Investing in China: Ten Points to Consider in Evaluating Local Investment Incentive Policies, Contributed by Carlo Geremia, NCTM Shanghai
Since 2008, when China Corporate Income Tax legislation was amended and preferential tax treatment for foreign-invested companies abolished, Chinese local governments have introduced new and substantial incentive policies to attract foreign investors. Some local governments have adopted written investment incentive policies. Others have informally adopted incentive policies but not yet put these in writing. In both cases, there are several points foreign investors should consider in order to better evaluate the incentives offered. This article provides information on how to better understand and assess a local investment policy in China.
1. Compliance with National Laws, Regulations and Policies
A local investment policy must comply with national legislation. If there is any inconsistency between the local investment policy and the national laws, regulations and policies, legislation at the national level will prevail.
In particular, local investment incentive policies must comply with the relevant China five-year plan, currently the Twelfth Five-Year Plan (2011-2015). As a result, any undertaking or commitment by local governments in respect of investment incentives cannot be guaranteed to continue beyond December 31, 2015, the date marking the end of the Twelfth Five-Year Plan. For this reason, when written investment incentive policies are adopted, they usually have a final provision setting out their time frame (i.e., 2011-2015).1 Sometimes, however, the time frame is not very clear in the investment policy documents or, if there is no written policy, in the explanations provided by the local authorities.
A practical implication is that when a local policy grants a 100% tax incentive for the first two years from a company’s establishment and a 50% tax incentive for the remaining years, “remaining years” means the years left through 2015. After 2015, the local government might still be able to grant an extension of the incentives originally offered. However, this will depend on their compliance with the investment directives of the new five-year plan.
2. Tax Incentives: Their Nature
An important element of a local investment policy is the granting of tax incentives to companies newly established within the jurisdiction of the local government. The nature of the tax incentives under the local investment policies is substantially different from the tax incentives enjoyed by foreign-invested companies before the 2008 China Corporate Income Tax reform. The new tax incentives are not tax exemptions. The companies enjoying tax incentives will still have to pay taxes, although they will be entitled to a “refund” several months down the line.
Local investment policies refer to these tax incentives as “subsidies” (in Chinese: 补贴, butie). Their amount is determined with reference to the company’s corporate income tax, value-added tax or business tax revenue. Although the amount of these “subsidies” is based on the relevant tax revenue, technically they are neither tax exemptions nor even tax refunds, as they do not impact on the company’s tax obligations.
3. Amount of the “Tax Refunds”
In China, tax revenue is allocated between the central government and the local governments. A substantial portion goes to the central government. The remaining portion is divided among the various local governments at different levels. For instance, if a company is established in Shanghai, Jingqiao sub-district, the corporate tax revenue of this company will be split among the central government, the municipal government of Shanghai, the government of Pudong New District (the Shanghai district where Jingqiao is located) and, finally, the government of Jingqiao. The local government providing the tax refund (Jingqiao in our example) will be able to refund only an amount equal to the portion of corporate tax revenue allocated to it. Therefore, when an investment policy states that the local government will grant a 100% “subsidy” of the corporate income tax, this actually refers only to 100% of the corporate income tax portion allocated to the local government in question.
4. Timing of the “Tax Refund”
In China, companies have to pay taxes on a monthly basis (value-added tax and business tax) or on a quarterly basis (corporate income tax). The tax refunds offered by the local governments, however, will be implemented several months down the line. This will usually happen between April and May of the following year, after the company has submitted its audited balance sheet and a final tax assessment has been made. For instance, taxes paid in 2011 will be (partially) refunded in April-May 2012.
The time lapse between tax payment and “tax refund” may have (among other things) a cash flow implication, as well as a risk of delay/risk of non-payment implication.
- Cash flow implication: the investors should be aware of the time lapse between tax payment and tax refund because this will reduce the cash resources of the company for several months.
- Risk of delay/risk of non-payment implication: local governments may not have the money (or all the money) to implement the tax refund on time. Delays may occur. This is unlikely to happen in Shanghai, Beijing or other major cities in China (especially in the central districts of those cities). However, it cannot be completely ruled out for other cities or for outlying and less wealthy districts of the major cities.
5. Tax Formalities: Hidden Costs
Investment incentives may induce a foreign investor to choose a rather remote location for the registration of its company. But, establishing a company in an outlying district may involve additional costs that, at the time of the establishment of the company, an investor may overlook.
Some of the additional costs arise from tax formalities. A company established in an outlying district may need an office closer to the city center where its employees work and customers and suppliers come for meetings. Still, for certain formalities, the company’s employees or tax consultants will need to visit the tax office of the place of registration. This will be necessary to discuss certain issues with the tax official in charge of the company or to purchase the company’s invoices.2 Further, before obtaining ordinary taxpayer status,3 the company will need to go to the tax office for the issuance of VAT invoices. As a result, time and money will be spent travelling from the company office to the tax authority of the place of registration.
6. Rent Subsidies: Implications for the Registered Address of the Company
Rent subsidies are a very common incentive that local governments offer to attract foreign investors. Local governments4 often provide office space rent-free or at a discounted rent. Foreign investors can use such office premises as their companies’ official registered address. Sometimes the investors are also allowed to use the office premises for the company’s actual business operations. Sometimes they are not. The duration of this kind of “subsidized” office lease contract is usually just one or two years. It is uncertain whether, on the expiry of the first lease term, the local government will require a market rent for the office lease.
In order to maximize the benefit from rent subsidies, an investor should try to obtain, for as long as possible, a rent-free lease contract. It would also be helpful to try to obtain some written undertaking from the local government that no rent will ever be charged to the company in respect of the leased office.
In practice, local governments will adopt a very practical and business approach when deciding whether to grant any additional rent-free period. They will consider the tax revenue generated by the company in question (or, in certain situations, the future tax revenue) and decide whether it would be, from their point of view, a good “investment” to grant any extended rent-free period.
7. “Subsidized” Registered Address: Regulatory Implications
In China, a company’s registered address must be a real office, i.e., a place where the company’s employees work and the company conducts its operations. Nevertheless, quite often, rent-free or discounted-rent office premises are used for company registration purposes only. This is because they are located far away from the city center or are very small. Local governments (as opposed to local tax authorities)5 usually do not have strict requirements in respect of the actual use of the registered addresses. Actually, they may indeed have a quite flexible approach so that companies can register within their jurisdiction even if the companies’ operations are in another location (usually an office closer to the city center).
On the other hand, the local tax authorities have a much stricter approach concerning a company’s registered address. Local tax authorities want to ensure that the companies registered within their jurisdiction conduct real business activities and that they are not “scam companies” just engaged in printing invoices for tax fraud. For this reason, the tax authorities will conduct (at least) two site inspections at a company’s registered address. The first inspection will occur at the time of granting the tax registration. This will be shortly after the company has been established and has obtained its business license. The tax authority will conduct the second inspection before granting “ordinary taxpayer” status to the company.
In other words, local governments and tax authorities will very likely have a different approach in respect of a company’s registered address. Local governments are usually more flexible and do not require a company to have actual operations at the registered address. Tax authorities have much stricter requirements. These different views may delay the completion of a company’s registration process and, ultimately, the company’s operations. Foreign investors should be aware of all the regulatory implications of a “subsidized” registered address and be ready to deal with them well before establishing the company. Foreign investors will have to discuss this matter in advance with both the local government and the local tax bureau and try to make all the necessary arrangements for the site inspections by the tax bureau.
8. “Subsidized” Registered Address and Company Branch
If a company is established in an outlying district, it usually needs to have a branch closer to the city center where its administration is conducted.6 If a company needs to establish a branch closer to the city center, it will also need to register this new office as a company branch. This is because the Chinese regulatory environment requires each company’s address to be registered with the relevant Administration of Industry and Commerce.7
The opening of a company branch involves several costs, such as the rent for the new office, the administrative costs of registering the branch, as well as additional accounting and tax filing costs if the branch will be authorized to issue invoices. Thus, once again, the establishment of a company in an outlying area because of tax incentives may involve (unexpected) additional costs. These additional costs should be factored in when evaluating a local investment incentive policy.
9. Change of Registered Address: Impact on the Incentives
In China, a change of a company’s registered address is not an easy and straightforward process if the proposed registered address is located in a different district. District-level authorities do not encourage a cross-district change of registered address because this means that a source of tax revenue (i.e., the company in question) will move out of their jurisdiction.8 As a result, the administrative process for the change of registered address usually takes several months. The change can take place only after the company has obtained clearance from the tax authority of the district of establishment, confirming that all the taxes accrued since the company establishment date have been settled.
If the company in question has enjoyed investment incentives (whether tax refunds, rent subsidies or others), the local government will very likely require the company to return such funds to it. This will be a condition of the change of registered address, and is actually quite understandable from the local government’s perspective because the investment incentives were originally granted on the expectation that the company would stay in that district and generate tax revenue for many years.
Sometimes it is a more suitable option for the investor to keep the original registered address and register a new company in a new district. This will allow the investor to move operations from the old company to the new company without any business interruption. The investor is then free to consider the best time to liquidate the first company.
10. Written Agreements or Commitments from Local Governments
Chinese local officials are very eager to explain their investment incentive policies and reassure foreign investors of their commitment to implement them. The problem is that government officials change. They move to other positions, retire or, in certain situations, are dismissed. The new officials will not necessarily be willing to implement the investment policy on the same terms granted by their predecessors, especially if such a policy is not set out in writing.
An investor should try to obtain a written agreement with the local government or, at least, some written commitment setting out the investment incentives that the local government has promised. This is useful even when the local government has set out its investment incentive policy in an official and public document. In fact, quite often some commitments are fairly vague (e.g., “to grant a special incentive,” “to provide a specific subsidy”9), and need to be specified. The local government needs to know the scale of the investment in question and its financial projections in order to be able to make specific commitments.
Local governments are usually reluctant to enter into these sorts of written agreements or sign any written commitment. A probable reason is that the legal basis of these agreements is uncertain. Whether the local governments have the authority to undertake these commitments is also uncertain. On the other hand, even when these agreements are in place, it is very unlikely that the foreign investor will be able to enforce them against the local government. Almost certainly no local court will accept such a case. Still, it is better to try to obtain a written agreement with the local government rather than rely only on oral undertakings by the officials.
Reading and assessing a China local investment incentive policy requires an understanding of the Chinese regulatory environment and the policy objectives of the local governments, as well as the ability to read (also between the lines) the documents in Chinese. Local governments are eager to introduce local consultants to explain how these policies work. However, these consultants are usually (directly or indirectly) employed by the local government. They share with the local government the same objective: to have the foreign investor establish its company within the jurisdiction of the local government. Therefore, it is very advisable for foreign investors to seek independent legal advice when assessing a local investment policy.
Carlo Geremia is a senior associate at NCTM Shanghai. He is a qualified lawyer in Italy, England and Wales, as well as a fluent Mandarin speaker. Mr. Geremia has been working in China for the last ten years, helping foreign investors to set up or acquire entities in China. He also advises on commercial, employment and intellectual property matters. He can be contacted by e-mail at: email@example.com
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