Preferential taxes may have been a major attraction for foreign companies investing in China but that could all be about to change.

With the draft of the new corporate income tax law to be reviewed by China's top legislature in August, the unification of tax rates for foreign-funded and domestic companies seems just a matter of time.

According to the draft, companies in China will no longer see two sets of tax rates - more favourable ones for foreign-funded ones and almost double for their local counterparts. Instead, the corporate income tax paid will be the same, regardless of the ownership of the firm.

That should scrap the privilege foreign investors have enjoyed for more than 15 years and lower the tax burden for domestic businesses, enabling them to compete on an equal footing.

"Such an adjustment is in line with the overall strategic development of the Chinese economy," said Ni Hongri, a tax expert and researcher with the Development Research Centre under the State Council, a government think-tank. "The trend is unavoidable; what matters more is the new tax rate and the period of grace."

The current corporate income tax rate for Chinese companies stands at 33 per cent, compared to a maximum of 24 per cent for foreign-funded enterprises.

However, foreign-funded firms in the service industry are taxed at 33 per cent and those in economic zones pay 15 per cent. There are also numerous exemptions by local governments.

Alfred Shum, executive partner and deputy chairman for tax of Ernst & Young from Shanghai, predicted the unified tax rate would be somewhere around 25 to 27 per cent.

And a three to five year grace period would help companies adjust to the new tax rate.

The issue has been discussed for years, but resistance, for example from foreign companies in China and administrators of economic zones, pushed it off the agenda of lawmakers.

Ma Xiuhong, China's vice-minister of commerce, said last week that the time was ripe to introduce a unified tax system but a grace period would be allowed for the transition.

Wang Jianfan, deputy director of the tax policy department of the Ministry of Finance, said earlier this month that the unification of the corporate income tax was a top priority for tax reform in China.

Instead of allowing general and regional preferential taxes, the new system will give more incentives to companies in industries that encourage more investment, Wang said. The Chinese authorities amend the industrial investment guidebook every year.

The new tax law, drafted by the Ministry of Finance, will be submitted to the Standing Committee of the National People's Congress (NPC) for initial review in August. If approved by the committee, the draft will be voted on at the NPC meeting in March. The earliest timetable for implementation is 2008, according to Shum.

It is wise to base tax adjustments on the needs of industrial restructuring, he said.

China's reliance on foreign investment has decreased compared with more than two decades ago, when the country had just opened up. Now it has its preferences and favours investment in high-tech and industries with high-added value, said Shum.

China's actual foreign direct investment was US$72.4 billion in 2005, up nearly 20 per cent from the previous year, with a strong growth in investment in the financial sector, according to statistics from the Ministry of Commerce.

A general concern is that high taxes might drive away some foreign investors, but as Shum saw it, the impact on foreign investment is limited if the transitional period is carefully handled.

Many foreign-funded companies are eying the growth potential of the Chinese market and strong domestic demand. Higher taxes will not add too much of a financial burden and are acceptable compared to the profit generated and the overall strategic importance of the market, he said.

For companies in the service sector, such as finance, which has become a new focus for foreign investors, their income tax, currently at 33 per cent, will actually be lowered.

For the Chinese Government, now is a good time to conduct tax reform, given its smaller deficits and stronger fiscal strength, said researcher Ni Hongri.

China's deficit has dropped considerably over the past two years, so it is the right time to solve old problems and upgrade the tax system, she said.

"More favourable taxes in neighbouring countries and regions may lure some investors away from China," said Ni. "But you have to pay a price for every reform. And it is worthwhile for long-term development."

"The biggest attraction of a country to foreign investors should not just be preferential taxes," she added. A simplified tax system and administrative procedures, transparency and an environment of "fair play" are more attractive.

For Chinese companies, such elements will also encourage them to be more innovative and enhance their competitiveness on a level playing field; they will soon no longer enjoy government subsidies and preferential treatment as China is shortly to finish its five-year grace period after joining the World Trade Organization.

Editor: Yan