It was a busy day for Sarina when the news came that China and the United States had reached agreement on eliminating China's value-added tax (VAT) rebate policy on the semiconductor industry.

As a spokeswoman of the Shanghai-based Semiconductor Manufacturing International Corp (SMIC), she must ascertain the consequences of every policy change of the Chinese Government on the biggest semiconductor manufacturing company in China.

At the same time, she was also busy answering calls from the press on the impact of the July 9 agreement on SMIC.

SMIC is only one of the many semiconductor companies in China, the United States, Europe and Japan, which are interested in the development of the China-US talks and who will be affected by the agreement.

Not only a trade dispute

The story started with Circular Number 18 of the State Council, the Chinese cabinet, in 2000.

The regulation, with the aim of encouraging development of software and semiconductor industries, says that if the VAT burden for semiconductor firms exceeds 6 per cent, companies will have taxes over 6 per cent rebated until 2010. The VAT tax rate for both domestically-made and imported semiconductor products is 17 per cent.

In September, 2001, China stepped up encouraging policies for the industry and the highest tax burden was set at 3 per cent.

At the same time, many overseas investors including SMIC, Taiwan Semiconductor Manufacturing Corp, US giant Intel and South Korean firm LG began to build semi-conductor plants in China because of the fast growth of the Chinese market, low costs and support of the government.

Although it is still hard to prove there is a direct connection between the VAT policy and the tide of investment, the tax rebate policy raised an outcry in the United States, Japan and the European Union (EU) for discriminating against imported products and setting import barriers.

The Semiconductor Industry Association (SIA), a leading US industrial organization with 90 members, urged the US Government to take action to ask the Chinese side to eliminate the tax rebate policy.

"Foreign producers will continue to face significant disadvantages as China's production capacity ramps up, if they are subject to 14 per cent more in the World Trade Organization (WTO)-inconsistent value-added taxes than local producers," said George Scalise, president of SIA, in a statement in December 2002.

The World Semiconductor Council, comprising major industrial organizations, also urged its members to submit recommendations to their own governments to press China to give up the policy at its seventh annual meeting in Nice, France, in May 2003.

After several rounds of talks, the United States filed its first complaint to the WTO against China about the VAT issue in March, which was soon followed by Japan and EU.

Finally, China and the United States signed an agreement on July 14.

China promised to adjust the tax rebate policy and eliminate the "rebate after collection" policy on semiconductor products from April, 2005.

Semiconductor products, designed in China, manufactured overseas and then imported, from October 1 will no longer enjoy the tax rebate policy.

The US side will also withdraw its complaint filed with the WTO.

However, Yang Xueming, a senior consultant to the China Centre for Information Industry Development (CCID), says that the semiconductor VAT dispute is not only a trade war, although the United States said exports to China reached US$2.02 billion in 2003.

"The main purpose of the US side is to suppress China's production capabilities and ownership of technologies," said Yang.

Semiconductors, widely used in electronic and telecommunications devices from TV sets to computers to mobile phones, is regarded as the soul of the information industry and great importance is attached to them by governments of major industrial powers in the world.

Yang, who also helped draft Circular Number 18, said that in a time of peace, a developed semiconductor industry helps a country attain huge profits, while it controls and destroys enemies at war, so it is an industry of strategic importance.

The United States is almost the only country among the 33-nation Wassenaar Arrangement formed in 1996 with an aim to prevent the spread of arms, dual-use goods and technologies to have strict restrictions on exports of advanced semiconductor equipment and materials to China.

Despite that, China has become one of the fastest growing semiconductor markets in the world.

According to CCID Consulting Co Ltd, a market research house of the CCID, the semiconductor market grew from 55 billion yuan (US$6.64 billion) in 1999 to 207.4 billion yuan (US$25 billion) in 2003.

Seeing the huge potential of the market, more and more international investors began to build semiconductor plants and design companies in China.

CCID's Yang pointed out that with China becoming the world's largest TV set and mobile phone maker and the third largest computer market, semiconductor makers were also required to build local factories to supply their customers in China.

A strategic change

There is a feeling of victory over the tax rebate issue on the US side, but Chinese executives and experts say they believe its impact was not very significant and it might lead to a strategic change of the country's direction in the development of its semiconductor industry.

CCID's Yang explained the US confuses the concepts between tax rate and tax burden, which is the result of the actual tax divided by a company's total sales.

There are only few beneficiaries of that policy in the country.

Mo Dawei, a senior industrial expert, said that according to a survey conducted by official agencies before Circular Number 18, the tax burden for domestic semiconductor companies was about 6 per cent, so they would get 3 per cent of VAT rebates in average.

Considering the US$4.6 billion semiconductor output value in 2003, the tax rebates were only US$138 million, which is insignificant to many semiconductor companies in China.

Richard Chang, chief executive officer with SMIC, estimated that the elimination of the tax rebate policy would cause US$1.7 million of losses for his company this year, as compared with US$221 million of revenues of SMIC in the second quarter.

The company said in a statement: "The elimination of the VAT rebate will not materially impact SMIC's financial performance and its ability to compete in the global semiconductor market."

Mo said the elimination of VAT rebates might have bigger impacts on integrated circuit (IC) design companies, which are smaller in size and more vulnerable to policy changes.

However, according to the venture capital (VC) industry research company Zero2ipo.com Ltd, in the first half of this year, IC design became the hottest sector for VC firms and attracted US$125 million of investment, which has shown investors' expectations for the sector.

Yang with CCID said China could use the opportunity to make a strategic change in its policies on the development of the semiconductor industry.

"Enterprises won't lose anything in the adjustment, because the support from the government will be more aggressive under the principles of the WTO," he said.

With the developing of production capacities in China, Yang said he believed the country should give more support to semiconductor companies' research and development to help them upgrade their technologies.

Although several government agencies such as MII and the Ministry of Science and Technology have funds for upgrading in high-tech areas, it is necessary for the government to set up a special fund for the semiconductor industry, as a reward to the companies who spend a lot on research and development.

Liang Sheng, electronics and information development division chief of the Bureau of Industrial Development with the Beijing