Shanghai transfer pricing economist Glenn DeSouza posits a contrarian view that the massive trade dispute bedeviling the world’s two greatest trading nations won’t necessarily hurt U.S. multinational investment in the middle kingdom. Instead, tax directors of U.S. multinationals have a unique, nuanced, opportunity, to map out a holistic strategy to exploit the business and tax opportunities that lay below the surface.

For tax directors it is becoming increasingly important to understand the political and economic frictions with China and the dangers or opportunities they present. In this high-tension and volatile environment, tax in China can no longer be successfully approached as a purely technical matter of “transfer pricing comparables” and “tax treaties.”

These are interesting times in China-U.S. relationships. At the G-20 dinner on December 1, President Xi Jinping and President Trump reached a consensus to hold off adopting more tariffs. But on the same day, supposedly unbeknownst to Trump, came the thunderbolt that Canada had arrested the CFO of Huawei, Meng Wanzhou, for potential extradition to the U.S. This action hammered the stock prices of Apple and other hi-tech companies with heavy dependence on China.

China Reassures Foreign Investors

China appears determined to keep its cool, bide its time and play the long game. Chinese and American accounts of the ongoing tit-for-tat tariff escalation are philosophically different. In China, the politically correct term is “Trade Friction” not “Trade War” and its impact is downplayed. By contrast, articles in the New York Times and Wall Street Journal paint a larger and darker picture and cite a broad bipartisan consensus in both red and blue states for punishing China.

Conventional wisdom has it that Mike Pence’s speech at the Hudson Institute announced Cold War II and that the first collateral damage would be to U.S. companies in China. Back on March 15, 2017, a senior official had warned the Trump administration “We don’t want a trade war but if there is one, it would be foreign-invested companies, in particular U.S. firms, that would bear the brunt of it.” So it was expected that U.S. companies would be in for a hard time with tax audits and consumer boycotts.

But instead the official media in China has been very careful not to inflame the populace and has tried to cool down the passions. The Communist Party of China at a November 8, 2018 at a meeting, chaired by President Xi Jinping, announced that “China will continue proactively attracting foreign investment and safeguarding the legitimate interests of foreign-invested businesses as part of an effort to shore up the economy.” Provincial governments are also getting the message and we see headlines such as “Chengdu opens its arms to overseas investment.”

The CPC is concerned that foreign investors will re-locate to countries such as Vietnam, Mexico or India who are not subject to the tariffs. About 70% of China’s exports to the United States come from foreign investors, including Japanese, Korean and European investors. A survey by the European Union Chamber of Commerce in China found that nearly 54% of nearly 200 respondents feel the U.S. tariffs will cause significant disruptions to the global supply chain and some 7% have either moved or are planning to move their production out of the mainland.

To quote the China Daily, “one of the intentions behind the U.S. move is to crack down on the foreign direct investment into China, in order to impede China’s industry upgrading and squeeze China out of the global value chain.”

So rather than play into this trap, China is reassuring foreign investors, opening up new sectors, enforcing intellectual property rights more forcefully and considering tax reductions.

On November 12, 2018, Finance Minister Liu Kun stated that “tax and fee reductions are in the pipeline to promote economic development.” We also hear anecdotally that tax audits have stalled, as no one wants to be seen as beating up on U.S. companies.

The Tariff Timeline

After making nice with China in 2017, President Trump started the New Year by placing a 30% tariff on solar panels and a 20% tariff on washing machines on January 23, 2018. And on June 15, he imposed a 25% tariff on $50 billion of Chinese exports.

On September 17 the U.S. announced its 10% tariff on $200 billion worth of Chinese starting September 24, increasing to 25% by the end of the year and threatened tariffs on an additional $267 billion worth of imports if China retaliates, which China promptly did on September 18 with 10% tariffs on $60 billion of U.S. goods.

In addition, the U.S. Committee on Foreign Investment in the United States has blocked some Chinese acquisitions of U.S. companies on national security concerns.

At the G-20 meeting on December 1, Trump agreed to pause for 90 days a 25% tariff on $517 billion of Chinese imports.

How Long Will It Last?

The hawks in the White House want a total war. National Trade Council Director Peter Navarro, an obscure academic and author of “Death by China: Confronting the Dragon—A Global Call to Action” says “We lost the trade war long ago” and is pushing President Trump to insist on massive changes in China’s economic, military and political activities to accommodate U.S. demands or face prolonged hostilities.

Vice President Mike Pence played “bad cop” in his October 2018 speech at the Hudson Institute charging that “the Chinese Communist Party has used an arsenal of policies inconsistent with free and fair trade, including tariffs, quotas, currency manipulation, forced technology transfer and intellectual property theft. China’s actions have contributed to a trade deficit with the United States that last year ran to $375 billion—nearly half of our global trade deficit.“

Jack Ma of Alibaba is among the pessimists: “It’s going to last long, it’s going to be a mess,” he said in September. “The U.S.-China trade war will last not for 20 months or 20 days, but maybe 20 years.” Then on November 5 at the import exhibition in Shanghai, he doubled down asserting that “Trade war is the most stupid thing in this world.”

On other hand, the seasoned business folks within the administration such as Secretary of Treasury Steven Mnuchin, former Chief Information Officer of om Goldman Sachs, are pushing for a deal. An official close to President Trump says to expect a “beautiful deal” with China in summer of 2019; especially if the current U.S. stock market slide deepens. A Cold War will not bring back jobs to Trump’s “forgotten people” in the American heartland. Apple iPhones are never going to be assembled in the United States—the last time Apple made anything stateside was back in 1980s when it manufactured the Macintosh in Fremont, California. And, of course, China is by far the largest foreign market for a score of foreign companies including Apple. Which is why Apple iPhones —“America’s hi-tech crown jewel”—have been exempted from tariffs, and Tim Cook has proclaimed “I’m optimistic that the two countries will sort this out and life will go on.”

Update on G-20--China Sees It Differently

In the Official White House Statement released on December 3, President Trump stated: “This was an amazing and productive meeting with unlimited possibilities for both the United States and China. It is my great honor to be working with President Xi.” Trump went further in a tweet lauding the “incredible deal” and asserting that “relations with China have taken a BIG leap forward and … “China will buy massive amounts of agricultural products from our farms.” It was also noted that “US and China will immediately negotiate on compulsory technology transfer, intellectual property protection, non-tariff barriers and cyber theft.”

The Trump spin is that China has been given a 90-day deadline to agree to a wide range of reforms or be hit by tariffs and fails to mention some of the concessions made by the U.S. such as its reiterated support of the “one-China policy”.

The tone from China was far more tempered and made it crystal clear that this was a consensus between equals: the China Daily stating that “President Xi Jinping and his United States counterpart, Donald Trump, agreed on Saturday to continue bilateral trade negotiations, stop the imposition of new tariffs and exchange visits at an appropriate time.” There was no reference to the IP issues and agricultural purchases claimed by Trump. The China Daily suggested that Trump made the deal due to U.S. stock market decline and points out that “The automaker General Motors announced at the end of November that it will shut down seven plants around the world, including four in the U.S. but none in China, resulting in huge pressure on the U.S. government.” The editorial goes on to note that “the US trade deficit in goods reached a record high in October of $77.2 billion,” and that the trade dispute “has not led to reshoring of capital or jobs to the United States and foreign direct investment in the second quarter slid into negative territory, with a divestment of $8.2 billion.”

Will China Compartmentalize the Huawei Arrest?

Arresting the daughter of the Huawei founder would be like arresting a daughter of Steve Jobs. This company is China’s crown jewel. It is the world’s largest manufacturer of telecommunications equipment, second largest manufacturer of smartphones, and a leader in development of 5G technology.

So far the China Daily has taken a restrained tone on reporting on the arrest of the Huawei CFO for “alleged violations of U.S. curbs on trade with Iran.” But China sees a more sinister motive in play with the real goal being to exclude Huawei from international deals. “This week Britain’s largest mobile provider BT revealed it was stripping equipment of Huawei from its core 4G cellular network after similar moves by the U.S. and New Zealand. Australia announced on Friday that it will ban Huawei from its 5G network.” The perception is that it reflects” Washington’s cold war mentality, with which it continually distorts the reality of international relations.”

The big question is can China compartmentalize the Huawei arrest from the ongoing trade negotiations and whether there will be a blowback on U.S. hi-tech companies. Based on China’s moderate response to date, there is reason for optimism.

China Opening Up Its Economy in Response to Trade Friction

China has responded to the trade friction by taking the high road. China has opened up a number of sectors to foreign investment, strengthened IP protection, and undertaken efforts to increase imports. For example, this month (November 5-8), there was a very unusual exposition in Shanghai—designed to promote imports not exports. Foreign companies set up import booths at the Import Exposition which brought 150,000 buyers to Shanghai to check out imports offered by businesses from 130 countries. The event was opened by President Xi who said “openness has become a trademark of China and the world has benefited by China’s opening up”—he went on to add that “the law of the jungle and winner takes all lead to a dead end.”

Making it Easier to Do Business

The World Bank released a report Doing Business 2019, which ranks China 46th worldwide on its “ease of doing business” list. China ranked 78th in last year’s report and 96th in 2013. Now it is among the top 50, marking a giant step forward. China was listed among the world’s top 10 countries for its improvement.

The China Daily quotes an official expert, “An environment friendly to businesses is friendly to all, because all will benefit from the prosperous economy. There will be no end to improving the business environment.”

U.S. Investment into China Grows—Did China Win the First Round?

China’s strategy is paying off. U.S. foreign direct investment into China has not only kept flowing but actually increased this year. According to the China Daily, quoting statistics from the Ministry of Commerce, “foreign investment from January to July this year has not declined but instead increased since the breakout of frictions between China and the US. In particular, the US investment in China increased 29.1 percent in the first half of 2018, which was higher than the average level.”

A number of companies including BASF, Exxon Mobil and Tesla have rushed to take advantage of opening up of sectors and signed big deals. For example, Shanghai has become the first place outside of California, where Tesla will build cars--Model 3 and the upcoming Model Y, an SUV--with estimates ranging from 250,000 to 500,000 cars a year. Tesla will operate the first fully-owned foreign auto company in China.

At the same time China’s trade surplus with the U.S. has soared to record levels this year leading the Financial Times to assert “Round One to China.”

Using Favorable Tax Policies to Encourage Investment

The Paying Taxes 2017 report published by the World Bank Group and PwC Global ranked “China’s total tax and contribution rate” as the 12th heaviest among 190 economies in 2015. The China total tax contribution rate is 67.3% versus 20.3% for Singapore, 28.7% for Thailand and 47.4% for Japan. China’s corporate tax rate is about average but the World Bank-PwC study claims that China’s labor taxes are at 48.1%. Rather than taking offense at this conclusion, the front page of China Daily refers to this study in pushing for a more tax-friendly environment.

The senior members of the tax bureaus are usually CPC members and are required to participate in CPC activities and surely understand that in this climate the last thing they want is another Seagate-type debacle, where the company upped and moved to Thailand a month after a USD 225 million tax adjustment. Thus, we may going back to the old days when tax officials were flexible, respectful and encouraging in dealing with U.S. and other foreign investors. On November 14, Wang Jun, SAT head pledged more supportive policies and better services to encourage investment.

A Tax Action Plan

Foreign investors should take advantage of this new investor-friendly window and establish their bona fides as all-weather friends. A visit by the CEO or other very senior officials along with a strong affirmation of their commitment to China can build guanxi at a critical juncture and help whatever may happen down the road.

First, U.S. companies need to speak out. A Chinese proverb has it that friendship can only be determined when there is a storm. American companies must stand up and demonstrate that they are true all-weather friends. The Chinese are looking for this type of support. The participation of Bill Gates at the Shanghai import exposition this month was most welcomed and highly profiled. But many U.S. companies are in hiding. Commenting on this, the head of US-China Business Council warned that “it is time for US companies to take a stand and iterate that US-China cooperation is good for both of our countries.”

There is a widely exaggerated U.S. claim that China is engaged in forced technology transfer and IP theft. The reality on the ground is that most U.S. investors in China operate wholly foreign owned enterprises (WFOEs) and continue to dominate their market niches very profitably and with no Chinese competition. So American companies could speak to truth and defend China against false charges based on their experience.

In speaking with Chinese officials and tax bureaus it is important to be politically correct and very respectful. Politically correct terminology is important—it is not a “Cold War” but “Trade Friction” and it is not a “90-day Deadline” but a “90-day Trade Truce.” And, there should be no direct “threats to move to another country” but instead the spin should be that the company is facing a tough time in China due to Trump’s tariffs, high wages, high rents or other factors and welcomes the understanding and support of officials and that the company is committed under all circumstances to investing in China.

Second, U.S. multinationals need to take a holistic approach and recognize that tax in China has always been subordinate to meeting strategic economic and technological goals. This means developing alliances with the Mayor’s office, municipal CPC, and bureau of finance, who have a strong goal of promoting investment.

Third, in communication with tax bureau, multinationals need to communicate their total value contributions. The tax bureau should be seen as partner not adversary. Investors should ask for tax relief to offset the tariff burdens.

Fourth, this is a time to take bold action in terms of restructuring and making new investments into China. For example, U.S. companies contemplating major investments in China can consider setting up a Chinese Holding Company (CHC) and transferring ownership of the Chinese entities from foreign ownership to that of the CHC. Joining the CHC club is very powerful as it consists of a small group of super companies such as GE, Microsoft, and Siemens. It requires a $30 million investment but rules have been liberalized so that investment can now be made over a period as long as 30 years. A CHC will elevate a company’s stature and gain it subsidies and concessions and goodwill in terms of showing its commitment to investment in China.

The China-U.S. relationship is of existential importance. Greater China accounts for 24% of Apple revenue and Apple products are made in China. Loss of this market and unique production capability would be catastrophic. For GM, China is not only the largest market but also traditionally its most profitable and dynamic. U.S. semiconductor companies receive as much as 50% of their global revenues from China. And China is also the world’s largest market for fast food, agricultural products, mobile phones and various types of raw materials. Given this dependence on China and the critical political dynamic, tax directors need to map out a strategy to exploit the opportunities that are presented.

Author Information

Glenn DeSouza is a national transfer pricing leader at Dentons China based in the firm’s Shanghai office. Glenn may be reached at Glenn.Desouza@dentons.cn

DeSouza is a winner of the prestigious best business economist award in the United States. A former economics professor at University of Massachusetts, DeSouza has authored 2 books and more than 300 articles. He has presented at over 500 global seminars for organizations such as Tax Executives Institute and advised over 100 of the Fortune 500 companies.

The first foreigner to practice transfer pricing economics in China, DeSouza has conducted trainings for over 500 tax officials including tax officials from China’s State Administration of Taxation, the UN and OECD.

DeSouza was previously China Transfer Pricing leader for PricewaterhouseCoopers and also served as their Asian Regional TP leader and a member of their Global TP Executive Committee.