While there is a law/policy/regulation/suggested standard promulgated by Beijing for almost every aspect of doing business, for the typical Western-owned company operating in China, the problem is two-fold:
1. Interpretation and enforcement of the law varies greatly, not only from province to province,
but even from district to district within a single municipality.
2. The level of interpretation and enforcement can change at any moment.
Beijing formulates the policy; local government decides how to implement it.
There is often a conflict between the agenda of the central government and the desires of the local governments. This conflict is found in almost all nations, but in China the conflict is played out on a massive level. Think of the balance of power between the local and central government as a pendulum. It is swinging in one direction or another at any given time. The same thing happens back home, but the difference in China is that the central government is all-powerful and can change the direction and speed of the pendulum at the national or local level at any time, as it sees fit. Furthermore, it doesn’t allow a “grandfather” clause if you find yourself on the wrong side of the policy swing.
The policy pendulum is swinging quickly in the following areas: Minimum Wage, Transfer Pricing, Internet Access, Workplace Safety, Environmental Protection, and even the official Holiday Schedule. Let’s look at Minimum Wage and Transfer Pricing in particular.
How are changes to the enforcement of the Minimum Wage and Transfer Pricing impacting the bottom line of foreign-owned companies in China?
Transfer Pricing refers to the price at which an item is sold between subsidiaries (or controlled entities) of a multinational enterprise. As the different jurisdictions have different tax rates, manipulation of the inter-company sales price could help reduce the overall tax burden for the parent company. Some countries have strict rules about transfer pricing, others do not.
Let’s look at the impact of the policy shift happening right now as regards how the Chinese government views transfer pricing.
Take a Hong Kong-based company that sources products/services from China as an example. The key point is that no profits taxes are applied in Hong Kong to Hong Kong companies (even if foreign-owned) that source products or services in China and resell those items to clients outside of Hong Kong. This is called “offshore income” and is not taxed in Hong Kong. It is one of the many polices that make Hong Kong so business-friendly.
Until recently, in the interests of supporting export-led economic growth, the China tax authorities didn’t look too hard at issues of transfer pricing between China and Hong Kong. As long as the China-based entity was charging a “reasonable” price and thus paying some profits tax in China, the Chinese taxman didn’t ask about the price at which the Hong Kong company re-sold the products, nor did the China tax authorities question whether the price at which the PRC exporter sold the product from China to Hong Kong was on par with other Mainland exporters. The Beijing law may have said something different, but in actual practice, down in the heart of China’s manufacturing base of Southern China, the unwritten understanding among exporters and the local tax authorities was that the Chinese entity needed to pay tax on a declared profit margin of at least 3% to 5% (depending on the industry) to stay in good favor with the tax officials. Most tax authorities would even give a new business a few years to get out of the red and into the black.
The enforcement of the transfer-pricing policy was so loose that an exporter had to blatantly abuse the system to get into any trouble. For example, some Taiwanese-owned Chinese factories were so brazen as to declare a loss for their Chinese business for many years in a row, yet show growth in employees and export volume during those same years. Most Western-owned exporters in China were more conservative and declared a reasonable profit on their books.
Fast-forward to the present and the pendulum has swung dramatically with regard to transfer pricing in China as the PRC taxman is now paying close attention to this at a national level, especially in the traditional manufacturing areas of Southern and Eastern China. I believe there are two primary reasons for this shift in policy enforcement:
Develop the West Campaign
Central and Western China has traditionally been poor while the coastal areas grew prosperous, thanks to easier access to foreign markets. Today the country is undergoing a massive redistribution of wealth as the central government aims to develop the interior and west, some would say at the expense of the coastal provinces and their exporters, as officials enforce the tax policy, including transfer-pricing rules, with renewed zeal.
The days of free-flow money are over
For the first time in the past few decades, we are hearing about municipalities in China on the verge of bankruptcy. The concept of a city going out of business is nothing new if you live near Detroit, but in China, the phenomenon is just starting to surface and local authorities now take their potential tax-income streams a lot more seriously, especially since Beijing will no longer write a blank check as it has done in the past when local governments go into the red.
In order to stay out of tax trouble, PRC exporters are now building in a “more reasonable” mark-up and paying profits tax accordingly. There is still variability from city to city in terms of what exactly is considered “reasonable”, but as a national trend, being “reasonable” has become two to three times more expensive than it was just a few years ago. Non-compliance can result in stiff penalties and even jail time.
Among the various shifts taking place in China, the one that is having the greatest impact on the profitability of the typical manufacturer or service provider is the enforcement of minimum-wage policies.
Earlier in this article we discussed how economic planners in Beijing are attempting to move away from the export-oriented economic model that served them well during the last century and to build a consumer-based economy by increasing the disposable income of the working class. Late in the first decade of this century, the central government used the enforcement of overtime pay as a tool to increase the earnings of the middle class. This decade we are seeing an even more direct approach as the minimum wage has been going up year on year with no end in sight. The authorities are essentially telling manufacturers in China “your labor costs have gone up 15% each year for the past five years and this will continue well into the future, so get used to it.” As a result, Chinese companies are finally abandoning the “throw-another-body-at-it” philosophy of manufacturing in favor of ISO, lean manufacturing, and even automation/robotics! Manufacturing has not left China en masse for the simple fact that there is no “next China”.
While many countries have lower labor rates than China, China’s rates are still a fraction of the labor rates in the US or EU and no other country has the infrastructure needed to handle even a small slice of the China manufacturing base in strategic industries. Yes, shoes are made in Vietnam and socks in Pakistan, but it’s going to be a long time before the iPad can be made anywhere other than China. As the South China Morning Post put it, “increased costs may force some factories out of the Pearl River Delta, but the mainland will remain the workshop of the world” because they have the manufacturing experience, access to capital, the infrastructure and supply base well entrenched.
While both large and small corporations operating in China are exposed to changes in government policy and enforcement, it is important for them to keep a close track on such changes and react to them promptly.
By Mike Bellamy
Mike Bellamy is an Advisory Board Member & Featured Blogger at the not-for-profit China Sourcing Information Center . He is also the author of, “The Essential Reference Guide to ChinaSourcing” and founder of PassageMaker Sourcing Solutions.