AmCham-China

By Gary Wang and Amy Wendholt

The global economic crisis has caused a severe contraction in international investment. Global flows of foreign direct investment (FDI) have plummeted as multinational companies (MNC) are less able and willing to invest due to decreased access to capital and internal cost reductions. China, historically a top destination for FDI, has witnessed its own FDI growth rates decline over the last year and remain below zero for the last nine months.

Despite the adverse global investment environment, incentives to attract FDI are available for companies operating in China’s high-and-new technology industry (HNTI) industry. These incentives, in part, stem from Deng Xiaoping’s 1986 National High-Tech Research and Development Plan, which first defined the industry and created a framework for government support.

In recent years, national and local government support for the high-tech sector has increased as leaders seek to foster domestic innovation. In 2006, for example, the central government outlined a five-year plan to invest in 16 key scientific and technological innovation projects. The plan provides RMB 32.8 billion and RMB 30 billion for 2009 and 2010 respectively for projects encouraging the development of new energy sources, 3G telecommunications, aircraft and moon-landing capabilities, new medicines, and water conservation initiatives. Efforts by the central government to encourage high-technology investment have taken on many forms, and offer significant incentives to companies.

Financing
In response to the global financial crisis, the central government passed an RMB four trillion stimulus package designed to “promote indigenous innovation and to upgrade industry structure through technological development and HNTI.” More than RMB 370 billion, or nine percent of the total funds, were designated for investment in high and new technology enterprises (HNTE), as well as for technology upgrades in traditional industries. HNTEs have also indirectly benefited from increased access to capital. Chinese banks have issued more than RMB seven trillion in new loans in the first half of 2009 in accordance with provisions of the stimulus package.

In June 2009, China’s Ministry of Science and Technology (MOST) initiated a plan to provide financing, in the form of subsidized loans, for initial public offerings (IPO) of small and medium-sized HNTEs, the construction of national-level high and new technology parks and companies hoping to “go abroad.” This plan follows temporary administrative measures issued in March 2009 by the China Securities Regulatory Commission to help small and medium-sized HNTEs raise capital for eventual IPOs via the Growth Enterprise
Market.

Central government leaders are also focused on increasing efficiency and innovation within the HTNI. In May 2009, the National Industrial Technology Upgrading Fund was established and will provide RMB 20 billion annually in subsidized loans to upgrade industrial technologies and improve manufacturing processes. Moreover, the government’s 10 major industrial adjustment and revitalization plan provides structural support through direct funding and tax incentives for 10 of China’s core industries. In the automobile industry, for example, the plan provides RMB 10 billion annually for the next three years to support technological innovation, technical upgrading and research and development (R&D) on automobiles that use nontraditional energy sources.

Tax support
China has in place an aggressive tax policy to court high-tech investment. HNTI is one of a limited number of sectors entitled to preferential treatment for corporate income tax (CIT). Qualified HNTEs can take advantage of a 15 percent CIT rate, instead of the standard 25 percent rate, regardless of their location (i.e., within or outside of high technology parks) and investment vehicle (i.e., joint venture, wholly foreign-owned enterprise, etc.).

In addition, the first RMB five million in annual revenue resulting from technology transfer is exempt from CIT and any amount that exceeds RMB five million is subject to a discounted rate of 12.5 percent. Companies are permitted to deduct R&D expenses from their CIT tax liability at a rate of 150 percent. In addition to these CIT reductions, revenue for companies developing or transferring technology or performing consulting services associated with these activities is exempt from China’s business tax.

Prioritized industries can benefit from tax incentives created to provide additional support. Qualified high-technology business process outsourcing (BPO) enterprises operating within 20 identified cities are subject to a CIT rate of 15 percent from 2009 to 2013, while off-shore BPO services are exempt from business tax. Software development and integrated circuit production enterprises can receive a value-added tax (VAT) refund equal to the portion of the actual VAT liability in excess of three percent for the sale of software products and six percent from integrated circuit production through the end of 2010. In combination, these policies make China a highly attractive destination for hightech sector MNCs.

Local Government Incentives
In addition to the incentives provided by the central government, local governments have developed policies to encourage investment by HNTEs. These incentives vary substantially between cities and are often subject to negotiation. The Xi’an municipal government’s policy can serve as a very good example of local government’s courting high-tech businesses. As part of its effort to be the “economic and technological center of central and western China,” the city has provided multiple incentives to attract investment, including:
• Subsidies (one-time only) for establishing operations in Xi’an, discounted office rental rates (for three years), funding for overseas exhibitions, and reimbursements for employee training and recruitment;
• CIT, VAT, business tax and individual income tax rebates for HNTEs in Xi’an—rebate rates depend upon total investment levels and annual profits;
• Four government funds to support HNTEs in Xi’an, including RMB one billion for innovation support, RMB two billion for industrial support, RMB one billion for enterprise support via loans and an RMB one billion venture capital fund offering equity investment;
• Assistance for HNTEs issuing bonds and conducting IPOs, constructing credit systems and promoting overseas M&A;
• An RMB 50 million fund supporting high-tech specialists through relocation subsidies, bonuses and direct support of R&D;
• And support for enterprises applying for HNTE recognition.

The Xi’an government has created additional benefits for specific investments. Tax refunds of up to 50 percent are available for regional or global headquarters that move to Xi’an and for R&D facilities or enterprises whose total investment exceeds US $100 million or whose projects have strategic significance. Other provinces and municipalities offer similar incentives, meaning that companies looking to invest need to carry out thorough due diligence when comparing different locations.

Challenges Securing Recognition as an HNTE
In order to secure most of the central and local government support measures detailed above, a company must first qualify as a HTNE. In April 2008, the government released new, stricter criteria stipulating that HNTEs must:
• Be established within China;
• Have existed for more than one year;
• Continuously conduct R&D activities;
• Own the IPR of its main products core technology (IPR cannot be owned by overseas holding companies);
• Conduct business in one of eight qualifying sectors within high and new technology;
• Engage 10 percent of employees on R&D work with 30 percent of employees having an associate degree or above;
• Invest between three and six percent of revenue on R&D with 60 percent of R&D expenses occurring in mainland China;
• And earn more than 60 percent of total revenue from HNT products and services.

These changes have made securing HNTE status more difficult. The percentage of successful HNTE applicants has plummeted from over 50 percent of all applicants before the reforms to 15 percent in 2008. These new requirements, in particular those covering mainland R&D expenditures and IPR listings, are particularly burdensome for foreign-owned enterprises. As of 2008, only approximately 20 foreign companies listed on the Fortune 500 had been recognized as HNTEs.

Central policy makers are aware of such difficulties and have called for reforms. In April 2009, Premier Wen Jiabao explicitly ordered MOST to make HNTE qualification more accessible. In addition, several local governments have issued their own criteria lists, making the landscape more complicated for companies. However, with this differentiation in government policies comes great opportunity for those willing to carry out due diligence.

Suggestions for Foreign Investors
In order to ensure companies make the most of the benefits available, here are a few recommended steps before making major investment decision:

Understand the range of available incentives
The incentives available to HNTEs through both central and local government provisions continue to evolve. This is especially true as China seeks to counteract the effects of the global economic crisis. In order to maximize benefits, companies should conduct extensive research on the existing incentives and continuously monitor for policy updates.

Conduct regional and industry-wide research
Officials negotiating with potential HNTEs are often given leeway on the final terms of negotiation, so it is helpful to have clear knowledge of the types of incentives previously provided to other, similar companies. Companies should study the experiences of their peers in order to gain insight into the local incentive system and identify potential obstacles and challenges. Speaking to companies already in a given municipality can be extremely useful in getting a grasp on a city's business and regulatory environment.

Maintain strong government relationships
Most of the available incentives require government approval, so it is crucial for companies to identify the key stakeholders associated with these benefits and maintain regular contact in order to ensure that the company's goals and needs are understood. As always, companies should be sure to conduct vigorous negotiations with the relevant authorities since incentives are known to vary considerably amongst different parties.

Analyze the associated costs
Although tax beneftis, financial support and other incentives provided for HNTEs are certainly appealing, these incentives require specific investments and actions for companies seeking HNTE recognition. Companies should thoroughly analyze the economic benefit associated with this preferred treatment and weigh the potential costs, which include localization of intellectual property rights and R&D investment.

Gary Wang is a consultant and Amy Wendholt is a senior consultant at APCO Worldwide’s Beijing office. They routinely advise high and-new technology companies on opportunities in China.