Ever since China joined the WTO, clients have been asking me if/when preferential tax breaks for foreign companies were going to end. My answer has been consistent over the years. The tax breaks will end some day, but not for a while because of the political realities of FDI in China and the economic mindset of Beijing.

Looks like I will finally get to change my stock answer. Nothing is going to happen tomorrow, but it appears as though Beijing is going to start the long-awaited process of drafting a law to unify tax rates for foreign and domestic enterprises:

China plans to enact a bill that would eventually unify income tax rates for domestic and foreign companies at 25 percent after years of criticism that the tax policies are unfair to domestic entities.

    The Standing Committee of the National People’s Congress (NPC),or China’s top legislature, has initiated the lawmaking process to discuss a bill on corporate income tax on Sunday.

    China’s current dual income-tax structures have long been the subject of intense debate. Many Chinese economists, government officials and business leaders have openly criticized the tax policies as being unfair to domestic businesses, while offering advantages to foreign-invested enterprises (FIEs).

Why was this inevitable? First, there are a lot of very unhappy domestic companies that have complained about their higher tax burden for some time. The government can’t keep ignoring this forever. Second, the current structure simply does not conform to the spirit of the WTO with regard to the fundamental idea  of national treatment. In almost all investment disputes, you have foreign companies on one side and a national government on the other side, with the former complaining that they are being discriminated against in favor of domestic firms. In this case, it is the opposite, and of course you would never see this as the basis for a formal dispute. In my opinion, however, it just doesn’t sit well with current thinking on foreign investment.

Why has China waited so long? A lot of folks in Beijing (i.e. the central government) believe that China’s large flow of FDI in recent years has been bolstered by its tax policy. Even now, according to the Xinhua story above, there is a vocal group that is still supporting that notion. Personally, I really couldn’t tell you how much a unified tax rate, meaning an increase in the tax rate for most FIEs, will decrease FDI inflows. I have nothing but anecdotal evidence, and of my clients, many would have set up here anyway, while others might have opted for other destinations. My gut feeling is that these days, China is not just a low-cost manufacturing destination. So many FIEs are set up for strategic reasons having more to do with the China market than selling product back home. In this sense, a rise in tax rates may not hurt as much as some people might think.

Before anyone freaks out, the law has not even been drafted yet. Even when we have a draft to kick around, the lobbying will be fierce. Moreover, there will undoubtedly be transitional periods for a gradual phase-in of the new rates. Finally, we might see a more active use of tax preferences to encourage certain kinds of activities (the article cites high-tech and environmental, but there could be others), so tax breaks may still be available to many FIEs.