Dangerous China Investment Incentives

June 19, 2008 Posted by China Briefing Reading Time: 4 minutes

June 19 – One of the issues that many foreign investors face in China, when deciding on a location for their business, is evaluating the various incentives offered by the local government.

The problem with this is that many local governments, or even officials, do not follow state law when it comes to offering incentives to foreign investors. At worst, they can sell you something that can be immensely damaging, sacrificing your investment to local business interests, or more commonly, provide incentives that may not be actually backed up in written format and cannot be replied over the long term. These can also prove to have a longer-term impact on your business. It is important to check off investment incentives that are offered to you as part of a package to attract your business with an experienced firm familiar with the issues and able to offer an opinion on the credibility of the deal.

Soft incentives
These typically involve a manipulation of the local government’s tax collection, and can include rebates on business taxes, VAT or similar taxes. Because Chinese tax collection is a two-tiered structure, part collected by the state level tax bureau’s local office and part by the Regional level tax bureau, the local part can be used by the local government to offer this back as an investment to foreign investors. However, in doing so they are out of compliance with their own State directives that specify that such collected revenues go towards local urban development; roads repair, hospitals, schooling, civic amenities and so on. Such revenues are not supposed to be used to attract foreign investment. Accordingly, this is why in practice a local government will never provide a written guarantee of such incentives; they can’t as the money is not supposed to be used in this manner. There are three ways to assess these types of incentives.

1) Strictly speaking, it is the duty of the foreign investor to abide by the laws of China. Ignorance is no defense. The worst case scenario is that such a case is uncovered, the investor could be liable to refund back all the rebated incentive (remember it is tax-based income) to the local tax authorities. A late payment penalty could also be imposed: of up to 5 times the original amount due. It is also correct to state that receiving such incentives effectively put you out of compliance, and that this could be used later as a negotiating tool against you later in the businesses lifespan. The risk maybe small, however it is there.

2) In accepting the incentive, it is important to note that due to its informal nature it could be withdrawn at any time if pressure is extended to stop this type of rebate. Accordingly it is best to factor in two business plans, one with the incentive, and one without. If the incentive is an important financial bonus to your business, then your business model is essentially unsound. You need to be able to financially structure the business so such an incentive is not important. And if this is the case, what is the true value of having it in the first place?

3) Far better would be to use the offering of a tax based incentive as a negotiating tool to obtain a more formal incentive that can be subject to a contractual agreement. Rejecting a tax-based incentive with no guarantee in return for an agreed reduction in rental (or similar arrangement) to the same amount of money places the incentive into a definable commercial agreement and out of the bounds of a more dubious tax manipulation-based incentive. We would recommend exploring with officials how to move the incentive value away from a tax based structure and into a commercial contractual agreement.

Hard incentives
The most common form of hard incentive that goes wrong is nearly always a property or land based incentive. Serious fraud or negligence on the part of the government can cause severe damage to foreign investor. In a one-party state, suing the local government is never really an option. So it pays to get substantial land based incentives looked at carefully. There are some typical issues where it can all go wrong.

1) Land use rights not in line with your business use
It sounds crazy, but it happens. You are given the permission by the local government to use the land, but the state level land use right has it earmarked for agricultural, or other uses. If this is uncovered, and you have built a factory on land allocated for other uses, you can be stopped in your tracks overnight. Many foreign investors and local governments have been caught out because the issue of land use rights was ignored and the land provided was not actually suitable for commercial use. A legal due diligence on the status of the land before committing to it is a sensible precaution.

2) Land rights sold at inflated prices
China has two types of land use rights, granted, and allocated. Granted means you own title to the land, and it is an asset that can be developed and sold on later. Allocated rights mean you purely have the ability to use the land. Granted rights are obviously more expensive. When being quoted for land use rights you need to make sure that the price quoted is for which of the two. Many foreign investors have naively parted with money sufficient to actually purchase the land, but only been given allocated rights in return. Again, a legal due diligence will help determine what is actually on offer and pertinent clarification entered into investment contracts to support your choice.

Even though the local government may be friendly and supportive, they have targets to meet to attract certain levels of foreign investment. Bonuses are also paid to them upon achieving these. Accordingly, when investment incentives are offered in China, it is always wise to get them checked over by a separate third party who is familiar with the issue.

Dezan Shira & Associates is a premier boutique professional services firm in China providing legal and tax advice to foreign investors in the country. Established in China 16 years ago, they maintain nine China offices. This website and the China Briefing Magazine are produced by the firm. For advice on foreign investment legal and tax issues in China, please email info@dezshira.com or visit www.dezshira.com.