China Rules: How China Built ‘iPhone City’ With Billions in Perks for Apple’s Partner

China Rules: How China Built ‘iPhone City’ With Billions in Perks for Apple’s Partner

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China, no longer content with just being the world’s factory floor, is moving aggressively to develop its own technology giants. Beijing is pressuring local governments to cut subsidy programs that the country heartily encouraged even just a few years ago. And big exporters, courted and protected for decades by Beijing, now face broad scrutiny.

Regulators shut down Apple’s iTunes Movies and iBooks Store last spring, just six months after the services were introduced in China. The Chinese authorities fined the technology giant for failure to fully pay its taxes. And Apple went through a national security review in China for the iPhone 6, delaying its release in the country.

Apple is now engaged in the corporate version of shuttle diplomacy. In December, the company’s chief executive, Timothy D. Cook, along with other Silicon Valley executives, met with Mr. Trump in New York, part of an effort to build bridges with the incoming administration. It followed a similar good-will tour in China in August, when Mr. Cook sat down with the country’s vice premier at Zhongnanhai, the government’s walled leadership compound in what was once part of Beijing’s Imperial City.

The two countries are playing a high-stakes game.

Apple, like many multinationals, depends on a vast global supply chain that includes multiple companies and countries, each with its own expertise and advantages — a complexity that is often lost in the political debate over trade. The iPhone is a collection of intricate parts that are made around the world and assembled in China, spurring employment in many countries; Apple says it supports two million jobs in the United States.

As China and the United States both brandish a new form of economic nationalism, they risk disrupting the system, without necessarily achieving their goals. And multinationals and their manufacturing partners would face serious financial trade-offs.

As the Zhengzhou operation shows, China not only provides a large pool of labor; it also offers incentives that would be difficult to replicate in the United States or anywhere else. The trove of benefits in Zhengzhou flows through the production process for the iPhone, from the factory floor to the retail store.

Foxconn receives a bonus when it meets targets for exports. Those subsidies, according to the government records, totaled $56 million in the first two years of production, when the factory was exclusively dedicated to the iPhone.

The bonus is small on each of the tens of millions of iPhones produced during that period. But the subsidies add up: The government records list more than a dozen other forms of financial aid at the Zhengzhou operation.

A Hidden Bounty

About half of the world’s iPhones are made at the Foxconn facility in Zhengzhou, a city in one of China’s poorest regions. The local government has provided sweeteners and incentives to Foxconn, Apple’s manufacturing partner — a package of benefits that supports iPhone production there in a variety of areas.




Benefits supplied to Foxconn by the Zhengzhou government

Built and partly financed the construction of a huge manufacturing complex at a cost of $600 million.

Spent around $1 billion to build housing that could accommodate hundreds of thousands of workers.

Provides a discount that reduces the cost of power by 5 percent annually.

Built infrastructure, including power generators and a 24-kilometer pipeline.

Eliminated corporate taxes and value added taxes for five years, then halved the usual rate for the next five years.

Granted a $250 million loan from the municipal treasury.

 

Helps recruit and train workers, as well as paying subsidies for new hires.

Lowered the amount of social insurance and other payments by up to $100 million a year.

Offers bonuses tied to the growth of exports.

Pays out a subsidy to help defray the cost of shipping goods.

Benefits supplied to Foxconn by the

Zhengzhou government

Built and partly financed the construction of a huge manufacturing complex at a cost of $600 million.

Spent around $1 billion to build housing that could accommodate hundreds of thousands of workers.

Provides a discount that reduces the cost of power by 5 percent annually.

Built infrastructure, including power generators and a 24-kilometer pipeline.

Eliminated corporate taxes and value added taxes for five years, then halved the usual rate for the next five years.

Granted a $250 million loan from the municipal treasury.

 

Helps recruit and train workers, as well as paying subsidies for new hires.

Lowered the amount of social insurance and other payments by up to $100 million a year.

Offers bonuses tied to the growth of exports.

Pays out a subsidy to help defray the cost of shipping goods.


The Zhengzhou government eliminated corporate taxes and value-added taxes that Foxconn pays for the first five years of production; they are half the usual rate for the next five. The city lowered Foxconn’s social insurance and other payments for workers, by up to $100 million a year.

The customs operation is also in a so-called bonded zone, an area that China essentially considers foreign soil, subject to different import and export rules. This setup allows Apple to sell iPhones more easily to Chinese consumers.

Pursuing the iPhone

Apple was late to China.

In a bid to lower costs, some of the biggest American technology companies, including Compaq, Dell and Hewlett-Packard, began dismantling their domestic manufacturing in the 1980s and moving work overseas, largely to Asia. Not Apple. The company’s co-founder, Steven P. Jobs, believed that software and hardware development had to be closely integrated.

Rather than close plants, Apple decided to build them — in Colorado, Texas and California. Apple would maintain some of them long after Mr. Jobs left the company in 1985. The plants were highly automated, with the walls painted white, just as Mr. Jobs liked them, and they were promoted as a symbol of American ingenuity.

“This is a machine that is made in America,” Mr. Jobs trumpeted in 1984, after Apple opened a manufacturing facility in California to produce the Macintosh personal computer.

Finances forced Apple to change course. As Mac sales plummeted and inventories began to bulge in the mid-1990s, Apple had to embrace outsourcing, something with which it had only just experimented. After Mr. Jobs returned to the company in 1997, he turned to his new operations chief, Mr. Cook, who had recently joined from Compaq, to figure out how.

Under the direction of Mr. Cook, Apple shifted more business to Foxconn, then an up-and-coming Taiwanese contract manufacturer that had started to gain a following among big American brands like Compaq, IBM and Intel. The partnership freed up Apple to focus on its strengths — design and marketing. Apple would come up with a new idea, and Foxconn would find ways to produce millions of units at a low cost.

“They have brilliant tooling engineers, and they were willing to invest a lot to keep pace with Apple’s growth,” said Joe O’Sullivan, a former Apple executive who worked in Asia.





When Apple’s sales took off after the introduction of the iPod in 2001, Foxconn had the heft and expertise to meet the demand that accompanied each hit product. Foxconn’s factories could quickly produce prototypes, increase production and, during peak periods, hire hundreds of thousands of workers.

Foxconn’s founder, the Taiwanese billionaire Terry Gou, provided political clout. Over the years, he frequently visited China to meet local officials and members of the decision-making Politburo to lobby for subsidies, cheap land, workers and infrastructure for facilities that churned out iPods, iPads and iPhones.

“The reason Foxconn’s so big is Terry Gou,” said Tony Fadell, a former Apple executive who helped design the iPod. “He said he’d create the manufacturing, and the Chinese government would give him some of the money to do it. As Terry grew with the Apple business, no one else could compete.”

After the first iPhone was rolled out in 2007, Foxconn moved to expand production and began scouting new locations around China — unleashing a fierce competition among cities eager for the business. Officials from various regions camped out at hotels in Shenzhen, where Foxconn had its main operations.

“These have become like Olympic competitions,” said Gao Yuning, who teaches public policy at Tsinghua University in Beijing.

The Zhengzhou government saw the factory as a huge opportunity for development in an area that had been bypassed by China’s boom. Officials wanted to rebrand a place derided as a source of migrant laborers and unfairly tarnished as a land of thieves and counterfeiters.

City officials lavished money and favorable investment terms on Foxconn, according to the government records. They promised discounted energy and transportation costs, lower social insurance payments, and more than $1.5 billion in grants for the construction of factories and dormitories that could house hundreds of thousands of workers.

The city created a special economic zone for the project and provided a $250 million loan to Foxconn. The local government also pledged to spend more than $10 billion to vastly expand the airport, just a few miles away from the factory.

The Zhengzhou government pledged to spend more than $10 billion on an airport just a few miles from the iPhone factory.

Credit
Gilles Sabrié for The New York Times

“We know that China has all sorts of policies to promote development, and this one ticks all the right boxes,” said Barry Naughton, an authority on the Chinese economy at the University of California, San Diego.

The city moved quickly. Factories were built, licenses were approved and assembly lines began operating in August 2010, just a few months after the government signed the deal. In Zhengzhou, the Chinese government effectively took a huge tract of land on the barren, dusty plains of central China and transformed it into a sprawling industrial park.

“I was impressed,” said Jeff Williams, Apple’s chief operating officer, who was part of the early discussions about setting up a factory. “They were very focused.”

Made, and Sold, in China

When Apple first moved into China, the country was largely a low-cost production site. It quickly evolved into one of the world’s biggest consumer markets, with more than a billion potential customers.

But Apple initially had to take the “Hong Kong U-turn” to get its products into the hands of Chinese consumers.

Since China began opening its economy to the outside world in the 1980s, the government’s policies have encouraged manufacturing and exports with the creation of special economic zones. But those same policies have discouraged domestic consumption of overseas brands.

Most products made in China by big multinationals had to be physically shipped out of the country and then brought back so that they could be taxed as imports — hence, the U-turn employed by many companies.

In 2005, Apple’s best-selling portable music device, the iPod, was manufactured in southern China. To comply with the country’s stringent rules, iPods were loaded onto a cargo ship and sent to Hong Kong. Often, when the ship arrived, it was simply turned around and sent back to China.

Behind an open-air mall, dormitories for Foxconn factory workers. The local government built large sections of employee housing as part of its deal with Foxconn.

Credit
Gilles Sabrié for The New York Times

“This was really a legacy of China’s old export-oriented economy,” said Edwin Keh, the former head of global procurement at Walmart, who worked for the retailer and other multinationals in China for 20 years. “Back then, we built supply chains good at making things in the East and selling them in the West.”

Apple and other multinationals wanted a better system.

By the time Apple released the iPhone in 2007, China faced growing pressure to loosen its restrictions and give global companies easier access to its market. Apple and other companies believed that shipping goods to Hong Kong was a waste of time and energy. They wanted to send goods from the factory gate in China directly to their stores and distribution centers inside the country.

In discussions with Zhengzhou officials, Foxconn insisted that the operation be located inside a bonded zone, equipped with customs right at the factory gate to facilitate iPhone exports. It also wanted the factory to be built within a few miles of the city’s airport, to expedite Apple’s global shipments.

Although it wasn’t the first city to create such a cohesive operation, Zhengzhou provided a convenient system, since it would serve what would become the world’s largest iPhone manufacturing facility.

A bonded zone functions much like a diplomatic territory, in that the government regards it as foreign soil. The zone eliminates the need for global brands to pay duties or taxes on imported components. And it makes it unnecessary to physically export the goods. In those zones, products can be imported and exported virtually at customs, without crossing a single border. After that, they can move swiftly around the country, or out to the rest of the world.

As the final assembly point for the iPhone, China also functions as a base for Apple’s global tax strategy.

In the Zhengzhou bonded zone, typically at customs, Foxconn sells the finished iPhones to Apple. After purchasing the iPhones, Apple then resells the goods to Apple subsidiaries. The process largely takes place electronically.

The process also plays out with other Apple goods that are produced in the country. Apple can assign some profits on these goods to an affiliate in Ireland, a tax-advantageous locale, according to a 2013 American congressional report on the company’s tax practices. It is a practice commonly employed by many big technology brands and is not unique to China.

How Does an iPhone Get From Factory Floor to Retail Store?

“U.S. multinationals are the world leaders in tax avoidance strategies,” said Edward D. Kleinbard, the former chief of staff of the congressional Joint Committee on Taxation. “In doing so, they create stateless income — income that has become unmoored from the countries to which it has an economic connection.”

According to the congressional report, the process allowed Apple to move tens of billions of dollars offshore and substantially reduce its tax bill, which one senator called the “holy grail of tax avoidance.” The European Union in August ordered Ireland to claw back more than $14.5 billion from Apple in unpaid taxes from a decade-long period.

Apple said it follows all applicable tax rules, insisting that the company pays all its taxes. The company said it had made some changes to its tax procedures to comply with new laws, including registering a subsidiary in Ireland that previously had no tax jurisdiction. It is appealing the ruling in the European Union.

In Zhengzhou, local officials have lauded the package of incentives provided to Foxconn, confident that the city’s iPhone production will continue to pay huge dividends.

In August 2014, the city’s top leaders held a special meeting to discuss “deepening collaboration” with Foxconn, according to the government records obtained by The Times. They crowed that Zhengzhou was the “biggest production base for Apple iPhone worldwide.”

There were 94 production lines producing the iPhone 6 and iPhone 5s, and the government said about 230 million smartphones had already been exported from Zhengzhou, making it one of the nation’s crucial export centers. Production capacity had reached half a million iPhones a day. The city’s tax revenue was rapidly rising.

Officials had a name for it all: “Zhengzhou Speed.”

A State-Recruited Army

A crushing work force begins arriving for the early shift at 6:30 a.m. They travel by foot, by bus, by motor scooter and even by pedicab.

They file steadily into dozens of factory sites, spread out across 2.2 square miles. At the peak, some 350,000 workers assemble, test and package iPhones — up to 350 a minute.

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