The 1994 tax reform in China marked a turning point - it abolished the dual-tax system and adopted a single unified tax system for domestic and foreign companies (either wholly foreign-owned or joint venture), to close up the gap with international common practices. Before 1994, none of the tax reforms, including decentralization and profit-to-taxation transaction, had made fundamental changes to the system. The 1994 tax regulations were announced as "unified regulation, justified burden, simplified process and rationalized decentralization." The reform has brought significant impact to both domestic and foreign enterprises in China.

Change in investment environment

At the early stage of China's economic reform, there was intense competition among local governments: they all made favorable tax policies to attract foreign investment. However, things went contrary to their wishes. Many foreign investors held back because they felt that these policies would be short-term and unstable. Different regulations in different areas created difficulties and increased the cost of doing business. The 1994 tax reform brought about the following changes to the investment environment.

First, the reform was to treat Chinese and foreign investors equally on some aspects. This had both positive and negative effects: it broadened the range of business that foreigners can enter while foreign investors lost some advantages.

Second, the reform shifted the focus of the favorable tax treatments. Foreign investors used to receive more tax benefits than domestic investors. But now, foreigners and Chinese can receive same favorable tax treatment if .they are investing in China's priority industries.

Better implementation of regulations

Many foreign investors observe that regulations, for many Chinese, are just document papers. They may carry out and interpret regulations on their own wish. To better supervise the implementation of the new regulations, the 1994 reform set up a comprehensive management system which coordinates tax service and auditing operations. Severe penalties are imposed on violation and evasion of tax regulations. The management system is also in the process of automation to increase efficiency.

Less tax burden for foreign investors

The 1994 tax regulations established the circulation tax and income tax as the principal taxes.

Under the old system, the circulation tax included the Product Tax (PT), the Value-Added Tax (VAT) and the Business Tax (BT) for domestic companies. For foreign companies, there was one tax -the Consolidated Industrial and Commercial Tax (CICT). Among 141 industries and products on the CICT list, foreigners had to pay 10-15% more tax than domestic circulation tax on 94 (66.7%) products. Meanwhile, CICT and VAT were are calculated on different bases. CICT based on sales value was often larger than VAT. Under the unified tax system, CICT has been eliminated and all companies (domestic or foreign) now pay VAT, BT and Consumption Tax (CT).

The following three key points also contribute to less circulation tax burdens on foreign companies:

The taxing methods

Both old CICT and new VAT use the same method: taxing on each transaction during production and sale. For products with same added values, VAT remains the same regardless of the number of transactions made during processing. As for CICT, products requiring more transactions pay more than those having fewer transactions, even when they have the same added values. Since foreign companies usually manufacture multiple-processed products and go through more sale channels than domestic companies, a non-transaction based tax is definitely a better one for them. Since 1994, VAT has accounted for 56.4% of total tax revenue in China.

Exemptions

CICT was collected on each transaction and exempted only on the last transaction for export products. Currently, VAT on export products is zero. All VATs collected at each transaction during the processing from raw material to finished product are returned when the product is exported. Overall, new VAT is more beneficial to foreign than domestic companies because about 60% of foreign companies are engaged in export-oriented products.

Principle of balance

The 1994 tax reform set up a principle of balance: reforming the system without increasing enterprises' tax burden and without decreasing the government's tax income. Two measures have been adopted to reduce negative impact of the reform on foreign companies. First, for the foreign-invested enterprises registered before the end of 1993, increased tax generated by the new system can be returned with government approval for up to five years. Second, the previous preferential tax regulations for foreign companies retain effective. As a result, those foreign companies established before the end of 1993 are not affected by the new system.

Equal CIT for domestic and foreign companies

The Corporate Income Tax (CIT) is given the same priority as circulation taxes (VAT, etc.) in the reform. A significant change is that the new regulations reduced CIT rate for domestic companies from 55% to 33%, the rate paid by foreign companies. The regulations on income tax for foreign companies remained unchanged. Thus, foreign companies lost advantage of paying lower income tax. However it does not help domestic companies gain power in competition with foreign companies due to the following reasons.

First, most large domestic companies are state-owned enterprises which, for quite a few years, have been in a depressing situation. Statistics show that 2/3 state-owned enterprises have made little or no profits and the rest 1/3 have been loss making in recent years and never enjoyed benefit of the lowered C1T rate, unable to compete with foreign companies.

Second, the current VAT standard rate of 17% for most products and 13% for essential items, such as food, running water, petroleum, natural gas and books are equivalent to the previous Product Tax paid at the rate of 14.5%. Thus, the enterprises paying 3-14% PT under the old system have increased their tax burden under the new standard VAT rate. According to the principal of balance, to keep the total tax burden unchanged for enterprises, the increase in circulation tax has to be deducted by the same amount in income tax'. Under such rules, the poor companies get poorer by paying more circulation tax and the rich companies get richer by reducing income tax. This kind of balance pays the price of decreasing domestic enterprises' efficiency and financial capability.

Third, foreign companies in Special Economics Zones and other government designated areas receive many more local favorable tax policies than domestic companies, such as exemption of 3% local tax, tax holidays, favorable treatment on the scope and standard of taxable income.

These facts imply that the reduction of CIT for domestic enterprises has indirect and very limited impact on foreign enterprises.

Less personal income tax for foreigners

The 1994 tax reform merged the previous three types of Personal Income Taxes (PIT) into one. In addition, it made a few adjustments on PIT:

• The concept of taxpayer was redefined with reference to international conventions: tax-resident and non-tax-resident are differentiated. As for a tax-resident, all income is subject to taxation; for a non-tax-resident, income earned in China is subject to taxation. Residence and its duration are both taken as criteria to define tax-resident status;
• The PIT rate was adjusted. The old PIT was 45% for monthly income exceeding RMB 12,000 while the 45% rate now applies to monthly income exceeding RMB 100,000. The new criteria is more beneficial to foreigners since they usually belong to the high income group; and
• Total deductible PIT increased. The new regulations allow foreigners to deduct RMB 3,200 monthly in addition to the deduction of RMB 800 for everyone.

Regulation adjustment after the 1994 reform

Although China made no significant change to its tax system after the remarkable 1994 reform, some changes were made to tax regulations, causing negative effects on the foreign companies established in China after January l, 1994.

First, the Chinese government abolished its tariff exemption policy on some exported items and the exemption policy on exported equipment for foreign companies.

Second, in the very year of reform 1994, China collected RMB 48 billion more on VAT and CT, but also paid RMB 40 billion more on total returned taxes for exports. Half of the extra returned taxes went to many foreign companies and local tax authorities, who got more VAT returned than what they had paid to the central government. They took the advantage of the imperfect new administrative system. Since the Chinese government could not afford such extra burden and had no quick way to stop such activities, it decided to reduce the highest rate for returned tax from 17% to 14% on July 1, 1995 and again from 14% to 9% on January 1, 1996. Therefore, the export-oriented foreign companies enjoy no more advantage of returned taxes for exportation since the rate is similar to the one before the 1994 reform. The Chinese government is expected to fix these unexpected problems.