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China's tech boom at risk over muddled tax hike proposals

A Bank of China employee in Hefei, Anhui province. China introduced new individual income tax laws last month and said fund partners should follow an existing - yet often exempted - rule with tax rates of as much as 35 per cent.

Hong Kong

THE venture capitalists of China are starting to get nervous. Venture investments have driven a boom in technology startups over the past five years, but funding has started to slow in recent months. Now the government is floating new tax policies that could hammer investors, persuading some to pull back on cutting deals until they get more clarity.

The latest scare came from two announcements that could hike taxes on China technology investors and high-skill employees recruited from abroad. The first suggested raising tax rates to as much as 35 per cent of investment gains from 20 per cent, while the second would require anyone who lives in China for 183 days a year to pay levies on their global income. Though one top official suggested the government could backtrack on the first proposal, investors are spooked and reconsidering their investments and residency in China.

"It's caused a lot of potential limited partners to sit back and say 'let's wait to see what the potential policy is, I don't want to rush into things," said James Ding, managing director at China's GSR Ventures.

China has seen an unprecedented funding boom in the past few years, fuelling startups such as Meituan Dianping - which hit a valuation of more than US$50 billion in its Hong Kong initial public offering on Thursday.

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Amid the get-rich bonanza, local governments introduced waivers that lowered taxes for investors to boost support for startups.

Then China introduced new individual income tax laws last month and said fund partners should follow an existing - yet often exempted - rule with tax rates of as much as 35 per cent.

The proposal was met with objections from investors and an unusual critique from the state-owned People's Daily. China's Premier Li Keqiang quickly softened the message - saying that no tax hikes would occur for funds investing in sectors that benefit innovation.

But the shifting government stance left much uncertainty. It wasn't clear which sectors would qualify as innovative, for example, or whether individual investors would be able to claim the lower tax, according to Jeremy Ngai, China South tax leader at PricewaterhouseCoopers Ltd.

That may exacerbate a funding squeeze that's pinching Chinese startups and causing some to shut operations. Capital raised by investment firms intended for seed and early funding plunged 53 per cent to 3.82 billion yuan (S$762 million) in the first half, according to a survey of 36 funds by Chinese researcher Zero2IPO.

"Investors in local funds are very concerned about the potential tax changes and further investment will likely slow down before policies clear up," said Jenny Lee, a partner at Menlo Park, California-based GGV Capital that has backed some of China's largest startups.

Tax hikes could put China at a disadvantage compared with countries such as the US where such taxes are typically capped at 20 per cent, according to Jeff Zhang, a partner at law firm Orrick. "The timing is especially critical as the US government has been issuing tax cuts to attract funds," he said.

Residency has become another issue. Foreigners who work in China haven't been taxed on global income unless they spend the full year in the mainland, so many travel a few days to lower-tax places such as Hong Kong. They also haven't had to pay that tax until they've lived continuously in China for five years. But China announced that starting January next year it would tax individuals based on their global income if they resided in the country for 183 days or more, without mentioning the five-year grace period.

"The 183-day tax limit is prompting entrepreneurs and VC investors alike to re-consider how long they can stay in China," said GGV's Lee. "It could present challenges for tech companies when they try to hire talent." Jason Mi, a Beijing-based tax partner at Ernst & Young, expects the country to soon come out with more clarity and says the new updates should be positive for the industry as a whole.

"At least now people are expecting China to put down these tax policies in writing and that would make things much clearer," said Mr Mi. "We expect the country to continue its support for the tech and innovative sectors." BLOOMBERG

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