I nitially set up to attract foreign investment, China's special development zones have become central to many foreign companies' China strategies. Because they allow companies to import, process, and export with fewer taxes and less red tape than other places in China, development zones have helped foreign firms integrate China into their global supply chains. As export-processing trade in these zones took off in the mid-1980s, the zones' popularity prompted the PRC government to offer incentives to encourage still more growth, and China now boasts dozens of zones with a confusing array of options. A review of just two of the most popular types of zones illustrates the factors a foreign company needs to consider before setting up operations—or incorporating China more broadly into its supply chain.

Zones and more zones

China has many types of zones and bonded areas (both of which offer relaxed import restrictions) at the state, provincial, city, and district level. Both foreign and Chinese companies may set up in all types of zones. National-level zones fall into seven main categories:

• Economic and technological development zones are areas that provide international-standard facilities and supporting services.
  
  
• Free-trade zones (FTZs) are specialized areas for international trade, foreign investment, bonded warehouses, and export processing.
  
  
• High-technology industrial development zones encourage the transformation of scientific and technological advances into marketable products.
  
  
• Border and economic cooperation zones encourage frontier trade and export processing, improved relations with neighboring countries, and better economic conditions in areas populated by national minorities.
  
  
• Export-processing zones (EPZs) are special enclosed areas supervised by the General Administration of Customs.
  
  
• Tourist and holiday resort zones encourage foreign investment in certain resort areas.
  
  
• Taiwan investment zones aim to attract investment from Taiwan.

Of these various types of zones, free-trade and export-processing zones offer the incentives most attractive to a broad class of foreign investors.

What is a free-trade zone?

In an effort to increase exports and foreign investment, the central government approved 15 national-level free-trade zones in the 1990s (see Table 1). FTZs are geographically defined areas of 6 km² to 10 km² that permit a wide range of business activity such as warehousing, foreign exchange transactions, marketing, trading, and export processing. FTZs generally allow only simple processing, such as freight classification, parts loading, storing, packing, and branding. In practice, however, most companies engage in trading and warehousing operations. Of the more than 4,000 companies that operated in Shanghai's Waigaoqiao FTZ in 2002, only 167 engaged in export processing.

Various incentives, such as exemption from customs duty and value-added tax (VAT), liberal foreign exchange rules, and the absence of bond requirements for imports within the zone, were designed to attract new investment and to lure existing investment away from other structures, such as bonded warehouses, which the central government found difficult to oversee.

The national government has standardized most preferential policies for FTZs, including a package of tax incentives: For the first two years of operations, companies are exempt from enterprise income tax. During the next three years, companies are taxed at 50 percent of the normal foreign-invested enterprise (FIE) tax rate of 15 percent. After five years, in-zone enterprises pay the full FIE tax rate.

More important, the standard FTZ package also offers various customs incentives, such as duty exemptions on all construction or infrastructure imports necessary for production and on all equipment, parts, and components imported for self-use. Imports entering the FTZ from outside China proper are exempt from customs duties and VAT; customs duties and VAT are assessed only after the finished products leave the FTZ for regions outside the bonded area. If more than 70 percent of the finished product is re-exported outside PRC territory, any remaining product is taxed at a reduced rate based on the original imported components. All finished goods "imported" from the FTZ into China proper will have customs duty and VAT assessed based on a ratio of locally sourced inputs to imported components.

Each zone can, and often does, offer its own incentives on top of the central government ones. Local authorities can establish land-use or utility incentives and may also decide to exempt in-zone enterprises from local income tax.

Notably, FTZs remain the only locations in which a foreign company may establish a wholly foreign-owned trading company—though these wholly foreign-owned companies did not possess trading rights (the right to import and export) until very recently. To sell products in mainland markets, these companies were required to engage agents with trading rights to handle customs procedures for transactions with the non-FTZ enterprise.

FTZs offer a Bonded Commodities Exchange Market or exhibition center through which in-zone enterprises sell their products to Chinese buyers and distributors for sale in mainland markets. Exchange market administrators clear the goods through Customs and issue VAT invoices. Given these restrictions on trading companies in the FTZs, only five were set up between 1997 and 2003 (three in Shanghai and two in Shenzhen), and none is wholly foreign owned.

In June 2003, the State Council, the Ministry of Commerce, and Customs issued a notice allowing enterprises in Futian-Shatoujiao, Tianjin, Waigaoqiao, and Xiamen Xiangyu FTZs to register for the right to conduct domestic trade without using an intermediary with trading rights. Because the notice leaves the drafting of detailed application rules to the zones themselves, it will be some time before the effects of this new policy on the zones, on the companies in the zones, or on future investment become clear.

What is an export-processing zone?

Customs and the State Council approved the establishment of 15 EPZs in 2000. That number has since grown to 38 (see Table 2). Limited to an area of 2 km² to 3 km², all EPZs must be established within the confines of an existing economic or development zone. The central government set up these small areas, completely fenced in and under 24-hour Customs supervision, to promote exports and crack down on the illegal sale of duty-free imports of raw materials. Establishing EPZs at central locations throughout the country has helped Customs achieve these goals.

EPZs differ from FTZs in several ways. First, EPZs permit fewer types of business activities. Only export processing, warehousing related to the processing activities of in-zone enterprises, and freight transport are allowed. The narrow purpose of the EPZ allows China to offer incentives to export processors that are not available in the FTZs or at a standalone, bonded facility. Second, unlike in FTZs, there are no VAT charges on public utilities. Third, only companies that export more than 70 percent of their output are eligible for the income tax breaks available to all companies in FTZs. And because EPZs are export oriented, all companies located in an EPZ qualify for trading rights and do not need to work through an in-zone commodities market if they have product to sell on the domestic market.

EPZs share some traits with FTZs—the import duty on a product sold in China will depend upon the item's specific product category. Also, as in FTZs, VAT is not levied on any activity that takes place within the EPZ, and imports are tax-exempt.

Though the PRC designates EPZs as "closed," this term only refers to the fact that EPZs are physically segregated from the rest of the economic development area in which they are located. All goods, persons, and vehicles must be inspected upon entry and exit of the zone; no personnel may reside within the EPZ. Legally and practically, however, the EPZs are open and accessible to foreign investment.

Because EPZs focus exclusively on export processing, the most significant difference between them and FTZs is the export rebate policy. If a company within an EPZ purchases goods from an enterprise within China, the selling enterprise will receive an export rebate, and the in-zone buying enterprise will not have to pay VAT. In contrast, companies in FTZs, or bonded facilities outside of zones, must pay VAT up front on any good sourced in China and apply for an export rebate only after the good has been exported.

Enterprises in EPZs also benefit from priority Customs clearance over those located outside the zone and more streamlined clearance than those in FTZs. All companies in an EPZ must have a computerized database connected with Customs to clear goods electronically. Currently, companies that pay customs duties on time (A or B grade [see box, Duty Calls]) and have a reliable, computerized tracking system can apply for paperless customs clearance. EPZs enjoy 24-hour Customs support and make no distinction between bonded and non-bonded imports, a practice that results in faster processing.

Choosing a base: FTZ vs. EPZ

As evidenced by the thousands of companies located in free-trade zones across China, FTZs can be strategic places to invest, depending upon a company's business scope and structure. Many companies currently use these FTZs to warehouse high-end imports, sell across the Asia-Pacific region, or coordinate exports among their PRC-based original equipment manufacturing operations.

Export-processing activities are listed among the activities permitted in FTZs, but most companies that want to focus exclusively on the export market find better incentives in the export-processing zones. Some companies have reported that FTZs such as Waigaoqiao, TEDA, or Futian-Shatoujiao are preferable for logistics and warehousing activities rather than export processing. One manufacturing company currently located in an EPZ had originally planned to invest in Waigaoqiao. But after comparing Waigaoqiao's offerings against its business plan, which entailed substantial manufacturing, the company decided that Waigaoqiao's system would not support large-scale processing of mostly imported components.

Although Shanghai, in particular, has taken important steps toward improving customs practices and clearance times, the FTZs lag behind the EPZs in developing electronic customs clearance systems. In FTZs, Customs tracks imports on a piece-by-piece basis, with separate books for bonded and non-bonded imports, and checks the books with each import and export—as opposed to a monthly or quarterly reconciliation process. Companies engaged in extensive processing find this to be a paper-intensive and time-consuming process.

The compact geographic area and sole focus on exporting allows Customs to create an especially user-friendly import-export environment. Many company representatives, legal professionals, and zone commissioners agree that locating in an EPZ is ideal when a company's export and import activities are complex, as would be the case if a company were to import damaged goods for repair and re-export, for example. This type of operation involves a substantial amount of paperwork and interaction with Customs because no regulations explicitly cover the import of damaged goods for repair and re-export. Customs officials in EPZs work closely with companies on a case-by-case basis. In this re-export example, Customs can log the imports, and then inspect the goods when they are ready for re-export.

This does not mean that dealing with Customs, even in an EPZ, is effortless. Companies report that speed remains one of the most significant drawbacks of the Chinese customs system, even within the EPZs. And, regardless of location, companies still must constantly educate Customs officials about the company's business scope and import-export needs. A company must be willing to spend the time and legal resources to educate and work with Customs officials to receive all the duty exemptions to which it is entitled.

Proximity to the rest of the supply chain, as well as to the overall market, is also a factor, not only in selecting which type of zone, but also in which specific zone, to establish (see box, China's Most Popular Zones). The Tianjin FTZ, known as a gateway to Northeast China, is the central location for most of China's car imports. In 2002, 60 percent of imported cars sold in China came through Tianjin. On the other hand, Shanghai offers a critical mass of manufacturing and skilled labor. One machine tool company selected Waigaoqiao FTZ over Hong Kong because its suppliers were there, even though the company believed that Hong Kong's port was of significantly higher quality than Shanghai's. (Port facilities were especially important to the company as it hoped to develop its China operations into a logistics hub for the Asia-Pacific region.)

Companies continue to search for incentives even after initial operations placement. When one technology firm was considering investing in China in 1997, Shanghai's Waigaoqiao was the only viable option. Although the firm has been pleased with the zone's facilities and infrastructure, as the firm expands its China operations it is seriously considering moving into other FTZs or EPZs that could better meet its needs.

The future of the zones

One question that has yet to be resolved is what impact implementation of China's World Trade Organization (WTO) commitments will have on the future of its free-trade and export-processing zones. Under its WTO entry agreement, China must give trading rights (import and export rights) to all enterprises by December 11, 2004. Some trade analysts think most FTZs will either die out or be scaled back after full trading and distribution rights are implemented because so much of their current attraction stems from the trading rights they offer.

Another issue to watch is how the zones fare once China merges FIE and domestic company tax rates and incentives in the next three to five years. Though FTZs and EPZs will probably manage better than the other zones because companies do not invest in them simply for tax breaks, a unified tax policy, unless augmented by other incentives, could spell the demise of many development zones. Even FTZs will need to specialize and develop additional incentives to remain competitive. Officials in Tianjin FTZ and Waigaoqiao point to their niche markets, autos and information technology, respectively, as indicators that they are well positioned to survive. They also cite the expertise they have developed in catering to the needs of foreign investors as a key advantage that will make them attractive investment options even after FIEs get trading and distribution rights and tax incentives are phased out.

Some investors believe that EPZs will overtake FTZs in popularity, as processing trade will remain an integral part of China's economic machine for several years to come. The customs clearance policies and rebate incentives that EPZs offer export-oriented firms are here to stay, and will deepen the advantage that EPZs have over FTZs. While EPZ commissioners in TEDA, Jinqiao, and Longgang said that they were not concerned that their operations would be shut down as WTO commitments take effect, they also admitted that they will have to specialize in a particular sector or industrial segment to compete.

One place to look for clues about the zones' future is in PRC government policy. Most of the 38 new EPZs the State Council approved in 2003 are located in central and western China. In China's drive to develop its hinterlands, EPZs could draw foreign investment to the interior, particularly if the cost of manufacturing continues to rise along the coast. This movement would fit into China's overall policy of promoting exports and trying to create jobs in second- and third-tier cities to absorb ever-rising numbers of rural migrants. But expanding EPZs to the interior will only work if the infrastructure, technical know-how, and local government sensitivity to the needs of foreign investment are fully developed.