CHINA’S GLOBAL TRADE 

BALANCE DISCREPANCY:

HONG KONG ENTREPÔT EFFECTS AND ROUNDTRIPPING CHINESE CAPITAL 

Yanchun Liu 

Matthew M. Kemper 

Dr. Patrick Magrath 

GEORGETOWN ECONOMIC SERVICES, LLC 

Craig R. Giesze, Esq 

CRG CONSULTING TEXAS, INC. September 12, 2008
 

Copyright © 2008 by The Trade Lawyers Advisory Group LLC 

This project is funded by a grant from the U.S. Small Business Administration (SBA). 

SBA's funding should not be construed as an endorsement of any products, opinions or 

services. All SBA-funded projects are extended to the public on a nondiscriminatory basis. 
TABLE OF CONTENTS

Page

-iI. EXECUTIVE SUMMARY...........................................................................1 

A. Purpose of this Study .....................................................................1 

B. Round-trip Capital—An Under-emphasized Cause of 

Chinese Trade Balance Discrepancy .............................................3 

C. Empirical Findings and General Conclusions.................................5 

II. OVERVIEW OF THE CHINA-HONG KONG ENTREPÔT 

EFFECTS ON THE PRC’S GLOBAL TRADE SURPLUS .........................6 

III. SUMMARY OF TRADITIONAL EXPLANATIONS ON CHINA’S

TRADE DISCPREPANCY.......................................................................17 

IV. SUMMARY OF THE APPLICABLE RESEARCH METHODOLOGY.......24 

V. HONG KONG’S POLITICAL, LEGAL, AND ECONOMIC 

STRUCTURE THAT FACILITATES ENTREPÔT TRADE AND 

“ROUND-TRIPPING” PRACTICES .........................................................26 

A. Hong Kong’s Political, Legal, and Economic History and 

Policy............................................................................................26 

B. Hong Kong’s Favorable Tax Regime............................................28 

C. Unique Mainland and Hong Kong Bilateral Trade and Tax 

Relationship..................................................................................30 

1. 2004 Hong Kong-China Free Trade Agreement ................30 

2. 2007 Hong Kong-China Bilateral Tax Treaty .....................31 

VI. TRADITIONAL EXPLANATIONS TO RECONCILE THE CHINESE 

STATISTICAL BALANCE-OF-TRADE DISCREPANCY: CURRENT 

ACCOUNT ANALYSIS............................................................................35 

A. China-Hong Kong Entrepôt Trade ................................................35 

1. Definition of Hong Kong’s Re-Export Trade and its 

Impact on China’s Merchandise Trade Balance ................35 

2. Rationale that Warrants Making Data Adjustments to 

Reconcile Official Aggregate Chinese Export-andImport Statistics, Official Hong Kong Government 

Data, and Official Aggregate Statistics of China’s 

Trading Partners................................................................36 

B. Adjustments to Reconcile Inaccurate Chinese Trade 

Statistics Caused in Part by the Hong Kong Re-Export Trade 

Phenomenon: Misattribution of Trade; Under-Counting; 

Double-Counting; Middleman Mark-Ups; and Inconsistent 

Valuation of Exports and Imports..................................................38 
TABLE OF CONTENTS

(continued) 

Page

-ii1. Volume and Middleman Mark-up Adjustments ..................38 

a. China’s Trade with the Rest of the World: 

Inbound-Import Transactions ..................................38 

b. China’s Trade with the Rest of the World: 

Outbound-Export Transactions ...............................39 

c. China’s Global Merchandise Trade Surplus as 

Adjusted for Indirect Hong Kong Re-Export 

Trade.......................................................................40 

2. Adjustments to Reconcile Inconsistent Customs 

Standards Employed Internationally to Value Exports

and Imports........................................................................42 

C. “Phantom” Chinese Exports and Imports......................................43 

D. Third-Country Transshipment or False Invoicing of Chinese 

Products .......................................................................................45 

E. Smuggling ....................................................................................46 

F. Timing of Exports and Imports......................................................46 

G. Geographic Coverage Inconsistencies.........................................47 

H. Misclassification of Goods............................................................47 

I. Exchange Rate Fluctuations.........................................................48 

J. Conventional Errors and Omissions .............................................48 

VII. INTEGRATED CURRENT ACCOUNT AND CAPITAL ACCOUNT

ANALYSIS – ROUND-TRIPPING: A COMPREHENSIVE 

EXPLANATION TO RECONCILE THE CHINESE STATISTICAL 

BALANCE-OF-TRADE DISCREPENCIES..............................................49 

A. Background ..................................................................................49 

B. Economic and Legal Incentives that Trigger Round-Tripping 

of Chinese Capital Through Hong Kong and Other Offshore 

Tax Havens ..................................................................................51 

1. Transfer-Pricing Practices and Offshore Tax Havens........52 

2. Trade and Investment Barriers on the Mainland................54 

3. Chinese Tax and Investment Incentives that 

Heretofore Discriminated in Favor of Foreign Direct

Investment .........................................................................55 

C. Data Analysis that Corroborates Chinese Round-Tripping 

Practices.......................................................................................57 
TABLE OF CONTENTS

(continued) 

Page

-iiiD. Current Account Implications of China’s Round-Tripping 

Practices.......................................................................................61 

E. China Round-Tripping Practices in the Future..............................66 

1. Factors that May Diminish the Incidence of PRC 

Round-Tripping Activities in the Short Term ......................66 

2. Factors That May Encourage Chinese RoundTripping Practices in the Short Term .................................69 

VIII. RESEARCH FINDINGS AND CONCLUSION.........................................71 
1

I. EXECUTIVE SUMMARY 

A. Purpose of this Study 

The U.S.-China Security Review Commission and the United States Congress, 

commissioned the Trade Lawyers Advisory Group (“TLAG”) -- specifically, members CRG 

Consulting Texas, Inc. (“CRG-Texas”) and Georgetown Economic Services LLC (“GES”) – to 

undertake a comprehensive study of the persistent and growing discrepancy in the trade balance 

data of the People’s Republic of China (“China,” the “Mainland,” or the “PRC”) and the data 

reported monthly by trade partner governments. The purpose of this study is to examine the role 

of Hong Kong in the various explanations of the statistical discrepancies that readily emerge 

when one compares official Chinese trade data with those of its trading partners. 

Today, many international scholars and researchers are of the view that China’s entrepôt

trade through Hong Kong is to the largest factor responsible for the widening Chinese trade 

balance discrepancy. The distortion becomes apparent after one examines China’s official trade 

statistics in light of the corresponding “mirror” trade data compiled by its partner nations. In other

words, a comparison of export statistics recorded by the Chinese customs authority and the 

corresponding import data published by China’s trading partner countries reveals a significant 

and widening inconsistency over the past several years. Chinese export values, as recorded by 

Mainland authorities, are significantly lower than Chinese import values as reported by China’s 

trading partners. Similarly, Chinese exports values, as reported by Mainland authorities, are 

significantly higher than values of exports to China as published by China’s partner countries. 

Consequently, China's balance of trade (consistently in surplus), as determined by official 

Chinese government statistics, is substantially lower than the global trade surplus as reported by 

its trading partners. Specifically, based on the Global Trade Information Services database—

World Trade Atlas (“GTIS,” “GTA” or “WTA”), China’s trade-in-goods surplus that was reported by 

41 major trading partner countries (accounting for approximately 97 percent of total China trade) 

was US$554.2 billion in 2007. By contrast, Chinese trade surplus with the same 41 trading 

partner countries, as reported by China, was only US$234.8 billion during the same year -- a

US$319.4 billion discrepancy. Furthermore, this discrepancy has been trending upward during 
2

the period from 1999 to 2007, increasing in eight of the past nine years. The discrepancy has 

ranged from a low of US$90.8 billion in 1999 to a high of US$319.4 billion in 2007, thus more 

than tripling over the period. 

The reconciliation of this growing data discrepancy is essential for policymakers 

worldwide – not only to determine China’s true global trade surplus, but also to understand the 

unique role that Hong Kong has played with regard to China’s overall economic strategy. 

Therefore, the primary objective of this study is (i) to scrutinize the unique relationship between 

the Mainland and Hong Kong, and (ii) to attempt to explain the statistical discrepancies that 

distort China’s official trade data. 

The initial hypothesis that our team sought to prove or disprove was that China’s entrepôt

re-export trade through Hong Kong – that is, China’s indirect export and import trade undertaken 

through the former British territory – constitutes the major trade factor that accounts for the 

statistical discrepancy and distortion summarized above. To test this hypothesis, we first 

analyzed various economic studies that had examined this issue during the past 25 years 

together with the underlying data, and determined that not all of the data discrepancies could be 

explained by each of those individual studies. We then carefully reviewed all of the relevant legal 

modifications, including international treaties and conventions that China and Hong Kong have 

enacted and ratified during the past decade, to try to identify additional explanations for the 

discrepancy. 

Next, we collected our own data through an internationally-recognized source (e.g., 

Global Trade Information Services) and conducted our own field studies with U.S., Chinese, and 

Hong Kong customs officials in the U.S., Hong Kong, Beijing, China, and Qinhuangdao City, 

China. With regard to China’s entrepôt trade through Hong Kong, we obtained contemporaneous 

estimates of Hong Kong re-export “middlemen” markups and applied such markups to the most 

recently available data to reconcile in part China’s reported trade statistics. Finally, we performed 

our own independent statistical analyses. 

Based on these multiple criteria, our team rejected the Hong Kong re-export trade 

hypothesis as the only major explanation accounting for the growing trade data inconsistency 
3

highlighted above. The compelling factor supporting our conclusion is that China’s indirect export 

and import trade through Hong Kong represented only 18 percent of China’s aggregate 

multilateral trade with the 41 trading partner countries in 2007, a significant decrease from the 60 

percent figure that prevailed approximately two decades ago. It is noteworthy that the 18 percent 

is calculated using China’s total trade volume reported by 41 trading partner countries. Along the 

same calculation basis, the proportion of Hong Kong re-export trade to China’s total trade with its 

trading partner countries had seen a gradual decrease, from 36 percent in 1999 to around 19 

percent in 2006. In other words, even though the China-Hong Kong entrepôt effect is still 

responsible for a share of the statistical discrepancy at issue, that factor cannot by itself constitute 

an exclusive reason for the data discrepancies, based on contemporaneous Chinese trade flows. 

Furthermore, the recent appreciation of the Chinese currency, the renminbi, the rise of material 

costs, and increase in labor costs due to passage of the new labor law on January 1, 2008, all 

have serious negative impacts on Hong Kong middleman companies’ business with the Mainland. 

For these reasons it is likely that Hong Kong’s role in the Chinese trade surplus discrepancy may 

continue to decline in the future. 

B. Round-trip Capital—An Under-emphasized Cause of Chinese Trade 

Balance Discrepancy 

Although China’s entrepôt trade through the former British colony has decreased 

substantially during the past 20 years, the statistical discrepancy explained above has been 

steadily increasing during this same period. As a result, our team had to search for alternative 

hypotheses to identify and explain the real cause or causes underlying the data problem. Based 

on our integrated analysis of China’s current-account and capital-account transactions, we 

hypothesize that a phenomenon referred to as “round-tripping” is principally responsible for the 

bulk of the trade data incompatibilities highlighted above. 

“Round-tripping” is a trade-tax-investment strategy whereby Chinese enterprises 

undervalue exports or artificially overvalue imports, in order to move Chinese capital across the 

Mainland border through current-account transactions. Specifically, Chinese enterprises export 

domestic capital from the Mainland to related-party enterprises situated outside China in offshore 

tax havens, such as Hong Kong, pursuant to non-arm’s length transfer-pricing transactions that 
4

are designed to circumvent Chinese capital controls. The exported Chinese domestic capital is 

then recycled abroad and returns to the Mainland in the form of foreign investment, and as such, 

receives a lower tax rate on profits. 

Three economic and legal elements should be in place to encourage round-tripping. First, 

investors from a tax jurisdiction such as China must have access to a foreign tax haven through 

which they can establish related-party companies with which to engage in non-arm’s length 

transfer-pricing transactions. Second, the primary tax jurisdiction must have trade and investment 

barriers that significantly impede and discriminate against domestic investment. Third, the primary 

jurisdiction must have on the books tax or other incentives that discriminate in favor of foreign 

investment. The China-Hong Kong relationship satisfies all of these elements. 

Even though Hong Kong is not a de jure tax haven, international practitioners universally

consider the former British colony to constitute a de facto tax haven for the following reasons: (i)

its relatively low corporate income-tax rate of only 17.5 percent; (ii) the taxation of only Hong 

Kong-source income; (iii) an extremely tax-friendly territorial principle that is flexibly applied to 

rather loose and relaxed residency and income-sourcing criteria; (iv) the notable absence of 

taxes on such traditional income items as capital gains, dividends, and retained earnings; and (v) 

statutory provisions that allow taxpayers to carry forward losses indefinitely. Significantly, despite

the People’s Republic of China’s sovereignty over the island, Hong Kong does not even form part 

of the customs or tax territories of the PRC. Rather, Hong Kong constitutes a separate “foreign 

customs territory,” as well as a distinct “foreign fiscal territory,” situated within China’s national

geographic territory. 

Under the “One Country, Two Systems” legal-and-economic framework, Hong Kong 

becomes an ideal destination for Mainland investments, governed by the series of Mainland-Hong 

Kong bilateral treaties. The Mainland has imposed a strict foreign currency control policy, which 

results in significant obstacles to the free flow of capital across the border of China. On the other 

hand, local governments in China have a strong incentive for soliciting foreign direct investments 

and have issued a set of favorable policies for these foreign investments (e.g., reduced corporate 

tax rate for foreign invested enterprises). It is noteworthy that effective as of January 1, 2008, the
5

new corporate taxation law of the Mainland eliminates the gap between the domestic and foreign 

corporate tax rates. Therefore, the adjacent geographical location of Hong Kong, the particular 

institutional setting of the Mainland on foreign investment, and the Mainland’s foreign currency 

exchange controls provide an ideal environment for round-tripping capital. One bit of evidence is 

the relatively high and stable proportion of Chinese FDI that originates in Hong Kong: from 1999 

to 2006, Hong Kong investments had accounted for at least 33% of China’s total FDI. 

In the practice of round-tripping, Mainland enterprises export Chinese capital through 

current-account transactions that artificially inflate the value of imported components sourced 

from affiliated enterprises located in offshore tax havens, such as Hong Kong. As explained 

above, the second economic and legal element that facilitates round-tripping practices comprises 

trade and investment barriers that actively impede and discriminate against domestic investment

in the primary tax jurisdiction. China’s capital controls, inadequate protection of private property, 

and overall lack of domestic bank credit constitute such restrictive impediments. 

Yet, to ensure that private Chinese domestic invested enterprises and foreign invested 

enterprises (“FIEs”) operating on the Mainland receive adequate financial credit and resources to 

prosper and expand under such circumstances, Chinese authorities can simply direct such 

entrepreneurs to Hong Kong, one of the world’s leading international financial centers, a ready 

offshore source for needed financial credit and capital. In fact, the recently-ratified Hong KongChina bilateral free-trade agreement and bilateral tax convention mentioned above actively 

encourage Chinese domestic and FIE investors to obtain financing in the Chinese Special 

Administrative Region (“SAR”). As Beijing’s seventh Special Economic Zone (“SEZ”) on a de 

facto basis, Hong Kong plays the indispensable role of the Mainland’s offshore international 

financial and banking magnet. 

C. Empirical Findings and General Conclusions 

By virtue of the integrated statistical reconciliation process carried out in this study that 

performs all pertinent trade data adjustments, including that for Chinese round-tripping activities, 

we are able to draw the following general conclusions concerning the China-Hong Kong entrepôt

effect and its overall impact on the PRC’s global merchandise trade surplus. In 2007, the 
6

individual causes underlying the growing statistical discrepancy that distorts official Chinese trade 

data break down as follows: (i) China-Hong Kong entrepôt effect – that is, Hong Kong’s re-export 

trade and middleman markups; (ii) divergent customs standards used internationally to value 

exports and imports; (iii) “phantom” Chinese exports-imports; (iv) round-tripping of Chinese 

capital recycled abroad in foreign tax havens (e.g., Hong Kong) that subsequently returns to the 

mainland disguised as foreign investment (of which Hong Kong comprised 36% of total FDI in 

2006); (v) smuggling; and (vi) residual discrepancy due to other factors such as statistical errors 

and omissions, servicing trade, timing of imports and exports, etc. 

The Sino round-tripping practices and capital-flight activities carried out through Hong 

Kong comprise a major factor that not only contributes to divergent private savings and 

investment levels in the Mainland and the rest of the world, but also is a major facto in the 

understated current-account surplus.

The trade data and capital-flow discrepancies evaluated in this study have implications 

that run deeper than simple statistical errors and omissions. China’s entrepôt trade, roundtripping practices, and capital-flight activities -- a great majority of which are carried out through

Hong Kong -- have contributed to negative trade consequences in the rest of the world, including 

in the United States, by masking the effects of the PRC’s mercantilist trade policies. 

II. OVERVIEW OF THE CHINA-HONG KONG ENTREPÔT EFFECTS ON 

THE PRC’S GLOBAL TRADE SURPLUS 

The reunification of Hong Kong with China in 1997,1 the PRC’s subsequent accession to 

the WTO in 2001, the ensuing implementation of the Hong Kong-China free trade agreement in 

2004, and the effective ratification of the Hong Kong-Sino bilateral tax treaty in 2007 have all 

contributed to an unprecedented growth in trade and capital flows between the Mainland and the 

former British colony (see Graph 1 and Graph 2). As a free port not levying any import duties or 

customs tariffs, Hong Kong also establishes its trade-promoting taxation regime without value 

added taxes or general servicing tax. Other characteristics of the free port are manifested in the 

free inflow and outflow of international financial capital, in direct contrast to the tight foreign 

exchange controls of the Mainland. All these factors mentioned above jointly contribute to the 
7

proliferation of the so called entrepôt trade activities between Hong Kong and China, which have 

been widely recognized by academians as the major cause of the dramatic trade surplus 

discrepancy between China and its trading partner countries (see Graphs 3 & 4). As stated by 

Feenstra, Hai, Woo, and Yao one decade ago, “[t]he official trade statistics of the United States 

and China have huge discrepancies.”2 “Much of the difference is due to...the different treatment 

of Hong Kong’s entrepôt trade by the two sides.” 3

 

GRAPH 1 

Chinese Exports to Hong Kong

 (in billions of dollars)

0.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

160.00

180.00

1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

Export Value

Source: GTIS, World Trade Atlas, as reported by Hong Kong 
8

GRAPH 2 

0

20

40

60

80

100

120

140

160

180

Import Value

1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

Chinese Imports from Hong Kong

(in billions of dollars)

Source: GTIS, World Trade Atlas, as reported by Hong Kong 

GRAPH 3 

0

50

100

150

200

250

Re-export Value

1999 2001 2003 2005 2007

Year

HK Re-export Value without 

Adjusting for Middleman Markups

(in billions of dollars)

"HK Re-export to China"

"HK Re-export from China"

Source: World Trade Atlas, as reported by Hong Kong. 
9

GRAPH 4 

HK Re-export after Adjusting for 

Middleman Markups

(in billions of dollars)

0

20

40

60

80

100

120

140

160

180

1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

Re-export Value

"HK Re-export to China"

"HK Re-export from China"

Source: World Trade Atlas, as reported by Hong Kong. 

Besides the significant magnitude and scale of Hong Kong entrepôt trade, another 

feature of Hong Kong’s re-export of goods from China is the related party transactions between 

Hong Kong companies and Mainland companies. In many cases the Hong Kong middleman 

companies are not independent from their suppliers in the Mainland. In fact, most related 

suppliers locate their manufacturing bases in Guangdong province due to its geographical 

adjacency to Hong Kong. The close relationship between the middleman companies and their 

Mainland suppliers justifies their collection of premiums (in the form of markups) for their ability to 

deal with the complicated institutional environment and other cultural barriers of China. As will be 

discussed in greater depth later in this paper, such related-party relationships also make it simple 

for transfer-pricing practices to occur that take advantage of Hong Kong’s low corporate taxation 

rates. 

Today, “indirect trade” through an entrepôt is a common phenomenon.4

 By 2005, Hong 

Kong -- the world’s largest entrepôt economy5

 with a population of only 6.8 million inhabitants -- 

had become China’s fourth leading trading partner and primary foreign investor after the 

European Union (“EU”), the United States, and Japan,

6

 and had emerged as the planet’s eighth 
10

largest trading economy overall.7 Globally, indirect trade has been increasing three times faster 

than world trade as a whole, rising from roughly 5 percent in the mid-1980s to approximately 17 

percent today.8 In addition to Hong Kong, roughly 30 other territories or countries are currently 

engaged in significant indirect entrepôt-trade activities, including Macau, Cyprus, Fiji, Senegal, 

Jordan, Armenia, Seychelles, Honduras, Benin, Montserrat, Singapore, Vietnam, and Indonesia.9

Some authors are even of the view that entrepôt economies are a major source of international 

tariff evasion.10

China’s well-documented entrepôt trade and capital flows through Hong Kong have 

engendered significant debate and research on account of the unique legal status of the former 

British territory vis-à-vis the Mainland. Although Hong Kong has been part of Chinese national 

territory since 1997, its customs and fiscal territories are legally separate and distinct from those 

of the PRC by strict operation of Chinese and Hong Kong law.11 In fact, the PRC’s current 

sovereignty over Hong Kong is exclusively limited to foreign policy and national defense matters. 

This “One Country, Two Systems” framework – which allows Hong Kong to act as a sovereign 

nation for all economic purposes -- will remain in effect until 2047. 

One link between entrepôt trade and the statistical trade discrepancy resides in the 

significant markups of goods by middleman companies located in Hong Kong for provision of 

services such as design, re-packaging, technological innovation, etc. China’s trading partner 

countries consider the value of goods from Hong Kong (including markup portions) as their 

imports from China, while no reconciliation or adjustment will be made on their trade statistics by 

either China or its trading partner countries for Hong Kong’s share. It is noteworthy that trade 

statistics of Hong Kong are compiled by several Hong Kong governmental agencies among which 

Trade & Industry Department and Census & Statistics Department represent the two major 

responsible agencies. However, as commented by officials from these two agencies, the sole 

purpose of Hong Kong trade statistics is for purely informational use. Neither agency shoulders 

responsibility to verify or corroborate transfer-pricing practices of Hong Kong trading companies 

or other similar trade-related issues such as the aforementioned round-tripping capital 

phenomenon. Actually, transfer-pricing practices are not explicitly forbidden in the Hong Kong 
11

trade regulations, nor is there any arm’s-length transaction consideration in trade statistics 

compilation by the Census & Statistics Department. 

GRAPH 5 

China Trade Surplus as Reported by China and Trading Partners

90.8

117.0

125.1

142.8

171.6

229.1

232.0

288.5

319.4

0

100

200

300

400

500

600

1999 2000 2001 2002 2003 2004 2005 2006 2007

Surplus in 

Billions of US Dollars

0.0

50.0

100.0

150.0

200.0

250.0

300.0

350.0

Discrepancy in 

Billions of US Dollars

As Reported by Partner

Countries

As Reported by China

*Surplus based on 41 trading partners 

that account for over 90% of total trade 

with China. Sources: China Customs and GTIS Global Trade Atlas

Both China’s entrepôt trade and capital flows through Hong Kong are responsible for the 

significant Chinese trade balance discrepancy. This distortion becomes apparent after one 

examines official PRC trade statistics in light of the corresponding data compiled by its trading 

partner nations (see Graph 5). A comparison of import and export statistics recorded by Mainland 

customs authorities and the analogous data published by China’s partner countries (i.e., World 

Trade Atlas database by Global Trade Information Services, Inc.) reveals a significant and 

growing discrepancy over the years (see Tables 1, 2, 3 & Graph 6). 
12

Table 1 Chinese Balance of Trade Reported by China 

Chinese Imports* Chinese Exports Chinese Surplus: 

1999 148,904,712,395 176,969,865,701 28,065,153,306

2000 194,243,182,887 225,166,296,661 30,923,113,774

2001 212,406,253,822 238,638,711,561 26,232,457,739

2002 258,674,549,135 290,563,563,192 31,889,014,057

2003 358,222,776,524 388,932,075,031 30,709,298,507

2004 479,510,654,448 526,386,206,320 46,875,551,872

2005 525,271,781,312 671,310,474,930 146,038,693,618

2006 659,500,473,067 835,570,759,763 176,070,286,696

2007 792,980,489,730 1,027,794,837,176 234,814,347,446

Source: GTIS, World Trade Atlas database 

Table 2 - Chinese Balance of Trade Reported by 41 Partner Countries 

Chinese Imports* Chinese Exports Chinese Surplus:

1999 104,517,543,045 223,409,694,886 118,892,151,841

2000 132,795,003,528 280,757,735,603 147,962,732,075

2001 143,273,888,619 294,650,582,343 151,376,693,724

2002 179,867,687,161 354,537,894,845 174,670,207,684

2003 256,917,468,233 459,234,934,795 202,317,466,563

2004 340,568,925,838 619,489,825,295 278,920,899,457

2005 402,137,392,933 777,248,188,137 375,110,795,204

2006 484,999,380,799 949,537,753,135 464,538,372,336

2007 587,237,693,828 1,141,444,693,736 554,206,999,908

Source: GTIS, World Trade Atlas database 

Table 3 - Chinese Balance of Trade Discrepancy 

Chinese Imports* Chinese Exports Chinese Surplus: 

1999 44,387,169,350 46,439,829,185 90,826,998,535

2000 61,448,179,359 55,591,438,942 117,039,618,301

2001 69,132,365,203 56,011,870,782 125,144,235,985

2002 78,806,861,974 63,974,331,653 142,781,193,627

2003 101,305,308,291 70,302,859,764 171,608,168,055

2004 138,941,728,610 93,103,618,975 232,045,347,586

2005 123,134,388,379 105,937,713,207 229,072,101,586

2006 174,501,092,268 113,966,993,372 288,468,085,640

2007 205,742,795,902 113,649,856,560 319,392,652,462

Source: GTIS, World Trade Atlas database 
13

GRAPH 6 

Total Discrepancy between China-reported and Trading Partner-reported 

Chinese Trade Surplus

0.0

50.0

100.0

150.0

200.0

250.0

300.0

350.0

1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

Billions of US Dollars

Sources: China Customs and GTIS Global Trade Atlas

Chinese export values, as recorded by China’s Customs General Administration 

(“Chinese Customs”), are significantly lower than Chinese export values as officially reported by 

the PRC’s trading partners, including the United States, Canada, and a majority of European 

countries.12 Similarly, a comparison of the import trade data published by Chinese Customs and 

those compiled by the customs authorities of the Mainland’s partner nations establishes that 

China-reported import values are significantly higher than Chinese import values as officially 

reported by the partner countries. 

Consequently, China's balance of trade appears to be substantially lower than its true 

global surplus. In fact, in each of the past nine years, China-reported trade data showed lower 

surpluses for the Mainland than the official statistics maintained by the PRC’s partner nations. 

Specifically, based on the trade figures appearing in the WTA, China’s trade-in-goods surplus to 

41 trading partner countries was US$554.2 billion in 2007, after adjusting for middleman markups 

and CIF/FOB variances. By contrast, official PRC statistics state that the Mainland’s surplus with 
14

these same countries was just US$234.8 billion for that year -- a US$319.4 billion discrepancy 

(See Table 4 & 5). 

Contrary to conventional wisdom, the main source of this widening statistical 

inconsistency – when China’s multilateral trade with the rest of the world is examined – occurs 

with westbound trade. In other words, the inconsistency is weighted more heavily on foreign 

goods that are imported into China, as opposed to eastbound trade in which Chinese goods are 

exported from the Mainland and imported by China’s partner countries, including the United 

States. WTA data for 2007 show that PRC imports (as shipped from the rest of the world to the 

Mainland) are responsible for roughly 64 percent of the statistical discrepancy described above, 

while Chinese exports (as shipped from the Mainland to the rest of the world) account for 

approximately 36 percent of the data inconsistency. For every year since 2000 through 2007, the 

discrepancy between China’s official trade statistics and those of its trading partners has weighed 

more heavily on the Chinese import side (westbound trade), rather than on the Chinese export 

(eastbound) side of the equation (see Graph 7). 
15

Annual 1999-2007

All Commodities

FOB Values in US Dollars

CHINA DATA (41 PARTNERS):

1999 2000 2001 2002 2003 2004 2005 

Chinese Imports* 148,904,712,395 194,243,182,887 212,406,253,822 258,674,549,135 358,222,776,524 479,510,654,448 525,271,781,3Chinese Exports 176,969,865,701 225,166,296,661 238,638,711,561 290,563,563,192 388,932,075,031 526,386,206,320 671,310,474,9Chinese Surplus: 28,065,153,306 30,923,113,774 26,232,457,739 31,889,014,057 30,709,298,507 46,875,551,872 146,038,693,6Source: GTIS Global Trade Atlas--Data Reported by China (See Table 5 for list of 41 partner countries).* Imports valued at CIF less 5% to approximate FOB values.41 PARTNER DATA:

1999 2000 2001 2002 2003 2004 2005 

Chinese Imports 104,517,543,045 132,795,003,528 143,273,888,619 179,867,687,161 256,917,468,233 340,568,925,838 402,137,392,9Chinese Exports* 223,409,694,886 280,757,735,603 294,650,582,343 354,537,894,845 459,234,934,795 619,489,825,295 777,248,188,Chinese Surplus: 118,892,151,841 147,962,732,075 151,376,693,724 174,670,207,684 202,317,466,563 278,920,899,457 375,110,795,2Source: GTIS Global Trade Atlas--Data Reported by Partner Countries (See Table 5 for list of 41 partner countries).* Exports (Partner-reported imports) valued at CIF less 5% to approximate FOB values.NOTE: (1) The adjustment for Hong Kong re-export trade was only required for data reported by the partner countries (Table 4B).

TABLE 4A: AS REPORTED BY CHINA FOR 41 PARTNER COUNTRIES

TABLE 4B: AS REPORTED BY 41 PARTNER COUNTRIES 

TABLE 4: CHINA'S BALANCE OF TRADE BASED UPON DATA FROM VARIOUS SOURCES USING 5% CIF/FOB DEFLATOR, ADJUSTED FOR HON
16

TABLE 5: LIST OF 41 PARTNER COUNTRIES

1 ) Argentina

2 ) Australia

3 ) Austria

4 ) Belgium

5 ) Brazil

6 ) Canada

7 ) Chile

8 ) Colombia

9 ) Denmark

10 ) Finland

11 ) France

12 ) Germany

13 ) Greece

14 ) Hong Kong

15 ) Iceland

16 ) Indonesia

17 ) Ireland

18 ) Italy

19 ) Japan

20 ) Luxembourg

21 ) Malaysia

22 ) Mexico

23 ) Netherlands

24 ) New Zealand

25 ) Norway

26 ) Peru

27 ) Philippines

28 ) Portugal

29 ) Russia

30 ) Singapore

31 ) South Africa

32 ) South Korea

33 ) Spain

34 ) Sri Lanka

35 ) Sweden

36 ) Switzerland

37 ) Taiwan

38 ) Thailand

39 ) Turkey

40 ) United Kingdom

41 ) United States
17

GRAPH 7 

China's Imports and Exports as a Percentage of Total Reported 

Discrepancy

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1999 2000 2001 2002 2003 2004 2005 2006 2007

Exports

Imports

Source: GTIS, World Trade Atlas. 

III. SUMMARY OF TRADITIONAL EXPLANATIONS ON CHINA’S TRADE 

DISCPREPANCY 

Dramatic annual discrepancies on the reported trade imbalances between the Chinese 

and the U.S. governments has paralleled the gradually increasing trans-border trade activities 

between the two countries since the mid-1980s. The scale of such a statistical discrepancy – first 

highlighted in the 1990s – is exhibited in both an upward trend in total volume of the bilateral 

trade as well as the actual gap between the trade surplus as reported by the two governments. A 

pair of numbers may better illustrate this story: from 1995 to 2007, the discrepancy on the 

reported trade surplus of China with the U.S. increased from US$24.4 billion to US$95.7 billion. 

Additionally, this almost fourfold jump was accompanied by an accelerating rate of increase. This 

topic, in the context of political economy considerations, evolves into a particularly prominent 

issue for policymakers from both countries. It would be undeniable that such an accelerating 
18

divergent measurement of a trade balance by two trading partners could lead to different 

viewpoints on the “fairness” of on-going bilateral trading practices. 

Studies on the significant difference in the bilateral trade imbalance between the two 

governments are not few in the current literature (e.g., Feenstra, Hai, Woo & Yao, 1998; Fung & 

Lau, 1999; Barton, 2000, Schindler & Beckett, 2005). Factors contributing to the discrepancy on 

which researchers have focused include indirect trade through Hong Kong – especially the 

markups by Hong Kong trading companies, and variances in measurement calibration on imports 

and exports (e.g., Feenstra & Hanson, 2002; Fung & Lau, 2003; Ferrantino & Wang, 2007; Martin, 

2007). Nonetheless, some studies (e.g., Tong, 2005; Fung, Lau & Xiong, 2006; Zhang, 2007, etc.) 

argued that the widening discrepancy in the trade surplus is also attributable to factors such as 

exclusion of servicing trade as well as intangible trade, underestimating false invoicing, 

transshipment, and the essence of Chinese exports as a “process and improvement” trade. The 

table below summarizes the main themes found in the current literature concerning the Sino-U.S. 

trade imbalance: 
19

Table 6 – Thematic Cross-Table for Sources of US-China Trade Imbalance Discrepancy Among the Curre

Indirect Trade 

through Hong 

Kong 

Hong Kong 

Price Markup 

Imports/Exports 

Measurement 

Discrepancies 

Exclusion of 

Servicing Trade

Exclusion of 

Intangible Trade 

Un

I

Tr

Zhang (2007) in Chinese X X X X X Feenstra, Hai, Woo & Yao (1998) 

X X 

Fung & Lau (1999) X X X X Customs Service (2000) 

Barton (2000) 

Bao (2000) X X X 

Zhou (2006) X X X 

SCIO (1997) X X X 

Schindler & Beckett (2005) X X 

USITC (1996) X X 

Martin (2007) X X 

Tong (2005) X X X X 

Ferrantino & Wang (2007) X X X 

Wang, Gehlhar, & Yao (2006) X X X 

Fung, Lau, & Xiong (2006) X X X X 

Fung & Lau (2003) X X X X 

Feenstra & Hanson (2002) X X X 
-20- 

Some researchers have posited alternative hypotheses to reconcile the growing 

statistical discrepancy outlined above: (i) the recording of export-and-import trade using 

inconsistent customs standards of valuation (e.g., FOB, FAS, CIF); (ii) so-called “phantom” 

Chinese goods exported to, and imported from, Hong Kong; (iii) transshipment (i.e., false 

invoicing) of Chinese merchandise traded through third countries; (iv) smuggling; (v) the timing of 

the recording of exports and imports; (vi) geographic-coverage inconsistencies (i.e., divergent 

definitions employed by China and the United States concerning the scope of the the U.S. 

customs territory); (vii) misclassification of goods; and (viii) exchange-rate fluctuations. None of 

these alternative theories adequately explains the significant and growing statistical discrepancy 

compiled above, however. 

The literature summary table shows that nearly all of the studies reviewed attribute the 

statistical discrepancy between Chinese and the U.S.-reporting agencies to the indirect trade 

between the two countries through Hong Kong (e.g., USITC, 1996; SCIO, 1997; Fung & Lau, 

1999, 2003; Zhou, 2006; Zhang, 2007). Hong Kong complicates the task of accounting for SinoU.S. trade practices by serving a twofold role: on the one hand, the ultimate destination country of 

re-exports through Hong Kong are not recorded by the original exporter country, whereas the 

importer country usually records such re-exported goods as from the correct origin; on the other 

hand, the importing and exporting businesses in Hong Kong usually add on additional value to 

the trans-border goods and charge the importer country a significant mark-up price. For example, 

Feenstra et al. (1998) concluded that proper adjustment for value-added in Hong Kong on 

China’s exports to the U.S. could on average reduce as much as 91 percent of the discrepancy 

between the two countries’ official estimates of the balance of trade. Hong Kong’s role as reexporter was recognized as “prominent” by Schindler and Beckett (2005) on the Sino-U.S. trade 

statistics issue. The authors argue that without appropriate identification of the impact of reexports from Hong Kong, the current reporting practices by both China and the U.S. may result in 

a misleading picture of the increasing trade deficit faced by the United States. Schindler and 

Beckett (2005) further contended that it is not the Chinese government’s deliberate 

undervaluation of its trade surplus that causes the sizable trade imbalance discrepancy, and this 
-21- 

study joins Feenstra (1998) in concluding that Hong Kong’s re-exports and markups eliminate a 

majority of such discrepancy. Another study by Tong (2005) estimated the Hong Kong re-export 

markups range from 20.5% in 1991 to 28.5% in 2000. Other studies (e.g., Fung, Lau & Xiong, 

2006; Zhou, 2006; Ferrantino & Wang, 2007, etc.) also included Hong Kong re-exports as a nonnegligible factor in their analyses and recognize that Hong Kong plays a major role in the SinoU.S. trade imbalance discrepancy. Furthermore, in accordance with the view of Mr. Osbert Wang 

and Ms. Freda Tung, Statisticians in the Trade Analysis Section of the Census and Statistics 

Department of Hong Kong, the Hong Kong middleman markup rate for imported goods from the 

Mainland is higher than that for imported goods from other regions. Specifically, the rate of the 

Mainland re-export margin is estimated to be as high as 20 percent, while U.S. re-exports to the 

Mainland, for example, only incur a markup of 2-3 percent on average, and at the most 5 

percent.13

Most studies in the current literature also resorted to technical explanations on the 

sizable trade imbalance discrepancy. It has been recognized that different countries do not 

necessarily use the same definitions on imports and exports. For example, valuation methods 

vary between China and the U.S. in that the former uses “free on board” (F.O.B.) and the “cost, 

insurance and freight” (C.I.F) for measurement of exports and imports, respectively, whereas the 

U.S. adopts “free along side” (F.A.S) for export valuation and a “customs value” for import 

valuation (Martin, 2007). Reconciliation is necessary to reveal the more accurate, if not possibly 

exact, trade imbalance between China and the U.S. For instance, Fung, Lau, and Xiong (2006) 

adjusted their estimates by conducting both the F.A.S. — F.O.B. and the C.I.F. — F.O.B. 

conversions. Both conversions slightly reduce the discrepancies in the examined period (1989-

2005), based on the authors’ estimation. Two Chinese studies (Zhou, 2006; Zhang, 2007) also 

considered the statistical measurement difference as a contributing factor to the bilateral 

statistical discrepancy on trade imbalance. Generally, the current literature recognizes the 

different statistical definitions of imports and exports used by China and the U.S. as a factor, but 

with a relatively small impact on the total discrepancy. 
-22- 

Another complication to the reconciliation process involves the proper treatment and 

valuation of the services trade and other forms of unquantifiable trade. Typically, it is assumed 

that the U.S. is considered the party that has the comparative advantage in the services trade 

with most of its trading partners, including China (e.g., Tong, 2005). Fung and Lau (1999, 2003) 

argued that the services trade is an important component in bilateral trade, and as such, should 

not be neglected in the calculation of trade balances. However, the authors’ estimate on the U.S. 

services trade surplus is comparatively small, ranging between $1.37 billion in 1997 to $2.3 billion 

in 2001. It is noteworthy that the services trade has been growing between China and the U.S. in 

recent years, and trade in this sector may become an increasingly important constituent of the 

trade balance between the two countries. A more recent estimate put the U.S. net trade surplus in 

commercial services at $9 billion in 2003 (Tong 2005). Tong expounded on this estimate agreeing 

with Fung and Lau’s analysis (1999, 2003) that the China net services trade with the U.S. has 

been increasing since early 1990s, but Tong’s study also pointed out that the services trade is far 

from being a significant part of the overall bilateral trade relationship. Zhang (2007) disagreed that

the services trade is not yet a significant factor and summarizes that the exclusion of both the 

services trade, and intangible trade like “e-trade,” is a major cause of the current huge statistical 

discrepancy in the reported bilateral trade imbalance. 

In addition to the above mentioned factors, “phantom” exports and imports exacerbate 

the situation by distorting China’s exports to and imports from the U.S. (Fung & Lau, 1999; 

Customs Service, 2000). False invoicing, deliberate or not, comes from Chinese exporters 

claiming VAT tax and customs duties rebates from the Chinese government (Fung & Lau, 1999). 

Bao (2000) confirmed the local smuggling of goods and values such activities at a cost of more 

than 8 billion RMB per year on average. He also corroborates additional varied forms of illegal 

trade activities including more-import-less-reporting, more-reporting-less-export, and organized 

large-scale smuggling operations by corporations. A rough estimate of goods smuggled from the 

U.S. into China is around $500 million to $700 million (Bao, 2000). The smuggling factor further 

gains recognition in some quantitative studies (e.g., Wang, Gehlhar, & Yao, 2006). For instance, 

Wang, Gehlhar, and Yao (2006) included the existence of anti-smuggling programs by both the 
-23- 

U.S. and Chinese governments as a dummy variable in their equation accounting for the bilateral 

trade imbalance discrepancy. One Chinese customs broker believes that smuggling is a much 

larger factor than most analysts take into account, especially in the high-tech sector.14 Accurate 

estimations of the true value of smuggled goods, therefore, has a genuine impact upon the 

reconciliation process regarding the dramatic statistical discrepancy between the two countries. 

Despite these previous investigative findings, research recently undertaken at the U.S. 

International Trade Commission (“ITC”) definitively calls into question the validity of the ChinaHong Kong entrepôt trade hypothesis as the most important explanation to account for the trade 

data inconsistency summarized above. Based on our integrated analysis of China’s currentaccount and capital-account transactions, we determine that a phenomenon referred to as the 

round-tripping of Chinese capital comprises a significant portion of the data discrepancy involving 

official Mainland export and import statistics. As emphasized by international researcher and 

scholar of Chinese round-tripping FDI, Geng Xiao states, “[o]n the whole, [the] PRC’s round 

tripping [foreign direct investment] is more of a statistics interpretation problem than a substantive 

constraint or drawback for PRC in the global economy.”15

Simply put, “round-tripping” is a trade-tax-investment strategy whereby Chinese 

enterprises undervalue export or overvalue import transactions so as to move Chinese capital 

across the PRC border via transfer-pricing practices. Specifically, Chinese enterprises export 

domestic capital from the mainland to related-party foreign enterprises situated outside China in 

offshore tax havens, such as Hong Kong, pursuant to non-arm’s length transfer-pricing 

techniques designed to circumvent Chinese capital controls. The exported PRC domestic capital 

is then recycled abroad and subsequently returns to the Mainland in the disguised form of foreign 

investment. In short, round-tripping is a form of tax-investment-trade arbitrage that seeks to 

exploit the differential tax-and-investment treatment heretofore afforded by the Government of 

China to domestic and foreign enterprises. 

As explained by ITC researchers Ferrantino and Wang, “[o]ur results...suggest that 

reporting of different values to importing and exporting authorities might be a significant source of 

discrepancies in trade data.”16 It is therefore essential for policymakers worldwide to understand 
-24- 

the crucial role that Chinese round-tripping practices play with regard to the PRC’s overall 

economic performance, and its true merchandise trade surplus. 

IV. SUMMARY OF THE APPLICABLE RESEARCH METHODOLOGY 

Previous studies evaluating the subject trade data inconsistency for current account

purposes failed to take into consideration and correctly quantify the effect that Chinese roundtripping practices had on the PRC’s global trade surplus. Likewise, previous foreign-investment 

studies that focused on Sino round-tripping activities for capital account purposes ignored the 

trade-balance or current-account implications of such activities as well. As a result, these 

previous studies were not able to fully explain the emerging statistical discrepancy that 

materializes as a consequence of comparing official Chinese trade data with those of its partner 

nations. 

Therefore, the primary objective of our study was to perform an integrated analysis 

evaluating in simultaneous fashion current-account (e.g., merchandise-trade balance),17 capitaland-financial-account (i.e., foreign investment),18 and Sino round-tripping data so as to attempt to 

expound upon the widening statistical discrepancy at issue. Only by conducting such an 

integrated analysis can researchers comprehensively explain China’s trade surplus discrepancy. 

We began our study by providing an overview of Hong Kong’s political, legal, and 

economic structure that facilitates both entrepôt trade and the round-tripping of Chinese capital 

between the Mainland and the former British territory. In particular, we examined the Chinese 

SAR’s political and economic history and policy, its favorable tax regime, and the unique 

Mainland-Hong Kong legal-economic relationship that today is governed by a free trade 

agreement and a stand-alone tax treaty that is grounded on the principles espoused by the 

Organization for Economic Cooperative Development (“OECD”). 

The following section evaluates the traditional and alternative hypotheses posited by 

researchers to explain the data discrepancy described above: (i) Hong Kong’s re-export trade 

and “middlemen” markups; (ii) divergent customs standards employed internationally to value 

exports and imports; (iii) so-called “phantom” Chinese exports and imports; (iv) transshipment 

(i.e., false-invoicing) activities undertaken through third countries; (v) smuggling; (vi) timing of 
-25- 

exports and imports; (vii) inconsistent geographic coverage; (viii) misclassification of goods; and 

(ix) exchange-rate fluctuations. With regard to China’s entrepôt trade through the former British 

territory, we obtained (by means of public surveys and private interviews) contemporaneous 

estimates of Hong Kong re-export “middlemen” markups and applied such markups to the most 

recently available statistics to reconcile in part China’s reported trade data. 

Next, we scrutinized the effect that Sino round-tripping practices have had on the 

calculation of China’s true global trade surplus, thus, revealing a major cause of the growing 

statistical inconsistency between official Chinese trade data and those recorded by the PRC’s 

partner countries. Specifically, our calculation process involves the following: 

China-Hong Kong entrepôt effect (i.e., Hong Kong’s re-export trade and “middlemen” 

markups): the markup rate of 25% for goods from Mainland China is used in this analysis (e.g., 

Fung and Lau, 1999); the markup rate for goods from countries other than the Mainland, however, 

is 6% as reported by the Census & Statistics Department of Hong Kong for 2003. Given the rising 

trend of markup rate for goods from countries other than Mainland from 1999 to 2007, it is 

reasonable to use the 2003 markup rate as a proxy for goods to China in this analysis; 

Divergent customs standards employed internationally to value exports and imports: the 

FOB and CIF difference rate of 5% is used (e.g., Fung and Lao, 1999); 

“Phantom” Chinese exports-imports: we employed the research of the U.S. Department 

of Treasury study in 2005 (see Note 105) that found Chinese “phantom” goods were valued at

about US$55 billion; the value of this “phantom” trade in other years within the examined period 

of this analysis (i.e., 1999-2004 and 2006-2007) are consequently estimated using the average 

of total Chinese imports and exports as reported by both China and its 41 trading partner 

countries; it is noteworthy that we hereby assume that Chinese “phantom” trade volume closely 

followed that of China’s total international trade in the examined period 1999 to 2007; 

Smuggling activities: we borrowed the finding of Bao (2000) that indicates a value of 

US$700 million for 1999 for smuggled goods; the volume of smuggled goods for other years in 

the examined period are estimated using the average of China’s total imports and exports as 

reported by both China and its 41 trading partner countries. Thus, we follow the logic of the 
-26- 

“phantom” trade assumption in (iii) for the smuggling activities. However, the relative scale of 

these activities is small: not exceeding 1% of total trade in all of the years from 1999 to 2007; 

Round-tripping of Chinese domestic capital recycled abroad in offshore tax havens (e.g.,

Hong Kong) that subsequently returns to the Mainland disguised as foreign investment: we used 

the Chinese round-tripping FDI ratio of 50% and the ratio of returned round-tripping FDI to total 

Chinese capital flight of 25% per Geng Xiao’s 2004 study. The assumption hereto is that all 

capital that flies out of the Mainland is through an overstatement of Chinese imports. Considering 

the conservative estimate of the 50% round-tripping ratio (Xiao, 2004), we argue that the 

offsetting effects from this conservative ratio can enhance the accuracy of our calculation; 

Due to the unavailability of relevant data, we grouped the following factors into the 

residual portion of our discrepancy breakdown, which includes: transshipment (i.e., false-invoicing) 

activities undertaken through third countries; timing of exports and imports (i.e., negligible trade 

impact); inconsistent geographic coverage issues (i.e., inconsequential trade effect); 

misclassification of goods (i.e., negligible trade consequences); exchange-rate fluctuations; and 

statistical errors and omissions, as well as other factors mentioned in various literature; 

Finally, we examined the multiple factors that may diminish or accelerate the incidence of 

Chinese round-tripping practices in the future, including the PRC’s new enterprise income-tax law, 

China’s current monetary policy and related capital-flight activities. 

V. HONG KONG’S POLITICAL, LEGAL, AND ECONOMIC STRUCTURE 

THAT FACILITATES ENTREPÔT TRADE AND “ROUND-TRIPPING” 

PRACTICES 

A. Hong Kong’s Political, Legal, and Economic History and Policy 

This version of so-called “Chinese federalism” 19 allows Hong Kong to act as a sovereign 

nation for all economic purposes. Significantly, the former British colony does not even form part 

of the customs or tax territories of China. Instead, Hong Kong constitutes a separate “foreign 

customs territory,” as well as a distinct “foreign fiscal territory,” situated within China’s national

borders. Even though Hong Kong has formed part of Chinese national territory since 1997, the 

customs and fiscal territories of the SAR are legally separate and distinct from those of the PRC 

by strict operation of Chinese and Hong Kong law. For this reason, the Mainland and Hong Kong 
-27- 

recently negotiated, concluded, and ratified a bilateral free trade agreement and a stand-alone 

bilateral tax treaty. China and Hong Kong are even separate signatory members of the WTO 

given that each jurisdiction constitutes an independent customs territory.20 

Consistent with this unorthodox legal structure under “Chinese federalism,” Beijing’s 

current sovereign authority over the SAR is exclusively limited to foreign policy and national 

defense matters.21 Accordingly, Hong Kong maintains its own police force, central bank, and 

monetary system and formulates its own independent customs, tax, trade, investment, and 

immigration policies. 22 In essence, Hong Kong constitutes -- on a de facto basis -- Beijing’s 

seventh SEZ that provides Mainland enterprises engaged in international trade with financial 

capital and sophisticated commercial banking services. (For a comparative analysis of 

international and Chinese SEZs, see infra., notes 343-381 at 51-55, with accompanying text.) 

Like any typical SEZ or free port internationally, Hong Kong is characterized by a freemarket, capitalist economy with a policy of free trade, low taxation, and laissez-faire government 

non-intervention. Trade barriers, restrictive trade practices, and foreign-exchange controls are 

limited in this capitalistic enclave. Adhering to the economic philosophy established under British 

rule, the SAR leaves the direction of the economy to free-market forces. The free-trade oriented 

Heritage Foundation has cited Hong Kong, year after year, as constituting the “freest economy in 

the world.”23 Similarly, in its Index concerning the Protection Afforded to Investors, the World 

Bank deems Hong Kong the world’s fourth best jurisdiction to conduct business, after New 

Zealand, Singapore, and Canada.24 

Hong Kong’s political-legal-economic strengths include the following: 

• A duty-free port with a favorable tax regime; 

• Very small degree of government involvement in business activities and overall 

minimal government regulation; 

• Low inflation; 

• Almost no barriers to foreign investment; 

• A modicum of restrictions covering banking and finance activities; 

• Low level of government intervention in wages and prices; 
-28- 

• Strong and effective protection and enforcement of private property rights, 

including intellectual property; and 

• Only a modest level of informal market activity or corruption.25 

Hong Kong’s economy is dominated by services, which account for over 90 percent of its 

gross domestic product. 26 Even though traces of its past can still be found in the fishing villages 

scattered in the outlying islands, Hong Kong has transformed itself from a post-World War II 

manufacturing base to a major international financial, banking, trade, and services center 

featuring state-of-the-art infrastructure.27 Hong Kong enjoys a robust and stable financial regime, 

exemplifying the vitality and dynamism of an economy that has the ability to prosper in an everchanging global political economy. 28

 

Thus, in addition to constituting a major international trade entrepôt, Hong Kong is a 

leading financial and banking center. Hong Kong commercial banks are experienced, and suited 

to engage in a full range of mainstream international financial and banking transactions, including 

processing letters of credit, preparing import-export documentation, and opening commercial 

bank accounts in which stocks and shares can be traded on the world’s major stock exchanges.29

The relatively easy access that clients have to a major international stock exchange, as well as to 

large multinational commercial banks for all classes and kinds of equity, debt, and derivative 

transactions, makes the Chinese SAR a particularly attractive financial center for both Mainland 

and FIEs engaged in international commerce. 

B. Hong Kong’s Favorable Tax Regime 

Although Hong Kong does not appear on the OECD tax-haven watch list, international 

practitioners generally consider the Chinese SAR to constitute an “offshore” jurisdiction or, 

alternatively, a de facto tax haven. Hong Kong’s extremely low corporate income tax rate of 

17.5%,30 as assessed pursuant to a tax-friendly territorial principle,31 justifies this characterization. 

In accordance with the territorial principle, the Hong Kong income/profits tax applies only to 

corporations, companies, partnerships, joint ventures, trusts, sole proprietorships, and other 

business entities32 with Hong Kong-source income; that is, only income derived from, or arising in, 

Hong Kong and not from any income sourced from outside the territory.33 Income paid in Hong 
-29- 

Kong that relates to services rendered outside the island is generally exempt from Hong Kong tax 

liability as well. 

Hence, the SAR is not an offshore tax jurisdiction in the traditional sense, but, instead, 

comprises a fiscal enclave with a non-discriminatory, low-tax regime that is governed by a taxfriendly territorial principle. The attraction of Hong Kong as a international financial center lies not in 

the tight secrecy and minimal corporate disclosure provisions that characterize a number of offshore 

common-law jurisdictions, but rather in low taxes, generous tax-deductible allowances,34 a policy of 

taxing only Hong Kong-source income, and the absence of the following commonly-imposed taxes: (i)

capital gains tax; (ii) dividend tax; 35 (iii) withholding taxes; 36 (iv) sales taxes; (v) value-added tax; (vi)

tax on interest generated by overseas and certain other bank deposits; (vii) tax on profits derived 

by non-resident offshore funds; (viii) annual net worth tax; and (ix) accumulated earnings tax 

assessed on companies that retain earnings.37

 

Unlike the tax jurisdictions of almost all countries that have international financial centers, 

Hong Kong does not actively regulate transfer-pricing activities carried out by affiliated 

enterprises in cross-border trade or financial transactions. 38 Furthermore, consolidated group 

accounting – in accordance with which the profits of one company in an affiliated corporate group 

can offset losses of another related enterprise of the same group – generally does not exist in the 

Chinese SAR either. Nonetheless, the losses of a Hong Kong business entity can be carried 

forward indefinitely. This feature compares very favorably with other jurisdictions (e.g., China) 

which allow losses to be carried forward for a fixed period of time, typically 5 years.39 

Finally, inasmuch as there are no “debt-equity thin-capitalization” rules in Hong Kong, a 

foreign parent (domiciled in the Cayman Islands, for example) can constitute a subsidiary in the 

Chinese SAR with a minimum amount of capital and a maximum amount of debt. As a 

consequence, the Hong Kong subsidiary of the Cayman Islands parent can substantially reduce 

its taxable income arising in Hong Kong through the payment of excessive, albeit deductible, 

interest expenses. Nonetheless, to avoid any potential adverse tax consequences, the loan 

agreement executed by the Cayman parent and its Hong Kong subsidiary should stipulate that 
-30- 

the Cayman loan proceeds are specifically made available to the borrower in the Chinese SAR, 

and that the corresponding interest income is deemed Hong Kong-source income. 

C. Unique Mainland and Hong Kong Bilateral Trade and Tax Relationship 

The reunification of Hong Kong with China in 1997, together with the PRC’s subsequent 

WTO accession in 2001, has triggered such an unprecedented growth in undetected trade and 

capital flows between the Mainland and the former British territory that policymakers worldwide 

have been unable to measure accurately China’s global economic impact. As a threshold matter, 

a wave of relocations from Hong Kong to China in the aftermath of reunification set the initial 

stage for such unchecked trade and capital flows. Specifically, relocations in the businessservices sector jump-started unprecedented cross-border transactions between affiliated 

enterprises in the former British territory and the Mainland.40 The Hong Kong-China Free Trade 

Agreement and the Hong Kong-China Bilateral Tax Treaty subsequently further stimulated these 

cross-border activities. 

1. 2004 Hong Kong-China Free Trade Agreement 

After China acceded to the WTO on December 11, 2001, the PRC almost immediately 

signed an innovative bilateral free trade and investment agreement (“FTA”) with Hong Kong; 

namely, The Mainland and Hong Kong Closer Economic Partnership Arrangement 

(“CEPA”). The FTA entered into legal force and effect on January 1, 2004. 41 The primary 

purpose of the trade-investment pact is to increase Hong Kong’s access to the Mainland market 

for business services, to take advantage of the trade synergies already existing between the 

former British colony and Guangdong Province, and to promote efficient “customs clearance 

facilitation” in the separate customs territories of each jurisdiction.42

 

By virtue of the innovative FTA, Hong Kong pledged to “continue to apply zero tariff[s] to 

all imported goods of Mainland origin.”43 Meanwhile, China obligated itself, effective January 1, 

2004, to offer duty-free treatment to an initial list of Hong Kong-origin products; that is “[f]rom 1 

January 2004, the Mainland [agreed to] apply zero tariff[s] to the import of those goods of Hong 

Kong origin listed in Table 1 of Annex 1.” 44 China further pledged to provide duty-free treatment 

to virtually all imports of Hong Kong origin by January 1, 2006.45 
-31- 

An attractive 30-percent value-added test under the FTA rules of origin makes it relatively 

easy for Hong Kong entities to confer CEPA origin status to material inputs, components, and 

parts sourced from third countries, such as Vietnam or Singapore, before the exportation of the 

finished processed product to the Mainland.46 In fact, a Hong Kong entrepreneur can include any 

related intellectual property expenses allocated in the SAR as part of the local value-added 

content to confer Hong Kong-origin status for preferential CEPA purposes. 47 Additionally, the 

parties sought to liberalize trade in services, including (a) professional services, such as law, 

accounting, and architecture, (b) commercial services, and (c) finance and banking. 

As stated above, Beijing targeted CEPA at Guangdong Province, which consequently 

has been at the forefront in attracting foreign trade and investment on the Mainland.48 Today, 

Guangdong Province boasts China’s highest provincial GDP, accounts for more than one third of 

the PRC’s annual foreign trade, and is the country’s most attractive foreign investment destination.

49 The Chinese province is also the home of nearly 25 percent of China’s FIEs, which generate 

more than 50 percent of Guangdong’s industrial exports.50Guangdong Province has historically 

benefited economically from its geographical proximity to Hong Kong. The China-Hong Kong FTA 

has further solidified this natural comparative advantage by creating, in essence, a Hong KongGuangdong Province free trade zone that facilitates the free movement of goods, services, and 

people between Hong Kong and the Mainland province.51 

In addition to creating the above trade effects, CEPA, as explained more fully below, has 

accelerated round-tripping practices between the Mainland and Hong Kong. Inasmuch as the 

FTA has eliminated or reduced Chinese import tariffs on a significant share of products sourced 

from Hong Kong, no real adverse customs-duty consequences attach to the strategy of artificially 

inflating the value of specialized components imported from related-party enterprises situated in 

Hong Kong. 

2. 2007 Hong Kong-China Bilateral Tax Treaty 

On August 21, 2006, Hong Kong and China signed a landmark bilateral tax convention; 

namely, the new Arrangement for the Avoidance of Double Taxation on Income and 

Prevention of Fiscal Evasion Between the Mainland of China and the Hong Kong Special 
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Administrative Region. This tax treaty -- which replaced an earlier tax arrangement executed by 

the parties in 1998 -- entered into legal force and effect in both jurisdictions on April 1, 2007.52 Mr. 

Donald Tsang, the Chief Executive of the Hong Kong SAR, explained the primary objective of the 

Hong Kong-China tax convention in the following terms: 

The conclusion of a comprehensive double-taxation arrangement with the 

Mainland, together with the Mainland and Hong Kong Closer Economic 

Partnership Arrangement, will provide added incentives for international investors 

to enter the Mainland market through Hong Kong. It will also enhance crossborder financing arrangements and the transfer of technical know-how and 

patent rights between the two places. These will help promote Hong Kong’s 

economy, enhance our competitiveness and overseas capital.53

In contrast to several bilateral tax treaties worldwide, the Hong Kong-China arrangement 

does not set forth any limitation-on-benefits provisions.54 This specific tax feature can potentially 

foster so-called “treaty-shopping” by foreign investors.55 The Hong Kong-China treaty employs 

the tax-credit mechanism as the primary instrument to avoid double taxation in both jurisdictions. 

As pertinent here, Chinese resident enterprises are liable for the payment of PRC income tax for 

any revenue generated on a worldwide basis; that is, income that is sourced both inside and 

outside the Mainland.56 If, however, such a Chinese enterprise has already paid corporate income 

tax on any revenue attributable to Hong Kong, the amount of any Hong Kong income tax paid to 

SAR authorities may be credited against the income-tax liability that is due in China.57 

In accordance with the convention, the highest Chinese withholding tax rate applicable to 

dividends that a resident of Hong Kong receives from its Mainland investment has declined from 

20 percent to 10 percent.58 Likewise, the corresponding PRC withholding tax for dividends that a 

Hong Kong business enterprise receives from its Chinese affiliate has fallen from 10 percent to 5 

percent,59 provided that the Hong Kong entity holds at least 25 percent of the capital stock of the 

Mainland company.60 By way of relevant comparison, dividend tax rates in OECD-consistent 

treaties are usually set at 15 percent. As a result of this relatively favorable tax feature, more 

overseas investment earmarked for Chinese business entities should be channeled through Hong 

Kong going forward.61

Additionally, the highest PRC withholding tax rate applicable to interest income that a 

resident of Hong Kong derives from its Mainland investment has decreased from 20 percent to 7 
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percent. 62 Similarly, the corresponding withholding rate for interest income that a Hong Kong 

business enterprise generates from its Mainland holdings has fallen from 10 percent to 7 

percent.63 In parallel fashion, the highest PRC withholding tax rate for royalty income that a 

resident of Hong Kong derives from its Mainland investment has also declined from 20 percent to 

7 percent, while the corresponding Chinese rate for royalty income that a Hong Kong business 

entity receives from its Mainland affiliate has fallen from 10 percent to 7 percent.64 By way of 

comparison, interest and royalty tax rates appearing in typical OECD-based conventions are 

usually set at 15 percent. These generous withholding rates should attract even more overseas 

passive and intellectual property investment into the Mainland through Hong Kong.65 

The Hong Kong-China bilateral tax treaty also incorporates provisions that govern capital 

gains realized on the Mainland. According to international practitioners, a full tax exemption in 

China is available on capital gains derived by a Hong Kong investor from the profitable disposal, 

transfer, or sale of shares of stock of a Mainland company, (i) provided that the sold shares 

comprise less than 25 percent of the stock ownership of the Mainland company, and (ii) provided 

that the assets of the Chinese company do not primarily consist of immovable property (i.e., real 

estate) situated on the Mainland.66 The implementation of this questionable treaty provision – 

specifically, paragraph 5 of Article 13 of the tax convention – is subject to the administrative 

interpretation of the Chinese tax authorities.67 Given that no capital-gains tax exists in Hong Kong 

for such a transaction, this specific treaty provision may arguably give Hong Kong taxpayers a 

unilateral tax benefit through tax-free transactions.68 

Finally, the convention provides for the exchange of information between China’s State 

Administration of Taxation (“SAT”) and Hong Kong’s Inland Revenue Department. The exchangeof-information provisions, based on the 1995 OECD model convention, are designed to facilitate 

the implementation of the treaty.69 Even though the pertinent provisions do allow for a certain 

amount of information exchange between Mainland and Hong Kong authorities to facilitate taxcollection and enforcement activities, the treaty article is much more restrictive in scope than the 

corresponding provision set out in the 2004 OECD model treaty.70 Pursuant to the Hong KongChina convention, only information that is necessary to carry out the new arrangement or 
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implement the domestic tax laws of China or the SAR – “in particular, information for the 

prevention of fiscal evasion”71 – may be exchanged. 72 Neither government is obligated to supply 

information that is not obtainable under the domestic tax laws of either jurisdiction or that would 

lead to the disclosure of any trade, business, industrial, commercial, or professional secrets or 

trade processes.73

The tax exemption for Mainland-sourced capital gains under the Hong Kong-China treaty 

– coupled with the relatively low Chinese withholding tax rates for dividends, interest, and 

royalties – not only enhances Hong Kong’s natural competitiveness, but also provides added 

incentives to use the SAR as a conduit to do business or invest in China. In fact, the new bilateral 

arrangement actively encourages using a Hong Kong company as (i) an intermediate holding 

company for passive-income investments situated on the Mainland, (ii) a corporate vehicle to 

finance active business operations in China, and (iii) a commercial means for licensing 

intellectual property to PRC companies. As explained later in this study, the new tax treaty also 

has the potential to accelerate Sino round-tripping practices, because the convention entices 

Chinese business entities to establish related-party holding companies in Hong Kong, an 

essential pre-requisite for the round-tripping merry-go-round. 

In this regard, as previously explained in note 41, the residency concept has no real 

practical application under Hong Kong tax law. Only Hong Kong-source income is subject to SAR 

tax liability in accordance with the tax-friendly territorial principle. For this reason, the former 

British colony is an extremely advantageous site from which to administer an offshore affiliate, 

without any real tax consequences, provided that the related enterprise does not conduct any 

business with other Hong Kong residents. This characteristic is one of the key reasons why the 

use of offshore Hong Kong companies has proliferated to such a great extent in recent years. 

Such enterprises can conveniently have SAR-based directors and a Hong Kong bank account, as 

well as a Hong Kong office address, without being subject to the tax net of the SAR. A Hong 

Kong company is not even required to state on its letterhead its registered office address or place 

of incorporation.74

 
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VI. TRADITIONAL EXPLANATIONS TO RECONCILE THE CHINESE 

STATISTICAL BALANCE-OF-TRADE DISCREPANCY: CURRENT 

ACCOUNT ANALYSIS 

A. China-Hong Kong Entrepôt Trade 

1. Definition of Hong Kong’s Re-Export Trade and its Impact on 

China’s Merchandise Trade Balance 

Today, the relatively tiny island of Hong Kong is China’s leading “foreign investor” and its 

fourth leading trading partner as a result of its proximity to the Mainland, convenient 

transportation and communication systems, culture and language similarities, and the creation 

and efficient administration of the recently-ratified FTA and bilateral tax arrangement. 75 With 

regard to the Mainland’s complex international-trade relationship with the former British territory 

and its worldwide trading partners, goods can enter or exit the PRC in one of two ways: first, they 

can be shipped directly to and from the Mainland; and second, they can travel through Hong 

Kong, the world’s premier entrepôt. 

As a result, Hong Kong has emerged as the main indirect-trade center for all of Asia, 

where extremely large volumes of goods are first imported and then are re-exported elsewhere. 

Virtually none of this re-export trade is consumed in the former U.K. territory; yet, official Hong 

Kong trade statistics capture all of these re-exported goods. During the nine-year period 

comprising 1997 through 2005, official Hong Kong trade data show that Hong Kong’s re-exports 

of Chinese goods destined for overseas markets accounted for, on average, roughly one third 

(i.e., 33%) of all of China’s total reported exports.76 By 2005-2006, however, the value of such 

Chinese-Hong Kong re-export trade, as well as that of U.S. goods re-exported to the Mainland 

through the former British colony, had fallen to only 14 percent of total China-US bilateral trade.77

The Hong Kong Census and Statistics Department defines the term “re-exports” to mean 

“products which have previously been imported into Hong Kong and which are re-exported 

without having undergone in Hong Kong a manufacturing process which has changed 

permanently the shape, nature, form or utility of the product.”78 In other words, the essential 

characteristics of the re-exported goods are not fundamentally changed or altered by means of a 

“substantial transformation” operation that confers Hong Kong- origin status. This same outcome 
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prevails under CEPA even when more than 15 percent, but less than 30 percent, of the value of 

the finished export product is added in the former British territory.79

Previous researchers initially concluded that the failure to track and properly record 

China’s entrepôt trade through Hong Kong was the major reason that accounted for the growing 

statistical discrepancy that emerges as a result of comparing official Chinese trade data with the 

mirror trade of the PRC’s trading partner countries. Even though recent research has called into 

question the validity of the China-Hong Kong entrepôt trade hypothesis as the most important 

explanation to account for the data discrepancy, China’s re-export trade through the former 

British colony still remains one cause that distorts China’s true trade performance with the rest of 

the world. Indeed, despite the implementation by Chinese Customs of new procedures (including 

requests for Census & Statistics Department’s cooperation in trade data reconciliation) in 1993, 

meant to identify more accurately the ultimate destination of the exportation of Chinese goods 

and the importation of foreign products that are re-exported through Hong Kong, and despite the 

reunification of Hong Kong with the Mainland in 1997, the misattribution-of-trade problem is still 

thought to be a major source of the trade data discrepancy. 

2. Rationale that Warrants Making Data Adjustments to Reconcile 

Official Aggregate Chinese Export-and-Import Statistics, Official 

Hong Kong Government Data, and Official Aggregate Statistics of 

China’s Trading Partners 

Given that Hong Kong trade statistics are included in Chinese partner-country data used 

to calculate China’s total merchandise-of-trade surplus with the rest of the world, that portion of 

Hong Kong re-export trade originating in the Mainland is sometimes double-counted (i.e., 

misattribution of trade) as trade with China by both Hong Kong authorities and China’s partner 

countries. An additional problem for policymakers, as already emphasized, is that the PRC 

partner-country statistics do not make any adjustments for the mark-ups charged by unrelatedparty Hong Kong “middlemen” for their re-exporting activities and ancillary services undertaken in 

the SAR.80 The difference is significant in not only the omission of Hong Kong re-export by these 

partner countries but also the fact that the re-export value is already higher than Chinese exports 

to Hong Kong due to the middleman markup. 
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As articulated above, Chinese Customs began implementing new procedures in 1993 to 

identify more accurately the ultimate destination of the exportation of Chinese products, as well 

as the importation of foreign goods, that are re-exported through Hong Kong.81 Notwithstanding 

these new customs procedures, Fung and Lau have already established that Mainland customs 

authorities have not been able to eliminate completely the statistical discrepancy caused by Hong 

Kong re-export trade. Consequently, one must make a series of data adjustments to the official 

export-and-import statistics maintained by China, Hong Kong, and the PRC’s partner countries in 

order to isolate the economic effect that such China-Hong Kong entrepôt trade has had on the 

Mainland’s true global balance of trade during the past decade. One must also strip out the Hong 

Kong middleman mark-ups for both eastbound and westbound entrepôt trade transiting the freezone enclave, because the value added by such “middlemen” is not attributable to either Chinese 

exporters shipping abroad or to foreign exporters trading with the Mainland. According to Fung 

and Lau (1999), examples of Hong Kong middleman markups are for providing services such as 

design, marketing, financing and sourcing. 

Hong Kong customs authorities measure these middleman mark-ups annually in 

accordance with periodic surveys. Based on this official compilation of data, international trade 

researchers have estimated in a number of public studies the magnitudes of the Hong Kong reexport mark-ups charged by the unrelated-party Hong Kong “middlemen”. These researchers 

include Sung (1991), Lardy (1994), West (1995), Fung (1996), Fung and Lau (1996), Fung and 

Lau (1999), Feenstra et al. (1999), Fung and Lau (2003), Schindler and Beckett (2005), and 

Statistics Canada (2005). Consistent with the general results of these studies,82 our own research 

for calendar-year 2007 establishes that the unrelated-party Hong Kong middleman currently 

charge, on average, a mark-up of approximately 25 percent for Chinese goods shipped through 

Hong Kong before re-exportation to other foreign destinations and roughly 6 percent for foreign 

goods (e.g., U.S. goods) shipped via Hong Kong before re-exportation to the Mainland. 
-38- 

B. Adjustments to Reconcile Inaccurate Chinese Trade Statistics Caused in 

Part by the Hong Kong Re-Export Trade Phenomenon: Misattribution of 

Trade; Under-Counting; Double-Counting; Middleman Mark-Ups; and 

Inconsistent Valuation of Exports and Imports 

As demonstrated above, China’s export-and-import trade activities are complex. On the 

one hand, China engages in direct export-and-import transactions with its trading partners, 

bypassing Hong Kong altogether. On the other hand, the PRC also makes substantial indirect 

export shipments to, and receives indirect import shipments from, its partner nations via Hong 

Kong. As a result, China’s re-export trade through Hong Kong presents issues of misattribution of 

trade, under-counting, double-counting, middleman mark-ups, and inconsistent customs valuation 

techniques employed internationally to measure exports and imports.83 For example, the Census 

& Statistics Department of Hong Kong records total value of exported goods instead of the value 

added portion generated in Hong Kong territory as their exports, resulting in double-counting of 

the portion of exported goods generated in the Mainland. 

To eliminate the trade distortions caused by China’s entrepôt trade through Hong Kong, 

one must make three specific data adjustments.84 The first statistical adjustment consists of (a)

correctly attributing all indirect Mainland exports traded through Hong Kong to the official Chinese 

export database and the corresponding import database maintained for the PRC’s partner 

countries, as well as (b) correctly attributing all indirect Chinese imports of foreign (non-Hong 

Kong) origin goods re-exported through the SAR to the official Chinese import database and the 

corresponding export database of China’s partners. The second adjustment entails stripping out 

the Hong Kong “middlemen” mark-ups for all indirect eastbound and westbound trade that passes 

through the former British colony. The third adjustment involves taking into account and 

neutralizing the freight and insurance costs for China’s direct and indirect export and import trade. 

1. Volume and Middleman Mark-up Adjustments 

a. China’s Trade with the Rest of the World: Inbound-Import 

Transactions 

Like its trading-partner countries, China is usually able to identify the country of origin of 

imports that enter the Mainland from the rest of the world even after such merchandise has 

transited through Hong Kong.85 Nevertheless, the resulting Chinese import values include the 
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average Hong Kong middleman markup of 6 percent for such indirect trade. As a consequence, 

the reported value for PRC imports of foreign goods that enter into the Mainland after passing 

through Hong Kong typically overstates the value of such partner-country trade by approximately 

6 percent per inbound shipment.86 Accordingly, to correct the aggregate Chinese import figure, 

one must strip out the average Hong Kong middleman mark-up of 6 percent for each indirect 

import shipment that transits through Hong Kong before its final entry into China’s national 

customs territory.87 

From the perspective of China’s partner nations, partner customs authorities sometimes 

do not know the final destination of a portion of their export goods shipped to Hong Kong. 88 As a 

result, China’s partner countries sometimes incorrectly record such goods as exports to Hong 

Kong, even when some of those goods are subsequently re-exported from the SAR to the 

Mainland. Accordingly, to make China’s partner-country export data comparable with the adjusted 

Chinese import statistics, one must add to the partner-countries’ export database only the volume 

and value of such partner-country trade shipped to Hong Kong for subsequent re-exportation to 

the Mainland that the partner countries fail to record as legitimate export trade with China.89 Such 

indirect exports must necessarily exclude the average Hong Kong middleman mark-up of 6 

percent to achieve statistical parity.90 

b. China’s Trade with the Rest of the World: Outbound-Export 

Transactions 

Inasmuch as Chinese Customs authorities sometimes do not know the final destination of 

a portion of Chinese goods initially exported to Hong Kong that are subsequently re-exported to 

third countries, Mainland authorities sometimes incorrectly record such shipments as Chinese 

exports to Hong Kong, even when such goods are re-exported from the former British territory to 

the rest of the world.91 As a result, the reported volume and value figure for China’s exports to its 

partner nations often does not fully capture those Chinese goods that are exported to the PRC’s 

trading partners via Hong Kong. 92 

To correct China’s official export volume and value in this regard, one must add to the 

PRC’s aggregate export figure only the volume and value of China’s indirect exports shipped 

through Hong Kong (for ultimate re-exportation to the rest of the world) that the Mainland 
-40- 

authorities fail to capture as legitimate export trade with the rest of the world.93 Such indirect 

exports must necessarily exclude the average Hong Kong middleman outbound markup of 25 

percent to achieve statistical parity. 94 No adjustment is warranted in those cases in which

Chinese Customs can correctly identify the country of ultimate destination (e.g., the U.S.) for any 

indirect Mainland exports shipped through Hong Kong. 

Adjustments are slightly different for China’s partner nations.95 Partner-country customs 

officials usually can identify China as the country of origin of the subject imports -- even when 

Chinese merchandise is re-exported through Hong Kong -- by virtue of careful document 

inspection.96 However, partner countries’ statistics include the average Hong-Kong middleman 

mark-up of 25 percent per shipment.97 One must, therefore, subtract the average Hong Kong 

mark-up figure of 25 percent from the reported partner countries’ import data to render aggregate 

trading-partner import statistics comparable with adjusted Chinese export data.98

 

c. China’s Global Merchandise Trade Surplus as Adjusted for 

Indirect Hong Kong Re-Export Trade 

After taking into account and adjusting for the Chinese eastbound and westbound reexport trade that transits through Hong Kong, as well as the Hong Kong middleman mark-ups, we 

calculated a revised Chinese merchandise trade surplus with the rest of the world that totaled to 

US$464.5 billion in 2006. After performing this same adjustment for calendar-year 2007, we 

calculated an adjusted Chinese global trade surplus of US$554.2 billion for that year. 

Nevertheless, China’s indirect import and export trade through Hong Kong has decreased 

significantly over the past decade. The proportion of Hong Kong re-exports to China’s total trade 

has declined from 36 percent in 1999, to only 18 percent in 2007 (See Graph 8). 
-41- 

GRAPH 8

Quantity of China Trade Re-Exported Through Hong Kong 

versus Total Partner-Reported Imports and Exports

(Middle-Man Markup Removed)

0

200

400

600

800

1000

1200

 1999 2000 2001 2002 2003 2004 2005 2006 2007

Quantity (Billions of US$)

Chinese Imports Re-exported through HK

Partner-reported Chinese Imports

Chinese Exports Re-exported through HK

Partner-reported Chinese Exports

Source: GTIS, World Trade Atlas 

While re-export trade through Hong Kong remains a factor in the growing statistical trade 

discrepancy, it’s affect has diminished considerably. Based on this partial statistical reconciliation, 

we determine that the Hong Kong re-export trade phenomenon, coupled with Hong Kong 

middleman mark-ups, is responsible, on average, for approximately 18 percent or US$57.5 billion 

of the statistical discrepancy in 2007 that emerges as a result of comparing official and 

unadjusted Chinese trade data with those of its partner countries (i.e., 18% x US$319.4 billion = 

US$57.5 billion).99 
-42- 

2. Adjustments to Reconcile Inconsistent Customs Standards 

Employed Internationally to Value Exports and Imports 

The United States measures the value of exports using the FAS [Free Alongside Ship] 

methodology, while China, together with almost all other countries of the world, employs the FOB 

[Free On Board] method to value exports. Likewise, the United States measures imports using a 

“customs value” definition which is a de facto FOB standard (i.e., actual cost of goods excluding 

insurance and freight), while China values imports at the CIF level of trade.100 U.S. import data 

are somewhat unusual in that U.S. customs authorities collect and report separate insurance and 

freight costs, because the United States assesses customs duties based on the de facto FOB 

value of the imported merchandise, rather than on the CIF value as is the practice in almost all 

other nations.101 This inconsistent practice with regard to export and import valuation also distorts 

the current-account balance with regard to trade between China and the United States. 

Hence, a direct comparison of the official Chinese trade balance with those of its bilateral 

trading partners provides somewhat inaccurate results. Chinese Customs records PRC exports 

on an FOB basis, while the majority of customs authorities around the world record direct and 

indirect imports shipped from China on a CIF basis. China’s re-export trade through Hong Kong 

then aggravates this asymmetrical customs treatment. Accordingly, to measure Chinese direct 

and indirect trade more precisely under any circumstances, it is necessary to express both PRC 

exports shipped to its trading partners, as well as Mainland goods imported by China’s partner 

nations, by using the same valuation technique; that is, the FOB basis of measurement.102 The 

difference between FOB and CIF is generally the insurance and freight costs incurred when 

transporting the goods from the exporting to the importing country. 

To convert the CIF value of Chinese export products, as imported by the PRC’s trading 

partners, into an FOB value for purposes of this study, we relied on the U.S. ITC CIF/Customs 

Value (CV) ratios for U.S. imports for consumption from Asia. These data illustrate the U.S. ITC’s 

estimate of the mark-up of U.S. imports reported on a CIF basis over their FOB or customs value. 

The average calculated mark-up from 1999-2002 was 4.46 percent. This figure is corroborated by 

the average differences in the FOB and CIF indices of actual shipment data as reported in 

numerous U.S. Department of Commerce antidumping proceedings over the years. For simplicity 
-43- 

sake, the present analysis discounts imports reported on a CIF basis by 5 percent, a round 

number derived from the chart below. In fact, the consensus internationally is that the CIF import 

value is, on average, five percentage points (5%) higher than the corresponding FOB value:103

Annual Data on CIF/CV Ratios for All Import Commodities from Asia 

1998 1999 2000 2001 2002 2003

Country In Actual Dollars 

China 105.55 107.34 107.56 106.94 106.66 107.15

Hong Kong 103.73 104.41 104.55 104.39 104.78 104.94

India 105.28 105.58 105.81 105.65 105.33 105.37

Indonesia 105.65 108.06 107.97 107.92 107.70 107.68

Japan 102.53 102.61 102.73 102.43 102.56 102.58

Korea 103.61 103.66 103.50 103.72 103.75 103.72

Malaysia 102.67 103.07 103.16 103.22 103.00 101.54

Phillipines 103.18 103.66 103.69 103.90 104.04 104.31

Singapore 101.58 101.95 101.91 101.86 102.00 101.54

Taiwan 103.68 104.44 104.30 104.15 104.09 104.50

Thailand 103.99 105.80 106.02 105.71 106.00 106.12

Total--All Asia (including not 

shown) 103.65 104.39 104.52 104.35 104.54 104.51

1999-2002 Average 4.46% 

 

Source: US International Trade Commission 

Therefore, given the relatively small scale of the CIF/FOB adjustments in the total 

discrepancy, we simplify the process by assuming that 5% should be used as the percentage to 

adjust the total unadjusted Chinese trade balance discrepancy. In other words, all inbound and 

outbound trade, directly shipped or re-exported through Hong Kong, have been adjusted to 

correlate on an FOB basis. As a result, we find that in 2007 there was a total of US$16.0 billion of 

CIF/FOB adjustment. 

C. “Phantom” Chinese Exports and Imports 

Besides the China-Hong Kong entrepôt effect, the so-called Chinese “phantom” 

shipments may also distort the real Chinese trade surplus. Specifically, these phantom shipments 

refer to trade transactions that do not actually exist, but that are used for fraudulent purposes 

(Fung & Lawrence, 1999).104

 
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Obviously, no publicly available data exist for Chinese “phantom” exports to enable us to 

make the necessary statistical adjustment to the official PRC database. Nevertheless, such an 

adjustment is should be of decreasing relevance under the current circumstances, because 

China’s “phantom” exports should be on the decline in light of the Mainland’s new enterprise 

income-tax law. The new Sino tax statute, which entered into legal force and effect on January 1, 

2008, eliminates some of the Mainland export incentives that previously had encouraged PRC 

exporters to engage in smuggling activities for China’s outbound trade. Consistent with this 

observation, the major proportion of China’s “phantom“ trade is now occurring on the inbound 

(import) side of the equation – an outcome that artificially decreases the PRC’s merchandise 

trade surplus with the rest of the world by artificially increasing the value of Chinese imports 

relative to its exports. 

The U.S. Department of Treasury stated in a 2005 study that China’s “phantom imports 

from China” totaled US$55 billion, a value “explained in large part by goods that are exported 

[from the Mainland] to Hong Kong and then re-exported back into China.”105 As further explained 

by the Treasury Department: “[s]o, Hong Kong data for re-exports from China to China, adjusted 

with the markup for outward trade, is [sic] used to create an estimate for China’s exports [or 

imports] to itself.” 106 The corresponding data adjustment that reconciles these “phantom” 

transactions necessarily reduces the trade-balance discrepancy between China’s official export 

database and the corresponding import database maintained by the rest of the world for its 

international trade with the PRC. More important, such an adjustment increases the Mainland’s 

true global trade surplus, because, as explained above, Chinese “phantom” import trade 

artificially increases the aggregate value of Mainland imports (Fung & Lau, 1999). 

Accordingly, after taking into account and adjusting for Chinese “phantom” trade in 

keeping with Treasury’s analysis, we determined that Chinese “phantom” trade is responsible, on 

average, for approximately 18 percent or US$ 57.5 billion of the trade data inconsistency that is 

the subject of this study (i.e., US$57.5 billion/US$319.4 billion = 18%). Additionally, as further 

demonstrated below, China’s “phantom” trade is directly linked with the PRC’s growing problem 

of round-tripping; that is, the export of Chinese domestic capital through the Mainland’s current 
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account that is subsequently recycled abroad in an offshore tax haven before returning to China 

in the disguised form of foreign direct investment.

D. Third-Country Transshipment or False Invoicing of Chinese Products 

Other researchers have pointed out that the third-country transshipment (i.e., false 

invoicing) of Chinese merchandise imported into the United States as products from other foreign 

nations prevents U.S. trade statistics from capturing the true value of U.S. imports from China. 

Transshipment of Chinese goods to the United States involves the shipping of Mainland goods to 

a third country, such as Vietnam, to be labeled in that country as exports of that nation for 

purposes of later exporting those same Chinese products to the United States as “products of 

Vietnam”. 107 Naked and fraudulent “[m]is-attribution [of trade] takes place when [exporters] 

deliberately make false declarations about the origin or destination of a good.”108

 

For years, U.S. customs authorities have sought to curtail the transshipment of Chinese 

textile-and-apparel products that evade U.S. quota restrictions. Similarly, the U.S. Department of 

Commerce is legally responsible for administering anti-circumvention proceedings whenever PRC 

exporters transship their goods through third countries to evade U.S. antidumping or 

countervailing duties. According to U.S. authorities, the majority of the illegally transshipped 

textile-and-apparel articles originate from China. In fact, U.S. customs authorities have 

investigated firms in Hong Kong, Taiwan, Macau, Malaysia, Singapore, Thailand, and Cambodia 

for re-labeled textile-and-apparel goods originally produced in China that have circumvented U.S. 

customs restrictions.109 

Interestingly, the countries and provinces that have consistently reported lower Chinese 

import volumes based on their own official trade statistics than the corresponding PRC export 

volumes based on official Mainland data include the following jurisdictions: (i) Taiwan; (ii) Russia; 

(iii) Chile; (iv) Indonesia; (v) the Philippines; (vi) Brazil; (vii) Saudi Arabia; and (viii) South 

Africa.110 This finding suggests that Mainland entities may be misinforming Chinese Customs that 

their export shipments are destined for one of the above customs territories, but, in reality, the 

PRC export goods are ultimately transshipped to another venue, such as the United States.111

Notwithstanding the above analysis, we did not -- indeed, cannot -- make any adjustments to 
-46- 

account for Chinese third-country transshipment activities, because no reliable data exist that 

correctly captures the incidence of such illicit trade entering into the United States or other trading 

partners’ jurisdictions. 

E. Smuggling 

Aside from Hong Kong re-exports, middleman markups, the FOB customs standard to 

value exports, the CIF basis to measure imports, Chinese “phantom” trade, and transshipped 

PRC goods, other factors that complicate the measurement of China’s (or any country’s) true 

trade flows include smuggling. 112 Feenstra, Hai, Woo, and Yao have found that some Mainland 

exporters smuggle goods out of China en route to Hong Kong and, thereby, understate the PRC’s 

export trade.113 Hong Kong trade statistics sometimes report these rogue shipments when the 

Chinese products are subsequently re-exported from the former British colony to the rest of the 

world.114 Likewise, some Mainland importers understate the volume and value of Chinese imports 

– principally, an important volume and value of clandestine trade involving foreign automobiles, 

cigarettes, and refined petroleum products115-- by virtue of smuggling activities.116

 

It is difficult, if not impossible, to estimate on an annual basis the value of goods 

smuggled out of and into China.117 Some researchers contend that smuggling has been on the 

wane in recent years in the PRC on account of the central government’s crackdown on such 

fraudulent activity one decade ago.118 In one study, Fung and Lau found that “[o]n average, taking 

smuggling into account increases U.S. exports to China by a modest amount of less than US$0.5 

billion a year, and lowers the bilateral trade imbalance in goods by the same amount.” 119 “Thus, 

[what data that are available indicate that] smuggling does not seem to have a large impact on 

the U.S.-China bilateral trade balance.”120 Therefore, we estimated for all other years in the 

examined period that about 1% of the total discrepancy is attributable to smuggling activities. 

Specifically, US$3.2 billion goods were smuggled in 2007 in accordance with our estimation. 

F. Timing of Exports and Imports 

In some cases, a four-to-six week lag exists between the recording of an export from the 

exporting country and the registering of an import by the importing country. These time lags 

typically affect export sales shipped during the month of December of one calendar year and 
-47- 

imported during the month of January of a subsequent year. In the case of China-US trade, a 

four-to-six week lag does indeed exist between the recording of an export from the Mainland and 

the registering of an import by the United States and vice versa. Therefore, “[g]oods in transit at 

the end of the year are counted as exports by China, but are not counted as imports by the 

United States.”121Such lags, however, cannot by themselves account for the growing statistical 

discrepancy outlined above, because they are expected to be smoothed out over time. As the 

U.S. International Trade Commission analysts point out, “This [time lag] could be a big problem 

for monthly data, but for annual data the differences in the beginning and end of the year are 

likely to balance out.”122 Furthermore, compilation of Hong Kong trade statistics can be viewed as 

timely given its import and export declaration period of 14 days. Accordingly, we made no 

adjustments for time lags. 

G. Geographic Coverage Inconsistencies 

A very small amount of the statistical discrepancy that exists between the official Chinese 

export database and the corresponding import database of the PRC’s partner countries pertains 

to geographic-coverage inconsistencies. For example, China and the United States maintain 

divergent legal definitions concerning the scope of the U.S. customs territory. The United States 

includes Puerto Rico and the U.S. Virgin Islands as part of its customs territory, whereas China 

does not.123 To render official Mainland export statistics compatible with the corresponding U.S. 

import data, one must strip out any Chinese trade involving Puerto Rico and the U.S. Virgin 

Islands.124 Although we made a similar adjustment on an across-the-board fashion to the import 

database maintained for the rest of the world, we found that such an adjustment had a statistically 

negligible effect. 

H. Misclassification of Goods 

Even when China and one of its trading partners reports the same export-import 

transaction at the same customs value, the Chinese exporter may classify certain goods under 

one tariff heading in the PRC, while the importer classifies the same products under a different 

tariff heading in the importing nation. Stated otherwise, “[i]t is not uncommon for one trading 

partner to record the transaction according to the actual type of good[s] under Chapters 1 through 
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97 of the Harmonized System, while another trading partner records [the products] in Chapter 98 

or 99 to identify goods covered by special programs and policies.”125 In reality, misclassification of 

goods, as is similar with mis-invoicing practices, is common. As for either the China customs 

agency or Hong Kong customs agency, it is not cost effective to frequently compare their 

respective customs declaration forms submitted by importers and exporters. 

Nevertheless, while there may be statistically significant inconsistencies pertaining to 

classifications of goods at a micro-level of analysis, we have maintained a much more macro 

view of the data. Because our analysis relies on total trade values between China, Hong Kong 

and China’s trading partners, it is not necessary to account for potential misclassifications as all 

values in the various trade databases were taken into account. Also, it can be assumed that 

misclassifications occur on both incoming and outgoing goods, and therefore may roughly cancel 

each other out. 

I. Exchange Rate Fluctuations 

Although the Chinese yuan has appreciated incrementally against the U.S. dollar in 

relative terms over the past few years, previous researchers have already determined that 

“exchange rates are not a major factor in the discrepancy in the trade figures.”126 In other words, 

the Chinese yuan/dollar relationship has not been subject to volatile exchange-rate fluctuations 

that warrant any kind of data adjustment.127 Furthermore, the yuan has not been subject to any 

volatile exchange-rate fluctuations with any other major world currencies to warrant any statistical 

adjustment either. For these reasons, we made no adjustment to take into account the relatively 

slight appreciation in nominal terms the Chinese yuan has experienced vis-à-vis the major global 

currencies over the past two years. 

J. Conventional Errors and Omissions 

Even the export-and-import databases compiled and maintained by the most developed 

countries of the world, including the United States and the EU nations, suffer from standard errors 

and omissions. As mentioned in the summary of methodology section, the conventional errors 

and omissions, together with other non-identifiable factors D, F, G, H and I discussed above, are 

added up together as the “residual” portion of the Chinese trade balance discrepancy. 
-49- 

VII. INTEGRATED CURRENT ACCOUNT AND CAPITAL ACCOUNT

ANALYSIS – ROUND-TRIPPING: A COMPREHENSIVE EXPLANATION 

TO RECONCILE THE CHINESE STATISTICAL BALANCE-OF-TRADE 

DISCREPENCIES 

A. Background 

As explained throughout this study, previous researchers concluded that the failure to 

track and properly record China’s entrepôt trade through Hong Kong was the major reason that 

accounted for the statistical discrepancy that emerges as a result of comparing official Chinese 

trade data with those of its partner nations. Other hypotheses, including phantom shipments, 

were also reviewed in this study. Nevertheless, none of these theories by themselves adequately 

explains and reconciles the statistical inconsistency outlined above. Our research findings 

establish that a phenomenon referred to as round-tripping is a in fact a major contributor the 

statistical discrepancies involving official Chinese trade data. 

Round-tripping is a trade-tax-investment strategy whereby some Mainland enterprises 

undervalue export and/or overvalue import transactions so as to move Chinese capital across the 

PRC border via transfer-pricing practices with related-party enterprises.128 Specifically, Chinese 

resident enterprises, including the non-Chinese FIEs, export domestic capital from the Mainland 

to related-party enterprises situated outside China in offshore tax havens pursuant to non-arm’s 

length transfer-pricing techniques designed to circumvent Chinese capital controls. 129 The 

exported Chinese capital is then recycled abroad and thereafter returns to the Mainland in the 

disguised form of foreign direct investment.130 The primary tax havens responsible for China’s 

round-tripping activities include first and foremost Hong Kong, as well as the British Virgin Islands,

and the Cayman Islands.131 As emphasized by ITC researchers Ferrantino and Wang, “[o]ur 

results...suggest that reporting of different values to importing and exporting authorities might be 

a significant source of discrepancies in trade data.”132

 

Chinese resident enterprises, including FIEs, systematically have been under-reporting 

the customs value of their exports shipped to Hong Kong and other destinations by virtue of 

transfer prices paid to related-party agents located in offshore jurisdictions.133 Funds “harvested” 

from the under-reported Chinese export earnings are first retained by the related-party agent and 
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then are later returned to the Mainland as recycled PRC capital that is disguised as foreign direct 

investment to take advantage of the multiple Chinese tax incentives heretofore aimed at foreign 

investors.134 Likewise, Chinese resident enterprises systematically have been overvaluing the 

customs value of their imports sourced from Hong Kong and other foreign tax havens on a 

relatively large scale by means of non-arm’s length transfer prices paid to related parties situated 

in the former British territory or other tax havens.

 135

 

Ferrantino and Wang (2007) at the ITC describe the intricate nature of the complex 

China-Hong Kong transfer-pricing network, as well as the commercial rationale underlying such 

non-market transactions: 

Transfer pricing refers to mis-invoicing engaged in by related parties in different 

countries, such as different branches of a multinational corporation. The 

incentives to do this are particularly strong when firms ship to themselves 

specialized “firm-specific” components or intermediate goods for which there is 

no obvious market equivalent to establish an “arm’s-length” price...The role of 

Hong Kong, which is both a duty-free customs area and a low tax location, in 

U.S.-China trade suggests that the incentives for mis-invoicing and misattribution may be particularly high.136

 

The U.S. Department of Treasury published its own study, the findings of which are 

consistent with those of the ITC researchers concerning transfer-price schemes undertaken by 

affiliates situated in the Mainland and Hong Kong: 

Hong Kong presents an ideal location for Chinese portfolio diversification and it is 

possible that China-domestic Hong Kong trade is distorted by financial flows 

moving through the current account, which can be achieved through the underreporting of exports or over-reporting of imports. Additionally, Chinese funds are 

reportedly taken out of the country and then reinvested in China as foreign funds 

in order to take advantage of the favorable tax treatment for foreign investors, 

referred to as “round tripping” of funds. 137

 

Mainland FIEs constituted with foreign capital (which account for more than one half of 

China’s exports), 138 other foreign enterprises with “permanent establishments” in China, and 

Chinese state-owned enterprises (“SOEs”) -- with the latter group still comprising “a crucial part of 

the [PRC] economy”139 – are the primary entities responsible for the cross-border round-tripping 

activities taking place between China and Hong Kong. Chinese FIEs (i.e., “productive” FIEs, 

trading FIEs, service FIEs, wholesale FIEs, and retail FIEs), in turn, generally include (i) wholly 

foreign-owned enterprises (“WFOEs”), (ii) majority foreign-owned entities, such as equity or

contractual joint ventures (e.g., partnerships), and (iii) minority-owned FIEs with non-state 
-51- 

partners.140 FIEs and other foreign enterprises generally are more capable than their private 

Chinese domestic counterparts of importing non-Chinese origin components and inputs from 

abroad as a result of the know-how and relations of their foreign investors. Furthermore, unlike 

the Chinese private sector as a whole, FIEs and other foreign enterprises are typically not 

hampered by limited access to private bank credit on the Mainland as they usually look to offshore bank financing to capitalize their on-shore Chinese operations.141 Thus, FIEs and other 

foreign enterprises are generally more likely to engage in round-tripping practices than their 

Chinese domestic counterparts; however, as quoted above, Chinese SOEs appear to be the 

major entities responsible for round-tripping on the whole. 

The foreign investors that control Chinese FIEs generally include (i) any foreign 

enterprise, economic entity, or individual, (ii) any Chinese enterprise registered outside the 

Mainland, and (iii) Hong Kong, Macau, and Taiwanese individuals or business enterprises.142

Hong Kong is, by far, China’s leading foreign investor. According to the Chinese Ministry of 

Commerce, more than one-half (50%) of China’s foreign direct investment originates from Hong 

Kong, a relatively tiny island comprised of only 6.8 million inhabitants.143 Although the United 

States is the leading foreign-investor country in China, Japan is the predominant source of Asianbased FIEs domiciled in the PRC, representing more than two thirds (66%) of all Asian-owned 

multinationals that have shifted production to China during the past decade. 144 Other Asian 

nations that have witnessed a recent proliferation of FIEs into China include Singapore, South 

Korea, and Malaysia. 145 The major European multinational companies that have moved 

production to China are headquartered in Sweden, the Netherlands, Germany, Finland, and the 

United Kingdom. 146 

B. Economic and Legal Incentives that Trigger Round-Tripping of Chinese 

Capital Through Hong Kong and Other Offshore Tax Havens 

Several economic and legal elements must be in place before the phenomenon of roundtripping of domestic capital can take place. First, investors from a tax jurisdiction such as China 

must have access to a foreign tax haven through which they can establish related-party 

companies with which to engage in non-arm’s length transfer-pricing transactions. Second, the 

primary tax jurisdiction must have enacted trade and investment barriers that impede and 
-52- 

discriminate against domestic investment. Third, the primary tax jurisdiction must have on the 

books tax and investment incentives that discriminate in favor of foreign investment. The ChinaHong Kong relationship satisfies all of these elements. 

1. Transfer-Pricing Practices and Offshore Tax Havens 

The general purpose of non-arm’s length transfer-pricing practices is to shift income from 

a high-tax to a low-tax jurisdiction.147 Multinational corporations are the chief players that engage 

in transfer-pricing activities internationally. As explained by Charles McLure Jr., at the Hoover 

Institute, “[t]he parent company [e.g., Chinese parent company] could undercharge on the 

transactions between it and the [foreign] tax haven subsidiary [e.g., Cayman Island subsidiary] 

and the subsidiary could overcharge on the related transaction between it and the subsidiary in 

the developing country [e.g., Mexican subsidiary], so the larger profit will reside in the tax 

haven.”148

 

Today, transfer pricing is a business practice carried out by different multinational units of 

the same affiliated corporate group that generally consists of dual-invoicing strategies that 

undervalue exports and/or inflate imports to evade taxes and national capital controls as well.149 

Multinational corporations can manipulate transfer prices for a variety of their related-party 

transactions involving finished goods, licensing of technology, input-and-component sourcing, 

purchase or sale of other intangible assets, loans, the provision of services and technical 

assistance, quality control, marketing, consulting, research and design (“R&D”), distribution, and 

other similar activities.150 By carrying out such pricing practices, multinational enterprises can 

effectively distort their costs and, thereby, disguise the correct amount of income, as well as 

financial capital, attributable to a particular jurisdiction. 151 Given its current-account implications, 

transfer-pricing activities performed by private affiliated enterprises also distort the balance-oftrade statistics maintained by public customs authorities of the major trading countries.152

 

Furthermore, “Once transfer pricing and tax havens are combined, the benefits of 

manipulating transfer prices [by multinational corporations] increase dramatically.” 153 In fact, 

round-tripping activities become virtually unchecked when multinational enterprises involved in 

global trade engage in transfer-pricing arrangements through a tax haven – a “creature of the 
-53- 

twentieth century [that] began to be used extensively because of the high levels of tax which 

prevailed after the First World War.”154 Often described in different manners, the tax haven has 

been identified as an area in which “the existence of a composite tax structure [is] established 

deliberately to take advantage of, and exploit, a worldwide demand for opportunities to engage in 

tax avoidance.”155 This exactly fits into Hong Kong’s case. Without transfer-pricing regulations or 

any governmental interference based on arm’s length transaction rationale, Hong Kong 

successfully enhances its attraction to those round-tripping capital flow practitioners. 

Freda Tung, a statistician with the Census and Statistics Department in Hong Kong, 

confirms that Hong Kong does not have any transfer-pricing regulation. As explained by Ms. Tung, 

the Census & Statistics Department has periodical programs for checking average unit values of 

their imports and exports, but such information is only used for trade data compilation purposes 

due to the absence of import duties in Hong Kong.156

International practitioners universally consider the Hong Kong SAR to constitute a de 

facto tax haven for the following reasons: (i) its relatively low corporate income-tax rate of only 

17.5 percent; (ii) the taxation of only Hong Kong-source income; (iii) an extremely tax-friendly 

territorial principle that is flexibly applied to rather loose and relaxed residency and incomesourcing criteria; (iv) the notable absence of taxes on such traditional income items as capital 

gains, dividends, and retained earnings; and (v) statutory provisions that allow taxpayers to carry 

forward losses indefinitely.157

 

For this reason, the World Bank has found that the lion’s share of recycled or roundtripped Chinese capital that re-enters the Mainland as disguised foreign investment originates 

from Hong Kong.158 Hong Kong is then followed in relative importance for Sino round-tripping 

purposes by other well-known international tax havens – the British Virgin Islands, the Cayman 

Islands, Taiwan Province, Macau, Mauritius, Samoa, and Bermuda. The United States, Japan, 

Germany, South Korea, and Singapore comprise the remainder of the fiscal conduits through 

which Chinese domestic capital is recycled back into the Mainland disguised as foreign 

investment.159

 
-54- 

2. Trade and Investment Barriers on the Mainland 

The second economic and legal element that must be in place before the phenomenon of 

round-tripping can occur is that the primary tax jurisdiction must have enacted trade and 

investment barriers that hinder or discriminate against domestic investment. China’s capital 

controls, inadequate protection of private property, and overall lack of domestic bank credit 

constitute such restrictive impediments. In countries with heavily regulated and restricted capital 

accounts such as the PRC, “it is common for asset holders to find ways to circumvent capital 

controls by using over- and under-invoicing of trade transactions to move capital across 

borders.”160 

As a threshold matter, Chinese exporting firms often engage in round-tripping as a 

mechanism to evade certain currency-conversion restrictions, as well as the maze of restrictions 

governing capital and investment on the Mainland. Specifically, many Chinese resident 

enterprises convert their arm’s-length-generated export earnings into other currencies on foreign 

exchange markets through current-account transactions that fall outside the reach of China’s 

stringent capital controls. To do so, such Chinese business entities simply carry out seemingly 

routine import-and-export transactions with affiliated entities situated principally in Hong Kong.161

As explained in the previous section of this study, Chinese export earnings funneled offshore can 

later be returned to the Mainland disguised as “foreign direct investment” thanks to a related party 

situated in a foreign tax haven that acts as a conduit for the Mainland exporter. Even though 

some of the PRC export earnings return to the Mainland, some of the PRC capital remains 

offshore as a hedge against a sudden depreciation of the Chinese yuan, expectations of 

additional capital controls, and potentially adverse political changes on the Mainland. It is 

noteworthy that most companies that conduct round-tripping practices are state-owned 

enterprises.162 These SOEs often list their stocks on the Hong Kong Stock Exchange. As pointed 

out by Dr. Dong He, the Head of Economic Research at the Hong Kong Monetary Authority, such 

SOEs are usually those that are especially profitable on the Mainland “because [SOEs are] 

usually monopolies with very high margins in China, such as banking, telecommunications, and 

real estate.”163
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China’s lack of private property regulations, coupled with its relatively poor enforcement 

of the private property rights that do exist, constitutes yet another factor that encourages Sino 

round-tripping practices. Academic researcher Geng Xiao states that one reason the Chinese 

government and resident enterprises continue to purchase relatively large quantities of U.S. 

government bonds and notes is that these groups have a greater trust in the private property 

protections accorded by U.S. law. Specifically, Xiao writes: 

[There is a belief] that the property rights of their U.S. investments are well 

protected...In particular, [the] PRC has increased its purchases of USD bonds 

dramatically through both official and non-official channels...This can be 

regarded as a hedging strategy against large [foreign direct investment] 

inflows...It also reflects the role of cross-border capital flows into the protection of 

property rights...The Chinese government is protecting the property rights of 

foreign investors through improved business environments in [the] PRC while the 

U.S. government is protecting the property rights of the Chinese investors in the 

U.S. bond markets...Clearly [the] PRC is exporting capital to [the] U.S. to finance 

the U.S. trade deficits with [the] PRC while at the same time [the] PRC is 

receiving [a] large amount of [foreign direct investment] from the US.”164

Finally, the relatively poor development of China’s domestic financial markets – including 

the overall lack of available domestic bank credit to finance private-sector projects on the 

Mainland – constitutes another important factor that motivates businesses, especially FIEs, to 

redirect their financial capital outside China. To ensure that private Chinese resident enterprises 

operating on the Mainland receive adequate financial credit and resources to prosper, Chinese 

authorities can simply direct such entrepreneurs to Hong Kong, one of the world’s leading 

international financial centers, a ready source for needed financial credit and capital.165 In fact, 

the Hong Kong-China FTA and bilateral tax treaty, in tandem, actively encourage Chinese 

domestic and FIE investors to obtain financing in the Chinese SAR. As the state-run banking 

sector continues to grant an increasing volume and value of loans to Chinese SOEs on noncommercial terms, SOE managers enjoy an almost guaranteed source of unlimited funding to 

divert to private-sector activities to maintain the round-tripping loop. 

3. Chinese Tax and Investment Incentives that Heretofore 

Discriminated in Favor of Foreign Direct Investment 

The third economic and legal element that should be in place to facilitate the 

phenomenon of round-tripping is that the primary tax jurisdiction must have on the books tax and 

investment incentives that entice foreign investments into the target country at a higher rate than 
-56- 

what the country’s natural comparative advantage would dictate. To understand this third 

component, one must grasp the economic and legal factors that have been responsible for 

China’s economic surge internationally. “The rapid [foreign direct investment] inflows into [the] 

PRC, following its economic opening and reform [in 1978], are essentially driven by [three] factors: 

[i] [the] PRC’s large surplus labor [i.e., its natural comparative advantage]; [ii] [the] PRC’s 

declining barriers for [the] cross-border mobility of [foreign] capital [that enters the 

Mainland]...”;166 and [iii] China’s heretofore comprehensive tax concessions aimed exclusively at 

foreign investors on a de jure basis.167

 

In this context, the “PRC allows a large amount of processing trade, which requires [a] 

large amount of imported components.”168 Additionally, “Large-scale processing trade is only 

possible for very open economies with close to zero transaction costs, tariffs and other taxes.”169

Consistent with this economic policy, China allows FIEs and other foreign enterprises to remit 

profits, dividends, and bonuses abroad, without requiring the prior approval of Chinese 

authorities.170 

More importantly, Chinese FIEs have been entitled to extremely generous tax incentives 

while operating on the Mainland. During the past 16 years through December 31, 2007, FIEs in 

China were subject, in theory, to a 30-percent national corporate income-tax rate as 

supplemented by an additional 3-percent local corporate tax.171 In practice, however, FIEs were 

rarely required to bear the full Chinese national-local corporate tax burden. During the relevant 

period, so-called “productive” FIEs operating in China for at least 10 years were granted a series 

of corporate income-tax concessions.172

 

Specifically, during their first 2 years of profitable operation, FIEs in certain “productive” 

sectors with an operating period of at least 10 years were fully exempt from all classes or kinds of 

Chinese corporate income tax.173 An additional 50-percent income-tax reduction then kicked-in 

during the ensuing 3-year period.174 Stated otherwise, the PRC tax incentives consisted of a 

national corporate tax rate of only 15 percent during the subsequent 3-year period, after the initial 

2-year tax holiday, once the FIEs began registering profits. This treatment compared very 
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favorably with the total effective tax rate of 33 percent that applied to Chinese domestic firms 

operating on the Mainland during the corresponding period.175 

Additionally, the PRC government aggressively encouraged FIEs and other foreign 

enterprises to locate in China’s SEZs, designated coastal economic development zones, free 

trade zones (“FTZs”), and other areas by offering these business entities other preferential 

income tax rates.176 The Chinese income-tax rate for FIEs and other foreign enterprises located 

in such economic zones generally was set in perpetuity at a flat rate of 15 percent or 24 percent, 

with the final tax rate dependent on the kind of free zone regime at issue.177 During the pertinent 

period, FIEs and other foreign enterprises were also entitled to value-added tax (“VAT”) and 

customs-duty concessions for imported equipment, 178 improved land-use rights, and other 

economic advantages.179 Other tax concessions were available when profits generated from an 

FIE or other foreign enterprise were reinvested in another PRC resident enterprise. 180 This 

extremely favorable tax treatment targeted exclusively at foreign investors and foreign investment 

has been a major driving force fueling Sino round-tripping practices, especially through Hong 

Kong.181 

Accordingly, investment incentives heretofore offered by the PRC central government to 

foreign investors, including corporate income-tax concessions, the forgiveness of import-andexport duties, and the remission of VATs, as well as priority treatment accorded to FIEs and other 

foreign enterprises for infrastructure services, have provided a major catalyst that aggressively 

encouraged the re-routing of recycled Chinese capital via Hong Kong back to the Mainland 

disguised as foreign investment. 

C. Data Analysis that Corroborates Chinese Round-Tripping Practices 

A practical example, as illustrated by the so-called “unbundling” of company functions, 

fleshes out the theoretical discussion set out above. Assume that foreign investors or Chinese 

nationals – whether private citizens or members of the PRC central government – establish a 

Hong Kong holding corporation, Company A, which, in turn, acts as the parent company of a new 

wholly-owned Chinese FIE, Company B, situated on the Mainland. 
-58- 

Additionally, the Hong Kong parent company, Company A, owns all of the intangible 

assets of the affiliated corporate group, including all intellectual property rights that it licenses to 

Company B on the Mainland. Company A also arranges for the input-and-component sourcing, 

manufacturing, distribution, and other functions of the related corporate group. The Chinese FIE, 

Company B, pays a fee to its Hong Kong parent for such functions, but another subsidiary in 

Hong Kong, Company C, actually performs the procurement, invoicing, shipping, and other backoffice operations for the business group.182

 

Assume further that Company B needs to source from Hong Kong specialized imported 

parts, components, and technology from Company A in order to carry out its manufacturing 

operations on the Mainland. Rather than charge the arm’s-length, market-benchmark price of 

US$1,500 per unit, for example, the Hong Kong parent (Company A) charges the Chinese FIE 

(Company B) US$7,500 by virtue of multiple non-arm’s length transfer-price transactions. In other 

words, Company A makes excessive profits for each related-party transaction consummated with 

Company B, its Mainland subsidiary. The fact that most international trade activities in China 

focus on processing trade indicates that import duties are usually exempted for the related 

company B, which significantly lowers the transaction costs for this Mainland-based company. 

According to legal counsel for Company A, such transactions are not prohibited by the 

Hong Kong-China bilateral tax treaty. From the point of view of China Customs agency, it does 

not have any incentive to control the inflated price for imports due to a simple logic: highly priced 

goods bring more import duties to them (although in Hong Kong’s case, the bilateral trade treaty 

waives import duties for many categories of goods between Hong Kong and China). Given that it 

is a Hong Kong company that is charging the transfer prices in question, and given that the treaty 

does not define the phrase “non-arm’s length transfer-price transaction,” Hong Kong domestic law 

must necessarily provide the governing legal standard by operation of the convention default 

rule.183 Inasmuch as the Chinese SAR does not have any transfer-pricing rules on the books, and 

Article 9 of the treaty regulates only the under-reporting of related-party profits 184 - instead of 

proscribing any over-invoicing of Hong Kong components shipped by a Hong Kong entity to its 
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Mainland affiliate (i.e., excessive related-party profits) – the transfer prices set out above are 

consistent with the treaty. 

As a result of these non-market transfer prices, Company B effectively transfers cash for 

each transaction shipment an extra US$6,000 from the Mainland to Hong Kong through China’s 

current account (i.e., non-arm’s length price of US$7,500 minus the arm’s length price of 

US$1,500 = US$6,000) and, thereby, evades China’s capital controls. By engaging in the nonarm’s length transfer-price transactions described above, both Company B and Company A 

artificially increase the value of China’s imports, a result that skews China’s merchandise-of-trade 

balance. Additionally, instead of paying its related-party enterprise in Hong Kong a hypothetical 

rate of US$5,000 per month for sales, distribution, shipping, and invoice fees, Company B pays 

its affiliated Hong Kong partner US$9,500 per month. By doing so, Company B again effectively 

transfers an extra US$4,500 for each transaction from the Mainland to Hong Kong (i.e., non-arm’s 

length price of US$9,500 minus the arm’s length price of US$5,000 = US$4,500) and again 

evades China’s capital controls. A similar result prevails with respect to the intellectual property 

rights licensed by Company A to Company B on the Mainland. 

Lastly, after Company A has accumulated a significant sum of money by virtue of the 

above transfer-pricing machinations, it decides to form another FIE subsidiary on the Mainland, 

Company D. To do so, Company A makes a capital contribution into Company D that totals 

US$10,000,000. Given that the inflow of recycled Chinese capital back to the Mainland 

constitutes a capital contribution into Company D, that specific business transaction is not subject 

to any PRC or Hong Kong tax. Inasmuch as the capital contribution constitutes a “foreign direct 

investment” within the meaning of Chinese law, the so-called “new investment” is entitled to all of 

China’s tax incentives applicable to foreign direct investment. 

A careful examination of the unadjusted trade databases maintained by China and the 

rest of the world corroborates the existence of Chinese round-tripping practices as illustrated by 

the preceding example. Contrary to conventional wisdom, the main source of the ever-widening 

statistical discrepancy that materializes as a consequence of comparing official PRC trade data 

with those of its partner countries – especially when China’s multilateral (rather than bilateral) 
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trade is examined – occurs with its inbound trade, that is, foreign goods that are imported into 

China, as opposed to its outbound trade in which PRC goods are exported from the Mainland and 

imported by China’s partner nations (e.g., United States). This view is compatible with that of the 

Hong Kong Monetary Authority: theoretically, Hong Kong companies may tend to overprice their 

exports to their related Mainland companies, though it is hard to test this practice in reality. 

World Trade Atlas data for 2007 show that Chinese imports (as shipped from the rest of 

the world to the Mainland) are responsible for roughly 60 percent of the statistical inconsistency at 

issue, while PRC exports (as shipped from the Mainland to the rest of the world) account for the 

remaining 40 percent of the discrepancy. Stated otherwise, for every year since 2003 through 

2007, the data inconsistency between the PRC’s official statistics and those of its trading partners 

has weighed more heavily on the Chinese import side, rather than on the PRC export side, of the 

equation:185

 

2007 

Difference in Imports 205,742,795,902 64.42% 

Difference in Exports 113,649,856,560 35.58% 

Total Discrepancy 319,392,652,462 100.00% 

 

2006 

Difference in Imports 174,501,092,268 60.49% 

Difference in Exports 113,966,993,372 39.51% 

Total Discrepancy 288,468,085,640 100.00% 

 

2005 

Difference in Imports 123,134,388,379 53.75% 

Difference in Exports 105,937,713,207 46.25% 

Total Discrepancy 229,072,101,586 100.00% 

 

2004 

Difference in Imports 138,941,728,610 59.88% 

Difference in Exports 93,103,618,975 40.12% 

Total Discrepancy 232,045,347,586 100.00% 

 

2003 

Difference in Imports 101,305,308,291 59.03% 

Difference in Exports 70,302,859,764 40.97% 

Total Discrepancy 171,608,168,055 100.00% 
-61- 

These empirical data are remarkably consistent with the theoretical model of roundtripping; essentially, that Chinese resident enterprises, including FIEs and SOEs operating on the 

Mainland, artificially inflate the customs value of imported components, inputs, intellectual 

property, and services sourced from affiliated parties located in offshore tax havens, such as 

Hong Kong. The data themselves confirm that the round-tripping of recycled Chinese capital does 

indeed constitute a form of tax-investment-trade arbitrage that seeks to exploit the differential taxand-investment treatment, as well as the import, export, and tax incentives, heretofore 

afforded by the Government of China to PRC domestic enterprises, FIEs, and SOEs.186

 

D. Current Account Implications of China’s Round-Tripping Practices 

In their study published in 2006, Fung, Yau, and Zhang stated that their initial hypothesis 

and ultimate finding was that Chinese round-tripping practices begin in China’s current account

with foreign trade transactions that undervalue exports and overvalue imports. 187 These 

researchers then found that the principal foreign tax-haven conduits for Sino round-tripping 

activities are Hong Kong, Taiwan, and Macau,188 even though other researchers have pointed to 

the British Virgin Islands and the Cayman Islands as well. The relatively tiny island of Hong Kong 

has emerged as China’s leading foreign investor. In fact, Hong Kong has increasingly poured its 

FDI into the Mainland since the 1990s (see Graph 9). Hong Kong is, by far, the major foreign 

source of Chinese “round-tripped” capital that is recycled offshore into “foreign investment” and 

then returned to the Mainland. 
-62- 

GRAPH 9 

Hong Kong Direct Investment

 Abroad and FDI Balances

0

10000

20000

30000

40000

50000

60000

70000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

Millions of Dollars

Direct Inv. Abroad

FDI

Source: IMF International Financial Statistics monthly reports. 

Hong Kong is only one of the representative regions that facilitates China’s round-tripping 

FDI activities. Other regions include so called “tax havens” such as the Cayman Islands, Samoa, 

Bermuda, British Virgin Islands, and Mauritius. A closer examination of the annual FDI statistics 

as reported by China National Statistics Bureau reveals that the above-named countries or 

regions, although small in geographical area, account for 49%, 51%, and 58% of China’s total 

FDI inflows in 1999, 2002, and 2006, respectively (see Graph 10-12). 
-63- 

GRAPH 10 

41%

2% 6%

51%

Hong Kong

British Virgin Islands

Cayman / Samoa /

Bermuda / Marutitius

All Other Origins

Structure of China's FDI Origins (in 1999)

Source: China Statistics Yearbook 2000, by National Statistics Bureau, China. 

GRAPH 11 

Structure of China's FDI Origins (2002)

35%

11%

5%

49%

Hong Kong

British Virgin Islands

Cayman / Samoa /

Bermuda / Marutitius

All Other Origins

Source: China Statistics Yearbook 2003, by National Statistics Bureau, China. 
-64- 

GRAPH 12 

Structure of China's FDI Origins (2006)

33%

17%

8%

42%

Hong Kong

British Virgin Islands

Cayman / Samoa /

Bermuda / Marutitius

All Other Origins

Source: China Statistics Yearbook 2007, by National Statistics Bureau, China. 

Graph 13 clearly exhibits the increasing trends of China’s FDI from these tax haven 

regions from 1999 to 2006. It is clearly shown in Graph 13 that the British Virgin Islands joins 

Hong Kong in providing substantial FDI flows to China, which can be interpreted directly as 

evidence of the existence of round-tripping FDI practices. 
-65- 

GRAPH 13 

China's FDI by Origins

0

5

10

15

20

25

1999 2000 2001 2002 2003 2004 2005 2006

Year

Billion Dollars

Hong Kong

British Virgin

Islands

All Other

(Cayman,

Samoa, Bermuda

and Mauritius)

Source: China Statistics Yearbook 2000 to 2007, by National Statistics Bureau, China. 

To adjust China’s official import database for Sino round-tripping activities for purposes of 

our study, we relied on the overall figure of 50 percent as established by researcher Geng 

Xiao.189 However, our approach results in an extremely conservative current-account adjustment, 

(i) because Sino round-tripping practices have accelerated since 2004 (as a consequence of the 

Hong Kong-China FTA), (ii) because the 50-percent ratio is based only on “rent-seeking” roundtripping practices to the exclusion of “value-seeking” round tripping, and, most importantly, (iii)

because the 50-percent figure applies only to recycled Chinese capital that actually returns to the 

Mainland disguised as foreign investment, to the exclusion of any exported Chinese capital that 

remains outside the Mainland in offshore tax havens for extended periods. To compensate for our 

conservative assumption, we further assumed that total capital exiting China is as much as 4 

times China’s FDI inflow190 and all the capital flight is due to overstatement of Chinese imports. 

This measure can at least partially offset the possible underestimation of trade distortion due to 

round-tripping FDI practices in China. 
-66- 

Nevertheless, relying on the conservative 50-percent round-tripping figure to adjust 

China’s official import database for such practices, we calculated that Chinese round-tripping 

practices are responsible, on average, for approximately US$159.7 billion of the statistical 

discrepancy that materializes as a consequence of comparing official Mainland trade data with 

those of its 41 partner nations (i.e., U.S. $319.4 billion x 50% = U.S. $159.7 billion). 

E. China Round-Tripping Practices in the Future 

1. Factors that May Diminish the Incidence of PRC Round-Tripping 

Activities in the Short Term 

On March 16, 2007, the Chinese National People’s Congress enacted a new corporate 

income-tax statute, the Enterprise Income Tax (“EIT”) Law, to comply with the WTO national 

treatment principle and the Agreement on Subsidies and Countervailing Measures (the “WTO 

Subsidies Agreement”). China’s new fiscal regime entered into effect on January 1, 2008.191 The 

fundamental effect of the EIT Law was the repeal of the discriminatory tax treatment that 

previously had favored all Chinese FIEs and other foreign enterprises operating on the Mainland. 

Such foreign invested enterprises were generally entitled to a lower real effective tax rate that 

ranged between 15 percent and 24 percent, while their Chinese domestic counterparts operating 

on the Mainland were subject to an effective tax rate of 33 percent.192

 

In this regard, the new PRC legislation adopts a general unified tax rate of 25 percent 

that, in theory, is applicable to all Chinese resident legal entities regardless of the nationality of

their owners.193 Stated otherwise, the general unified rate of 25 percent applies to both FIEs and 

Chinese domestic enterprises alike.194 Therefore, effective January 1, 2008, all newly-created 

FIEs and all existing Chinese domestic invested enterprises became subject in principle to the 

same general tax (as calculated and assessed on an accrual basis) 195 at the rate of 25 percent. 

According to tax lawyers at PriceWaterhouseCoopers-China, all business entities established in 

Chinese SEZs after December 31, 2007, similarly became subject in theory to the new unified 

rate as well, an outcome that represents a 10-percent marginal tax-rate increase for FIEs.196 

Furthermore, the new Chinese EIT Law eliminates the previous tax holidays for FIE 

“productive,” as well as export-oriented, enterprises.197 As explained by the Chinese Finance 

Minister, Jin Renqing, “[s]ome preferential policies are canceled. For example, the regular tax 
-67- 

reduction and exemption for production-orientated foreign-funded enterprises as well as the 50 

percent tax reduction for export-oriented foreign-funded enterprises are abolished.”198 To achieve 

this end, Article 60 of the new statute repeals the 1991 Income Tax Law of the People’s Republic 

of China for Enterprises with Foreign Investment and Foreign Enterprises, as well as the 1993 

PRC Provisional Regulations on Enterprise Income Tax.199 As a result, FIEs operating in certain 

traditional industries, including low-end manufactured products and labor-intensive production 

activities, will face adverse tax consequences after the partial “grandfathering” provisions of the 

new EIT Law expire.200 

Despite the new unified tax structure, FIEs established in China before January 1, 2008, 

including those created in Chinese SEZs before that date, are entitled to partial “grandfathering” 

and “gradual-transition” provisions.201 For these business entities, the new 25-percent Chinese 

tax rate will be gradually phased-in over a period of 5 years commencing on the effective date of 

the new law.202 

In addition to establishing a unified tax rate, the new Chinese legislation on its face (a)

strengthens the PRC’s transfer-pricing provisions for transactions between “related parties,”203 (b)

adopts “thin capitalization” rules (pursuant to which interest accruing from related-party loans that 

exceeds a prescribed debt-equity ratio can be disallowed as a tax-deductible expense),204 and (c)

codifies new controlled foreign corporation (“CFC”) rules. 205 In accordance with these latter 

provisions, Chinese authorities can now tax Sino-resident shareholders on their portion of 

undistributed profits retained by an offshore CFC subsidiary situated in a low-tax foreign 

jurisdiction206 that has an effective corporate income-tax rate that is generally below 12.5%.207 As 

relevant here, Hong Kong’s effective corporate income-tax rate is 17.5 percent, 5 percentage 

points higher than the Chinese floor. 

With regard to transfer-pricing practices generally, China’s SAT is required under the new 

law to ensure that transactions between “related parties” – that is, “associated enterprises” within 

the meaning of the China-Hong Kong tax treaty – be carried out in accordance with the “arm’slength principle” as articulated by OECD guidelines.

208 The term “related parties” means 

“enterprises, other entities and individuals, which have any of the following relationships with an 
-68- 

enterprise: 1) direct or indirect control over such matters as finance, business operations, 

purchases and sales...; 2) both directly or indirectly controlled by a third party; 3) other 

relationship due to associated interests.”209

A hallmark feature of the new law relates to the authority of China’s SAT to impose a 

special tax/interest levy 210 that takes the form of a tax adjustment and an interest payment 

assessed for any transfer prices charged for tax-avoidance purposes.211 PRC authorities may 

now impose the special tax/interest levy within a 10-year statute-of-limitations period beginning 

on the date of the non-market transaction.212 Before the promulgation of the new statute, no 

legislative authority existed for Chinese administrators to assess any kind of monetary penalties 

for transfer-pricing infractions, except for collecting the correct tax after authorities had made the

necessary price adjustments. 213 This deficiency in the superseded legal framework severely 

limited compliance incentives for taxpayers. The implementation of the special tax/interest levy 

should now increase the economic costs associated with such illicit transfer-pricing activities and 

provide the requisite disincentives to dissuade taxpayers from engaging in such behavior.214

Notwithstanding all of these tax-compliance features, the new EIT Law recycles many of China’s 

previous tax incentives, including fiscal exemptions, reductions, and deductions, into the current 

regime. 

Whether the new EIT Law and implementing regulations eliminate the Chinese roundtripping phenomenon is an open question at this juncture. On the one hand, the new tax regime in 

theory should partially reduce round-tripping, because the new framework repeals the de jure

discriminatory tax treatment that previously had favored FIEs doing business in China vis-à-vis

their domestic counterparts. Moreover, the new legislation appears to provide Mainland tax 

authorities with the requisite enforcement teeth to regulate effectively non-arm’s length transferpricing practices between Chinese enterprises and their Hong Kong affiliates. On the other hand, 

the new EIT Law recycles many of China’s formerly prohibited de jure export subsidies into 

equally prohibited de facto export subsidies, as well as into actionable specific domestic subsidies, 

that may foster continued round-tripping in the future. Furthermore, the profit margins that are 

retained in Mainland China are intentionally set at very thin levels by the related parties. The rise 
-69- 

of corporate tax rates may not effectively restrain the behavioral pattern of these parties due to 

the insignificant increase of their corporate taxes. 

2. Factors That May Encourage Chinese Round-Tripping Practices in 

the Short Term 

Although the new Chinese EIT Law eliminates on a de jure basis the discriminatory tax 

treatment that heretofore favored FIEs and other foreign enterprises over their PRC domestic 

rivals, several factors caution against leaping to the general conclusion that Sino round-tripping 

activities will become an issue of the past. With the exception of the statutory repeal of the 

discriminatory tax treatment described above, neither Beijing nor the new tax legislation has 

effectively confronted and remedied the other economic and legal factors that have heretofore 

provided entrepreneurs with the necessary incentives to carry out round-tripping practices in 

China’s offshore conduits. 

First, Hong Kong is still a de facto foreign tax haven without any transfer-pricing rules, 

CFC provisions, or “thin-capitalization” controls that can combat and effectively regulate transfer 

prices charged by Chinese and Hong Kong affiliates. Moreover, Hong Kong’s corporate incometax rate of only 17.5% is 7.5 percentage points below China’s new unified rate of 25% and 

provides the necessary cross-border fiscal differential that encourages the first step of roundtripping, namely, disguised capital flight. The 7.5 percentage-point differential gives Chinese 

enterprises with SAR affiliates the incentive to undervalue export or overvalue import transactions 

on an artificial basis in order to show lower profits on the Mainland and higher profits in Hong 

Kong. By doing do, such affiliates can evade not only the full Chinese tax liability of 25 percent 

but also the PRC’s capital controls as well. Article 9 of the bilateral tax treaty then further 

encourages such strategies by providing SAR enterprises with the added incentive to over-charge 

their Mainland affiliates for Hong Kong-sourced components imported into China. 

Second, the Mainland has had statutory transfer-pricing provisions on the books since 

1991,215 but has been extremely lax in enforcing such legal requirements. No guarantee exists 

that China’s SAT will enforce the new transfer-pricing obligations aggressively. In this context, 

one study quoted above has underscored that SOEs in the PRC are primarily responsible for the 

round-tripping of recycled Chinese domestic capital. This finding provides SAT authorities with a 
-70- 

disincentive to enforce the new transfer-pricing provisions vigorously, because the Government of 

China may be reluctant to enforce its new tax law against PRC government individuals. As an 

aside, the new statute does not eliminate transfer-pricing practices per se, but rather provides 

PRC taxpayers with the opportunity to utilize more sophisticated transfer-pricing schemes, such 

as Advance Pricing Arrangements (“APAs”)216 and Cost Sharing Arrangements (“CSAs”).217

Third, China has neither repealed its capital controls nor improved its domestic financial 

markets or its private-property regulatory regime to such an extent as to eliminate or reduce the 

incentives for Sino round-tripping activities. Stated otherwise, the same economic and legal 

impediments that hindered PRC domestic investment before the passage of the new Enterprise 

Income Tax Law continue to exist today. Consequently, the economic and legal conditions that 

are necessary to trigger Mainland capital flight that eventually evolves into full-blown roundtripping activities continue to exist despite the enactment of the new law. 

Fourth, both the Hong Kong-China FTA and the Hong Kong-China bilateral tax treaty 

actively support the continuation of round-tripping practices. The former pact provides importers 

with incentives to artificially inflate the customs value of China’s imports sourced from the SAR, 

while the latter treaty entices PRC taxpayers to establish affiliated enterprises in tax-haven Hong 

Kong, an outcome that is an essential pre-requisite for round-tripping. Similarly, Article 9 of the 

tax convention not only tolerates, but insulates from any legal attack the practice whereby Hong 

Kong enterprises systematically overcharge their Chinese affiliates for Hong Kong-sourced 

component parts imported into China. 

Fifth, the new law codifies a variety of interrelated statutory provisions that create 

potential loopholes. Most notably, apparently “to avoid double taxation,”218Chinese lawmakers 

surprisingly excluded partnerships, partnership enterprises, and Sino-foreign contractual jointventure arrangements from the legal ambit of the new EIT Law.219 Furthermore, in sharp contrast 

to other affiliated Chinese resident enterprises operating on the Mainland,220 those that establish 

branches, partnerships, or any other non-legal entities in China have the legal right to prepare a 

consolidated income-tax return.221 As a result, such Chinese entities can lower their overall PRC 

tax liability by having a branch or partnership (that acts as a de facto subsidiary) show losses. 
-71- 

Loopholes such as these will most likely facilitate round-tripping practices to the extent that 

foreign investors learn how to exploit the legal deficiencies to their advantage. 

Sixth, the new statute sets out vague tax incentives that are susceptible to administrative 

abuse. In particular, the new law confers extremely broad authority on the PRC State Council to 

establish at any time new tax exemptions by means of administrative fiat: “[n]on-taxable income 

shall include:...[o]ther non-taxable income as [defined] by the State Council.”222 Likewise, the new 

law ambiguously provides that “[e]nterprise income tax incentives shall be awarded to industries 

and projects on which the State has placed heavy emphasis to promote their development and 

growth.”223 Consistent with the above principles that are subject to potential manipulation, Article 

35, in tandem with Article 36, of the EIT statute specifies that the “actual implementation of tax 

incentives as [established] by this Law shall be tailored by the State Council...in accordance with 

[China’s] economic and societal development needs....”

224 These provisions as a whole can 

encourage non-transparency that can lead to a reduced Chinese tax burden for certain FIEs. 

Seventh, in the event of a conflict between the new tax law and the China-Hong Kong tax 

convention, the latter prevails, because, as previously demonstrated, Hong Kong is a “foreign 

government” for PRC taxation purposes.225 Significantly, in contrast to China’s new statute, the 

treaty expressly covers “partnership[s].”226 In addition, the convention fails to define any of the 

key terms, phrases, or concepts related to non-arm’s length transfer prices charged by 

“associated enterprises” of an affiliated group. Accordingly, the treaty default rule curiously 

mandates that Hong Kong’s non-existent definition with regard to transfer pricing applies to such 

transfer prices charged by Hong Kong entities to their Mainland affiliates.227 Inasmuch as Article 9 

of the bilateral arrangement regulates only the under-reporting of related-party profits, 228 instead 

of proscribing the typical round-tripping practice whereby Hong Kong enterprises overcharge their 

Chinese affiliates for specialized SAR components, it is questionable as to whether either the 

Hong Kong’s tax law or the convention will dissuade round-tripping practices. 

VIII. RESEARCH FINDINGS AND CONCLUSION 

By virtue of the integrated and comprehensive statistical analysis carried out in this study 

that attempts to make estimated adjustments to the trade discrepancy, including that for Chinese 
-72- 

round-tripping activities, the following summarizes the major findings concerning the China-Hong 

Kong entrepôt effect and its overall impact on the PRC’s global trade surplus: 

The individual causes underlying the statistical inconsistency that distorts official Chinese 

trade data includes the following: (i) China-Hong Kong entrepôt effect – that is, Hong Kong’s reexport trade and middleman markups; (ii) divergent customs standards used internationally to 

value exports and imports; (iii) “phantom” Chinese trade; (iv) Sino round-tripping practices, which 

refer to Chinese domestic capital recycled abroad in offshore tax havens subsequently returns to 

the Mainland disguised as foreign investment (estimated for being responsible for approximately 

50% of China’s total trade discrepancy, or US$159.7 billion in 2007); (v) smuggling practices; (vi)

all additional unidentifiable factors such as transshipment activities undertaken through third 

countries, timing of exports and imports, inconsistent geographic coverage issues, 

misclassification of goods, exchange-rate fluctuations, and statistical errors and omissions. 

China’s new Enterprise Income Tax Law may not have much of an impact on the overall 

reported trade discrepancy as it does not address all variables and incentives that contribute to 

round-tripping practices. Specifically, Hong Kong continues to have a favorable corporate income 

tax rate of 17.5% versus China’s new unified rate of 25%. In addition, since a majority of 

companies participating in round-tripping practices are SOEs, China may be reluctant to enforce 

the EITL on governmental officials.

China’s round-tripping practices and capital-flight activities occurring in Hong Kong is a

major factor that not only contributes to divergent private savings and investment levels in the 

Mainland and the rest of the world, but also is the largest factor responsible for China’s currentaccount surplus.

Additionally, we found that the reunification of Hong Kong with China one decade ago, 

the PRC’s subsequent WTO accession in 2001, the ensuing implementation of the Hong KongChina FTA in 2004, and the effective ratification of the Hong Kong-China tax treaty in 2007 have 

all spawned such an unprecedented growth in undetected trade and capital flows between the 

Mainland and Hong Kong that policymakers are unable to measure correctly China’s economic 

impact globally. In this regard, we also found that the resulting trade-data and capital-flow 
-73- 

discrepancies have implications that run far deeper than simple statistical errors and omissions. 

Specifically, China’s entrepôt trade, round-tripping practices, and capital-flight activities – all of 

which are carried out through Hong Kong – largely provides the explanation for the substantial 

and growing divergence between China’s official trade statistics and its trading partners mirror 

trade data. Rather than provide an effective legal framework for the elimination of any of these 

tendencies, China’s new EIT Law, we concluded, may only partially address such noncommercial activities in the future. Discrepancies in reported trade data between China and its 

trading partners will likely continue to increase, as China’s share of global trade continues to grow.
-74- 

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Memorandum for David M. Spooner, Assistant Secretary for Import Administration, Antidumping 

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Mitchell Polinsky, An Introduction to Law and Economics. Aspen Publishers (2003). 

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2007). 
-78- 

PriceWaterhouseCoopers, Impact of China’s new Corporate Income Tax Law on Foreign 

Investors, March 2007, Issue 6, http://wwws.pwccn.com (downloaded on June 9, 2007). 

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2007). 

PriceWaterhouseCoopers, Transfer Pricing Implications of China’s New Corporate Income Tax

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05/26/content_1033.htm
-79- 

Statistics Bureau, Qinhuangdao. Various interviews took place on April 25, 2008. 

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Department), TUNG Sze-wan, Freda (Statistician, Trade Statistics Branch, Census and Statistics 

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Interviews took place on April 15, 2008. 

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statistics from China, Hong Kong and their major trading partners—a mathematical programming 

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-80- 

WTO Agreement on Subsidies and Countervailing Measures (1994). 

WTO Agreement on Trade Related Investment Measures (1994). 

WTO General Agreement on Trade in Services (1994). 

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November 2001). 

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2008. 

YAO, Dr. Shunli. China Center for Economic Research, Peking University. Interview took place 

on April 18, 2008. 

YU, Professor Yongda. Institute of International Affairs, Tsinghua University. Interview took place 

on April 23, 2008. 

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Chinese), 2007.Article retrieved on December 19, 2007 via: 

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ltiNo=0&issource=yes&type=bin&channelid=65015
-81- 

List of Interviews 

(Conducted April 2008) 

Location Interviewees 

Hong Kong Census & Statistics Department Freda Tung and other officials from the Hong 

Kong Census & Statistics Department 

Hong Kong Monetary Authority, Hong Kong Director of Research Department at Hong Kong 

Monetary Authority 

Bulova Watch International Ltd., Hong Kong Manager of Bulova Watch International Ltd. 

Phone Interview in Beijing, China Official from Customs General Administration, 

Beijing, China 

Peking University, Beijing, China Senior Research Fellow from China Economic 

Studies Center, Peking University, Beijing 

Beijing, China Director of Fair Trade Bureau, Ministry of 

Commerce, Beijing, China 

Beijing, China Chief Executive Officer of a Beijing based 

international trade company; trade official of a 

customs declaration broker house 

Qinhuangdao City, Hebei Province, China Customs officials from Qinhuangdao Customs 

Adiministration and Hebei Customs 

Administration 

Qinhuangdao City, Hebei Province, China Representative of a local international trading 

company 

Qinhuangdao City, Hebei Province, China Officials of city-level Bureau of Statistics 

Note: Names of some interviewees are omitted due to requests for anonymity. 
-82- 

ENDNOTES

 

1

See Kate Bronfenbrenner et al, Impact of the U.S.-China Trade Relations on Workers, Wages and 

Employment, 1, 42, Submitted to the the U.S.-China Security Review Commission/the U.S. Trade Deficit 

Review Commission (June 30, 2001)(“Bronfenbrenner Study”). 

2

Robert C. Feenstra, Wen Hai, Wing T. Woo, Shunli Yao, The the U.S.-China Bilateral Trade Balance: Its 

Size and Determinants, 1, 4, Department of Economics, University of California, Davis, (May 1998). 

3

Id. 

4

See Raymond Fisman, Peter Moustakerski, and Shang-Jin Wei, Outsourcing Tariff Evasion: A New 

Explanation for Entrepôt Trade, 2 (October 12, 2005). 

5

 UNCTAD Trade and Development Report, 3 (2005). 

6

See Jiang Jingjng, Wal-Marts China’s Inventory to hit US $18 b this year, China Business Weekly 

(November 29, 2004), http://www.chinadaily.com.cn (downloaded on June 6, 2007).

7

See Tax Havens of Asia, Africa, and the Pacific, http://www.lectlaw.com/filesh/bbg34.htm (downloaded on 

June 5, 2007). 

8

See Raymond Fisman, Peter Moustakerski, and Shang-Jin Wei, Outsourcing Tariff Evasion: A New 

Explanation for Entrepôt Trade, 2 (October 12, 2005). 

9

Id. 

10 See Raymond Fisman, Peter Moustakerski, and Shang-Jin Wei, Outsourcing Tariff Evasion: A New 

Explanation for Entrepôt Trade, NBER Working Paper, No. 12818 (October 12, 2005)(contending that 

entrepôt economies are used to facilitate tariff evasion). 

11 See UNCTAD Trade and Development Report, 3 (2005). The customs and fiscal territories of Macau, 

another Chinese SAR, are legally separate and distinct from those of China. See Hong Kong, 

http://en.wikipedia.org (downloaded on June 5, 2007). The same rule applies to Taiwan. 

12 The importing nations that have witnessed the largest statistical discrepancies with China whereby such 

countries’ official import data report volume-and-value figures that are significantly higher than those 

recorded by China’s official export statistics include the following countries: (i) all nations in North America; 

(ii) a majority of European jurisdictions; (iii) Australia; (iv) New Zealand; (v) Argentina; (vi) Malaysia; (vii)

Thailand; and (viii) India. See Michael J. Ferrantino, Zhi Wang, Accounting for Discrepancies in Bilateral 

Trade: The Case of China, Hong Kong, and the United States, Office of Economics Working Paper, the U.S. 

International Trade Commission, 1, 16-17 (April 2007). Findings of Canadian researchers analyzing bilateral 

China-Canada trade parallel those of the U.S. researchers evaluating China-US trade. See Sandra 

Bohatyretz and Bruna Santarossa, Merchandise Trade Reconciliation Study: Canada-China, 2002 and 2003, 

Analytical Paper, Statistics Canada, ISBN:0-662-39968-4 (August 2005). 

13 WANG Wai-yi, Osbert and TUNG Sze-wan, Freda. Interview with representatives of the Census and 

Statistics Department. 15 April 2008. 

14 Chinese customs broker. Interview took place 22 April 2008. 

15 Geng Xiao, People’s Republic of China’s Round-Tripping FDI: Scale, Causes and Implications, The 

University of Hong Kong, 1, 2, Reference No. 1137 (July 2004)(emphasis added). 

 
-83- 

 

16 Michael J. Ferrantino, Zhi Wang, Accounting for Discrepancies in Bilateral Trade: The Case of China, 

Hong Kong, and the United States, at 28, Office of Economics Working Paper, the U.S. International Trade 

Commission (April 2007).

17

 The merchandise trade balance forms part of the current account (i.e., trade in goods and services, net 

income flows, financial aid from governments abroad) which, in turn, comprises part of a country’s balance 

of payments. The balance of payments is generally determined by a country's exports and imports of goods, 

services, and financial capital, as well as financial transfers. The balance of payments reflects all payments 

and liabilities to foreigners (i.e., debits) and all payments and obligations received from foreigners (i.e., 

credits). Accordingly, the balance of payments is the sum of the current account, the capital account, and 

the financial account. The balance-of-payments mathematical identity provides as follows: current account 

+ capital account + financial account + net errors and omissions = change in official reserve account. The 

basic principle underlying this mathematical identity is that a country such as the United States can consume 

more than it produces (i.e., current-account deficit) only if nations from abroad with a capital-account surplus 

like China supply the United States with capital. See Herbert Stein, "The Balance of Payments" in The 

Concise Encyclopedia of Economics, http://www.econlib.org/library/Enc/BalanceofPayments.html

(downloaded on December 26, 2007). See also Charles P. Kindleberger, Peter H. Lindert, International 

Economics, 1, 119, 149, 159-60, 315, 319 (Richard D. Irwin, Inc., 1978). 

18 A country’s capital account records the international flows of transfer payments relating to capital items, 

including the country's inflows and outflows of payments and transfer of ownership of fixed assets (i.e., 

capital goods). The financial account, in turn, represents the net change in foreign ownership of domestic 

financial assets. See generally Charles P. Kindleberger, Peter H. Lindert, International Economics, 257 

(Richard D. Irwin, Inc., 1978). 

19 According to Black's Law Dictionary, “federalism” is a neutral term referring to the “interrelationships 

among [decentralized] states and [the] relationship between [such] states and the federal [central] 

government.” Black’s Law Dictionary, 612 (6th Ed. 1990). Federalism is a form of political-economic 

organization in which government powers are shared simultaneously by a national central government and

quasi-sovereign states, provinces, regions, districts, or municipalities of the same country.

20 See WTO Agreement, art. 12, para. 1 (“Any State or separate customs territory possessing full autonomy 

in the conduct of its external commercial relations and of the other matters provided for in this Agreement 

and the Multilateral Trade Agreements may accede to this Agreement, on terms to be agreed between it and 

the WTO. Such accession shall apply to this Agreement and the Multilateral Trade Agreements annexed 

thereto. 

21

 See Hong Kong, http://en.wikipedia.org (downloaded on June 5, 2007). A distinguishing characteristic of 

a typical federation is that government powers are shared simultaneously by a national central government 

and quasi-sovereign states, provinces, regions, districts, or municipalities of the same country. See Black’s 

Law Dictionary, 612 (6th Ed. 1990). In sharp contrast to mainstream federalist constitutions, the unorthodox 

China-Hong Kong legal structure does not set forth any concurrent government powers. Rather, pursuant to 

the Sino-British Joint Declaration signed on December 19, 1984, China’s zone of competency in Hong Kong 

is strictly and exclusively limited to the formulation of foreign policy and the execution of national security 

policy, including national defense and the armed forces. By contrast, Hong Kong’s sphere of competency in 

the former British territory broadly covers all remaining government powers and functions inherent to political 

sovereignty, including, but not limited to, the following powers and functions: (i) diplomatic representation 

before international trade bodies (e.g., WTO); (ii) negotiation, conclusion, and ratification of international 

trade, tax, and investment treaties; (iii) negotiation, conclusion, and ratification of debt policies; (iv)

formulation of foreign sovereign economic and trade policy; (v) formulation and regulation of immigration 

matters, including the issuance of visas and residency authorizations to foreign nationals, such as foreign 

investors; (vi) formulation and administration of fiscal (tax) and customs policy; (vii) issuance of currency; 

(viii) regulation of intra-region commerce; (ix) establishment of a regional budget; (x) formulation and 

execution of monetary policy; (xi) administration of a central bank; (xiii) formulation of the general budget bill; 

(xiv) formulation and regulation of planning policies relating to water sources from both inside and outside 

Hong Kong in accordance with international law and international conventions; (xv) maintenance of general 

population statistics and census, as well as trade and investment statistics; (xvi) regulation of electric energy 

and distribution; (xvii) formulation and execution of environmental and labor policies; (xvii) formulation and 
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administration of economic development and general planning policies; (xviii) formulation and administration 

of public health policy; (xix) formulation and execution of public educational and instructional policy; and (xx) 

creation, regulation, and disposition of private property rights. See generally Hong Kong, 

http://en.wikipedia.org (downloaded on June 5, 2007). 

 

22 See Hong Kong, http://en.wikipedia.org (downloaded on June 5, 2007). 

23 Press Release, Hong Kong remains world freest economy, 

http://www.info.gov.hk/gia/general/brandhk/0109165.htm (downloaded June 5, 2007). During the 

consecutive 10-year period comprising 1995-2004, the Heritage Foundation ranked Hong Kong as “the 

freest economy in the world”. The Heritage Foundation Index of Economic Freedom ratings reflect an 

analysis of 50 different economic variables that are grouped into 10 categories encompassing the following: 

(i) banking and finance; (ii) capital flows and foreign investment; (iii) monetary policy; (iv) fiscal burden of 

government; (v) trade policy; (vi) wages and prices; (vii) government intervention in the economy; (viii)

property rights; (ix) regulation; and (x) informal or black market activity. In 2004, Hong Kong recorded an 

overall score of 1.34, an improvement over its 2003 score of 1.44. Id. 

24

 World Bank, published in El Mercurio, B-1, (Santiago, Chile) (October 28, 2005). 

25 Press Release, Hong Kong remains world freest economy, 

http://www.info.gov.hk/gia/general/brandhk/0109165.htm (downloaded June 5, 2007).

26 See Hong Kong, http://en.wikipedia.org (downloaded on June 5, 2007). 

27 See Tax Havens of Asia, Africa, and the Pacific, http://www.lectlaw.com/filesh/bbg34.htm (downloaded on 

June 5, 2007). 

28 Hong Kong Economic and Trade Office, London, The Government of the Hong Kong Special 

Administrative Region, http://www.hketolondon.gov.hk (downloaded on June 5, 2007). 

29 See Tax havens of Asia, Africa, and the Pacific, http://www.lectlaw.com/filesh/bbg34.htm (downloaded on 

June 5, 2007).

30

 Although the 17.5 % rate constitutes the general company profits tax rate in Hong Kong, other rates apply 

as well: (i) companies and corporate entities are subject to a standard tax rate of 17.5% on “assessable 

profits”; (ii) business entities other than company-corporate entities are subject to a tax rate of 16% on 

“assessable profits”; (iii) interest made on qualifying maturity debt instruments is taxed at 8%; (iv) reinsurance of offshore risks is taxed at 8% of “assessable profit”; and (v) life-insurance policies are assessed 

at 5% of the value of the premiums arising in Hong Kong. A Hong Kong licensing company that grant rights 

to use a trademark, copyright, patent, or know-how pays a flat profits tax of 1.75% (i.e., 17.5% on 10%) of 

the ensuing royalty payments. Related expenses are non tax-deductible, however. Income from the 

international operations of shipping companies is exempt from the Hong Kong profits tax, unless the ships 

are operating in Hong Kong waters or proximate to the same, in which case only that portion of the income 

earned in Hong Kong is subject to the profits tax of 17.5%. The sale of goods on consignment in Hong Kong 

on behalf of a non-resident is subject to a tax of 1% of the turnover, without any deductions, unless accounts 

show that the consignment transaction would have been subject to a lower amount in profits tax than under 

the consignment tax. In the latter case, the 17.5% profit tax rate applies. The value-added by services 

provided by Hong Kong “middlemen” for the territory’s entrepôt trade, such as arranging for transportation 

and insurance, as well as identifying customers, is subject to Hong Kong income-tax liability. Despite the 

above, the following sources of trading income are exempt from the Hong Kong profits tax: (i) interest 

received or capital gains made on the purchase, retention, or sale of a government bond issued under the 

Loans (Government Bonds) Ordinance; (ii) exchange-fund debt instruments; (iii) Hong Kong dollardenominated multi-agency debt instruments; and (iv) specified investment schemes (e.g., unit trust, mutual 

funds) which comply with the requirements of a government supervisory authority tax. See Hong Kong 

Corporate Taxation, http://www.lowtax.net/lowtax/html/hongkong/jhkdctx.html (downloaded on June 6, 2007). 
-85- 

 

31 Hong Kong Corporate Taxation, http://www.lowtax.net/lowtax/html/hongkong/jhktax.html (downloaded on 

June 6, 2007); Cobus Group, Hong Kong Offshore, http://www.shelteroffshore.com (downloaded from the 

Internet on June 5, 2007). 

32

 Hong Kong corporate and trust laws are virtually identical to those of the United Kingdom. Consequently, 

most business activities are generally carried out by limited liability companies, limited partnerships, sole 

proprietorships, and even trusts. As a result of the common-law heritage of Hong Kong, trusts are widely 

understood and used in the former British territory. See Hong Kong Corporate Taxation,

http://www.lowtax.net/lowtax/html/hongkong/jhktax.html (downloaded on June 6, 2007); Cobus Group, Hong 

Kong Offshore, http://www.shelteroffshore.com (downloaded from the Internet on June 5, 2007). 

33 Application of the “territorial principle” entails that only income which meets the following 3 criteria is 

subject to the assessment of the Hong Kong profits tax: (i) the business entity must “trade” inside Hong 

Kong; (ii) the income must arise from such a trade; and (iii) the income must arise in, or be derived from, 

Hong Kong. Hence, the residence or non-residence status of a business entity is an irrelevant consideration 

for purposes of ascertaining whether that entity is subject to, or exempt from, the Hong Kong profits tax. 

Advanced tax rulings are available in the SAR and are particularly recommended with regard to the question 

of whether “trading income” constitutes “onshore” and taxable income or “offshore” and tax-exempt income. 

See Hong Kong Corporate Taxation, http://www.lowtax.net/lowtax/html/hongkong/jhktax.html (downloaded 

on June 6, 2007); Cobus Group, Hong Kong Offshore, http://www.shelteroffshore.com (downloaded from the 

Internet on June 5, 2007). Based on the above criteria, the profits and losses of a foreign (Chinese) 

branch or subsidiary of a Hong Kong parent company are neither taxable nor deductible in Hong 

Kong. Id. 

34 The following allowances are deductible for Hong Kong profits-tax purposes: (i) a deduction for a 

contribution (or provision for a contribution) by an employer amounting to not more than 15% of the 

employee's annual salary into a recognized retirement plan registered pursuant to the Occupational 

Retirement Schemes Ordinance. (Since the Mandatory Provident Fund Scheme became effective on 

December 1, 2000, allowable deductions are either 5% of an employee's gross salary or a maximum amount

of approximately the U.S.US$2,560 per month); (ii) a full deduction for charitable donations not exceeding 

10% of annual assessable profits after deducting depreciation allowances; (iii) any Hong Kong tax paid on 

foreign source income – which, by law, is chargeable to profits tax in Hong Kong. (N.B. Foreign source 

income is not customarily subject to taxation in the territory.); (iv) any property tax already paid; and (v)

depreciation allowances for capital equipment: (a) a 100% first-year allowance for manufacturing plant and 

machinery; (b) a 100% first-year allowance for computer equipment; (c) a 60% allowance for the cost of all 

other plant and machinery during the first year, with 10%-30% of the capital asset written-off thereafter; (d) a 

20% allowance for the cost of construction of an industrial building during the first year, with a 4% per 

annum depreciation rate thereafter; and (e) refurbishing/renovating expenditures in 5 equal installments at 

20% per annum. See Hong Kong Corporate Taxation, 

http://www.lowtax.net/lowtax/html/hongkong/jhkotr.html (downloaded on June 6, 2007). 

35 Dividend income received by a Hong Kong parent company from either a resident or a foreign subsidiary 

(e.g., Chinese subsidiary) is not considered income in the hands of the Hong Kong holding company and, 

therefore, is not subject to an assessment of the Hong Kong profits tax. See Hong Kong Corporate Taxation, 

http://www.lowtax.net/lowtax/html/hongkong/jhkotr.html (downloaded on June 6, 2007). 

36

 No withholding taxes as such exist in Hong Kong; however, there are certain circumstances in which a Hong 

Kong company making an income payment to a foreign subsidiary or holding company (which is deemed to be 

Hong Kong source income) needs to withhold the tax. For instance, when a Hong Kong entity pays royalties for 

the use of intellectual property to its own offshore licensing affiliate, then the tax due must be withheld by the 

Hong Kong company effecting the royalty payment. Hong Kong: Offshore Taxation Regimes, 

http://www.lowtax.net/lowtax/html/hongkong/jhkotr.html (downloaded on June 6, 2007). 

37 See Hong Kong Corporate Taxation, http://www.lowtax.net/lowtax/html/hongkong/jhkotr.html (downloaded 

on June 6, 2007); PriceWaterhouseCoopers, 2007 Corporate Tax Information for Asia Pacific Region–Hong 

Kong, http://wwws.pwccn.com (downloaded on June 9, 2007). 
-86- 

 

38 See PriceWaterhouseCoopers, Transfer Pricing in Hong Kong, http://wwws.pwccn.com (downloaded on 

June 9, 2007). In Hong Kong, transfer pricing is a term of art that generally describes all aspects of intracompany pricing arrangements between related business entities and typically applies to intra-company 

transfers of tangible and intangible property. Although intra-company transactions across borders are 

growing rapidly and are becoming much more complex in the globalized economy, the Hong Kong Inland 

Revenue Department has not yet focused its enforcements efforts on attempting to regulate transfer-pricing 

activities of related-party enterprises. 

39 PriceWaterhouseCoopers, 2007 Corporate Tax Information for Asia Pacific Region – Hong Kong, 

http://wwws.pwccn.com (downloaded on June 9, 2007).

40 Bronfenbrenner Study at 42. One noteworthy example involved the Hong Kong-Shanghai Banking 

Company (“HSBC”), Hong Kong’s oldest corporation, which transferred its data-collection office from the 

former British territory to Guangdong Province in 2001. Another noteworthy example involved Wal-Mart,

which moved its Hong Kong operations to Shenzhen, China, in February of 2002. See Wal-Mart’s China 

inventory to hit US$18 billion this year, http://www.chinadaily.com.cn/english/doc/2004-

11/29/content_395728.htm (November 29, 2004)(downloaded on June 6, 2007)(“If Wal-Mart were an 

individual economy, it would rank as China’s eight-biggest trading partner, ahead of Russia, Australia and 

Canada”). 

41

 Mainland and Hong Kong Closer Economic Partnership Arrangement, art. 3, para. 1 (2004).

42

 Hung-Gay Fung, Jot Yau, Gaiyan Zhang, Market Impediments, Trade, and Foreign Direct Investment: 

Evidence from China’s Round-Tripping, University of Missouri at Saint Louis and Seattle University, 1, 25, n. 

11 (November 27, 2006); Mainland and Hong Kong Closer Economic Partnership Arrangement, art 17, para. 

2 (2004) 

43 Id., art. 5, para. 1. 

44 Id., art. 5, para. 2. 

45

 Id., art. 5, para. 3 (“No later than 1 January 2006, the Mainland will apply zero tariff[s] to the import of 

goods of Hong Kong origin that are outside Table 1 of Annex 1. Detailed implementation procedures are set 

out in Annex 1”). 

46

 See Mainland and Hong Kong Closer Economic Partnership Arrangement, Annex 2 (2004) (setting out 

rules of origin for trade in goods). Export products that satisfy the CEPA rules-of-origin requirements are 

entitled to preferential tariff treatment upon their importation into the customs territories of either China or 

Hong Kong. Goods directly imported from “one side” into the “other side” that are entitled to zero tariff rates 

under CEPA comprise “originating goods”. The expression “originating goods,” in turn, refers to (a) “goods 

wholly obtained in one side,” or (b) “goods not wholly obtained in one side...[but having] undergone [a] 

substantial transformation in that side.” Id., Annex 2, para. 2 (2004). 

47 The CEPA value-added calculation formula provides as follows: “value of raw materials” + “value of 

component parts” + “labor costs” + “product development costs”/ FOB value of the exported goods x 100% ≥

30%. See Hong Kong Closer Economic Partnership Arrangement, Annex 2, para. 5(4) (2004). The phrase 

“product development costs” refers to both “product development” and related “development expenses”. Id., 

para. 5(4)(i). 

48

 See generally Canada China Business Council, Guangdong Region, http://www.ccbc.com (downloaded 

on June 6, 2007. 

49

 See id. 

50

 See id. 
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51 See Mainland and Hong Kong Closer Economic Partnership Arrangement, art. 14, para. 1 (2004)(“In 

order to further promote the development of the tourism industry of Hong Kong, the Mainland will allow

residents in Guangdong Province to visit Hong Kong individually. This measure will be implemented on a

trial basis first in Dongguan, Zhongshan and Jiangmen and it will be extended to the entire Guangdong 

Province no later than 1 July 2004”). 

52 See PriceWaterhouseCoopers, Comprehensive Double Tax Arrangement (“DTA”) between the Mainland 

of China and Hong Kong, August 2006, http://www.pwccn.com (downloaded on June 9, 2007). 

53 Hong Kong: Double Tax Treaties, http://www.lowtax.net/lowtax/html/hongkong/jhkotr.html (downloaded on 

June 6, 2007). 

54

 PriceWaterhouseCoopers, Comprehensive Double Tax Arrangement (“DTA”) between the Mainland of 

China and Hong Kong, August 2006, http://www.pwccn.com (downloaded on June 9, 2007). 

55

 See Richard L. Doernberg, International Taxation, West Nutshell Series, at 125 (West Group, 4th ed. 

1999)(explaining the concept of “treaty shopping”). 

56 See Enterprise Income Tax Law of the People’s Republic of China, art. 3 (2008) (unofficial English 

translated version prepared by Deloitte Touche Tohmatsu CPA Ltd). 

57 See Arrangement for the Avoidance of Double Taxation on Income and Prevention of Fiscal Evasion 

Between the Mainland of China and the Hong Kong Special Administrative Region, art. 21 (2007). See also

Enterprise Income Tax Law of the People’s Republic of China, art. 23 (2008) (codifying foreign tax-credit 

mechanism into Chinese tax law); Avoidance of Double Taxation between Hong Kong and the Chinese 

Mainland, http://tpwwbapp.tdctrade.com (downloaded on June 6, 2007). 

58 See Arrangement for the Avoidance of Double Taxation on Income and Prevention of Fiscal Evasion 

Between the Mainland of China and the Hong Kong Special Administrative Region, art. 11, para. 2 (2007); 

PriceWaterhouseCoopers, Comprehensive Double Tax Arrangement (“DTA”) between the Mainland of 

China and Hong Kong, http://www.pwccn.com (August 2006) (downloaded on June 9, 2007)(clarifying that 

the 7% withholding tax rate applies to interest payable from the Mainland). 

59 Id.; Avoidance of Double Taxation between Hong Kong and the Chinese Mainland, 

http://tpwwbapp.tdctrade.com (downloaded on June 6, 2007) (emphasizing that the “5% withholding tax rate 

applies to dividends paid by [a] Mainland company to a Hong Kong resident, provided that the recipient is a 

[Hong Kong] company that holds at least 25% of the capital of the Mainland company, 10% in all the cases”). 

60 See Arrangement for the Avoidance of Double Taxation on Income and Prevention of Fiscal Evasion 

Between the Mainland of China and the Hong Kong Special Administrative Region, art. 10, para. 2 (2007); 

but see PriceWaterhouseCoopers, Comprehensive Double Tax Arrangement (“DTA”) between the Mainland 

of China and Hong Kong, http://www.pwccn.com (August 2006)(downloaded on June 9, 2007) (“Although 

dividends received by foreign investors from a foreign invested enterprise domiciled in the Mainland are 

currently exempt from Mainland taxation, the provision in the new [Hong Kong-China bilateral tax] 

arrangement will provide some protection for Hong Kong investors from any possible withdrawal of this tax 

exemption at some later stage. It gives a greater level of certainty to those investing into China through 

Hong Kong. The reduced withholding rates on dividends, royalties, and interest are amongst the lowest 

rates available in double tax treaty signed by the Mainland”). 

61 Hong Kong: Double Tax Treaties, http://www.lowtax.net/lowtax/html/hongkong/jhkotr.html (downloaded on 

June 6, 2007). 

62 See Arrangement for the Avoidance of Double Taxation on Income and Prevention of Fiscal Evasion 

Between the Mainland of China and the Hong Kong Special Administrative Region, art. 11, para. 2 (2007); 

PriceWaterhouseCoopers, Comprehensive Double Tax Arrangement (“DTA”) between the Mainland of 

China and Hong Kong, http://www.pwccn.com (August 2006) (downloaded on June 9, 2007)(clarifying that 

the 7% withholding tax rate applies to interest payable from the Mainland). 
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63 See Arrangement for the Avoidance of Double Taxation on Income and Prevention of Fiscal Evasion 

Between the Mainland of China and the Hong Kong Special Administrative Region, art. 11, para. 2 (2007); 

PriceWaterhouseCoopers, Comprehensive Double Tax Arrangement (“DTA”) between the Mainland of 

China and Hong Kong, http://www.pwccn.com (August 2006) (downloaded on June 9, 2007). 

64 See Arrangement for the Avoidance of Double Taxation on Income and Prevention of Fiscal Evasion 

Between the Mainland of China and the Hong Kong Special Administrative Region, art. 12, para. 2 (2007); 

PriceWaterhouseCoopers, Comprehensive Double Tax Arrangement (“DTA”) between the Mainland of 

China and Hong Kong, http://www.pwccn.com (August 2006) (downloaded on June 9, 2007). 

65 Hong Kong: Double Tax Treaties, http://www.lowtax.net/lowtax/html/hongkong/jhkotr.html (downloaded on 

June 6, 2007). 

66 See Hong Kong: Double Tax Treaties, http://www.lowtax.net/lowtax/html/hongkong/jhkotr.html

(downloaded on June 6, 2007)(interpreting Article 13(5) of the Arrangement for the Avoidance of Double

Taxation on Income and Prevention of Fiscal Evasion Between the Mainland of China and the Hong Kong 

Special Administrative Region (2007)). In cases in which the transferred shares of stock are equal to or 

exceed 25% of the ownership interest of the Mainland enterprise, or in cases in which the assets of the 

Chinese resident enterprise are comprised principally of immovable property (i.e., real estate) situated on 

the Mainland, the resulting capital gain is taxable in China. See Hong Kong: Double Tax Treaties, 

http://www.lowtax.net/lowtax/html/hongkong/jhkotr.html (downloaded on June 6, 2007). 

67

 PriceWaterhouseCoopers, Comprehensive Double Tax Arrangement (“DTA”) between the Mainland of 

China and Hong Kong, http://www.pwccn.com (August 2006)(downloaded on June 9, 2007).

68 See Hong Kong: Double Tax Treaties, http://www.lowtax.net/lowtax/html/hongkong/jhkotr.html

(downloaded on June 6, 2007). 

69 Arrangement for the Avoidance of Double Taxation on Income and Prevention of Fiscal Evasion Between 

the Mainland of China and the Hong Kong Special Administrative Region, art. 12, para. 2 (2007); 

PriceWaterhouseCoopers, Comprehensive Double Tax Arrangement (“DTA”) between the Mainland of 

China and Hong Kong, http://www.pwccn.com (August 2006)(downloaded on June 9, 2007). 

70 See PriceWaterhouseCoopers, Comprehensive Double Tax Arrangement (“DTA”) between the Mainland 

of China and Hong Kong, http://www.pwccn.com (August 2006)(downloaded on June 9, 2007). 

71 Arrangement for the Avoidance of Double Taxation on Income and Prevention of Fiscal Evasion Between 

the Mainland of China and the Hong Kong Special Administrative Region, art. 24, para. 1 (2007). 

72 Id. 

73 Id., art. 24, para. 2. 

74

 See Tax Havens of Asia, Africa, and the Pacific, http://www.lectlaw.com/filesh/bbg34.htm (downloaded 

on June 5, 2007).

75 See http://forum.tdctrade.com (downloaded on June 5, 2007). 

76 See the U.S. Treasury Analysis—Semi-annual Report on International Economic and Exchange Rate 

Policies (June 2007 Report), Appendix 2, p. 2. Information can be retrieved via: 

http://www.ustreas.gov/offices/international-affairs/economic-exchange-rates

77 See the U.S. Treasury Analysis—Semi-annual Report on International Economic and Exchange Rate 

Policies (June 2007 Report), Appendix 2, p. 2. Information can be retrieved via: 

http://www.ustreas.gov/offices/international-affairs/economic-exchange-rates (emphasizing that the value of 

the U.S. goods re-exported to China through Hong Kong in 2005 comprised 14% of total reported the U.S.
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exports shipped to China) with Bronfenbrenner Study at 67 (stating that “[t]here is a significant share of the 

U.S. exports to China that are funneled through Hong Kong as re-exports to China [about 42 percent in 

1995]...some of these Hong Kong re-exports originating in the the U.S. and bound for China are not 

identified correctly as the U.S. exports to China in the U.S. trade data”). See also Michael J. Ferrantino, Zhi 

Wang, Accounting for Discrepancies in Bilateral Trade: The Case of China, Hong Kong, and the United 

States, Office of Economics Working Paper, at 1-4 (stressing that as “[e]xpressed as a share of the U.S. 

reported imports from China, the share of Hong Kong re-exports of goods of Chinese origin has declined

from about 61 percent in 1985 to about 14 percent in 2006”).

78 See John W. Schindler, Dustin H. Beckett, Adjusting Chinese Bilateral Trade Data: How Big is China’s 

Trade Surplus?, 27-55, Board of Governors of the Federal Reserve System, International Journal of Applied 

Economics, 2(2) (September 2005). 

79 See Hong Kong Closer Economic Partnership Arrangement, Annex 2, para. 5(4) (2004); see also K.C. 

Fung, Lawrence J. Lau, New Estimates of the United States-China Bilateral Trade Balances, at 1, 10, AsiaPacific Research Center, Institute for International Studies, Stanford University (1999)(“Re-exports, as 

defined by the Hong Kong government, occur when imports to Hong Kong are consigned to a buyer in Hong 

Kong who takes legal possession of the imported goods and then sells and ships the imported goods to 

another party in a third country. The buyer in Hong Kong may undertake minor processing of the imports

before re-exporting them elsewhere; however, the character and nature of the goods is not fundamentally 

altered so that no Hong Kong origin is supposed to be conferred. 

80 See also id. at 17 (“Another very important factor that renders both the U.S. and Chinese trade data 

inaccurate is the existence of Hong Kong re-export markups. The standard interpretation of these mark-ups 

is that [they are] profit margins of the unrelated-party Hong Kong middleman. The unrelated-party Hong 

Kong middlemen purchase goods from China or the United States, then add a profit margin to the value of 

these goods before they re-export them elsewhere. Information about these re-export markups is difficult to 

obtain. But in February of 1996, the Census and Statistics Department of Hong Kong released results about 

its annual surveys of re-export trade. From the results of these surveys, we obtain new estimates of these 

re-export markups for the period 1989-1994. Sources from China and personal interviews with Hong Kong 

government officials and businessmen supply the remaining estimates”)(emphasis supplied). 

81 Robert C. Feenstra, Wen Hai, Wing T. Woo, Shunli Yao, The the U.S.-China Bilateral Trade Balance: Its 

Size and Determinants, at 4, Department of Economics, University of California, Davis (May 1998). 

82 See, e.g., K.C. Fung, Lawrence J. Lau, New Estimates of the United States-China Bilateral Trade 

Balances, Asia-Pacific Research Center, Institute for International Studies, Stanford University, at 1, 17, n. 9 

(1999) (“In Fung and Lau [1996], we used re-export markups based on surveys conducted by the Hong 

Kong Trade Development Council. The markups we use here are newer and more comprehensive.” “It is 

interesting to note that the re-export markups are quite high for Chinese exports to the United States, on the 

order of 25 percent of the cost of the re-exported goods, whereas the re-export markups on the U.S. exports 

to China are quite low – approximately 6 percent. Thus, not adjusting for the re-export markups can also 

distort the measurement of US-China bilateral trade balance”); Sarah Y. Tong, The US-China Trade 

Imbalance: How Big is it Really?, China: An International Journal 3,1: 131-154, 136, 137-139 (March 

2005)(“Another adjustment to make when considering Hong Kong’s re-export trade is the re-export markup.” 

“These mark-ups may be interpreted as the value-added contribution of the Hong Kong middlemen.” “The 

Hong Kong government collects information about these re-export markups. See Hong Kong Monthly Digest 

of Statistics [(publishing estimates of Hong Kong re-export markups)]”. “Hong Kong’s re-export mark-ups are 

quite high for Chinese goods, around 25 percent of the cost of the goods re-exported.” “The re-export markups for goods imported from sources other than China are much lower, about 6 percent, including those reexported to China”); Bronfenbrenner Study at 67 (“A survey of re-export trade carried out by the Hong-Kong 

Census and Statistics Department showed the average re-export markup on Chinese exports to the United 

States is about 25 percent...The 25 percent markup [that] gets paid to Hong Kong middlemen, not to China, 

inflates the value of Chinese imports in the U.S. data”). 

83 See G. Hufbauer and D. Rosen, "American Access to China's Market: The Congressional Vote on 

PNTR," Institute for International Economics," No. 00-3, April, at 5. 2000. 
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84 See, e.g., K.C. Fung, Lawrence J. Lau, New Estimates of the United States-China Bilateral Trade 

Balances, at 14, Asia-Pacific Research Center, Institute for International Studies, Stanford University 

(1999)(“To take into account re-exports through Hong Kong, we assume that the official Chinese export data 

capture only direct exports and that re-exports through Hong Kong to United States constitute indirect 

exports”). 

85 See the U.S. Treasury Analysis—Semi-annual Report on International Economic and Exchange Rate 

Policies (June 2007 Report), Appendix 2, p. 2. Information can be retrieved via: 

http://www.ustreas.gov/offices/international-affairs/economic-exchange-rates

 

86 Id. 

87 Id. Such indirect Chinese import trade sometimes can present issues of double-counting as well. The

double-counting phenomenon occurs in cases in which China’s trading partners are indeed able to identify 

and correctly report their export trade to Hong Kong (that is then re-exported to the Mainland) as legitimate 

exports to China. However, the Hong Kong customs authorities also report such re-export trade to China as 

Hong Kong exports to China as well. As a result, China’s aggregate import volumes and values may 

sometimes be overstated by the volume and value of such Hong Kong re-export trade and must be reduced 

accordingly. To eliminate such double-counting, one must subtract from the Chinese import database only 

the volume and value of such Hong Kong re-exports shipped to China that originate from China’s trading

partners that the Mainland customs authorities erroneously double-count. When subtracting such Hong 

Kong re-export trade from the Chinese import database, one must strip out the 6%) Hong Kong “middlemen” 

mark-up attributable to such indirect trade. 

88 See the U.S. Treasury Analysis—Semi-annual Report on International Economic and Exchange Rate 

Policies (June 2007 Report), Appendix 2, p. 2. Information can be retrieved via: 

http://www.ustreas.gov/offices/international-affairs/economic-exchange-rates

 

89 Id. 

 

90

 Id. With respect to the U.S.-China bilateral trade, the United States trades goods not only directly with 

China, but also indirectly through Hong Kong. Under-counting with regard to such indirect Chinese trade can 

sometimes occur in certain circumstances, especially when the United States reports the U.S. goods 

shipped to Hong Kong that are re-exported to China as the U.S. exports to Hong Kong, instead of the U.S. 

exports to China. Although such a scenario occurs less frequently today, it still does take place at some 

indeterminate frequency. Even though Chinese customs authorities usually can attribute the actual origin of 

these Hong Kong re-exports to the United States (rather than to Hong Kong) and records them as such, the 

U.S. customs authorities sometimes do not report such trade as the U.S. exports destined to China. 

Therefore, the U.S. exports to China are sometimes understated by the volume and value of the indirect the 

U.S. export trade re-exported through Hong Kong for ultimate importation into China that the U.S. customs 

authorities sometimes erroneously fail to report as legitimate the U.S. trade with China. Simply put, if no 

adjustment is made for such Hong Kong re-export trade, then the U.S. exports shipped to China, as reported 

by the U.S. customs authorities, can be under-reported or under-counted. To eliminate the resulting trade 

distortion, one must add to the the U.S. export database the volume and value of only that indirect U.S. 

export trade shipped to China through Hong Kong that the U.S. authorities fail to record in correct fashion. 

91 See the U.S. Treasury Analysis—Semi-annual Report on International Economic and Exchange Rate 

Policies (June 2007 Report), Appendix 2, p. 2. Information can be retrieved via: 

http://www.ustreas.gov/offices/international-affairs/economic-exchange-rates

92 Id. 

93 Id. 

94

 Id. China trades goods not only directly with the United States, but also indirectly through Hong Kong. To

adjust for the under-reporting or under-counting of indirect Chinese exports shipped to the United States 

through Hong Kong, one must add to China’s reported exports only those Mainland shipments that are re-
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exported through Hong Kong before their final importation into the United States that Chinese authorities do 

not correctly record. The under-counting phenomenon sometimes occurs when China erroneously reports 

merchandise shipped to Hong Kong (that is then subsequently re-exported by Hong Kong “middlemen” to 

the United States) as Chinese exports to Hong Kong, rather than as legitimate Chinese exports to the United 

States. Although the U.S. customs authorities usually are able to attribute the origin of these re-exported 

goods to China (rather than to Hong Kong), Chinese customs authorities sometimes do not report such 

trade as Chinese exports to the United States. Therefore, China’s exports, as reported by Chinese customs 

authorities, are sometimes understated by the volume and value of Chinese export shipments re-exported 

from Hong Kong to the United States that Chinese Customs erroneously fails to record in proper fashion. 

95 See the U.S. Treasury Analysis—Semi-annual Report on International Economic and Exchange Rate 

Policies (June 2007 Report), Appendix 2, p. 2. Information can be retrieved via: 

http://www.ustreas.gov/offices/international-affairs/economic-exchange-rates 

96 Id. 

 

97 Id. 

 

98 Id. Such indirect Chinese import trade can sometimes present issues of double-counting as well. The 

double-counting phenomenon occurs in cases in which China is indeed able to identify and correctly report 

some of its export trade shipped to the rest of the world (that is re-exported to China’s trading partners

through Hong Kong) as legitimate Chinese exports to the rest of the world. However, the Hong Kong 

customs authorities also report such re-export trade to the rest of the world as Hong Kong exports to China’s 

trading partners as well. As a result, the aggregate import volumes and values of China’s trading partners 

are sometimes overstated by the volume and value of such Hong Kong re-export trade, because the 

customs authorities of China’s trading partners sometimes engage in double-counting. To eliminate this 

trade distortion, one must subtract from the import database of the rest of the world only the volume and 

value of such Hong Kong re-exports shipped to China’s trading partners that originate from China that the 

customs authorities of China’s partners erroneously double-count. When subtracting such Hong Kong reexport trade from the import database of the rest of the world, one must strip out the 25% Hong Kong 

“middlemen” mark-up attributable to such indirect trade.

99 See Michael J. Ferrantino, Zhi Wang, Accounting for Discrepancies in Bilateral Trade: The Case of China, 

Hong Kong, and the United States, at Abstract, 1-4, Office of Economics Working Paper, the U.S. 

International Trade Commission (April 2007)(emphasis added).

100 Michael F. Martin, What’s the Difference? – Comparing the U.S. and Chinese Trade Data, CRS Report 

for Congress (April 10, 2007). 

101 Id.; Bronfenbrenner Study at 42. 

102 See Michael J. Ferrantino, Zhi Wang, Accounting for Discrepancies in Bilateral Trade: The Case of 

China, Hong Kong, and the United States, at 1, 5-6, Office of Economics Working Paper, the U.S. 

International Trade Commission (April 2007). 

103 See K.C. Fung, Lawrence J. Lau, New Estimates of the United States-China Bilateral Trade Balances, at 

1, 8, Asia-Pacific Research Center, Institute for International Studies, Stanford University (1999). 

104

 Id. at 6, n.1. 

105

 See the U.S. Treasury Analysis—Semi-annual Report on International Economic and Exchange Rate 

Policies (June 2007 Report), Appendix 2, p. 2. Information can be retrieved via: 

http://www.ustreas.gov/offices/international-affairs/economic-exchange-rates 

106

 Id. 
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107 See Bronfenbrenner Study at 69; John W. Schindler, Dustin H. Beckett, Adjusting Chinese Bilateral 

Trade Data: How Big is China’s Trade Surplus?, at 27, Board of Governors of the Federal Reserve System, 

International Journal of Applied Economics, 2(2) (September 2005). 

108 Michael J. Ferrantino, Zhi Wang, Accounting for Discrepancies in Bilateral Trade: The Case of China, 

Hong Kong, and the United States, at 10, Office of Economics Working Paper, the U.S. International Trade 

Commission (April 2007). 

109 See John W. Schindler, Dustin H. Beckett, Adjusting Chinese Bilateral Trade Data: How Big is China’s 

Trade Surplus?, at 27, Board of Governors of the Federal Reserve System, International Journal of Applied 

Economics, 2(2) (September 2005); Bronfenbrenner Study at 69. 

110 Michael J. Ferrantino, Zhi Wang, Accounting for Discrepancies in Bilateral Trade: The Case of China, 

Hong Kong, and the United States, at 16-17. 

111 Id. 

112 Bronfenbrenner Study at 70. 

113 See Robert C. Feenstra, Wen Hai, Wing T. Woo, Shunli Yao, The the U.S.-China Bilateral Trade 

Balance: Its Size and Determinants, at 9, Department of Economics, University of California, Davis (May 

1998). Conceptually, smuggling may be viewed as the most extreme case of under-invoicing, because the

transaction is not recorded at all, and its value is zero. See Michael J. Ferrantino, Zhi Wang, Accounting for 

Discrepancies in Bilateral Trade: The Case of China, Hong Kong, and the United States, at 10, Office of 

Economics Working Paper, the U.S. International Trade Commission (April 2007). Situations that provide

incentives for under-invoicing also give rise to smuggling activities, especially if the incentives translate into 

an extremely high pay-off. Id. Incentives for smuggling are particularly enticing when either exports or 

imports of a commodity are illegal, such as certain drugs, explosives, weapons, pornography, and 

endangered species, as well as products that infringe vested intellectual property rights. Id. 

114 See Robert C. Feenstra, Wen Hai, Wing T. Woo, Shunli Yao, The the U.S.-China Bilateral Trade 

Balance: Its Size and Determinants, at 9, Department of Economics, University of California, Davis (May 

1998). 

115 Id. Automobiles and cigarettes, as well as fruit, used to be the major goods smuggled into China. 

Refined petroleum products have now displaced these products. By reconciling reported exports and 

imports of certain East Asian countries, the quantity of refined petroleum products smuggled into China has 

been estimated to be ten million (10,000,000) tons per year. Approximately one hundred thousand (100,000) 

automobiles, both new and used, are reported to be smuggled into China every year. As is well known, a

significant amount of cigarette trade between the United States and China takes the form of the U.S. exports 

smuggled through Hong Kong en route to the Mainland. See K.C. Fung, Lawrence J. Lau, New Estimates of 

the United States-China Bilateral Trade Balances, at 22-23, Asia-Pacific Research Center, Institute for 

International Studies, Stanford University (1999). 

116 See Bronfenbrenner Study at 70. 

117 Id. 

118 See K.C. Fung, Lawrence J. Lau, New Estimates of the United States-China Bilateral Trade Balances, at 

22, Asia-Pacific Research Center, Institute for International Studies, Stanford University (1999). 

119 Id. at 23.

120 Id. 
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121 Michael J. Ferrantino, Zhi Wang, Accounting for Discrepancies in Bilateral Trade: The Case of China, 

Hong Kong, and the United States, at 5, Office of Economics Working Paper, the U.S. International Trade 

Commission (April 2007). 

122 Id. 

123 See Michael J. Ferrantino, Zhi Wang, Accounting for Discrepancies in Bilateral Trade: The Case of 

China, Hong Kong, and the United States, at 14-15, Office of Economics Working Paper, the U.S. 

International Trade Commission (April 2007); Michael F. Martin, What’s the Difference? – Comparing the 

U.S. and Chinese Trade Data, at 20, CRS Report for Congress (April 10, 2007). 

124 Id. 

125 Michael J. Ferrantino, Zhi Wang, Accounting for Discrepancies in Bilateral Trade: The Case of China, 

Hong Kong, and the United States, at 7, 15, Office of Economics Working Paper, the U.S. International 

Trade Commission (April 2007). Issues also arise with regard to the difference between “general” versus 

“special” trade and “goods in transit”. Examples of imports that are included in “general” but not “special” 

trade are imports which are entered into special warehouses or free-trade zones, but which do not clear 

customs given that such goods do not enter into the customs territory of the importing country. Exports that 

are included in “general” but not “special” trade consist of re-exports of merchandise that are produced 

outside the country of re-exportation that are not “substantially transformed” in the country of re-exportation. 

The United States maintains both general trend trade data, known as “general imports” and “total exports,” 

and special trade data, known as “imports for consumption” and “domestic exports”. The difference between 

total exports and domestic exports in the the U.S. data is called “foreign exports.” Michael J. Ferrantino, Zhi 

Wang, Accounting for Discrepancies in Bilateral Trade: The Case of China, Hong Kong, and the United 

States, at 6, n.4, Office of Economics Working Paper, the U.S. International Trade Commission (April 2007). 

Even general trend data may omit merchandise that physically enters or leaves a port. There is an additional 

category, known as “goods in transit,” which includes merchandise that passes through ports, but which is 

not unloaded from the ship or aircraft. Most countries have little or no data for “goods in transit”. 

126 Michael F. Martin, What’s the Difference? – Comparing the U.S. and Chinese Trade Data, at 5, CRS 

Report for Congress (April 10, 2007). 

127 Id. 

128 See Hung-Gay Fung, Jot Yau, Gaiyan Zhang, Market Impediments, Trade, and Foreign Direct 

Investment: Evidence from China’s Round-Tripping, at 1, 2, 27 University of Missouri at Saint Louis and 

Seattle University (November 27, 2006). 

129 Id. 

130 According to China’s official legal definition, the phrase “foreign direct investment” refers to investment 

carried out through one of 3 legal types of Chinese foreign business entities: (i) WFOEs; (ii) Sino-foreign 

equity joint ventures; and (iii) Sino-foreign cooperative or contractual joint ventures (e.g., partnerships). See 

generally “China’s FDI merry-go-round,” FDI ForeignDirectInvestment, FT Business Financial Times, 

http://www.fdimagazine.com (April 2, 2003)(downloaded on June 6, 2007); Hung-Gay Fung, Jot Yau, Gaiyan

Zhang, Market Impediments, Trade, and Foreign Direct Investment: Evidence from China’s Round-Tripping, 

at 1, 2, University of Missouri at Saint Louis and Seattle University (November 27, 2006). Chinese FIEs trace 

their modern legal origins to the promulgation in 1991 of China’s FIE income-tax law. 

131 See “China’s FDI merry-go-round,” FDI ForeignDirectInvestment, FT Business Financial Times, 

http://www.fdimagazine.com (April 2, 2003)(downloaded on June 6, 2007); Hung-Gay Fung, Jot Yau, Gaiyan

Zhang, Market Impediments, Trade, and Foreign Direct Investment: Evidence from China’s Round-Tripping, 

at 2, University of Missouri at Saint Louis and Seattle University, 2 (November 27, 2006); UNCTAD 

Investment Brief, Number 2 (2007). 
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132 Michael J. Ferrantino, Zhi Wang, Accounting for Discrepancies in Bilateral Trade: The Case of China, 

Hong Kong, and the United States, at 28, Office of Economics Working Paper, the U.S. International Trade 

Commission (April 2007). 

133 See generally Hung-Gay Fung, Jot Yau, Gaiyan Zhang, Market Impediments, Trade, and Foreign Direct 

Investment: Evidence from China’s Round-Tripping, at 3, University of Missouri at Saint Louis and Seattle 

University (November 27, 2006). See also Michael J. Ferrantino, Zhi Wang, Accounting for Discrepancies in 

Bilateral Trade: The Case of China, Hong Kong, and the United States, at 9-10, Office of Economics 

Working Paper, the U.S. International Trade Commission (April 2007). 

134 Michael J. Ferrantino, Zhi Wang, Accounting for Discrepancies in Bilateral Trade: The Case of China, 

Hong Kong, and the United States, at 4, Office of Economics Working Paper, the U.S. International Trade 

Commission (April 2007). First, by means of underreporting exports, a Chinese exporting firm can avoid

certain Chinese currency-conversion restrictions and can freely convert its earnings to any foreign currency. 

Second, earnings kept offshore can be returned home through an affiliated foreign entity (but acting on 

behalf of the Chinese exporting firm) as so-called “foreign investment” that heretofore enjoyed preferential 

tax treatment on the Mainland. Some of the undervalued export earnings return to China, while another 

portion of these earnings typically remains offshore. This practice occurs with the assistance of a relatedparty trading partner of the Chinese exporting firm that is situated in the offshore conduit. To make the 

amount of money remaining in China look legitimate, the Chinese exporting firm must understate its export 

earnings to the Chinese authorities, so that any remitted earnings will match the reported earnings at home. 

See Hung-Gay Fung, Jot Yau, Gaiyan Zhang, Market Impediments, Trade, and Foreign Direct Investment: 

Evidence from China’s Round-Tripping, at 6, University of Missouri at Saint Louis and Seattle University, 

November 27, 2006); UNCTAD Investment Brief, Number 2 (2007). 

135

 Hung-Gay Fung, Jot Yau, Gaiyan Zhang, Market Impediments, Trade, and Foreign Direct Investment: 

Evidence from China’s Round-Tripping, at 4-5, University of Missouri at Saint Louis and Seattle University, 

(November 27, 2006). 

136 Michael J. Ferrantino, Zhi Wang, Accounting for Discrepancies in Bilateral Trade: The Case of China, 

Hong Kong, and the United States, at 10, Office of Economics Working Paper, U.S. International Trade 

Commission (April 2007). 

137

 See the U.S. Treasury Analysis—Semi-annual Report on International Economic and Exchange Rate 

Policies (June 2007 Report), Appendix 2, p. 2. Information can be retrieved via: 

http://www.ustreas.gov/offices/international-affairs/economic-exchange-rates 

138 Geng Xiao, People’s Republic of China’s Round-Tripping FDI: Scale, Causes and Implications, at 1, 6, 

10 The University of Hong Kong, Reference No. 1137 (July 2004). 

139 Memorandum, Countervailing Duty Investigation of Coated Free Sheet (“CFS”) Paper from the People’s 

Republic of China – Whether the Analytical Elements of the Georgetown Steel Opinion are Applicable to 

China’s Present-Day Economy, 1, 3 (May 29, 2007) (“Georgetown Steel Memorandum”). 

140 See Income Tax Law of the People's Republic of China on Enterprises with Foreign Investment and 

Foreign Enterprises, Art. 2 (1991)(superseded(“`Enterprises with foreign investment’ referred to in this Law 

mean Chinese-foreign equity joint ventures, Chinese-foreign contractual [partnership] joint ventures and 

foreign-capital enterprises that are established in China. `Foreign enterprises’ referred to in this Law mean 

foreign companies, enterprises and other economic organizations which have [permanent] establishments or 

places in China and engage in production or business operations, and which, though without establishments 

or places in China, have income from sources within China”). As set forth in the text of our study, foreign 

business entities established in China include (a) Sino-foreign equity joint ventures, (b) Sino-foreign 

contractual joint-ventures or partnerships, and (c) wholly-owned FIEs. Other foreign enterprises, in turn, 

generally refer to foreign companies, enterprises, and other economic organizations with “permanent 

establishments” situated on the Mainland that are engaged in production or business operations, as well as 

other entities and individuals that, although they do not have any kind of presence in China, derive income 

that is effectively connected with the Mainland. During the past decades through December 31, 2007, FIEs 
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and other foreign enterprises that had “permanent establishments” in China were generally subject -- in the 

absence of any tax incentives or concessions -- to the Chinese national corporate income-tax rate of 30%, 

as supplemented by a local income tax rate of 3%, for income attributable to the following activities: (i)

production and business operations; (ii) interest; (iii) rentals; (iv) royalties; and (v) income derived from 

sources both inside and outside China that is “effectively connected” with a Chinese “permanent 

establishment”. See PriceWaterhouseCoopers, Setting up in China, http://wwws.pwccn.com (downloaded on 

June 9, 2007). Foreign enterprises without any “permanent establishment” or other presence in China, but 

which derived profits, interest, rentals, royalties, and other income from Chinese sources, were taxed at the 

rate of 10% though December 31, 2007. Id. 

141 See Thomas Hall, Controlling for Risk: An Analysis of China's System of Foreign Exchange and 

Exchange Rate Management, 17 COLUM. J. ASIAN L. 433, 468, 2004 (explaining that “[f]oreign currency 

borrowing transactions...remain heavily restricted. However,...[t]he foreign debt regulations are less 

restrictive of borrowing by FIEs, which are generally free to borrow and repay foreign loans at will”). 

142 See Geng Xiao, People’s Republic of China’s Round-Tripping FDI: Scale, Causes and Implications, at 15, 

The University of Hong Kong, Reference No. 1137 (July 2004). 

143 Id. at Table 5 (showing that Hong Kong by itself accounted for 45.73% of China’s foreign direct 

investment in 2002). 

144 See Bronfenbrenner Study at 29. 

145

 Id. 

146

 Id. 

147 See Charles E. McLure Jr., Hoover Institution, Stanford University, Transfer Pricing and Tax Havens: 

Mending the LDC Revenue Net, 1, 8 (downloaded from the Internet on June 6, 2007). 

148 Id. at 16. 

149 See Bronfenbrenner Study at 70. 

150 See Charles E. McLure Jr., Hoover Institution, Stanford University, Transfer Pricing and Tax Havens: 

Mending the LDC Revenue Net, at 9 (downloaded from the Internet on June 6, 2007). 

151 Id. 

152 See Bronfenbrenner Study at 70. 

153 See Charles E. McLure Jr., Hoover Institution, Stanford University, Transfer Pricing and Tax Havens: 

Mending the LDC Revenue Net, at 9 (downloaded from the Internet on June 6, 2007). 

154 Tolley’s International Tax Planning (2002), para. 16.1, ISBN 0754513394 (2002). 

155 Doggart, Caroline, 2002, Tax Havens and their uses (originally published in 1970), Economist 

Intelligence Unit, ISBN 0862181631. 

156 TUNG, Freda. Statistician, Census and Statistics Department, Hong Kong Special 

Administrative Region. Interview took place 15 April 2008. 

157 Charles E. McLure Jr., Hoover Institution, Stanford University, Transfer Pricing and Tax Havens: 

Mending the LDC Revenue Net, at 3, (downloaded from the Internet on June 6, 2007). In this regard, 

Switzerland and the United States, both developed countries, are tax havens for passive-investment assets, 

because interest income generated by foreign nationals residing outside the United States and Switzerland 

are not subject to the income tax laws of those countries. Id. at 3, n. 6. In other words, Chinese foreign 

nationals residing on the Mainland do not pay any the U.S. income tax for any of their the U.S.-source
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interest income attributable to bonds, certificates of deposit, money markets, and other interest-bearing 

instruments. Id. 

158 See http://forum.tdctrade.com (June 5, 2007). See also See “China’s FDI merry-go-round,” FDI 

ForeignDirectInvestment, FT Business Financial Times, http://www.fdimagazine.com (April 2, 

2003)(downloaded on June 6, 2007); Hung-Gay Fung, Jot Yau, Gaiyan Zhang, Market Impediments, Trade, 

and Foreign Direct Investment: Evidence from China’s Round-Tripping, at 2, University of Missouri at Saint 

Louis and Seattle University (November 27, 2006); UNCTAD Investment Brief, Number 2 (2007). 

159 See generally Geng Xiao, People’s Republic of China’s Round-Tripping FDI: Scale, Causes and 

Implications, at 3, 10. The University of Hong Kong, Reference No. 1137 (July 2004); Paper can also be 

retrieved via: http://adbi.adb.org/conf-seminar-papers/2004/06/01/820.prc.fdi.cpp/

160 See generally “China’s FDI merry-go-round,” FDI ForeignDirectInvestment, FT Business Financial Times, 

http://www.fdimagazine.com (April 2, 2003)(downloaded on June 6, 2007); Hung-Gay Fung, Jot Yau, Gaiyan

Zhang, Market Impediments, Trade, and Foreign Direct Investment: Evidence from China’s Round-Tripping, 

at 2, University of Missouri at Saint Louis and Seattle University (November 27, 2006); UNCTAD Investment 

Brief, Number 2 (2007). 

161 See “China’s FDI merry-go-round,” FDI ForeignDirectInvestment, FT Business Financial Times, 

http://www.fdimagazine.com (April 2, 2003)(downloaded on June 6, 2007). 

162 Hung-Gay Fung, Jot Yau, Gaiyan Zhang, Market Impediments, Trade, and Foreign Direct Investment: 

Evidence from China’s Round-Tripping, at 2, University of Missouri at Saint Louis and Seattle University 

(November 27, 2006). 

163 HE, Dong. Head of Economic Research, Hong Kong Monetary Authority. Interview conducted 

on 16 April 2008. 

164 Id. at 13 (“What it means is that [the] PRC lends a lot of capital to the US in the form of current account 

surplus with [the] US but at the same time [the] PRC borrows a lot from its Asian neighbors in the form of 

PRC’s current account deficits with Asian neighbors”). 

165 Two types of round-tripping activities take place between China and Hong Kong: (i) rent-seeking roundtripping; and (ii) value-seeking round-tripping. Rent-seeking “round tripping” -- the initial purpose of which is 

to escape cumbersome Chinese impediments and regulations (e.g., capital controls) imposed on the 

Mainland -- creates no value-added. By contrast, “round tripping” for value-added services, by definition, 

does create value through superior offshore financing. Most cross-border mergers and acquisitions 

constitute value-seeking round-tripping activities, which refers to so-called “Red Chip” initial public offerings 

(“IPOs”) carried out on the Hong Kong stock exchange. Examples of such IPOs include China Unicom, 

China Mobile, Sinopec, PetroChina, China Telecom, CNOOC, MTR, China South Air, and j-Cable Comm. 

When a Mainland company prepares for a listing as a “Red Chip” company in Hong Kong, China, it registers 

on the Hong Kong stock exchange as a new local company in the SAR, with the accompanying injection of 

capital into Hong Kong from its Mainland parent company. Hence, the listing of Chinese companies in Hong 

Kong leads to an inflow of foreign capital from the Mainland into the SAR. This foreign capital inflow is 

considered foreign direct investment into Hong Kong, provided that the portfolio investment exceeds the 

10% Hong Kong threshold. After the “Red Chip” company in Hong Kong has acquired additional financial 

capital through the IPO consummated in the former British colony, the “Red Chip” company can then use the 

IPO-generated funds to purchase other substantive profit-generating projects on the Mainland, such as 

additional FIEs. This latter transaction constitutes foreign direct investment from Hong Kong into China, 

provided that the investment in question satisfies the 10% ownership threshold imposed by Chinese law.

Hence, the net result of the IPO listing of Mainland companies in Hong Kong triggers a relatively large 

foreign direct investment “merry-go-round” from China, to Hong Kong, and then back to the Mainland. See 

generally Geng Xiao, People’s Republic of China’s Round-Tripping FDI: Scale, Causes and Implications, at 

19-20, The University of Hong Kong, Reference No. 1137 (July 2004). 

166 Robert C. Feenstra, Wen Hai, Wing T. Woo, Shunli Yao, The the U.S.-China Bilateral Trade Balance: Its 

Size and Determinants, at 1, 7, Department of Economics, University of California, Davis, (May 1998). 
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167 Id. at 1, 9-10. To attract massive amounts of foreign investment and foreign technology into China during 

the past decades, the Chinese government enacted the following comprehensive labyrinth of tax 

concessions, exemptions, reductions, and other fiscal incentives targeted at FIEs and foreign enterprises 

that were in full force and effect through December 31, 2007. These multiple concessions embrace the 

following fiscal incentives: (1) Concessions on Business Tax, VAT, and Customs Duty: (a) incomes 

derived by R&D centers established by FIEs and foreign wholly-owned enterprises and incomes derived by

foreign enterprises and foreign individuals from technology transfer, technology development and related 

consultancy, and technical services were exempt from business tax; (b) raw materials, auxiliary materials, 

parts, components, accessories and packaging materials imported by FIEs for outward processing or 

assembly of products and for the production of goods for export were exempt from import tariffs based on 

the quantity of finished products actually processed and exported; (c) FIEs under the "encouraged category" 

were entitled to full VAT rebate on the purchase of domestically-produced equipment within their investment 

amount if such equipment appears in the catalogue of duty-free imports; (d) imports of equipment and 

supporting technologies, accessories and parts for own use by existing FIEs under the "encouraged 

category," foreign-invested research and design centers, and FIEs with advanced technologies and exportoriented FIEs were exempt from import tariffs and import-related taxes in accordance with the Circular of the 

State Council on the Adjustment of Tax Policy on Equipment Imports; (e) imports of equipment for own use 

by FIEs for producing products in the Catalogue of State New and High Technology Products and imports of 

supporting technology, accessories, and parts as set out in the controlling private-party contract were 

exempt from import tariffs and import-related VAT, with the exception of commodities listed in the Catalogue 

of Non-Duty-Free Commodities to be Imported for Domestic-Funded Projects; (f) imports by FIEs of 

advanced technology in the Catalogue of State New and High Technology Products and software fees paid 

overseas as stipulated in the governing contract were exempt from import tariffs and import-related VAT; 

and (g) for R&D centers established by FIEs, imports of equipment or related technologies, accessories and 

parts for own use that are not produced domestically, or the performance of those produced domestically 

fails to meet the needs of the enterprises were exempt from import tariffs and import-related VAT in 

accordance with the Circular of the State Council on the Adjustment of Tax Policy on Equipment Imports 

(Circular No. 1997/37), provided that the imports were within the enterprises' total investment amount; (2)

Concessions on Corporate Income Tax: (a) Preferential Tax Rate: FIEs in the following regions (sectors) 

were entitled to corporate income tax at the reduced rate of 15%: (i) FIEs in the Shenzhen, Zhuhai, Shantou, 

Xiamen and Hainan SEZs; (ii) foreign enterprises with establishments or venues in SEZs and engaged in 

production and business operations; (iii) production FIEs established in economic and technological 

development zones or areas approved by the State Council and in the Pudong New Area in Shanghai; (iv)

technology- and knowledge-intensive projects launched by FIEs in old urban districts of SEZs, economic

and technological development zones, and coastal economic open areas approved by the State Council with 

long investment recovery periods and foreign investment exceeding US$30 million; (v) production FIEs 

engaged in energy, transportation, and port construction projects; (vi) production FIEs engaged in export 

processing in bonded areas; (vii) recognized high-technology FIEs in new- and high-technology industrial 

development zones at state-level approved by the State Council; (viii) for foreign-invested banks, Sinoforeign joint venture banks, and other financial institutions in SEZs and other areas designated by the State 

Council with foreign capital investment or operating capital transferred from the head office to the branch 

office exceeding the U.S.US$10 million -- and with an operating period of 10 years -- corporate income tax 

was levied at a reduced rate of 15%. In addition, such enterprises were eligible for corporate income-tax 

exemption in the first profit-making year and for reduction by half in the second and third years with the 

approval of the local tax authorities. Production FIEs in the following regions were entitled to corporate 

income tax at the rate of 24%: (i) other types of production FIEs in old urban districts of coastal economic 

open areas, SEZs, and economic and technological development zones in which the 15% preferential tax 

rate was not applicable; (ii) open coastal cities, open cities along the Yangtze River, and in inland and 

border regions, as well as in other areas designated by the State Council; (iii) state-tourist resorts; (b) 

Specific Exemption and Reduction of Corporate Income Tax: (i) foreign-invested production 

enterprises in the following industries and sectors with an operating period of over 10 years were 

eligible for corporate income-tax exemption in the first and second profit-making years and for 

reduction by half (50%) in the third (3rd) to fifth (5th) years: machine building; electronics; energy 

(excluding exploration of oil and natural gas); metallurgy (excluding excavation of rare metals and precious 

metals); chemicals; building materials; light industries; textiles and apparel; packaging; medical equipment; 

pharmaceuticals; agriculture; forestry; animal husbandry; fishery; water conservancy; construction; 

transport (excluding passenger transport); technology development for producer services; 

geological surveying; industrial information consultancy; maintenance services for production equipment 
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and precision instruments; and other sectors endorsed by the state (such as enterprises engaged in 

engineering design for construction, installation, and assembly projects, as well as the provision of labor 

services for engineering projects, cultivation, farming, and plantation projects; R&D of production 

technology; provision of transportation and warehousing services to clients using their own transport and 

warehousing facilities). In addition, newly-established software companies could enjoy the above tax 

exemption and reduction, without being subject to the 10-year operating period requirement; (ii) FIEs 

under the encouraged category established in the central and western regions were entitled to the 

reduced 15% corporate income tax for 3 years upon expiration of the above mentioned tax holiday. 

During this period, if an enterprise is recognized as an “export enterprise” and its “export value” amounted to 

over 70% of its total output value in the current year, it would be entitled to pay corporate income tax at the 

reduced flat rate of 10%. Upon application and with the approval of the State Administration of 

Taxation (“SAT”), FIEs engaged in agriculture, forestry, and animal husbandry, as well as FIEs 

established in the economically-backward remote and border areas, could pay corporate income tax 

at the reduced rate ranging from 15% to 30% for another 10 years upon expiration of the above 

mentioned tax exemption and reduction period; (iii) Sino-foreign joint ventures engaged in port and 

wharf construction and with an operating period of over 15 years were eligible for corporate incometax exemption in the first 5 profit-making years and for reduction by half (50%) in the following 5 

years; (iv) infrastructure projects related to airports, ports, wharfs, railways, highways, power 

stations, coal mines, and water conservancy facilities, in addition to agricultural development in the

Hainan SEZ with an operating period of over 15 years were eligible for corporate income-tax 

exemption in the first 5 years and reduction by half (50%) in the following 5 years; (v) infrastructure 

projects related to airports, ports, railways, highways, and power stations in the Pudong New Area in 

Shanghai with an operation period of over 15 years were eligible for corporate income tax exemption 

in the first 5 years and for reduction by half (50%) in the following 5 years; (vi) the following types of 

enterprises were eligible for corporate income-tax exemption during the first profit-making year and for 

reduction by half (50%) in the second (2nd) and third (3rd) years with the approval of the local tax authorities: 

(a) FIEs engaged in services in SEZs with foreign investment exceeding the U.S.US$ 5 million and with an 

operating period of over 10 years; and (b) foreign-invested banks, Sino-foreign joint-venture banks, and 

other financial institutions in SEZs and other areas designated by the State Council with foreign capital 

investment exceeding the U.S.US$10 million and with an operating period of over 10 years; (vi) recognized 

high-tech Sino-foreign joint venture enterprises in state-level high-technology development zones 

with an operating period of over 10 years were exempt from corporate income tax in their first 2 

profit-making years with the approval of the tax authorities; (vii) foreign-invested export-oriented 

enterprises were entitled to pay corporate income tax at the reduced rate of 15% or 10% following the 

expiration of the corporate income-tax exemption-and-reduction periods, provided that their export sales 

value was over 70% of their total output value in the current year. FIEs under the “encouraged category” 

established in the central and western regions are entitled to pay corporate income tax at the 

reduced rate of 15% or 10% for an additional 3 years following the expiration of the above-mentioned 

tax exemption and reduction periods; (viii) foreign-invested high-technology enterprises were 

entitled to pay corporate income tax at the reduced rate of 15% or 10% for 3 years following the 

expiration of the corporate income-tax exemption and reduction periods, provided that their status 

as “high-technology enterprises” remains unchanged; (c) Tax Rebate on Re-investment by FIEs: any 

foreign investor of an FIE that re-invested its profits obtained from the enterprise directly into that enterprise 

or using the profit as capital investment to establish another FIE with an operating period of at least 5 years 

was, upon approval granted by the competent tax authorities, eligible for a 40% tax refund of the corporate 

income tax already paid on the re-invested amount. If the foreign investor re-invested its profit directly in 

establishing or expanding an export-oriented or high-tech enterprise in China, then the corporate income 

tax already paid on the re-invested amount would be 100% refunded; (d) Other Exemptions and 

Reductions of Income Tax: (i) profits of foreign investors derived from FIEs were exempt from income tax; 

(ii) interest revenue of international financial institutions derived from loans to the Chinese government or 

state banks were exempt from tax; (iii) interest revenue of foreign banks derived from loans to Chinese state 

banks at preferential rates were exempt from income tax; (iv) royalties paid to foreign enterprises for 

their provision of special technologies to China for scientific research, exploitation of energy 

resources, development of transportation, production of agriculture, forestry and animal husbandry, 

and development of important technologies, were eligible for income-tax assessment at the reduced 

rate of 10%, provided that the prior approval of SAT were obtained. For those enterprises that 

employ advanced technologies, income tax will be exempted; (iv) incomes from dividends, interest, 

rentals, royalties, and other sources of foreign enterprises effectively connected with SEZs, economic and 

technological development zones, coastal economic development zones, and other open areas designated 
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by the state were eligible for exemption from income tax or a reduced rate of 10%. In addition, for 

enterprises offering favorable terms for capital and equipment investment or involved in the transfer 

of advanced technology, the provincial or municipal governments enjoyed the discretion to decide 

whether to grant further exemptions and reductions to income taxes; (v) for foreign enterprises 

which have no permanent establishments or venues within Chinese national territory, but which 

derive income from interest, rentals, royalties, and other sources originating in China, and for those

foreign enterprises which do have permanent establishments or venues in China, but which derive 

incomes that are not effectively connected with such establishments or venues, apart from the 

exemption in income tax granted by law, such enterprises were eligible to pay income tax at the 

reduced rate of 10%; (vi) in the case of FIEs under the “encouraged category,” as well as foreign 

enterprises with permanent establishments or venues engaged in production or business operations 

within Chinese national territory, 40% of their investment in the purchase of domestically-produced 

equipment in the current year could be offset against the incremental corporate income tax of the 

preceding year. If the incremental corporate income tax in the current year were less than the 

equipment purchase value, then the balance could be carried forward to the following tax year for 

offset purposes against incremental corporate income tax (the payable income tax prior to the year 

of the equipment purchase is used as the base). The maximum period for such offset was 5 years. For

FIEs enjoying income-tax exemption and reduction in accordance with statutory and administrative 

regulations, application could be made during the tax-exemption period to extend the offset period to not 

more than 7 years; (vii) for FIEs that purchase domestically-produced equipment for the following 

purposes outside their total investment amount, 40% of the purchase amount could be offset against 

the incremental corporate income tax of the preceding tax year: (a) raising economic efficiency and 

product quality; (b) increasing product range; (c) promoting product upgrade; (d) expanding exports; 

(e) reducing costs; (f) conserving energy; (g) strengthening the comprehensive utilization of 

resources; (h) treating waste materials, waste water, and air pollutants effectively; and (i) protecting 

workers through improving existing facilities and production conditions by way of adopting 

advanced and new technologies, new processes, new equipment and new materials; (viii) with the 

approval of the tax authorities, FIEs that increased their technological-development expenses by more than 

10% over the previous year were allowed to offset their taxable income in the current year by 50% of the 

amount of technological-development expenses; (ix) governments of various provinces, autonomous 

regions, and municipalities also had introduced local income-tax exemptions or reductions for those 

sectors or projects in which foreign investment is encouraged; (3) Individual Income Tax 

Concession for Foreigners: The following personal income of foreign nationals was eligible for individual 

income-tax concessions: (a) housing allowance; meal allowance; removal expenses and laundry fees 

received in non-cash forms or in the form of cash reimbursement could be deducted from the taxable 

income; (b) travel allowance at reasonable levels were exempt from individual income tax; (c) a reasonable 

portion of home-visit allowance, language-training fees, and children's education expenses could be 

deducted from taxable income; (d) dividends and bonuses received from FIEs were exempt from individual 

income tax; (e) any foreign national residing in China consecutively or accumulatively for not more than 90 

days (or 183 days for those individuals from countries that have signed bilateral tax treaties with China) in a 

tax year were exempt from individual income tax if his or her wage or salary were not paid or borne by his 

employer in China and were not borne by a permanent establishment of his employer in China; (f) with the 

approval of the competent Chinese tax authorities, any foreign national residing in China for more than 1 

year, but fewer than 5 years, his or her wage or salary during the duration of work outside China and paid by 

the non-China employer could be exempt from individual income tax; (4) Tax Concessions for Central and 

Western Regions: FIEs under the "encouraged" category in the western region that enjoy the "twoyear exemption and three-year reduction by half" tax concession were eligible for corporate income 

tax at the reduced rate of 15% for 3 more years following the expiration of the initial tax concession. 

FIEs recognized as high-technology or export-oriented enterprises with an export value amounting 

to over 70% of their annual output value in the current year were eligible for a 50% reduction of 

corporate income tax during this 3-year period; however, the reduced tax rate could not below 10%. 

For textual support of the previous Chinese tax concessions, exemptions, reductions, and other fiscal 

incentives, see 4.2 Tax Exemption and Reduction, tdctrade.com, http://www.tdctrade.com/chinaguide/4-

2.htm (September 2006)(downloaded on January 3, 2008). As demonstrated in a subsequent section of 

the text of our study, the PRC central government effectively recycled the above fiscal incentives 

highlighted in bold italics when enacting China’s new Enterprise Income Tax Law, effective January 

1, 2008, together with the implementing regulations. 
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168

 Robert C. Feenstra, Wen Hai, Wing T. Woo, Shunli Yao, The the U.S.-China Bilateral Trade Balance: Its 

Size and Determinants, at 1, 8, Department of Economics, University of California, Davis, (May 1998). 

169 Id. at 1, 8. 

170

 Http://tpwwbapp.tdctrade.com (September 2006) (downloaded on June 6, 2007). 

171 See Income Tax Law of the People's Republic of China on Enterprises with Foreign Investment and 

Foreign Enterprises, art. 5 (1991)(repealed)(“The income tax on enterprises with foreign investment and the 

income tax which shall be paid by foreign enterprises on the income of their establishments or places set up 

in China to engage in production or business operations shall be computed on the taxable income at the rate 

of thirty percent, and local income tax shall be computed on the taxable income at the rate of three percent”).

172 Consistent with endnote 246, the repealed Chinese FIE income-tax law considered FIEs operating in the 

following Mainland industries or sectors during the period 1991 through December 31, 2007, to constitute 

“productive” FIEs that warranted preferential tax treatment: (i) machine manufacturing and electronics 

industries; (ii) energy-source sectors (not including exploitation of oil and natural gas); (iii) metallurgical, 

chemical, and building material industries; (iv) light industries, textiles, and packaging industries; (v) medical 

equipment and pharmaceutical sectors; (vi) agriculture, forestry, animal husbandry, fisheries, and water 

conservation sectors; (vii) construction industries; (viii) communication and transportation sectors (not 

including passenger transport); (ix) development of science and technology, geological survey, and 

industrial information consultancy; and (x) other industries as specified by the PRC State Council. See Ernst 

and Young, Special Economic Zones and Tax Exemption in China, China Competence Center, Tax, 1 

(downloaded from the Internet on June 6, 2007). In Coated Free Sheet Paper from the People’s Republic of 

China, a the U.S. countervailing duty action aimed at several PRC government programs, the U.S. 

Department of Commerce determined that China’s FIE tax-incentive scheme constituted a countervailable 

government subsidy under the WTO Agreement on Subsidies and Countervailing Measures (“WTO 

Subsidies Agreement”) and the the U.S. Tariff Act of 1930, as amended. In analyzing the Chinese fiscal

program, Commerce emphasized that the underlying purpose of the repealed FIE income-tax law was to 

attract foreign businesses to the Mainland. See Coated Free Sheet Paper From the People's Republic of 

China: Amended Preliminary Affirmative Countervailing Duty Determination, 72 Fed. Reg. 17,484, (April 9, 

2007); Final Commerce Decision Memorandum, 1, (October 17, 2007). 

173 See Income Tax Law of the People's Republic of China on Enterprises with Foreign Investment and 

Foreign Enterprises, art. 8 (1991)(superseded)(“Any enterprise with foreign investment of a production

nature scheduled to operate for a period of not less than ten years shall, from the year beginning to make 

profit, be exempted from income tax in the first and second years and allowed a fifty percent reduction in the 

third to fifth years. However, the exemption from or reduction of income tax on enterprises with foreign 

investment engaged in the exploitation of resources such as petroleum, natural gas, rare metals, and 

precious metals shall be regulated separately by the State Council. Enterprises with foreign investment 

which have actually operated for a period of less than ten years shall repay the amount of income tax 

exempted or reduced already”). 

174 See Income Tax Law of the People's Republic of China on Enterprises with Foreign Investment and 

Foreign Enterprises, art. 8 (1991); (Ernst and Young, Special Economic Zones and Tax Exemption in China, 

China Competence Center, Tax, 1 (downloaded from the Internet on June 6, 2007). 

175 Round-Tripping Foreign Direct Investment in the People’s Republic of China: Scale, Causes and 

Implications, at 11, ADB Institute, http://adbi.adb.org/discussion-paper (downloaded on June 6, 2007). 

176

 4.2 Tax Exemption and Reduction, http://tpwwbapp.tdctrade.com, (September 2006) (downloaded on 

June 6, 2007). 

177 See Income Tax Law of the People's Republic of China on Enterprises with Foreign Investment and 

Foreign Enterprises, art. 7 (1991)(repealed)(“The income tax on enterprises with foreign investment 

established in Special Economic Zones, foreign enterprises which have establishments or places in Special 

Economic Zones engaged in production or business operations, and on enterprises with foreign investment 

of a production nature in Economic and Technological Development Zones, shall be levied at the reduced
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rate of fifteen percent. The income tax on enterprises with foreign investment of a production nature 

established in coastal economic open zones or in the old urban districts of cities where the Special 

Economic Zones or the Economic and Technological Development Zones are located, shall be levied at the

reduced rate of twenty-four percent. The income tax on enterprises with foreign investment in coastal 

economic open zones, in the old urban districts of cities where the Special Economic Zones or the Economic 

and Technological Development Zones are located or in other regions defined by the State Council, within 

the scope of energy, communications, harbour, wharf or other projects encouraged by the State, may be 

levied at the reduced rate of fifteen percent. The specific measures shall be drawn up by the State Council”). 

178 Enacted in 1997, the Circular of the State Council on Adjusting Tax Policies on Imported Equipment, 

(GUOFA No. 37)(Circular No. 37) exempts both FIEs and certain Chinese domestic enterprises from the 

payment of Chinese VAT and customs duties that is due on imported capital equipment used for production 

purposes. The objective of this PRC government program is to encourage foreign investment and to 

introduce into China foreign advanced technology. All enterprises eligible for the VAT and customs-duty 

exemptions must have PRC government-approved projects that are consistent with the Catalog of Key 

Industries, Products, and Technologies the Development of which is Encouraged by the State. In Coated 

Free Sheet Paper From the People's Republic of China, Commerce determined that the VAT and customsduty exemptions governing imported capital equipment constitute a countervailable government subsidy. 

With regard to “specificity,” Commerce stressed that only certain Chinese domestic enterprises and FIEs are 

eligible to receive the VAT and customs-duty exemptions under the program. See Coated Free Sheet Paper 

From the People's Republic of China: Amended Preliminary Affirmative Countervailing Duty Determination, 

72 Fed. Reg. 17,484, (April 9, 2007); Final Commerce Decision Memorandum, 1, (October 17, 2007). 

 

179 Round-Tripping Foreign Direct Investment in the People’s Republic of China: Scale, Causes and 

Implications, at 11. ADB Institute, http://adbi.adb.org/discussion-paper (downloaded on June 6, 2007). 

180 See Income Tax Law of the People's Republic of China on Enterprises with Foreign Investment and 

Foreign Enterprises, art. 10 (1991)(repealed)(“Any foreign investor of an enterprise with foreign investment 

which reinvests its share of profit obtained from the enterprise directly into that enterprise by increasing its 

registered capital, or uses the profit as capital investment to establish other enterprises with foreign 

investment to operate for a period of not less than five years shall, upon approval by the tax authorities of an 

application filed by the investor, be refunded forty percent of the income tax already paid on the reinvested 

amount”). 

181 Robert C. Feenstra, Wen Hai, Wing T. Woo, Shunli Yao, The the U.S.-China Bilateral Trade Balance: Its 

Size and Determinants, 1, 4, Department of Economics, University of California, Davis, (May 1998).

182

 See Geng Xiao, People’s Republic of China’s Round-Tripping FDI: Scale, Causes and Implications, at 1, 

9, The University of Hong Kong, Reference No. 1137 (July 2004). 

183 See Arrangement for the Avoidance of Double Taxation on Income and Prevention of Fiscal Evasion 

Between the Mainland of China and the Hong Kong Special Administrative Region, art. 3(3) (2007). 

 

184 Id., art. 9. 

185

 By sharp contrast, when China’s bilateral trade with the United States is examined, the main source of 

the statistical discrepancy occurs in China’s export trade, as opposed to its import trade. See, e.g., Michael 

F. Martin, What’s the Difference? – Comparing the U.S. and Chinese Trade Data, at 2, CRS Report for 

Congress (April 10, 2007)(“most of the discrepancy between the trade data from the two nations stems from 

significantly different figures for China’s exports to the United States”). Data comparisons show large and 

increasing differences between China's exports to the United States, as recorded by official Chinese 

statistics, and the U.S. imports from China, as published in official the U.S. data. Cf. Sarah Y. Tong, The the 

U.S.-China Trade Imbalance: How Big is it Really?, China: An International Journal 3,1, at 137 (March 2005) 

(“[T]here is much more re-exporting of Chinese goods to the the U.S. through Hong Kong than there is reexporting of the U.S. goods to China. The former is generally more than five times larger than the latter. 

Thus the implication is that there is more serious distortion in the reporting of Chinese exports to the the U.S. 

than there is for Chinese imports from the the U.S.”). These discrepancies have increased dramatically from 
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$20.7 billon in 1995 to $59.1 billion in 2003. The top five harmonized system chapters in which the Chinesethe U.S. bilateral statistical discrepancies occur – namely, (i) footwear, (ii) machinery, (iii) electrical 

machinery, (iv) furniture, and (v) toys and sporting goods – account for approximately two thirds (66%) of 

the difference between the the U.S. and Chinese figures on both a volume and value basis. See Michael F. 

Martin, What’s the Difference? – Comparing the U.S. and Chinese Trade Data, at 3, CRS Report for 

Congress (April 10, 2007). With regard to the the U.S. export-China import side of the equation, there is 

also a consistent and growing discrepancy in the opposite direction, with the volume and value of the U.S. 

exports to China (as reported by the United States) being significantly less than the volume and value of 

Chinese imports originating from the United States (as reported by China). This discrepancy was the 

U.S.US$3.7 billion in 1995 and the U.S.US$5.5 billion in 2003. Chinese imports from the United States of 

machinery, electrical machinery, and optical medical equipment comprise the product categories with the 

greatest statistical discrepancies on the Chinese import side of the equation. With these two sets of trade 

statistics increasingly diverging in opposite directions, the overall discrepancy between official the U.S. and 

Chinese data has widened from the U.S.US$24.4 billion in 1995 to the U.S.US$64.6 billion in 2003. Recent 

studies have estimated the bilateral trade data trade discrepancy at the U.S.US$88.2 billion for trade-year 

2006; that is, according to the United States, the 2006 bilateral trade deficit with China was the 

U.S.US$232.5 billion, while, according to China, its trade surplus with United States was only the 

U.S.US$144.3 billion for that year. See Michael F. Martin, What’s the Difference? – Comparing the U.S. and 

Chinese Trade Data, at 1, CRS Report for Congress (April 10, 2007). See also John W. Schindler, Dustin H. 

Beckett, Adjusting Chinese Bilateral Trade Data: How Big is China’s Trade Surplus?, at 27, Board of 

Governors of the Federal Reserve System, International Journal of Applied Economics, 2(2) (September 

2005) (reporting that a the U.S.US$65 billion statistical trade discrepancy between official Chinese and the 

U.S. trade data exists for calendar-year 2003). “The United States has the largest discrepancy with China, 

while Japan, Taiwan, and Germany have the next three largest, respectively. Id. at 33; but see id. at 27 

(“And most remarkably, in 2003, China and Japan reported trade deficits with one another”). As 

demonstrated in the text of our study, Sino round-tripping activities contaminate China’s bilateral-trade 

statistics with the United States, Japan, Taiwan, and Germany. 

186 See Hung-Gay Fung, Jot Yau, Gaiyan Zhang, Market Impediments, Trade, and Foreign Direct 

Investment: Evidence from China’s Round-Tripping, at 1, 2, 27, University of Missouri at Saint Louis and 

Seattle University (November 27, 2006). Paper can be downloaded via: 

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=972174. 

See also “China’s FDI merry-go-round,” FDI ForeignDirectInvestment, FT Business Financial Times, 

http://www.fdimagazine.com (April 2, 2003)(downloaded on June 6, 2007); UNCTAD Investment Brief, 

Number 2 (2007). For an explanation of the concept of “tax arbitrage,” see Richard L. Doernberg, 

International Taxation, at 375-379, West Nutshell Series (West Group, 4th ed. 1999). 

187 See Hung-Gay Fung, Jot Yau, Gaiyan Zhang, Market Impediments, Trade, and Foreign Direct 

Investment: Evidence from China’s Round-Tripping, at 2, University of Missouri at Saint Louis and Seattle 

University (November 27, 2006). See also “China’s FDI merry-go-round,” FDI ForeignDirectInvestment, FT 

Business Financial Times, http://www.fdimagazine.com (April 2, 2003)(downloaded on June 6, 2007); 

UNCTAD Investment Brief, Number 2 (2007). 

188 See Hung-Gay Fung, Jot Yau, Gaiyan Zhang, Market Impediments, Trade, and Foreign Direct 

Investment: Evidence from China’s Round-Tripping, at 16, University of Missouri at Saint Louis and Seattle 

University (November 27, 2006). Paper can be downloaded via: 

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=972174. 

See also “China’s FDI merry-go-round,” FDI ForeignDirectInvestment, FT Business Financial Times, 

http://www.fdimagazine.com (April 2, 2003)(downloaded on June 6, 2007); UNCTAD Investment Brief, 

Number 2 (2007). 

189 Geng Xiao, People’s Republic of China’s Round-Tripping FDI: Scale, Causes and Implications, The 

University of Hong Kong, 1, 2, Reference No. 1137 (July 2004)(emphasis added). 

190 Id. 
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191 Enterprise Income Tax Law of the People’s Republic of China, art. 60 (2008) (establishing the effective 

date of the new legislation as January 1, 2008). 

192 See Explanation on the Draft Enterprise Income Tax Law of the People's Republic of China, delivered by 

Finance Minister, Jin Renqing, at the Fifth Session of the Tenth National People's Congress, 11 (March 3, 

2007)("With the entry into force of the new Tax Law, the statutory nominal income tax rate for...domestic 

enterprises...will see an eight percentage point decrease from 33 percent to 25 percent. However, for those 

foreign-funded enterprises that have been enjoying the preferential tax rate of 24 percent or 15 percent, their 

statutory nominal tax rate will rise by one or ten percentage points respectively”). 

193 Article 1 of the new PRC tax law provides that “[a]ll enterprises and other income receiving 

organizations...within the territory of...China shall be the taxpayer of the enterprise income tax....” 

Enterprise Income Tax Law of the People’s Republic of China, art. 1 (2008). See also Implementation Rules 

of the Enterprise Income Tax Law of the People’s Republic of China, art. 3 (2008)(defining the phrase 

“[e]nterprises established within the territory of China pursuant to Chinese laws” to include “enterprises, 

business units, social organizations, and other organizations that earn revenue, which are established within 

the territory of China in accordance with Chinese laws and regulations”). Article 4 of the new law further 

establishes that the “[e]nterprise income tax shall be levied at the rate of 25%.” Enterprise Income Tax Law 

of the People’s Republic of China, art. 4 (2008); PriceWaterhouseCoopers, Transfer Pricing Implications of 

China’s New Corporate Income Tax Law, Issue 7, http://wwws.pwccn.com (March 2007) (downloaded on 

June 9, 2007). 

194 Article 2 of the new fiscal statute provides that “[e]nterprises are classified as resident enterprises and 

non-resident enterprises. A resident enterprise...refers to [any] enterprise which is established within the 

territory of China pursuant to Chinese laws or an enterprise established within the territory of another 

country or other tax region pursuant to that country or that region’s laws whose actual management or 

control is located in China. A non-resident enterprise...refers to an enterprise established within the territory 

of another country or other tax region pursuant to foreign laws, whose actual management or control is

located outside of China but which has [a permanent] establishment in China or even if it does not have 

[such] an establishment in China, has income derived from China.” Enterprise Income Tax Law of the 

People’s Republic of China, art. 2 (2008)(emphasis added). Article 3 of the EIT law further provides that 

PRC “resident enterprises” shall pay the 25% Chinese income tax on all income generated on a worldwide

basis: “[r]esident enterprises shall pay the enterprise income tax for income sourced within and outside of 

China.” Id., art. 3. By contrast, non-resident enterprises shall pay PRC income tax only on Chinese-source 

income or on income effectively connected with a Chinese “permanent establishment”. 

195 See Implementation Rules of the Enterprise Income Tax Law of the People’s Republic of China, art. 9 

(2008) (articulating rule that “[t]axable income of an enterprise is calculated on an accrual basis”).

196 See PriceWaterhouseCoopers, Transfer Pricing Implications of China’s New Corporate Income Tax Law, 

Issue 7, http://wwws.pwccn.com (March 2007) (downloaded on June 9, 2007). In principle, all newly-created 

FIEs situated in Chinese SEZs are subject to the new unified tax rate of 25 percent, because Article 1 of the 

EIT statue provides that “[a]ll enterprises...within the territory of...China shall be the taxpayer of the

enterprise income tax [of 25%].....” Enterprise Income Tax Law of the People’s Republic of China, art. 1

(2008). Notwithstanding this language, the second paragraph of Article 57 of the new law authorizes the 

PRC State Council to provide foreign high-technology enterprises situated in Chinese SEZs with openended tax concessions. See id., art. 57, para. 2. 

197 See Enterprise Income Tax Law of the People’s Republic of China, art. 60 (2008) (repealing China’s 

1991 FIE income-tax law); PriceWaterhouseCoopers, Transfer Pricing Implications of China’s New 

Corporate Income Tax Law, Issue 7, http://wwws.pwccn.com (March 2007) (downloaded on June 9, 2007). 

198 Explanation on the Draft Enterprise Income Tax Law of the People's Republic of China, delivered by 

Finance Minister, Jin Renqing, at the Fifth Session of the Tenth National People's Congress, 5 (March 3, 

2007). 

199 See Enterprise Income Tax Law of the People’s Republic of China, art. 60 (2008). 
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200 See id., arts. 57, 60; PriceWaterhouseCoopers, Transfer Pricing Implications of China’s New Corporate 

Income Tax Law, Issue 7, http://wwws.pwccn.com (March 2007) (downloaded on June 9, 2007). 

201 Enterprise Income Tax Law of the People’s Republic of China, art. 57 (2008); Implementation Rules of 

the Enterprise Income Tax Law of the People’s Republic of China, art. 131 (2008)(“Enterprises which have 

been approved to be established prior to the promulgation of the EIT Law as cited in Article 57, paragraph 1 

of the Tax Law refer to enterprises which have completed business registration procedures prior to the

promulgation of the EIT Law”). 

202 Enterprise Income Tax Law of the People’s Republic of China, Arts. 57, 60 (2008); 

PriceWaterhouseCoopers, Transfer Pricing Implications of China’s New Corporate Income Tax Law, Issue 7, 

http://wwws.pwccn.com (March 2007) (downloaded on June 9, 2007). 

203 New transfer-pricing provisions appear in Chapter 6 (Special Tax Adjustments) of the new fiscal 

legislation. This chapter generally addresses both tax-avoidance schemes and transfer-pricing issues. 

Chapter 6 improves existing legislation and regulations, introduces new and modern concepts, and grants 

additional powers to China’s SAT. See PriceWaterhouseCoopers, Transfer Pricing Implications of China’s 

New Corporate Income Tax Law, Issue 7, http://wwws.pwccn.com (March 2007) (downloaded on June 9, 

2007). 

204 See Enterprise Income Tax Law of the People’s Republic of China, art. 46 (2008). The new Enterprise 

Income Tax Law introduces for the first time in China’s tax history so-called “thin-capitalization” rules to 

prevent Chinese enterprises that receive an excessive number and value of related-party loans, as opposed 

to capital-contributions, from evading Chinese tax liability. Article 46 of the new legislation provides that the 

ratio of debt to equity for related parties must follow a “specified ratio”; otherwise, the interest from the 

excess debt granted by a controlling entity to its affiliate “shall not be deductible when computing [Chinese] 

taxable income.” Id.; PriceWaterhouseCoopers, Impact of China’s new Corporate Income Tax Law on 

Foreign Investors, Issue 6, http://wwws.pwccn.com (March 2007)(downloaded on June 9, 2007). See also 

Implementation Rules of the Enterprise Income Tax Law of the People’s Republic of China, art. 119 (2008).

205 See Enterprise Income Tax Law of the People’s Republic of China, art. 45 (2008). 

206 See Enterprise Income Tax Law of the People’s Republic of China, art. 45 (2008). In cases in which the 

profits of any CFC -- situated in an offshore jurisdiction with an income-tax rate that is generally below 

12.5% -- are not distributed or are distributed in a reduced amount under a company policy lacking any

“reasonable operational need[],” Article 45 of the new legislation provides that such undistributed profits shall 

be considered a deemed dividend “attributed to the resident [controlling] enterprise[]” that is subject to 

Chinese tax liability. Id. 

207 See Implementation Rules of the Enterprise Income Tax Law of the People’s Republic of China, art. 118 

(2008)(“The effective tax rate as cited in Article 45 of the EIT Law, being significantly lower than the tax rate 

set forth in Paragraph 1 of Article 4 of the EIT Law, refers to the effective tax rate being lower than 50% of 

the tax rates set forth in Paragraph 1 of Article 4 of the EIT Law”). 

208 Enterprise Income Tax Law of the People’s Republic of China, art. 41 (2008). See also 

PriceWaterhouseCoopers, at 9. Transfer Pricing in China (October 2006)(citing to OECD Transfer Pricing 

Guidelines for Multinational Enterprises and Tax Administrations). The arm’s-length principle mandates that 

“associated enterprises” transact business with one another as if they were unaffiliated third parties. In other 

words, a Chinese FIE cannot sell products or services to its affiliate at a price that significantly deviates from 

the price at which the same products or services are sold to an unrelated third party under similar 

circumstances. Id. See also Implementation Rules of the Enterprise Income Tax Law of the People’s 

Republic of China, art. 110 (2008) (“The arm's length principle as cited in Article 41 of the EIT Law refers to 

the principle that unrelated parties abide to when carrying out business transactions in accordance with fair 

market prices and common business practices”). 

209 Implementation Rules of the Enterprise Income Tax Law of the People’s Republic of China, art. 109 

(2008). 
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210 Id., art. 115 (“Where the tax authorities deem an enterprise’s taxable income in accordance with Article 

44 of the EIT Law, the following methods may be used: 1) deem the taxable income by reference to the 

profit margin of same-type or similar enterprises; 2) deem the taxable income based on the enterprise’s cost 

plus reasonable expenditures and profit; 3) deem the taxable income by reasonable proportion of the 

consolidated profit of the related party group; and 4) deem the taxable income with other reasonable 

methods. Where an enterprise disagrees with the taxable income deemed by the tax authorities in 

accordance with aforementioned provisions, it shall provide relevant proof to the tax authorities. The

deemed taxable income may be adjusted subject to the tax authorities’ verification”). 

211 See PriceWaterhouseCoopers, Impact of China’s new Corporate Income Tax Law on Foreign Investors, 

Issue 6, http://wwws.pwccn.com (March 2007)(downloaded on June 9, 2007); PriceWaterhouseCoopers, 

Transfer Pricing in China, at 22, 23. http://wwws.pwccn.com (downloaded on June 9, 2007). Chapter 6 of the 

new EIT statue codifies a general anti-avoidance rule that expressly authorizes China’s SAT to make a 

price-tax adjustment (i.e., special tax levy), together with the assessment of an interest penalty (i.e., special 

interest levy), in cases in which the taxpayer enters into a non-arm’s length related-party arrangement 

“without [a] bona fide commercial purpose[]”. Enterprise Income Tax Law of the People’s Republic of China, 

art 41 (2008) 

212 See Implementation Rules of the Enterprise Income Tax Law of the People’s Republic of China, art. 123 

(2008) (“Where transactions between an enterprise and its related parties do not comply with the arm’s

length principle, or an enterprise makes other arrangements without bona fide commercial purposes, the tax 

authorities have the right to make tax adjustments within 10 years from the tax year when the transactions 

occurred”). 

213

 See PriceWaterhouseCoopers, Transfer Pricing Implications of China’s New Corporate Income Tax Law, 

Issue 7, http://wwws.pwccn.com (March 2007) (downloaded on June 9, 2007). 

214 Id. 

215 See PriceWaterhouseCoopers, Transfer Pricing in China, at 4 (October 2006); Income Tax Law of the 

People's Republic of China on Enterprises with Foreign Investment and Foreign Enterprises, Art. 13 

(1991)(repealed)(“The payment or receipt of charges or fees in business transactions between an enterprise 

with foreign investment or an establishment or a place set up in China by a foreign enterprise to engage in 

production or business operations, and its associated enterprises, shall be made in the same manner 

as the payment or receipt of charges or fees in business transactions between independent 

enterprises. Where the payment or receipt of charges or fees is not made in the same manner as in 

business transactions between independent enterprises and results in a reduction of the taxable 

income, the tax authorities shall have the right to make reasonable adjustment”)(emphasis supplied). 

216

 Enterprise Income Tax Law of the People’s Republic of China, art. 42 (2008) (legislating advance pricing 

agreements). Advance Pricing Arrangements (“APAs”) constitute agreements executed by the competent 

tax authorities and taxpayers concerning the future application of transfer-pricing policies. See

PriceWaterhouseCoopers, Transfer Pricing in China, at 7 (October 2006). APAs are an effective means to 

mitigate against future transfer-pricing risks by ensuring that Chinese authorities deem future profits 

generated by an affiliated corporate group to be “reasonable”. Id. Article 42 of the new legislation expressly 

authorizes taxpayers to negotiate and conclude APAs with China’s SAT with regard to “pricing principles and 

computation methods used in business transactions between the enterprise and its related party....” 

Enterprise Income Tax Law of the People’s Republic of China, art. 42 (2008). See also Implementation 

Rules of the Enterprise Income Tax Law of the People’s Republic of China, art. 113 (2008) (“An advanced 

pricing agreement as cited in Article 42 of the EIT Law refers to an agreement that is concluded after

negotiation and confirmation with the tax authorities, upon an enterprise’s application to them, in respect of 

the enterprise’s pricing principles and computation methods for related party transactions in future years in 

compliance with the arm’s length principle”). Although China’s SAT had previously provided detailed 

guidance concerning the use of APAs by virtue of Guo Shui Fa [2004] 118, the new APA mechanism 

legislated into the new EIT Law demonstrates strong support thereof by the central government in Beijing. 

See PriceWaterhouseCoopers, Transfer Pricing in China, at 7 (October 2006). 
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217 Enterprise Income Tax Law of the People’s Republic of China, art. 41 (2008) (legislating cost-sharing 

arrangements). Cost Sharing Arrangements (“CSAs”) are mechanisms pursuant to which affiliated 

enterprises of a related corporate group share the costs and risks of the development of intangible assets. 

See PriceWaterhouseCoopers, Transfer Pricing in China, at 7 (October 2006). Each related-party participant 

in the CSA bears its share of the costs and the risks of the venture and, in return, will own whatever

intellectual property is created by the arrangement. Id. By virtue of R&D evaluations, economic analysis, 

and negotiations with the Chinese tax authorities, CSAs can help mitigate against existing risks, such as 

international double taxation involving royalties generated by intellectual property rights. Id. The second 

paragraph of Article 41 of the new PRC tax law authorizes taxpayers to conclude CSAs with the Chinese tax 

authorities. See Enterprise Income Tax Law of the People’s Republic of China, art. 41 (2008) In the past, 

multinational companies were reluctant to share intellectual property or services with their Chinese affiliates 

for various reasons, with the key factor being that shared costs were nondeductible in the hands of the 

Chinese subsidiaries. Additionally, local tax authorities were unfamiliar with CSAs. See

PriceWaterhouseCoopers, Transfer Pricing in China, at 7 (October 2006). Thus, the new provision in the EIT 

Law provides a transparent framework that paves the way for China to attract more advanced intellectual 

property and sophisticated services from overseas investors, especially from Hong Kong, in accordance with 

carefully-crafted CPAs. See id. 

218 Explanation on the Draft Enterprise Income Tax Law of the People's Republic of China, delivered by 

Finance Minister, Jin Renqing, at the Fifth Session of the Tenth National People's Congress, 8 (March 3, 

2007). 

219

 The second paragraph of Article 1 of the new EIT Law expressly provides that “[s]ole proprietorships 

and partnerships are not under the purview of this law.” Enterprise Income Tax Law of the People’s 

Republic of China, art. 1 (2008) (emphasis added). See also Implementation Rules of the Enterprise Income 

Tax Law of the People’s Republic of China, art. 2 (2008) (“Sole proprietorship enterprises and partnership 

enterprises as cited in Article 1 of the EIT Law refer to sole proprietorship enterprises and partnership 

enterprises established pursuant to Chinese laws and regulations”). 

220 See Enterprise Income Tax Law of the People’s Republic of China, art. 52 (2008) (“Unless otherwise 

[approved] by the State Council, enterprises shall not be allowed to pay enterprise income tax on a 

consolidated basis”). 

221 Id., art. 50 (“When a resident enterprise within China sets up one or more operating units that are not 

separate legal entities, it shall combine the income of the home office and units and pay the computed

enterprise income tax thereon”). 

222 Id., art. 7(3). 

223

 Id., art. 25. 

 

224 Id., arts. 35, 36. See also id., art. 33 (“When computing taxable income, income derived from the 

production of goods by an enterprise which ensures the production of goods in line with state production 

policies as well as a comprehensive utilization of resources is eligible for deductions against total revenue”). 

 

225 Id., art. 58 (“Where the provisions of a tax treaty/agreement concluded between the government of the 

People's Republic of China and a foreign government are different from the provisions of this Law, the

provisions of the treaty/agreement shall prevail”).

226 Arrangement for the Avoidance of Double Taxation on Income and Prevention of Fiscal Evasion 

Between the Mainland of China and the Hong Kong Special Administrative Region, art. 3(1)(3) 

(2007)(defining the term “person” to include “an individual, a company, a trust, a partnership and any other 

body of persons”)(emphasis supplied). 

227 See Arrangement for the Avoidance of Double Taxation on Income and Prevention of Fiscal Evasion 

Between the Mainland of China and the Hong Kong Special Administrative Region, art. 3(3) (2007) 

(establishing the principle that “[a]s regards the application of this Arrangement by One Side, any term not 
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defined therein shall, unless the context otherwise requires, have the meaning which it has at the time under 

the laws of that Side concerning the taxes to which this Arrangement applies, and any meaning under the 

applicable tax laws of that Side prevails over a meaning given to the term under other laws of that Side”). 

 

228 See id., art. 9.