The United States Semiconductor Industry Association (SIA) is trying to persuade the Chinese government to end its policy of giving tax breaks to domestic chip-making operations, a practice that drives up the cost, and decreases the competitiveness, of imported semiconductors, the SIA says.

However, despite a good track record of helping to win trade concessions from China, the SIA may find it tougher to convince the country's government to end a tax break that presently is the only reason for the existence of some of the country's marquee semiconductor companies.

For the United States and other chip-making countries, the stakes are high. Electronics production is migrating to China rapidly, a transition that is expected to cause semiconductor consumption in the country to soar over the next several years.

The SIA said the Value-Added Tax (VAT) breaks put the chip-making industries of the United States and other countries at a significant disadvantage. The industry organization also said the preferential VAT rates violate the terms of the World Trade Organization (WTO), which China joined in December 2001.

China presently charges VAT at 17% on goods sold in the country, including on imported semiconductors. However, companies producing semiconductors in China receive a tax rebate on sales that effectively reduces the VAT to 3%. The Chinese government's intent with the VAT rebates is to promote domestic chip production and to encourage the growth of the indigenous semiconductor industry.

The tax break, combined with the huge rise in semiconductor consumption in China, has done wonders for the country's domestic chip industry. Multiple companies have jumped feet-first into the high-volume, high-end foundry business, including Semiconductor Manufacturing International Corp. (SMIC) and Grace Semiconductor Manufacturing Corp.However, questions have arisen about how competitive the high-end Chinese semiconductor foundries really are and can be.

Their offshore competitors, including Taiwan Semiconductor Manufacturing Co. Ltd. and United Microelectronics Corp. of Taiwan, are producing chips at more advanced geometries than they are, and at much higher volumes and efficiency.

Chinese foundries are offering manufacturing using 0.18-micron processes, as opposed to the less than 0.15-micron technology available from the Taiwanese chipmakers. The less than 0.15-micron processes are in demand from customers needing cutting-edge semiconductors, according to Len Jelinek, principal analyst for semiconductor supply with iSuppli.

The technology levels of the Chinese foundries are constrained by the < Wassenaar Arrangement on export controls, which limits the semiconductor production technology that can be imported into China to 0.25-micron or higher. Amid tough economic times, some European countries have elected to bend the rules and ship more advanced equipment to China, allowing the Chinese foundries to produce at 0.18-micron, Jelinek said.

Furthermore, while the Chinese foundries are establishing capacity to manufacture on 200-mm wafers, their Taiwanese competitors already have started some 300-mm wafer production, and are reaping the efficiency benefits of the larger wafer sizes.

With foundry utilization levels falling to just 67% in the third and fourth quarters, what is the business justification for companies like SMIC and Grace to make chips in China?

The major motivation for locating manufacturing operations in China is rock-bottom labor costs. However, this is less meaningful in the semiconductor business, in which the primary expenses are equipment and facilities, not workers.

This leaves only one competitive advantage for the domestic Chinese foundries: the VAT break.

Without the VAT break, much of the justification for the existence of the high-end Chinese foundries would go away, something that would conflict with the goals of the government.

However, the SIA has been persistent in its attempts to remove barriers to the trade of U.S. chips. The organization was at the forefront of efforts to open the Japanese market to imported semiconductors in the 1980s and 1990s. The organization also lobbied for many years to achieve the lifting of import duties on semiconductors in China.

Despite that, Tim Wang, director of iSuppli Asia, and previously a member of the SIA team that lobbied the U.S. and Chinese governments to end the Chinese duties, believes the Chinese government will not change its policy on VAT rebates in the near future.

The high-end Chinese foundries will have no reason to operate fabs in China if their VAT break is rescinded, Wang noted. These companies now are importing expensive new equipment that is not depreciated. It would not be economical for these companies to purchase and maintain such equipment if they did not have the tax break, Wang said.

However, other Chinese foundries, such as Advanced Semiconductor Manufacturing Corp., which have concentrated on producing commodity devices with used, fully depreciated equipment, stand to fare much better if their VAT-advantage goes away, Wang said.

With billions of dollars being invested in China's foundries, and with billions more expected to come, China's government is not likely to budge on this issue in the near future, Wang predicts. In negotiations over VAT, the Chinese government is likely to cite the limitations of the Wassenaar Arrangement as a motivation to maintain its preferential VAT policies, Jelinek said.

Besides ensuring the survival of its marquee foundries, China's VAT policies mean that the country's gray market for smuggled components will continue to flourish. The secreting and selling of components into the country in order to dodge the VAT represents an industry unto itself in China. With the VAT continuing to favor domestically produced chips, the gray market will be a feature of China's electronics industry for some time to come.

Jonathan Cassell is a principal analyst, electronic components for iSuppli Corp. Cassell is the editor of the weekly iSuppli Market Watch newsletter. Contact Cassell at jcassell@isuppli.com