Playing favorites.

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 Chinese tax liability.

* China-source income is subject to a flat-rate FE income tax plus a local income tax.

* The business tax is assessed on the gross amount of China-source income at various rates.

* Other income is subject to a withholding tax, usually 20 percent. However, a double-taxation treaty between the U.S. and China may reduce this rate.

But there are ways around the complexities. A foreign company that sells tangible goods to customers in China can be free from China tax if it meets all of the following criteria: The tangible goods aren't manufactured in China; the sale contract isn't concluded by a company's representative based in China; the purchase order of the customer isn't fulfilled from existing inventory already maintained in China; and the legal title of the goods passed to the customer outside China.

However, this tax-free position gets confusing when the contract isn't a simple equipment-sales contract. For instance, a composite contract involving on-site installation, assembly and training normally forces a company to declare a permanent establishment. If the contract involves technology transfer, the portion of the sales relating to the technology is considered a royalty and is subject to a withholding tax. The portion of the composite contract relating to the sale of tangible goods is still free from income tax but is liable for import duties and a value-added tax, unless it's specifically exempt.

FIEs have their own complexities. Those with head offices in China are liable for taxation on worldwide income. A withholding tax isn't imposed on repatriated earnings, and foreign tax credits and deductions are available against the Chinese tax the enterprise paid. Tax refunds also are available on the reinvestment of profits (usually 40 percent of the tax paid).

You may get a tax holiday or similar reductions in the early years of your FIE operation if your enterprise is productive in nature or if the State Council specifically exempts your firm and your business has been in China for 10 years or more.

WHICH WAY DO I GO?

FIEs and FEs produce the best investment results under different circumstances. So how do you decide whether to set up shop as an FIE or an FE? Here are some of the considerations:

First, how willing are you to get involved in the Chinese market? If you're a new player, you probably should invest in China as an FE, setting up a branch office or some other form of establishment. As you get more involved in the market, you could set up a subsidiary or an FIE to spin off an operation in China as a separate entity.

On the other hand, if you want to shelter all of the business risks associated with your Chinese investment with the Chinese entity, opt for an FIE with limited liability - for example, through an equity joint venture.

Flexibility can be an important consideration, too, especially when a foreign company enters a joint venture with a domestic party in China. Working within an FIE allows for more flexible planning.

If your presentation to customers is important, as an FIE, you can appear to be a domestically formed entity. This can be a crucial marketing factor.

Finally, if you're planning your U.S. taxes, conducting business in China as a branch of a foreign corporation subjects all of your overseas earnings to current taxation in the year the income is earned. If you're a separate entity earning income as an FIE, you can defer that income. Unlike an FIE, an FE's Chinese operation earns income outside of China - but the income is attributable to the Chinese operation - so the company can't take a tax credit on that income against income tax paid in China.

Since most of the ventures into China qualify as FIEs, we'll focus on the impact of the laws on that type of enterprise, unless otherwise noted. Under the tax reform in late 1993, effective on Jan. 1, 1994, China implemented a value-added tax, business tax, enterprise income tax, consumption tax, natural-resources tax, land-appreciation tax and amendments to the individual income tax.

Like most value-added taxes, the Chinese VAT is assessed on the sales of goods and some services (such as repairs), generally at a 17-percent rate. China's business tax, at a typical rate of 3 percent to 5 percent, applies to almost all services and business activities not covered by the VAT. That is, the VAT and business taxes are mutually exclusive.

You'll find the "turnover" taxes (the business tax, consumption tax and VAT) difficult to avoid because China now levies them independent of corporate income taxes. And that means an additional tax burden on foreign operations in China.

China's business tax varies from industry to industry. Here's a sampling of rates for select industries: construction, 3 percent; transportation, 3 percent; telecommunications, 3 percent; entertainment, 5 percent to 20 percent; general services, 5 percent; transfer of intangibles and immovable property, such as buildings and other structures affixed to the land, 5 percent.

Most important, the new laws instituted last year confirm that both FIEs and FEs are subject to the new turnover taxes. Unfortunately, the provisions in the laws that cover refunds of certain turnover taxes refer only to FIEs. When Chinese officials interpret the laws at a later date, this could have a big impact on how the tax rules influence foreign investment in China. Indeed, the outcome could be especially adverse for U.S. licensers to Chinese entities. The Chinese business tax most likely won't be covered by the U.S./China tax treaty, and, as such, the tax may not be considered a creditable income tax for U.S. foreign tax purposes.

Previously, when an FIE provided installation, assembly and supervision services in China as part of the sale of goods, the services were taxed under the then-applicable consolidated industrial and commercial tax, which typically ran much lower than the VAT. The new rules, however, say a transaction by a foreign company that normally engages in sales activities and performs non-value-added services in conjunction with the sale of goods is a "mixed sale" and thus all income falls under the VAT rate of 17 percent.

For instance, an American heating and ventilation company that installs a new air-conditioning system for a Chinese manufacturing plant in Guanghou will also often provide startup technical support. This transaction now qualifies as a "mixed sale" and receives the higher 17-percent VAT rate.

To avoid this new tax burden, you can create separate contracts for the service and goods portions of your transaction. This should help qualify the services aspect of the transaction at the 3-percent turnover rate. Note that, if your company is primarily involved in services and sells some goods as part of its contract, you'll still qualify for the lower business tax rate.

The provisions for technical services, license fees and assistance fees underwent a similar rehabilitation. Under the old rules, these "technology transfers" were subject to a 20-percent income tax (withholding) or a 10-percent tax if governed by a double-taxation treaty. The new rules, however, levy an additional 5-percent business tax if these services take place in China under an FIE.

Fortunately for foreign enterprises currently operating in China, a grandfather rule exists for those firms that have a heavier business tax after the new rules go into effect. These firms can receive a refund on the difference of their tax burden for a maximum of five years, starting Jan. 1, 1994.

Importers, however, will qualify only if the materials they bring into China are deemed necessary for the country's prosperity and can't be supplied domestically. This law creates yet another barrier to foreign companies trying to import finished products into China.

In a ruling issued on Aug. 25, 1994, the State Tax Bureau announced that goods exported by FIEs will be exempt from the VAT (instead of zero-rated under the VAT law). The result is that the input VAT a company incurs when it acquires domestic inputs isn't recoverable.

The State Tax Bureau also issued a notice in October 1994 explaining that its no-refund policy should contribute to its long-term goal of equalizing the tax burden of FIEs and China's domestic enterprises. That, in turn, will promote fair competition among the various forms of enterprises and maintain the continuity and stability of the country's tax policies. Practical application of the policy will be at the municipal level.

These regulations apply to domestic-owned businesses in China and only concern foreign companies that invest in those indigenous businesses through public stock exchanges, such as the so-called "B" shares listed on the Shenzhen and Shanghai Stock Exchanges and the "H" shares listed on both the Hong Kong Stock Exchange and, in some cases, indirectly listed in the form of depository receipts on other stock exchanges.

TAXES, TAXES EVERYWHERE

Another new tax regulation that could indirectly affect foreign operations in China is the enterprise income tax, which reduces the corporate tax rate on both domestic companies (previously taxed at 55 percent) and FIE businesses to 33 percent.

This new provision signals a distinct policy shift for China. Instead of focusing solely on attracting foreign investment, China seems to want to provide a more profitable environment for homegrown enterprises. This could make finding a Chinese joint-venture partner more difficult, because the 55-percent tax rate assessed on Chinese companies gave them a strong incentive to form joint partnerships to qualify for the 33-percent rate levied on FIEs.

Other tax changes for the people of China include a consumption tax. The new law applies a 30-percent to 40-percent tax on tobacco products, a 5-percent to 25-percent tax on alcohol, a 17-percent to 30-percent tax on cosmetics, a 15-percent tax on fireworks, a 10-percent tax on jewelry, a 3-percent to 10-percent tax on certain motor cycles and autos, and a 10-percent tax on tires. Though these taxes don't apply directly to foreign business entities, they could influence consumer buying patterns, so you should note the taxes in your business plans.

The new laws also add a natural-resources tax, which levies taxes on the assessable value of some "exploited" natural resources, presumably the raw materials in greatest demand, such as liquid and solid salt, ferrous metal and nonmetal ores, crude oil, natural gas and coal. The rates range widely among different materials, and the law allows the provincial authorities to reduce the tax if the operation using the resources is losing money.

Also part of the 1994 tax changes, the new land-appreciation tax is catching the attention of foreign real-estate investors. Its most noteworthy provision is the tax rate on capital gains from property sales. Property taxation ranges from a 30-percent rate for property that's appreciated less than 50 percent to a 60-percent rate for property that's appreciated more than 200 percent. However, local governments may have authority to rebate some of this tax, and the regulation is still being clarified.

While many other changes came from the 1994 tax code, their implications are still uncertain as the business community waits on rules from Chinese officials. To help ease the process, the overhaul that began in 1994 includes guidelines for creating a new tax-collection system. The guidance should clarify which governmental entity - central, provincial, state or local - collects which types of taxes, and that should alleviate some of the compliance difficulties foreign investors face. U.S. consulates in various Chinese provinces will have this information. In fact, you often can get updated, printed guidelines on taxes by contacting the appropriate local tax authorities. While the State Tax Bureaus of China formulate various nationwide tax policies, the local tax bureaus carry out the policies.

LOCAL ADVICE

The recent changes in China's tax laws make investment in China an even more complicated process. To get the greatest profit from a business venture there, American companies should examine how China's tax changes relate to the income-tax agreement between the United States and China. This document dictates how to repatriate funds from China to the United States and identifies the activities each country can tax and how you can credit certain taxes you pay in one country to another country to avoid double taxation.

Bearing this in mind, if you're entering into a venture in China, keep abreast of not only the latest changes by the central government but also the changes in U.S. international tax codes and any regulation relating to U.S. companies operating directly and indirectly overseas. You also should work closely with native Chinese advisors to identify any additional taxes from provincial and local governments. It's very common for the State Tax Bureau to draft a tax policy and the local tax authorities to modify it when they implement it.

In some situations, companies may need to invest in China through other foreign jurisdictions that have favorable local tax programs and that maintain strong relationships with China, such as Singapore and Hong Kong. Establishing a holding company in one of these sites may help insulate you from the tax complications of doing business in China.

RELATED ARTICLE: ALMOST LIKE BEING THERE

To set the stage for any company contemplating a move into China, here are some of the taxes you can expect if you're investing $1 million to $2 million:

* Income taxes

* Transaction taxes (including value-added taxes, a business tax and a consumption, or excise, tax)

* Custom duties

* Stamp taxes

* Vehicle and license-plate taxes

* Land-appreciation taxes

* Resources taxes

* Property taxes (typically on urban real estate)

RELATED ARTICLE: WHAT MAKES YOU SO SPECIAL?

China sometimes reduces its income-tax rate to 15 percent for foreign enterprises that invest in the country's "economic and technological development zones" and for those with production or business operations in "special economic zones." If you don't qualify for that rate, several companies have earned a 24-percent tax simply by locating in specific areas within economic open zones.

The Chinese also offer a special 15-percent income tax to certain industries - if they, too, agree to set up shop in one of the designated zones. Here are some of China's favorite visitors:

* Production enterprises working on technology or know-how-intensive projects

* Projects that invest more than U.S.$30 million and have long payback periods

* Energy, transportation and port-construction projects

* Joint ventures in port and dock construction

* Foreign banks, joint-venture banks and other financial institutions that are working in a special economic zone or other approved area, contributing more than U.S.$10 million in capital to its branches and operating there more than 10 years

* Production-oriented foreign-investment enterprises established in the Shanghai PuDong area and engaged in energy and transportation construction projects, such as airports, ports, railways, highways and power stations

* Approved new- or high-technology foreign-investment enterprises established in the new- and high-technology industrial development zones and new-technology enterprises established in the Beijing new-technology industrial development zone

* Foreign-investment enterprises involved in projects the state encouraged and in areas the State Council designated

- KT and AY

Mr. Theonnes is the director and Mr. Yeung is the assistant director for the international practice group of Yergen and Meyer, a regional accounting and consulting firm. The two are located in Bellevue, Wash.