Hong Kong China

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1 Index In this time of financial crisis, China is seen as one of the least contaminated countries. It is perceived by many companies to be a springboard for growth and continues to offer development prospects to companies that have already taken the leap. China remains attractive for those wishing to produce at low cost, but today, it is its internal market, more than anything else, that is the subject of envy. China, which will be the world s second-largest consumer market within five years, is a dream for a West that is entering a financial crisis. China is becoming more dynamic and is welcoming more and more foreign companies in the distribution and service sectors, while continuing to be the world s factory. All these changes have been accompanied by modification and greater complexity of the system, both legally and fiscally. Today, all companies interested in China have to ask themselves how they will structure their investments in Asia or whether to restructure them. To set up directly or via an intermediate entity, the answer is never definite and may change over time. The answer depends on the type of company, its organization, its operation and its medium to long-term plan in this vast part of the world. Companies have to correctly identify the pitfalls, both theoretical and practical, that must be avoided in order to correctly understand their requirements and to rethink models that work less well or no longer in a world where the rules are becoming clearer but more complicated. The purpose of this newsletter is to highlight the need to think about and plan ahead the optimizing of financial flows between companies that will be participating in the foreign company s China adventure. Hong Kong or not Hong Kong? Quite naturally, the first gateway that European investors think of is Hong Kong. A leading business center and financial hub in Asia, Hong Kong is the traditional and preferred way for foreign investment to enter mainland China. Despite the resumption of sovereignty by China, Hong Kong has retained its Special Administrative Region status, with its financial autonomy, a flexible legal system and an attractive fiscal framework for international investors in mainland China. Its geostrategic position, its autonomous status and the quality of its infrastructures are strengths that convinced many financial investors of the need to structure their investments in Hong Kong before accessing the Chinese market. In 2006, 30% of foreign investors in China had already opted for that solution. One might imagine that tax optimization alone is the reason, but that is not so. Hong Kong is chosen for many reasons, but above all because it is easier to structure investments owing to the flexibility of Hong Kong law and to possess an Asian holding company that can acquire interests in countries other than China.

2 China clearly encourages this. It needs Hong Kong, trusted by international companies, in order to attract the colossal investment still needed for its development. Hong Kong is in China, but is an extraterritorial part of China with a privileged tax and legal status based on Deng Xiaoping s principle of one country two systems in order to provide a privileged, stable legal framework that can rival with other financial centers such as Singapore, Luxembourg, etc. Comparison of regimes: Hong Kong vs. China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

3 A rapid comparison of the double taxation treaties to which China is a party confirms Hong Kong s position as an attractive investment center making it possible to limit tax imposed by China, and on cross-border transactions in particular. China again favours Hong Kong China arrangements, guaranteeing for example lower withholding tax on transactions between these two territories, provided that the Hong Kong company has an equity stake in the Chinese subsidiary. One should not be under any illusions however; in order to be of real benefit, an establishment in Hong Kong must be accompanied by a real activity, for all industry sectors, with dedicated offices and on-site staff. All too often, companies make the mistake of investing in China via a Hong Kong holding company, with a view to re-channeling all or part of their turnover, whereas their activity center is really in China. This is the case for instance with the Shanghai representative offices of certain trading companies in Hong Kong. In principle, the representative office must be merely considered as an office for liaising with the parent company. Sometimes however in practice it acquires a greater dimension and develops into an entity with commercial activity. Since invoices cannot be issued by the representative office, services or sales are carried out by the company in Hong Kong, whereas the commercial activity generating the income is based in Shanghai. Chinese tax offices have been tolerant up to now, but these practices will probably be systematically penalized in the future, particularly since the implementation of the new tax reform aimed at unifying the tax regime of domestic Chinese companies and foreign investment companies. Should companies set up directly in China? It is true that Hong Kong, Singapore, Luxembourg and other financial platforms may offer attractive tax advantages, but from another point of view, they may also be considered as tax havens by many European governments. Hong Kong, for instance, has, in the past, attracted the attention of the French tax authorities, who often give it a bad press. There is still no double taxation treaty between the two countries. The fact that on 1 April 2008, the corporate income tax rate in Hong Kong was reduced from 17.5% to 16.5% (now less than half the French corporate income tax rate) does not favor the signing of such a treaty. The French general tax code (CGI) also aims at fighting against investment in tax havens, justified by the extent of financial flows that find their way there. Thus, article 209 B of the CGI specifies, subject to saving clauses, that the profits received by a subsidiary that is subject to a preferential tax regime are taxable in France if the parent company is situated in France and holds, directly or indirectly, more than 50% of the shares, units, financial rights or voting rights. This is a way of penalizing companies that set up a shell company for their activities in France in order to receive income and shield it from applicable French taxation. In view of the tax problems mentioned above and the obvious substance requirement, it is sometimes worthwhile setting up directly in mainland China and not having to bear the costs of an intermediary managing company. Measures to encourage this type of structure setting up directly are being put in place in France to encourage French companies to develop internationally while increasing the value of their company in their home country. The absence of an intermediary structure makes it possible, in particular, to benefit from the advantages defined in the Franco-Chinese convention in relation to direct financial flows between the parent company and its Chinese subsidiary. In fact, under the

4 treaty signed in 1984, a fictitious tax credit is granted in order to encourage French investment in mainland China. The tax credit granted in this way by France is 20% of the gross amount of the dues (before withholding tax) paid by a wholly-owned foreign enterprise based in China, whereas the tax withheld in China is 10%. Thus, in the case of a wholly-owned foreign enterprise, the tax credit granted in France may exceed the tax withheld in China. It may be 20% of the gross dividends and gross dues paid by a WFOE, whereas the withholding taxes will only be 10%. Taxation of the cross-border transactions relating to the services below Having a holding company in Hong Kong would result in the loss of these advantages in the absence of a treaty between France and Hong Kong, noting that Hong Kong does not withhold any tax on dividends and interest. However, profit tax rate of 17.5% is withheld on the royalties. Should both parties to the contract be related, the profit tax rate will be due on 30% of the royalties to be paid only. As for the China Hong Kong agreement, it only makes it possible to reduce from 10% to 5% the withholding tax on dividends paid by the Chinese subsidiary to the Hong Kong structure, provided the latter owns at least 25% of the subsidiary. The treaty also makes it possible to reduce from 10% to 7% the withholding tax on interest and dues paid by a Chinese subsidiary to the structure in Hong Kong. Thus, as a general rule, the tax treatment of the flow of dividends and dues is more favorable if these flows go directly from China to France, without being channeled through a Hong Kong holding company. However this does not apply to interest in the absence of a fictitious tax credit granted in respect of interest under the Franco-Chinese convention.

5 Taxation of the financial flows relating to an establishment in China It is primarily the nature of the financial flows entering and leaving China (sale of goods and services, payment of dues, etc.) that will determine how they are taxed. To understand the taxation system, it is also important to distinguish between these types of flows by chronological order. All transfers of funds originating abroad are controlled in China by the bank that receives them, under the supervision of the State Administration of Foreign Exchange (SAFE). The bank may refuse the transfer if the Chinese subsidiary s justification is deemed insufficient or not compliant with its activity. A law promulgated on 5 August this year reaffirms the predominant role played by the SAFE in the management of cross-border financial flows. As a general rule a Chinese company is subject to corporate income of 25% and business tax of 5% on the supply of services and/or VAT if goods are bought or sold. Before a Chinese company is set up in any sector, the main financial flows that are going to enter China are (i.) either related to pre-registration expenses, which apart from those that go through the pre-registration bank account, are not deductible for the Chinese subsidiary, or (ii.) the capital injected, which must be paid in its entirety as from the obtaining of the business license, following the approval of the local authorities, within two years of its issuance. The case of representative offices is a very simple one, since only the parent company may transfer funds to the representative offices accounts. These representative offices carry on no activity other than the promotion of their parent company. They cannot therefore issue invoices. For the others, Chinese law requires compliance with the ratio between total investment and registered capital. Details of the capital/investment ratio * IV = Investment During the Chinese structure s existence, and within the limits of the above ratio, to make use of shareholder loans is an option that is sometimes used that makes it possible for investors to avoid entering the capital increase process and to optimize their working capital requirements by creating debt. These loans must be approved by the SAFE in advance, and the loan may be repaid to the parent company at a later date, with no taxation being levied on the transferred funds. In the case of thin capitalization, the local authorities can order a capital increase. This is a long process, which requires a change of business license. The procedure takes 2 months on average. Except for payments relating to sales of goods that are subject to VAT, financial flows exiting China are mainly governed by the application of a withholding and a business tax. Regardless of the setup method chosen or whether an intermediate holding company in Asia is used, cross-border transactions with China will be subject to the same principle described

6 above. Only the amount withheld may change, depending on the nature of the double taxation treaties negotiated with the country receiving the flows. Whereas the Franco-Chinese tax convention specifies that the amount withheld may not exceed 10% of the gross amount of the transaction, the China Hong Kong tax treaty guarantees a withholding tax of 5% on dividends if the Hong Kong company holds a stake greater than 25% in the Chinese subsidiary. Apart from dividends and payments relating to the sale of goods, all other transfers of funds will incur a business tax of 5% on the amount of the contract concerned. Transfer pricing is also a major issue where cross-border transactions are involved. Since the new tax law went into force on 1st January this year, the Chinese administration has clearly renewed its intention to exercise stricter control over transfer pricing policies between companies of the same group. In practice, tax audits are more frequent, particularly in Shanghai and Canton, allowing local authorities to carry out benchmarking in each controlled sector. Intra-group relations are therefore subject to greater scrutiny. Companies must expect they will have to justify their prices. Comparison of taxation: Hong Kong vs. China!"#"!$%&'' (%&)'*%&)'' +($&"''!"#"!$%&'! "#$$%&'$%()%&*!+$%,-%+)#!!.'&%',!'/!#//#-&%0#!1(,(2#1#,&! (//%$1#3!! +%,-%,"!.'$&+%/.'!"#'! 45678!',!+$'/%&9!! :78!',!+$'/%&9!! 012$&.22'!"#'! ;!! 78!',!9()#9!/'$!(!9#$0%-#!(-&%0%&*!! 3"!'! ;!! 4<=!4>=!4?=!<=!5!(,3!@8! 2!"/-'41!5'!?678!',!(0#$(2#!!?6?78!! 6$2+"7'5.",'! A$'1!4!B+$%)!&'!>4!C($-D!! A$'1!4!E(,F($*!&'!>4!G#-#1H#$! 4%107.'!,."!5'!!"#"!$%&' IJ!K!LD%,(!&$#(&*!MN"!,'!IJ!K! A$(,-#!&$#(&*!! LD%,(! K! IJ! &$#(&*! B.G! LD%,(! K! A$(,-#!&$#(&*!! +12!%/2'' (%&)'*%&)'' +($&"'' '+12!%/2'41!$.2'!.'!-F9&'19!3F&%#9!F+',!#,&$*! &'!IJ!9(0#!%,!9+#-%()!-(9#9!! G#+#,3%,2! ',! &D#!,(&F$#! '/! &D#! +$'3F-&!!

7 Conclusion The choice of one legal structure over another cannot be made without taking the above factors into account. In order for it to optimize its presence in mainland China, a company must consider this as a global project. Access to knowledge of legal practice in China is vital since it often differs from theory. This is the case with the refund of export VAT, for instance. An intermediate structure located in a tax-privileged region might make it possible to set up an Asian rather than a Chinese presence and may result in tax reductions upon exiting China. However, this intermediate structure must have substance, and cannot merely be an entity that accumulates offshore profits. Setting up directly, apart from the tax credits available upon entry into France, is mainly carried out in order to enhance the value of the parent company. Each option has its distinct advantages, and a strategy should be devised before developing any activity in mainland China. Contacts Paul-Emmanuel Benachi Partner pebenachi@lpalaw.asia Tel: Jérôme Patenotte Partner jpatenotte@lpalaw.com Tel: +33 (0) Fanny Nguyen Senior legal and tax advisor fnguyen@lpalaw.asia Tel: Lefèvre Pelletier & associés is one of France s leading law firm. With more than 150 lawyers, the firm has expertise in all areas of business law.