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• Author: Theonnes, Ken
• Position: Includes related article - International Business: China

The Chinese government has set up a tax system to attract the right kinds of foreign companies to its lucrative market. Does your firm fit into the plans?

For companies looking to expand globally, China is a tempting target. Its gross domestic product has sustained double-digit annual growth over the last decade, and some experts estimate that 25 percent of China's 1.2 billion citizens, or roughly 300 million people, will have the same buying power as middle-class Americans by the year 2000.

But hitting a financial bull's eye in China depends more than ever on accurate tax planning. Recent tax law updates are just one of many reforms transforming the economic environment. Besides far-reaching tax regulations initiated on Jan. 1, 1994, over the past year China updated regulations that affect such business elements as foreign trade, holding companies, asset valuation, fair competition and foreign-exchange control. These steps are all part of China's overriding goal to bring its economic system in line with the capitalistic economies of developed countries.

The changes, however, are a mixed blessing for financial executives heading a venture into China. Though in the long term they promise a more efficient business climate, in the short term they're confusing and leave many laws open to interpretation.

The recent tax-reform measures are a prime example. Some of the implications of the new regulations are still unclear, and Chinese officials are just now providing many interpretive rulings. Foreign companies are scrambling to catch up as translations of the codes' text slowly become available.

GETTING THE DEFINITIONS DOWN

Before you explore the tax regulations that went into effect in 1994, you should examine an earlier change to China's tax code - the unified income-tax law. Effective in 1991, this law clearly defines two categories of foreign businesses operating in China: foreign investment enterprises, or FIEs, and foreign enterprises, or FEs.

An FIE is a Chinese-foreign equity joint venture, a Chinese-foreign cooperative enterprise or a wholly foreign-owned enterprise established in China. An FE is made up of foreign entities with "establishments" or "sites" in China that engage in production or business operations, or foreign entities with no such establishments or sites in China but with income from sources in China. Under the unified tax rules, an establishment can be a management establishment; an office; a factory; a site for operating a contracted project or providing labor services; or a business agent.

These definitions are crucial to foreign investors in China. Many tax strategies are determined by the nature of the operation, since Chinese domestic taxes often provide relief for one type of company but not another.

The UITL parallels the overriding tax policies of China, which are designed to bring in foreign capital. Of course, the government wants foreigners to bring their hard currency, some expertise and their access to advanced economies. The composition of China's GDP illustrates the impact of this taxation policy. Roughly 37 percent of it is from joint ventures defined as FIEs.

Under the UITL, China imposes a uniform tax rate of 33 percent (30 percent to the central government and 3 percent to local authorities) on all of the taxable income of FIEs and FEs. However, article 7 of the law assigns lower tax rates to certain types of enterprises operating in China's special economic zones and investment areas or those engaging in particular projects. For example, FIEs or FEs involved in "production-oriented" activities within economic and technical development zones get a 15-percent tax rate. And the unified tax rules allow for more favorable rates in many other situations; in certain circumstances, they even offer "tax holidays," so foreign companies operate tax-free for several years.

Here are some of the tax ramifications for FEs:

* They're taxed on only China-source income.

* Resident representative offices of FEs acting as agents or consultants and rendering services to principals are subject to FE income taxes and business taxes (we'll discuss these later).

* A foreign corporation that uses a dependent agent to negotiate and conclude contracts may be treated as if it created a permanent establishment.

* FEs cannot claim a foreign tax credit against their...