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Path: Sourcing News & Advice
>> Import from
China Advice >> Compliance in China --
Challenges of transparency, interpretation & enforcement

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Compliance in China -- Challenges of transparency,
interpretation & enforcement

Posted: September 12, 2014

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:

Interpretation and enforcement of the
law varies greatly not only from province to province but even from district
to district with in a single municipality.

The level of interpretation and enforcement can change at any
moment.

Beijing makes the policy. Local government decided how
to implement it.

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.

2000-2010

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.

Overtime Pay

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.

VAT rebate

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.

How are changes to the enforcement of the Minimum Wage
and Transfer Pricing impacting the bottom line of foreign owned companies in
China?

Transfer Pricing

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.

Minimum Wage

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:

China
Sourcing Trends: The Big Picture in China 2010-2013

Reports
of China’s death as a sourcing destination are highly exaggerated.

Heavy
hitters weigh in on future of Sourcing in China

Closing words

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:

Free Resources:

Let’s help each other. If you have experience in China with the issues
addressed in this article, please add your comments to this article and I’ll
post it for group consumption.

At the risk sounding too commercial, please sign up for my blogs and
YouTube channel if you have not done so already. My blog here at CSIC is aimed
at medium to small sized companies. The YouTube channel below supports
professional buyers of all sizes and the advanced buyer blog is written with
buyers who purchase over 2 million USD in China per-annum.

Professional Buyers. Professional Blog

A blog written by professional buyers for
professional buyers.

Affordable Resources:

If you need formal support, consider engaging
the China Sourcing Service Center. Click here
to review 4 options.

Wishing you
successful China sourcing!

Mike
Bellamy is an Advisory Board Member & Featured Blogger at the not-for-profit
China Sourcing Information Center.
He is also the author of "The
Essential Reference Guide to China Sourcing" and founder of PassageMaker
Sourcing Solutions.

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