规范

Punishing the Righteous — How Lax Tax Compliance Distorts the Chinese Economy

1 Comment / July 23, 2013

The Chinese corporate tax system combines fairly high rates with low compliance. The result is that the companies that do pay all the tax legally owed will usually be at an enormous competitive advantage to the numerous competitors who pay little or nothing. Non-payers can either choose to earn fatter margins or undercut the price of their compliant competitors. Either way, the result is that profits flow to those least legally entitled to keep them.

This widespread tax avoidance is among the more serious distortions in the Chinese domestic economy. The government knows this, and so tries to level the field by giving special targeted tax breaks, subsidies, underpriced land (as well as awards of free land)  to the companies that do pay tax. But, this practice causes distortions of its own.

The corporate tax system in China is a cake of many layers. There is a VAT applied to most products along with a corporate profits tax of 25%, as well as a whole raft of other fees and levies, including taxes on real property and natural resources, and others to finance urban maintenance and construction.

In my experience, it’s exceeding rare to find a Chinese private company that obeys the rules and pays all that is asked of it. Doing so, in most cases, would render the company loss-making. The best payers are the private companies that have filed for an IPO, or have already been publicly-listed in China. It is the most critically important of all the prerequisites for IPO approval, that a company be fully compliant with all tax rules.

For companies we know, this process of becoming fully tax-compliant is the most painful and expensive thing they will ever undertake in business. In one case, a very successful retail jewelry company, has gone from paying almost nothing in tax to paying almost Rmb500mn (USD$80mn) during the three-year process of preparing to file the application for an IPO. An IPO in China is basically a way for a company to reclaim, from stock market investors, the cash it’s lost to the taxman over the preceding three to five years.

The government bestows favors on companies that do pay tax. Hanging prominently on the walls of many private companies I visit are plaques given to a locality’s largest tax-payers. The plaque is awarded for amounts paid, not amounts technically owed. So, it is possible to be both an award-winning local taxpayer and a world-class tax cheat at the same time.

Though there is no formal system of tax rebates, just about every business that pays some tax gets something back in return from the state. The more you pay the more you receive. The two most popular forms of rebate to companies are investment subsidies as well as the opportunity to buy land at concessionary price.

The investment subsidies can be very generous. Depending on industry and location in China, a companies will often get back one-third or more the cost of new factory machinery.  While this lowers breakeven cost and so improves a company’s profit margins, the investment subsidies help propel a system in China that often leads to rampant over-investment. This is especially noticeable in some favored high-tech areas like the manufacturing of LED chips or wind turbines. R&D spending is also often subsidized through a form of tax rebate.

Often, the best use of a company’s money would be to invest in marketing, or building its sales channels. The tax rebate system generally rewards none of this. So, arguably, companies can often end up worse off, with higher-than-needed outlay for fixed assets, because of the tax system.

The offer to purchase land at significant discount is a valuable perk, and one that’s available, in the main, only to Chinese companies that pay tax. It is probably the most frequent form of indirect tax rebate. I know of no specific formula, but the general principle is for every million in taxes you pay, you will be given a chance to buy land worth multiples above that, at a price at least 50% below market value.

Unlike factory equipment, which loses value every year, land is a scarce commodity in China. The government has lately tried to moderate price increases of land. But, overall, buying land in China, especially if done at a discounted price, is a winning one-way bet.

While a nice inducement to encourage tax compliance, the government’s offer of underpriced land to taxpaying companies also causes distortions. Chinese manufacturers, in general, are fixated on owning the land their factories sit on. Even if you can buy that land on the cheap, it is still a sink for capital that might be more efficiently invested elsewhere in your business. You also need to borrow the money, in most cases, to buy the land. Those interest payments can often lower your pre-tax profit margins.

There is also a problem of asyncrony.  You need to pay taxes for several years before you get a chance to buy land on the cheap. During that whole time, while you wait to make a profit on a land deal, your non-taxpaying competitors are enjoying much fatter margins than you. They can use this to steal lower prices, steal your customers and so lower your profits. This not only pushes you towards insolvency, it also reduces the ability to pay the taxes that generate the favors that offset the high tax rates.

From what I’ve been able to tell, nobody, including Chinese government officials, likes the current corporate tax system, with all its complexity and high headline rates. But, these same officials also argue that if they lowered taxes overall, there is no guarantee that the many tax-avoiding companies will then become taxpayers. They are probably right. From that simple standpoint, cutting corporate taxes may only lower the amount of money the government takes in each year. This, in turn, means less money to award to those who are paying.

China is likely stuck with its current corporate tax system. It punishes, then compensates, the righteous few who pay everything that’s owed.

 

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CFC’s Latest Research Report Addresses Most Treacherous Issue for Chinese Companies Seeking Domestic IPO

Leave a Comment / March 6, 2011

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For Chinese private companies, one obstacle looms largest along the path to an IPO in China: the need to become fully compliant with China’s tax and accounting rules.  This process of becoming “规范” (or “guifan” in Pinyin)  is not only essential for any Chinese company seeking private equity and an eventual IPO, it is also often the most difficult, expensive, and tedious task a Chinese entrepreneur will ever undertake.

More good Chinese companies are shut out from capital markets or from raising private equity because of this “guifan” problem than any other reason. It is also the most persistent challenge for all of us active in the PE industry and in assisting SME to become publicly-traded businesses.

My firm has just published a Chinese-language research report on the topic, titled “民营企业上市规范问题”. You can download a copy by clicking here or from Research Reports page of the CFC website.

The report was written specifically for an audience of Chinese SME bosses, to provide them both with analysis and recommendations on how to manage this process successfully.  Our goal here (as with all of our research reports) is to provide tools for Chinese entrepreneurs to become leaders in their industry, and eventually leaders on the stock market. That means more PE capital gets deployed, more private Chinese companies stage successful exits and most important, China’s private sector economy continues its robust growth.

For English-only speakers, here’s a summary of some of the key points in the report:

  1. The process of becoming “guifan” will almost always mean that a Chinese company must begin to invoice all sales and purchases, and so pay much higher rates of tax, two to three years before any IPO can take place
  2. The higher tax rate will mean less cash for the business to invest in its own expansion. This, in turn, can lead to an erosion in market share, since “non-guifan” competitors will suddenly enjoy significant cost advantages
  3. Another likely consequence of becoming “guifan” – significantly lower net margins. This, in turn, impacts valuation at IPO
  4. The best way to lower the impact of “guifan” is to get more cash into the business as the process begins, either new bank lending or private equity. This can replenish the money that must now will go to pay the taxman, and so pump up the capital available to expansion and re-investment
  5. As a general rule, most  Chinese private companies with profits of at least Rmb30mn can raise at least five times more PE capital than they will pay in increased annual taxes from becoming “guifan”. A good trade-off, but not a free lunch
  6. For a PE fund, it’s necessary to accept that some of the money they invest in a private Chinese company will go, in effect, to pay Chinese taxes. But, since only “guifan” companies will get approved for a domestic Chinese IPO, the higher tax payments are like a toll payment to achieve exit at China’s high IPO valuations
  7. After IPO, the company will have plenty of money to expand its scale and so, in the best cases, claw back any cost disadvantage or net margin decline during the run-up to IPO

We spend more time dealing with “guifan” issues than just about anything else in our client work. Often that means working to develop valuation methodologies that allow our clients to raise PE capital without being excessively penalized for any short-term decrease in net income caused by “guifan” process.

Along with the meaty content, the report also features fifteen images of Tang Dynasty “Sancai“ ceramics, perhaps my favorite among all of China’s many sublime styles of pottery.



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