by Mike Bellamy
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:
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.
At the risk of oversimplifying, here are two examples from the previous decade in China that demonstrate the variability in interpretation/enforcement and the massive pendulum swings that can occur.
The rule has been on the books for decades that work conducted beyond the standard workday hours must receive overtime pay. As the workers traveled to the factory from the country side and were in the city to make as much money as possible in a given period of time, they would actually ask the boss for more hours and were willing to wave the extra OT pay. This was against the spirit of the law as issued by the central government but at the local level, in the effort to boost exports and increase the local GDP, local authorities turned a blind eye to the factory bosses not paying OT. Over the years, entire industries build their internal cost structure around the assumption that they could get 50 to 60 hours out of an employee on the line without having to pay OT. I visited dozens of shoe factories in Fujian province at the time and not a single one of them paid OT.
Chinese manufacturing took a big hit in the 2008 global financial crisis when orders from the West slowed way down in 2009. The desire to avoid being at the mercy of the Western economies/consumers was the catalyst for a rapid departure from export driven economic growth. Around the year 2010 the central government decided it was time to build more of a domestic consumer-based economy rather than export-oriented economy and the way to do this would be to increase the spending power of the working class. The central government made OT a priority, put the pressure on the local authorities to enforce it, and almost overnight entire industries had their internal cost structure turned upside down. Many manufacturers were forced to close up shop.
The VAT rebate is essentially a tool the government can use to promote certain industries and disincentivize others. In the effort to help clean up certain product classifications which were perceived as “dirty” (from environmental perspective) (think zinc plated metal hardware where the plating process is very hard on the environment) had their VAT rebate reduced to 0 from 15-17% overnight without notice. The year was 2007 and the policy was called “circular 90.” (Read more about it here.)
How fast can the pendulum swing? In 2007, I was working on a project with a large N. American importer of metal hardware. Before circular 90 came into effect, they enjoyed very competitive pricing out of China as their wholly owned company in China received a 15% refund from the Chinese government as the goods were exported. There was no public notice given in advance of the 2007 sweeping VAT rebate changes. On the day circular 90 was announced by Beijing, the importer had over 1 million USD worth of hardware on order with their factories in China. Some of these orders were sitting at the port ready to ship, some had just shipped out and were waiting for the 15% refund. No refunds were given on any of the orders. Overnight, the government policy added 15% to the costs of doing business for this particular company.
2011 to Present
Fast forward to the present and 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.
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 prices, others do not.
Let’s look at the impact of the policy shift happening right now in regards to how the PRC government views transfer pricing.
Take the example of a HK based company that sources products/services from PRC. The key point to remember is that there are no profits taxes applied in Hong Kong to HK companies (even if foreign owned) that source products or services in the PRC and resell those items to clients outside of HK. This is called “offshore income” and is not taxed in HK. It is one of the many polices that make HK so business-friendly.
Until recently, in the interest of supporting export led economic growth, the PRC tax authorities didn’t look too hard at issues of transfer pricing between PRC and HK. As long as the PRC-based entity was charging a “reasonable” price and thus paying some profit’s tax in PRC, the PRC tax man didn’t ask about the price at which the HK company re-sold the products, nor did the PRC tax authority question if the price at which the PRC exporter sold the product from PRC to HK 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 S. China, the unwritten understanding among exporters and the local tax authority was that the PRC 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 PRC factories we so brazen as to declare a loss for their PRC 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 Chinese books.
Fast forward to the present and the pendulum has swung dramatically in regards to transfer pricing in China as the PRC tax man is now paying close attention 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 tax policy, including transfer pricing rules, with a new 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 is no longer to 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 has the greatest impact on the profitability of the typical manufacturer or service provider is the enforcement of the minimum wage policies.
Earlier in this article we talked how the economic planners in Beijing are attempting to move away from the export-oriented economic model that served them well last century and 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 past 5 years and this will continue well into the future, 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 mass for the simple fact that there is no “next China”.
While many countries have lower labor rates than China, China’s rate is still a fraction of the labor rates in US/EU and no other country has the infrastructure needed to handle even a small slice of 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, infrastructure and supply base well entrenched.
Blog posts related to China costs and alternative sources:
While both small and large corporations operating in China have exposure to changes in government policy and enforcement, most companies don’t have formal advisors in-house who are tasked with keeping a pulse on the changes and advising a course of action for a given company. I hope this blog post helps, but I’d like to offer some additional resources that are either free or affordable:
If you need formal support, consider engaging the China Sourcing Service Center. Click here to review 4 options.
Wishing you successful China sourcing!