Circular 698 caused a momentary pause throughout the business anglo-sino-blogosphere late last year.
China passed a retroactive look-through provision that effectively changed the rules for foreign investment structures in China. The Circular in and of itself is relatively innocuous. It highlights an oft misunderstood Chinese business sensitivity in China’s central economic planning: China for Chinese business only.
As China carries forward its strategy to adapt to and mitigate climate change, foreign owned clean technology businesses need to be aware of China’s position.
Circular 698 makes certain that all businesses doing business in China pay tax to the government; or restated: A portion of all revenue earned on the backs of Chinese citizens benefits Chinese citizens. According to Patrick Chovanec, a lecturer in economics and management at Tsinghua University in Beijing,
“This is both similar and dissimilar from what other countries do to the degree that this is sort of like a look-through provision: If you structured off shore purely for tax benefits, we will treat it as though it’s an onshore structure.”
Structuring private equity arrangements was convenient for Chinese citizens because it allowed them to avoid paying tax. But China’s State Administration of Foreign Exchange (SAFE) closed off this loophole, issuing a circular that stated that any Chinese citizens wanting to set up offshore companies needed state approval.
But, Chovanec says, these laws are “very typical Chinese regulation in the sense that it’s extremely vague and it’s vague on purpose because whenever China issues a regulation they tend to make it very broad so that they have maximum room for interpretation as time goes on.”
What is unique about this circular is that it “appears,” according to Chovanec, that “this is written in a way that seems to apply also to non-residents who use a holding structure to invest in China, and that’s very unusual.” In other words, any foreign nationals investing in China through an offshore structure will now be subject to Chinese capital gains taxes.
Many foreign investors set up offshore structures to invest in China. Not for tax reasons, explains Chovanec, but so “that you didn’t need regulatory approval from China to list the company and do whatever you wanted to do, reorganize it however you wanted to reorganize it. Also, you were not under Chinese corporate law, so you could set it up in a jurisdiction that allowed many more things like options, clawbacks, more typical things you would see in a private equity arrangement that Chinese corporate law doesn’t really allow for.”
International lawyer Steve Dickinson at Harris Moure places the regulatory laxity in context:
“For a brief period from 1998 to 2005, China just let this go because they were desperate for development. Starting in 2006, they started to reign things in. … In summary, China wants no unauthorized offshore market for Chinese business assets.”
Like the Google search censoring controversy, Circular 698 is a reining-in of foreign elements in China’s personal growth, a maintenance of China’s dominance in its own affairs.
Both the Internet and the energy market, key facets of China’s relationship with the U.S., are factors of the Chinese psyche. The Internet can be thought of as a means of expression and therefore plays a role in cultural identity. In the same sense, the domestic Chinese market is integral to national identity in its ability to provide for the Chinese people.
It wasn’t that long ago that China’s market was forcibly opened by the British with the Opium War and the succeeding Treaty of Tianjin and Beijing Convention. The period of approximately 1860-1950 was what China’s national narrative refers to as its “century of humiliation;” this narrative is often oversimplified by pundits as a “zero-sum” bargaining position when considering the Chinese negotiating position but always prescient in the minds of Chinese leaders.
The “century of humiliation” saw the systematic stripping of the Chinese government’s power ending in the bankruptcy of the Chinese government, complete erosion of Chinese national pride, and years of civil war. The aftereffects (famine, Great Leap Forward) are still in the living memory of some and within the immediate familial narrative of most Chinese.
Were it to be enforced (something Chovanec says is another matter entirely), the Circular would create a myriad of administerial and accounting issues, including disclosure requirements that may or may not be invasive and payment of tax before transaction clearance. From a mainstream business perspective, there might be unexpected benefits:
“The intention is not to stop people from investing. The intention is to capture more of the tax revenue from transactions that previously were structured offshore,” Chovanec said.
“In fact, this could make it easier, ironically. If this solves the tax concern China has and if China is able to tax offshore structures for companies, then they may go back to allowing people to structure offshore, which would be beneficial for regulatory purposes.”
But foreign firms expecting to benefit from early entrance in China’s market, like its emerging clean tech sector (wind, solar, and grid technologies), may be over estimating their ability to gain high market share in the Chinese market.
According to Dickinson, much of the energy business in China has been “packaged” to take advantage of the few remaining offshore vehicle mechanisms.
“To the extent that the viability of those projects relies on those mechanisms, they are at risk,” he said.
This is where China’s national narrative is implicit, explains Yuka Kobayashi at the SOAS Centre of Chinese Studies,
“I think that is the mentality with a lot of these officials. But to actually see the laws as saying that — they wouldn’t make it that obvious — but it is actually at the back of their interests.”
Kobayashi recently completed a study of China’s information technology sector and domestic implementation of WTO requirements. In her research, she found that while China’s economy is more open, it is strategically so: The IT Sector, like many sectors in the Chinese economy, has been protected such that the government has ensured that Chinese firms will dominate the Chinese domestic market.
“So they are very strategic in their way of doing this, and they’ve also done something crafty,” Kobayashi explains. “They’ve actually taken a lot of the value added and put it in the basic and saying it’s a lot more criteria you have to have, not just to put in the capital also but also in terms of the magnitude, etc.. So the requirements were set in such a way that made it nearly impossible.
“So people talk about the telecommunications joint ventures, you’re looking at very little activity, and there’s very little activity because it’s so unfair for the entrants that it was nearly impossible to set up these joint ventures.”
The same mentality has now transferred to China’s next most lucrative market: clean energy and, in particular, smart grid.
The New York Times noted last week that “a number of American companies, including General Electric, IBM and Hewlett Packard have entered the Chinese smart grid market, hoping to cash-in on some of the investments.”
“In a sense, they are opening it up to the CDM, where there’s a benefit for them to absorb foreign technology and foreign know-how,” Kobayashi says. But as with the telecommunications sector, she expects that China will limit foreign stakeholder benefits.
“With respect to carbon credits and the like, the Chinese have made it very clear that no foreign entity will be permitted to benefit in any way from such measures. Only the Chinese are permitted to benefit. Any attempt to evade that basic policy is certain to fail.”
Punditry on Google since the beginning of the row and about clean technology in China in general has been based upon the false presupposition that China’s endgame is Westernization, a market economy.
An op-ed book review in China Daily indirectly addressed the Google issue and is telling of China’s national socio-economic perspective. In it, Zhu Yuan writes:
“We should never take it for granted that everything our Western counterparts have done is right. We must learn to distinguish what is good and what is bad in the Western culture as well as in Western corporate culture.”