The U.S. semiconductor industry is accusing China of unfair trade practices, saying the country's 17 percent value-added tax (VAT) violates World Trade Organization rules by discriminating against foreign chip makers.

In a report released last week, the Semiconductor Industry Association (SIA) criticized China for using the VAT as a way of luring multibillion-dollar investments in semiconductor facilities that might have otherwise gone elsewhere, such as the United States. The SIA also charged that the VAT gives local design houses an unfair advantage over foreign IC designers.

"High-end Chinese foundries will have no reason to operate fabs in China if their VAT break is rescinded," the report states. The VAT affords an inequitable advantage, the SIA claims, in that the Chinese can import "expensive new equipment that is not depreciated. It would not be economical for these companies to purchase and maintain such equipment if they did not have the tax break."

China has enacted a series of incentives intended to speed the development of its semiconductor industry. Tax holidays; cheap land, electricity and water; science parks with lower tax rates; and cash incentives for returning Chinese tech workers are commonplace. To varying degrees, these practices can be found outside of China as well, most notably in Taiwan.

While the SIA acknowledged such breaks were hard for the United States to match, it did not overtly oppose them, because they have also been used by other countries. But the 17 percent VAT tax is unique to China and appears to violate free-trade practices, the SIA says.

WTO restriction

Global trade rules "prohibit a WTO member country from engaging in activity that treats domestic producers and products more favorably than imported products," said George Scalise, president of the SIA. "The SIA has discussed this matter on several occasions with the U.S. government and the Chinese government and industry. We will continue to raise this issue and we're hopeful it can be resolved quickly and amicably."

At meetings in Beijing last week, Commerce Secretary Donald Evans pressed Chinese officials to open their markets to U.S. companies. China has initiated one reform, allowing foreign companies to set up wholly owned subsidiaries there, beginning this month.

Under pressure from U.S. manufacturers and the high-tech sector, the Bush administration wants China to speed economic reforms required under WTO rules. The manufacturing issue is also creeping to the top of the agenda in next year's presidential election.

Evans stressed in several speeches that U.S. patience with Beijing is wearing thin. While not addressing specific issues like the VAT, Evans did say that "China needs to create an economic system that is more transparent, and one that allows capital to flow freely in response to market forces." VAT critics in the United States charge that the rebate distorts investment.

Since its entrance into the WTO, China has mostly done away with import tariffs on finished semiconductors. However, it levies the VAT against all chips sold in China. But local chip makers and designers are entitled to a rebate that effectively lowers the tax to either 3 percent or 6 percent. This is the focus of the SIA's ire.

In discussions with Zhao Jianzhong, general secretary of the Shanghai Integrated Circuit Industry Association, the SIA seemed to find little hope that China will change its VAT policy any time soon. According to the SIA, Zhao said, "If imported chips are also granted VAT rebates, then high-end products will flow in one by another, attacking the Chinese market and creating the disaster of all disasters for the design industry."

At the moment, however, the VAT rebate favors chip manufacturers more than designers. Theoretically, the tax is supposed to drop from 17 percent to 6 percent for chips made in China. It drops to 3 percent if those chips are also designed in China.

In practice, the VAT's application has other problems, too. The tax is interpreted differently from province to province, meaning that some officials may reject claims for a rebate. Even China-based foundries need to negotiate with the government on behalf of their clients, because it is the manufacturer that will receive the rebate, not the client.

Moreover, if a rebate is approved, it can take months or years before an actual refund is issued. It's also worth noting that many of the chips imported into China are re-exported in finished products, meaning they are not necessarily subject to the VAT. This year, China's chip market is expected to top $27 billion in sales. More than 80 percent of those chips will be imported — and likely exported in finished goods, thereby avoiding the VAT. But as China's market grows, and more chips find their way into the local market, it's expected that the pressure will increase on Beijing to do away with the VAT.

At the moment the SIA is suggesting bilateral talks between the United States and China to resolve the problem. But if Beijing resists, a showdown in the WTO may be the next step.

"No one can argue that it isn't unfair," said Chris Hsieh, a semiconductor and China market analyst based in Taipei.

During a recent visit to Taiwan, Richard Hill, the chairman and chief executive officer of U.S. semiconductor equipment maker Novellus Systems Inc., said that as long as there are barriers for nondomestic suppliers, plus value-added tax incentives as well as income tax incentives to manufacturers who locate in China, "we will see a preponderance of the investment continue to move there."