tax evasion by multinationals costs the country 30 billion yuan (US$3.88 billion) in tax revenue each year.

There are two main types of foreign-invested companies in China - Sino-foreign joint ventures and foreign solely owned firms.

Some joint ventures make losses partly because of their untrustworthy foreign partners. For example, the foreign partner of an automobile joint venture would import a huge amount of spare auto parts from its parent company in its home country instead of buying Chinese-made auto parts, which are much cheaper than imported ones. In this way, foreign companies not only transfer profits to their parent companies, but also hurt their Chinese partners by making their joint ventures lose money.

According to accounting experts, China's complicated policies on corporate income tax and preferential tax in various cities encourage tax avoidance. Some domestic enterprises would try every possible way to become "foreign companies" so as to enjoy tax breaks.

China launched a dual-corporate-tax system to attract foreign investment more than a decade ago, in which foreign-funded companies enjoy an income-tax rate of 15% while domestic firms pay 33%. In China's special economic zones (SEZs) or industrial parks, foreign manufacturers can also enjoy preferential tax policies including two-year full tax exemption and three-year partial tax exemption.

Feeling that the dual corporate income tax is unfair, many Chinese enterprises register overseas and return to the country as foreign enterprises to enjoy tax breaks, which are known as "fake foreign enterprises", said an accounting expert who asked not to be named.

"Once registered in offshore tax havens, the Chinese companies can return to China in the form of foreign direct investment, qualifying themselves for favorable taxation rates and tax incentives, paying income tax at rates as low as 10%," he said.

Among such Chinese enterprises-turned-foreign businesses, Gome, China's largest home-appliance retail chain, became a foreign company after its successful Hong Kong listing in June 2004. According to its reports, since its transformation, Gome enjoyed tax rates of 9%, 10.6% and 11.2% respectively in the second half of 2004, the whole of 2005 and the first half of 2006. By comparison, it paid corporate income tax of about 20% in 2003.

In contrast, Suning Appliance, China's second-biggest mainland electronic chain retailer and Gome's major rival, needs to pay average corporate income tax of 22%, given that its subsidiaries in the Shenzhen and Xiamen SEZs enjoy a tax rate of 15%, and its subsidiaries in other places have to pay 33%.

As of the first half of 2006, Gome had enjoyed a 200 million yuan tax discount since its transformation from a domestic company into a foreign company in June 2004.

Mei Xinyu, senior researcher at the Chinese Academy of International Trade and Economic Cooperation under the Ministry of Commerce, said earlier that according to estimates, of China's utilized FDI of $72.4 billion in 2005, one-third was Chinese investment overseas that came back disguised as foreign capital to take advantage of the tax breaks.

Among the top 10 countries or regions investing in China in 2005 were Hong Kong, the British Virgin Islands (a group of islands in the Caribbean with a population of only 22,000 but at least 400,000 registered companies) and the British-controlled Cayman Islands.

And the total utilized FDI from the 10 places reached $24 billion, far more than the amount invested by players in developed countries such as the US, Japan and South Korea.

However, China's main concern is not fake foreign companies' taking advantage of tax breaks, but their funds being recycled through the tax havens to transfer profits abroad.

Some foreign companies with affiliates operating offshore use "round-tripping", that is, funds leaving China only to return in the form of FDI, to dodge taxes. For example, they claim their investment comes from high-interest loans from their affiliates operating offshore and pay them interest on the loans, which could eventually lead to tax evasion and, even worse, money-laundering.

After enjoying the five years of tax benefits offered by the SEZs, some foreign manufacturers, either fake or real, use transfer pricing by importing raw materials at high prices and exporting finished products at low prices to shift revenues abroad and avoid paying tax in China.

According to officials at the anti-tax-evasion division of the State Administration of Taxation, transfer pricing is the most common way of evading taxes, accounting for 60% of all types of tax evasion. Foreign companies inflate the cost of production equipment, raw materials and labor, and export products at falsified low prices, transferring most of the profits - and tax liabilities - to their sister companies in other countries to capitalize on lower tax rates there.

Such business activities by foreign companies not only enable their enterprises in China to appear unprofitable, but also trigger an increasing number of anti-dumping charges, launched by the US and Europe, against Chinese products.

The accounting expert said transfer pricing has become a common practice for multinational companies under economic globalization.

"As multinational companies have businesses in different countries or regions, they can optimize transfer pricing and minimize overall tax payment after seeking advice from accounting firms," the expert said.

According to statistics quoted by the mainland media, from 1990 to 2004, revenues shifted by foreign-invested enterprises in China reached $250.6 billion.

"No wonder foreign-funded companies contributed to one-third of China's industrial output, but only generated one-fifth of the total tax revenues," a commentator was quoted as saying by the media, criticizing some foreign companies for tax avoidance.

Ironically, although the possible illegal business activities of foreign enterprises has been hotly debated in recent years, not a single foreign-invested company was involved in the top 10 tax-evasion cases investigated by China's public-security authorities in 2005.

The accounting expert blamed loopholes in China's existing laws - for example, the failure to distinguish between tax evasion and tax avoidance - for preventing tax officials from snooping into overseas bank accounts and shell companies.

They also attributed tax evasion to China's lax enforcement system for tax collection, which is partly due to a shortage of trained professionals and a backward information system.

Some believe the new Corporate Income Tax Law passed by the annual session of the National People's Congress last month, which comes into effect from next January 1, could create a level playing field for local and foreign-funded manufacturers. But Shanghai-based economic commentator Ma Hongman said the new law has little negative impact on foreign-invested companies.

"Whatever changes have been made in the Corporate Income Tax Law, many foreign-invested companies, particularly those who have been claiming losses in China, would not even pay a cent," Ma said.

"Besides, illegal tax evasion by multinationals not only results in a massive loss of tax from the central government's coffers, but also creates unfair competition between domestic companies and multinational companies, as the latter can use profits transferred abroad to enhance competitiveness to get a bigger share of the market," he said.

Ma said China's customs officials are able to identify the methods used by foreign companies to avoid tax - such as transfer pricing. He said the main reason for the rampant tax avoidance is that some local governments indulge multinationals.

"As many local governments use the amount of foreign investment and the sizes of foreign companies as the main yardsticks for [measuring] the performance of public servants, who will have the courage to look into the problem of tax avoidance?" he asked.

Olivia Chung is a senior Asia Times Online reporter.
source:AsiaTimes