Understanding the culture is vital to success in China – but this knowledge must also be backed by an understanding of the business infrastructure and, especially, the tax system.

It is often said that you can’t do business in China ‘by remote’. China is a market where it is absolutely vital to have people on the ground, representing your interests.

Business is always done face to face, because in the Chinese culture trust is the foundation of all business relationships – and you can only trust someone if you get to know them personally. Concepts like “mianzi” (face) and “guanxi” (connections) have real importance.

Of course, it isn’t just cultural issues that companies moving into China need to consider. There are a range of business and financial issues where detailed knowledge is vital – not least in taxation.

The difficulty arises in part from a conflict dating back centuries over the allocation of revenue between local provinces and the central government. Revenues from certain taxes belong to the central government, while revenues from others belong to the local governments.

Foreign enterprises in China can either be a foreign-invested enterprise or a foreign enterprise. In general, foreign-invested enterprises (which can take the form of Sino-foreign equity or contractual joint ventures or wholly foreign-owned enterprises) must contribute to the development of China’s economy. Foreign-invested enterprises are subject to tax on their worldwide income.

Foreign enterprises, which include foreign companies, enterprises and other economic organisations such as representative offices, contracted projects and royalty arrangements, are subject to tax only on their income from People’s Republic of China (PRC) sources. If the foreign enterprise has an ‘establishment’ in China it is subject to tax on all income derived from the PRC, otherwise it is subject only to 10 per cent withholding tax on income from PRC sources.

Foreign-invested enterprises and foreign enterprises are subject to corporate income tax at 30 per cent, which is levied by the central government, and local tax at 3 per cent. However, businesses are subject to lower tax rates if they are operating in any of the five special economic zones, or in one of the open coastal cities, coastal open economic zones, high-technology development zones or designated free trade zones.

There are other tax breaks available too. For example, foreign-invested enterprises engaged in production and manufacturing activities are granted two-year tax exemption and a three-year 50 per cent tax rate reduction beginning from the venture’s first profit-making year.

There are also other taxes that are payable in China including business tax, value-added tax, real property gains tax, stamp duty, deed tax, and social security.

Wholesale changes are expected to take place (probably in 2008) to certain aspects of the Chinese tax system because of commitments made when China was admitted to the WTO in 2001. One of the main areas of reform will be the harmonisation of tax rates that are currently applicable to local and foreign enterprises.

In place of the multi-tier rate system of 15 per cent, 24 per cent or 33 per cent for foreign enterprises, and 33 per cent for local enterprises, there will be one uniform rate of tax, which is expected to be less than 30 per cent. In addition, the current broad-based (geographic and production) incentive policy is expected to be replaced by a strategic incentive policy targeted at selected industries such as new and advanced technology, and those aligned with national policy such as environmentally-friendly technology. Even after the tax rate is aligned, it is likely that there will continue to be incentives for overseas investors.

Article by Alex Chow – a member of Ernst & Young’s Chinese Business Desk. The Chinese Business Desk advises both UK companies expanding into China as well as Chinese businesses investing in the UK.

This article was originally published in Ernst & Young’s Masterclass Magazine