Chinese people are wondering what to invest in Mauritius after a recent investment promotion in China by the small island country in the southwest Indian Ocean. But insiders know there is competition among tax havens for large amounts of offshore Chinese investment.

"Mauritius offers preferential conditions, better than the Virgin Islands," said Mei Xinyu, an expert on offshore investment from the Chinese Academy of International Trade and Economic Cooperation.

The British Virgin Islands is a major destination for China's offshore investment.

The 153-square-kilometre Virgin Islands are dotted with about 500,000 companies, among which 10,000 are from China.

Most China-originated money entering tax havens will re-enter China as "foreign investment," which is called "round tripping," Mei says.

Such money could be from State and privately owned mainland firms, Chinese individuals or mainland-based Hong Kong, Taiwan and foreign firms recycling earnings from their mainland operations.

Their overseas vehicles are typically holding companies that have no operating assets, except their mainland-registered ventures.

A closer examination of China's star foreign direct investment (FDI) figures reveal a large amount of capital going out of the country and returning under a different guise, Mei said.

The World Bank and other experts have estimated the scale of this round tripping could be as large as 20 per cent to 30 per cent of the total FDI inflow into China, but there is no clear definition and detailed estimation method behind the numbers.

Hong Kong is the most popular stop for such outflow, followed by the three financial havens of the British Virgin Islands, the Cayman Islands and Samoa. In 2003, Hong Kong took US$17.72 billion of the mainland's US$53.5 billion in utilized FDI. The Virgin Islands was the second largest source of FDI in China, with US$5.78 billion. The two other havens ranked eighth and ninth on the list.

Given their important places in China's FDI inflow, Mei said there are worries that stricter regulation on these tax havens by the European Union (EU) will hamper the flow to China because of the increased inconvenience to the two major sources.

But Mei said the round-tripping investment will find other places outside the EU, such as Mauritius.

"What should be a worry is the uncertainty caused by the round-tripping investment to China's financial system and the distortion to FDI utilization," Mei said.

There are political, taxation and other commercial reasons for such a merry-go-round of China-originated money. Some are legitimate, others clandestine.

Multinationals, for example, have been using offshore financial havens for years to protect and maximize profits from their mainland investments.

Mei said the round-tripping money of foreign multinationals is common in other places besides China.

"What is not normal is the unusually large volume of unrecorded domestic capital in and out of China, which distorts its FDI figures," he said.

Even worse is that the trend is growing bigger, Mei said.

An official from a company specialized in registering offshore investment, who declined to be named, said the amount has been larger in the last five years given the company's business increased by an average of 70 per cent in recent years.

"Offshore tax havens have been favorite locations for round tripping vehicles used for investing in China. I do not see the pattern changing," he said.

There are many established channels to do this, he said, despite the government's continuing tight control on foreign exchange.

A typical offshore structure that his firm arranges for his clients consists of a parent firm, a Hong Kong company registered in an offshore jurisdiction and a mainland operation.

The most common way to take the money out of the Chinese mainland is to overstate the value of exports and understate that of imports, a practice known as transfer pricing, he said.

In southern China, such offshore payment has become widespread and increasingly sophisticated. There are professional money brokers, underground cashiers and so-called cellphone banks that will respond promptly to requests for cash with just a phone call, he said.

Mei said there was no immediate and radical way to stop the unusual flow because the government has many objects to balance in trying to do so. He said the government should try to weaken them after finding the motivations behind the round tripping.

The biggest pay-off for recycling mainland-originated money through a web of companies offshore is the tax concessions that China grants to foreign firms, which are subject to a corporate tax rate of 17 per cent, half the 33 per cent imposed on domestic firms, Mei said.

Foreign enterprises also enjoy two years of tax holidays after turning profitable and another tax reduction of 50 per cent for the subsequent three years.

"China is the only major country that offers such generous tax concessions to foreign investors. It is much more profitable to have a foreign flag than a Chinese one for a mainland-based factory," said Mei.

Under the World Trade Organization (WTO) accord, China is supposed to end such preferential treatment of foreign companies but analysts say this is not going to happen soon.

Many experts have suggested foreign-funded enterprises that have for years enjoyed preferential tax incentives should eventually be treated the same as domestic firms for fair treatment.

But the problem is not only for fairness, Mei said. These activities created a distorted flow in FDI and influenced the effectiveness and official management of China's FDI utilization.

And the risks brought to the financial system could not be neglected, he said.

But the government is still hesitating on moves towards a unified tax system and is calculating gains and losses.

China's economic interests, roughly interpreted as high economic growth and low unemployment, have never before been bound so closely to the country's performance in attracting foreign investment.

But Mei said the government should do something as soon as possible, before the round-tripping money takes a major role part in China's FDI flow.

He said the government can go between the current tax rate and increase that for foreign investment or decrease that of domestic companies.

"That will make the round tripping less profitable," he said.

Mei said the tax change would inevitably sway foreign investors but would have a negligible impact on most of them seeking entry to China's vast market.

And China still has comparative advantages in low-cost labour and a massive domestic market.

Mei said the recent government's move to open the second board would also help weaken the motivation of round tripping.

Small and private Chinese firms have a problem getting listed on the domestic stock market, which favors state-owned enterprises, and they go overseas for funding.

To do so, they set up a shell company offshore to control their mainland assets and then list the shell abroad.

Many private Chinese firms have been listed on Hong Kong's second board Growth Enterprise Market in this way.

For example, Sina.com, China's best-known Internet content provider, has a parent based in the Cayman Islands, a mainland firm that operates the website and a mainland subsidiary of the Cayman parent that provides the Chinese operator with various services. Sina.com listed its Cayman Islands parent on the NASDAQ in 2000, something it could not do if it did not have an offshore vehicle.

"It is a demanding job to deal with the round-tripping money. But if the government cannot stop it, they should at least keep it at an acceptable level," Mei said.

The Ministry of Commerce set up a statistical analysis of China's outward investment this year. Ministry officials say they expect to get a complete idea on how much and where the money goes.

(China Daily June 22, 2004)