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The drive for growth can lead businesses into dangerous waters

China General Interest

by Joanna Doolan & Florence Wong

Regardless of melamine milk crisis, product recalls, corruption scandals and trade disputes, New Zealand businesses will be attracted by the lure of what China has to offer.

At a recent NZCTA seminar we likened investing in China to swimming at Piha beach.

Piha offers awesome surf, unpredictable rips that shift with little warning. The TV drama Piha Rescue brings the horrors of the silent dangers from the wild terrain and the unforgiving rips right into our living rooms but despite this thousands flock to Piha.

The same can be said for investing in China. It is an economy with exciting opportunities and dangers, you can never afford to sit back and relax. The word for crisis in Chinese is weiji, meaning 'danger' and 'opportunity.' The drive for growth, can lead businesses into dangerous waters.

The big step into China requires a disciplined and structured approach to ensure you cover every aspect of your business model including strategic, operational, financial, and tax components. Infrastructure and people requirements to ensure you have an efficient and effective operating base, networks, partners, market insights and access, capital structures, liquidity, market risk, profit repatriation, compliance requirements and so the list goes on.

The New Zealand Government has had an agenda of economic transformation and many of the tax and other changes may seem crazy when looked at in isolation, but added together they endeavour to build a platform that will form the foundation for this.

China in the five year guide that covers 2006-2010, outlines it's goals as developing a high-tech capability, building an environmentally sustainable economy and enhancing the quality of life for their 1.3 billion citizens by 2020.

China is not constrained by the quirks of MMP and three year electoral terms where the campaigning never seems to stop. It however shares similar goals to New Zealand in the drive to become a high value economy.

We can discount these hopes as meaningless platitudes but the plans and the building blocks are taking shape.

Many consider the tax system in China is new and in the development stage. There is no question that the tax system is rapidly changing, but remember China's tax system is said to date back to the Xia Dynasty in 2140-1711 BC. Until recently it has suited China to be generous when applying its tax system to foreign investors by providing tax holidays and often not actively enforcing transfer pricing or similar rules.

This type of thinking has been turned on its head; special incentives such as preferential tax rates are being provided to companies involved in the environmental protection, high-tech and venture capital fields to support these initiatives. Additional indirect taxes are being imposed at an alarming rate on undesirable industries.

Tax holidays are being phased out and replaced by incentives targeted to encourage businesses that will meet the overall goals. The dramatic change is that previously these incentives were targeted at foreign investors, under the new regime both domestic and foreign investors are eligible.

Recent changes include tax credits for equipment purchased which is environmentally friendly, conserves energy or water, or raises manufacturing safety.

As the drive to move away from toll processing and cheap exports continues it is no longer possible to go into China and compete solely on the basis it improves your overall operating efficiency. Companies have to prove they have a value proposition that fits into the desired goals.

Pollution regulations are already forcing companies to invest in new machinery and improve waste management. Stringent labour laws now give employees far more protection than they have had in the past. They also add around 15% to 20% to employment costs. Companies that cannot invest in advanced technology and improved products will continue to go out of business.

Your decision to enter the China market may be driven from the need to be closer to your customer base, the lure of the market for your goods or services, a competitive threat or from a need to capitalise on the operational efficiencies. The obvious is sound business reasoning, rather than a whimsical hope of hitting the jackpot, must form the foundation of your decision making process as another layer has now been added - your decisions must also fit with China’s overall objectives.

Being committed to the long term, not expanding on shoestring budgets and not miscalculating the actual costs are motherhood type statements that are often ignored. In this category, the item that is too often ignored is the potential cost of the many and varied taxes China can impose.

In addition to the highly publicised risk areas many run into trouble with complying with their tax obligations. The issues run from complex structuring to the simple compliance matters. For example, not meeting the requirements for keeping business tax and accounting recording in the local jurisdiction or having the wrong documentation and finding they are lumbered with crippling penalties.

The drive to improve the quality and reputation of China’s production, environmental degradation and social inequity are all on the Chinese Government’s agenda. Adopting higher standards by using its tax system to incentivise a change in behaviour and the adoption of enforced higher standards will be a direct by-product of this current crisis.

The speed of change in weeding out problems and changing tax rules to meet China’s overall objectives is challenging even for the experts.

The certainty is that issues will be dealt with and changes made at a pace you can only admire. The tragedy will be that if we see this crisis as a red light danger warning that causes us to stop and fail to also see the opportunities.

Joanna Doolan is a Tax Partner with Ernst & Young and Florence Wong is a Senior Tax Manager in our China Business Group.

Tags: tax