China Boosts Semiconductor Subsidies as US Tightens

Restrictions
thediplomat.com/2023/09/china-boosts-semiconductor-subsidies-as-us-tightens-restrictions

Arrian Ebrahimi

Headlines flashed last week as the U.S. Commerce Department

finalized guardrails limiting expansion in China by companies receiving
subsidies under the 2022 CHIPS and Science Act. Less widely
covered, however, was China’s latest round of semiconductor
incentives, upping the ante in its effort to reduce reliance on U.S.-
controlled technology.

With China already boasting chip subsidies worth at least $150 billion
in 2022, on September 19 China’s Ministry of Finance further upgraded
the country’s tax credit for investments in semiconductor R&D by 20
percent. This new subsidy comes in the face of U.S. export controls,
issued in October 2022 and rumored to be strengthened in late 2023.
These restrictions have left Chinese policymakers scrambling for
alternatives to advanced U.S.-controlled computer technology. These
export controls, as well as the recently finalized guardrails prohibiting
chipmakers receiving U.S. subsidies from expanding in China for 10
years, leave Beijing to plan for an economy receiving limited support
from foreign chipmakers.

As Nicholas Mulder argued in his 2022 book “The Economic Weapon:

The Rise of Sanctions as a Tool of Modern War,” countries facing
sanctions often learn to adapt their economies, either by finding new
trading partners or by “home-shoring” supply chains. Some industry
leaders in China do not agree that it is advisable or even possible to
develop an all-domestic chip ecosystem.

Nonetheless, some Chinese policymakers have been more aggressive

about domesticating the chip supply chain, branding such policies as
part of Chinese President and CCP General Secretary Xi Jinping’s
“dual circulation” policy, which seeks reduced dependence on foreign
markets. The September upgrade to China’s semiconductor R&D tax
credit is the latest sign of a country adapting – and maybe even
evolving – under U.S. pressure.

A Long Way to Self-Sufficiency

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As U.S. Secretary of Commerce Gina Raimondo visited China in late

August, Chinese smartphone maker Huawei released the Mate 60 Pro.
To the surprise of U.S. officials, the new Huawei phone featured a chip
capable of 5G communications that was allegedly designed and
manufactured by China’s semiconductor champion, SMIC. Whether or
not SMIC is capable of commercially producing such chips at 7-
nanometer process technology, American officials (especially
Republican members of Congress) are anxious that Beijing may be
close to catching up technologically to the U.S.-led coalition of
advanced semiconductor economies.
Rigorous analysis of the chip industry paints a much bleaker reality for
China, however. Although China relies heavily on semiconductor
imports, accounting for 24 percent of global chip demand, it only
contributes 9 percent of the global value-add in developing and
producing this technology. China’s General Administration of Customs
highlighted that in the first three quarters of 2023, China imported more
than $2 billion in chips but exported only $110 million worth of
semiconductors, leaving it with a massive trade deficit in this critical
technology. In fact, the only stage of the semiconductor supply chain
where China commands the largest global share, chip assembly and
packaging at 38 percent, is the industry’s lowest value-add step.

Chinese policymakers are increasingly anxious to close this technology

gap by subsidizing chip R&D and manufacturing, but key Communist
Party officials note that the country’s semiconductor subsidies are too
unaligned to effectively face this national challenge. Some 66 percent
of China’s semiconductor subsidies come from local governments and
only 34 percent from the central government. These provincial and
municipal semiconductor investment funds are primarily concerned
with promoting economic activity, so many do not consider national
supply chain needs when issuing incentives.

Recognizing this reality, a proposal made at this spring’s annual

session of the Chinese People’s Political Consultative Conference
urged national-level policymakers to align China’s various
semiconductor development efforts into “one chessboard,” meaning a
single national strategy.

Buying Freedom from Semiconductor Chokepoints

In response to growing economic pressure from the United States, Xi

Jinping has stressed that mitigating chokepoints, technologies where
China is reliant on foreign providers, should be a pillar of China’s
national science policies. In September 2022, he announced the New
Whole Nation System (新型举国体制), aimed at making China self-
reliant in national security-critical technologies by way of large new
central government incentives.

While local government subsidies still represent the lion’s share of

Chinese chip subsidies, last week’s R&D tax credit bump is the latest in
a series of tax policies that have increased Beijing policymakers’ weight
in incentivizing chip companies. A 2020 State Council policy excuses
corporate income tax for the initial five years of a semiconductor project
and levies a reduced rate of 50 percent in the following years. More
generally, in 1996, China first introduced a credit allowing companies to
deduct 50 percent of their R&D spending from taxable income. China’s
State Council raised this general R&D credit to 75 percent in 2016,
then again to 100 percent in March 2023. The tax credit hike from
March also created a massive new 200 percent credit bracket for R&D
activities that result in patents.

Last week’s announcement builds on the 100 percent and 200 percent
general R&D credits by adding a special sweetener for the
semiconductor industry. Research expenses in chip technology that do
not result in patents qualify for an additional deduction of 120 percent
of their taxable income. (This equation of the 100 percent general
deduction plus 120 percent semiconductor deduction results in a 220
percent deduction for non-patent producing chip R&D.) Research
expenses in chip technology that do result in patents qualify for a
deduction of 220 percent of their taxable income. However, the
announcement did not specify whether this deduction is on top of the
existing 200 percent bracket or not (to make 420 percent), and the
authoritative ministerial document on which the announcement is
based is not readily available.
Notably, the new semiconductor tax credits do not totally exclude
outsourced foreign research from the deduction. So long as outsourced
research does not exceed two-thirds of the total cost of research,
companies can claim 80 percent of their foreign research expenses in
the new deduction. This inclusion suggests that China’s policymakers
are focused on increasing the long-term technological capabilities of
Chinese companies, regardless of where that know-how originates. It
reflects a mature industrial policy, devoid of short-term protection.

Who Will Carry the Subsidy Torch?

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China’s R&D tax credits have long served to catalyze its overall
innovation ecosystem. At the behest of Xi Jinping’s call to mitigate key
technological chokepoints, however, policymakers are increasingly
concentrating their efforts on semiconductors and other key industries.
Tools like this semiconductor R&D tax credit will increase the pressure
on domestic champions to usher in China’s bid to catch up with the
West.

Two chipmakers will likely claim large deductions from the program.
Huahong Semiconductor is China’s leading chipmaker focused on
mature nodes (semiconductors with production process between 1
micron and 28 nanometers). A pure-play foundry, Huahong is key to
China’s “digitization through greenification” efforts by producing chips
for electric vehicles, smart grids, and the Internet of Things.

Closer to the cutting-edge, Semiconductor Manufacturing International

Corporation (SMIC) is China’s advanced chipmaking champion, as well
as the subject of intrigue amidst Huawei’s Mate 60 announcement.
SMIC manufactures chips for applications ranging from
telecommunications to advanced logic, and its production process
ranges from 28 nanometers to nodes theoretically as advanced as 7
nanometers. SMIC is key to developing China’s domestic advanced
chip capacity as U.S. restrictions increasingly cut China off from
leading American and allied chipmakers.

Semiconductor toolmakers are also key to the sustainability of China’s

increasingly decoupled chipmaking industry, and U.S. trade restrictions
are spurring a repeat of the industrial realignments recounted in
Mulder’s “The Economic Weapon.” Naura Technology Group,
Advanced Micro-Fabrication Equipment, and U.S.-sanctioned
Shanghai Micro Electronics Equipment were among the over 300
companies attending Wuxi’s 2023 China Semiconductor Equipment
Annual Conference. At the event, one industry official quipped that U.S.
export controls have made downstream Chinese electronics makers
more willing to buy tools from domestic equipment companies, as well
as to offer them venture funding.

Beijing is eager to further encourage these toolmakers’ investments in

R&D because China is particularly reliant on foreign advanced
manufacturing technology, with only 10 percent of “high-end machine
tools” being domestically developed. As the United States has
convinced the Dutch and Japanese governments to limit
semiconductor manufacturing equipment exports to China, Beijing
hopes to develop domestic alternatives to the likes of ASML and Tokyo
Electron Limited.

Not Just What is Possible, But What Beijing Thinks is Possible

China is nowhere near its “Made in China 2025” goal of fulfilling 70

percent of its own semiconductor demand. The country not only still
has a massive chip trade deficit, but its leading chip equipment makers
are also at least four years behind their foreign counterparts.
Regardless, Beijing is investing billions of dollars into developing
domestic alternatives to foreign semiconductors and manufacturing
equipment. For policymakers in Washington in particular, it is perhaps
less important to ask whether China’s semiconductor industry will
ultimately succeed in catching up with the West’s and more important
to ask whether Beijing thinks it can catch up. Each additional piece of
semiconductor technology the U.S. subjects to export controls is an
additional technology Beijing will attempt to make at home, pitting U.S.
export controls and “fences” against Chinese subsidies and tax credits.