SETTING UP IN CHINA. Setting up in China March

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1 SETTING UP IN CHINA

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3 SETTING UP IN CHINA This overview has been made possible with input from: Jacques Borremans, managing director of legal and commercial services firm Wyatt & Wang 1 Andries Verschelden, partner at accounting firm Moore Stephens Verschelden Shanghai 2 Flanders Investment & Trade Beijing has also sourced material from the KLAKO Group [ from the JLJ Group [www. jljgroup.com], from Dezan Shira & Associates [ and from the magazine Business Tianjin [ and the contributions therein by the legal services firm Garrigues Shanghai [ The information Flanders Investment & Trade Beijing collected and supplies in this document does not include all details. It is meant to be used as a general guideline only. In addition, Flanders Investment & Trade cannot assume any responsibility for contributions by any other party in this document. If one wants to tackle the Chinese market one has to be prepared to invest sufficient time and means, including financial, and expect it to be a long term project. A simple representative office, with one or two local staff, will require an outlay of approx. 60,000/annum and will take a couple of years to bring its first manifest results. A cheaper way is simply not possible. The Chinese market however will bring its rewards, in due time, when one can offer an innovative, advanced, quality product or service The Spaces International Center, 8 Dongdaqiao Road, Chaoyang District, Beijing (T) (F) (W) Mr Jacques Borremans, managing director & partner (E) Jacques@wyattandwang.com th Floor 889 Wanhangdu Road Shanghai 中 国 上 海 市 静 安 区 万 航 渡 路 889 号 悦 达 889 中 心 20 层 Andries Verschelden (T) (M) (W) (E) andriesverschelden@moorestephens.be Setting up in China March

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5 1 TABLE OF CONTENTS 2 HOW TO BE PRESENT WITH YOUR COMPANY IN CHINA Representative office Legal aspects Permitted scope of activities Requirements for a RO Branch office of an overseas company Industries permitted to set up a Branch Office Liabilities of a Branch Office Foreign Invested Enterprise [FIE] Most common types of FIE: WFOE EJV CJV FICE Liabilities Qualification as a shareholder Business scope of FIEs Minimum registered capital Registered capital requirements FIEs compared FIEs, Representative Offices and Branch Offices compared Outsourcing Administration Functions Foreign-invested Partnership ACQUISITIONS Equity Acquisitions Advantages Disadvantages Asset Acquisitions Advantages Disadvantages Restrictions Approval Due diligence OTHER WAYS OF DOING BUSINESS IN CHINA Sourcing Subcontracting (assembly, processing, etc) Franchising HONG KONG HOLDING COMPANIES TRANSFER PRICING CORPORATE & INDIVIDUAL TAX IN CHINA Corporate Income Tax Business Tax Withholding Tax Value Added Tax (VAT) Individual Income Tax (IIT) Social Security Other Taxes ACCOUNTING PROCEDURES AND PRACTICES Setting up in China March

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7 2 HOW TO BE PRESENT WITH YOUR COMPANY IN CHINA Option 1: Set up your own entity Option 2: Acquire an existing entity 2.1 REPRESENTATIVE OFFICE Usually the first type of registered presence a foreign investor sets up in China. Useful to become acquainted with the Chinese market, to get closer to possible Chinese or other local suppliers, to get closer to customers, to conduct market surveys, to start building your Chinese staff, etc. In short: a good preparation for a possibly more direct entrance at a later stage LEGAL ASPECTS A RO does not enjoy the status of an independent legal person under Chinese law Does not have a registered capital Does not have a board of directors Legally deemed to be an extension of the head office (mother company) and therefore the mother company assumes liability for all activities conducted in China by the RO PERMITTED SCOPE OF ACTIVITIES 3 Can support the mother company Collect market information Can conduct activities related to its own office administration Cannot employ (Chinese) staff directly, etc. Cannot employ in excess of four foreign staff, including the chief representative. Cannot engage in direct operational activities which generate profit Cannot manufacture, distribute or purchase products 3 The RO represents the interests of the foreign investor by acting as a liaison office for the parent company. RO can conduct market research, develop partnerships and business channels; however, all business transactions, including issuance of invoices, are managed by the parent company. ROs will have to pay an RMB 50,000 to RMB 200,000 penalty for profit activity involvement, and RMB 10,000 to RMB 100,000 for exceeding the activity scope mentioned above. Setting up in China March

8 2.1.3 REQUIREMENTS FOR A RO CAPITAL CONTRIBUTION REQUIREMENTS There are no capital contribution requirements for a RO. Establishing a RO is therefore largely a matter of complying with the prescribed application procedures. The time frame of the application procedure is approx. one month. A series of documents must be submitted and the timeframe for preparation is dependent upon the parent company. The parent company's business license and other relevant documents set below must be notarized by a local public notary officer and then endorsed by the Chinese embassy in the home country OFFICE SPACE A RO must either be situated in an office where the landlord has a right to rent his office space to RO's or in a Grade "A" office building. A list of rental certificates and contracts are required and must be submitted to the government authorities for approval. It is highly suggested that no leasing contract be signed until it is certain that the RO can be registered in the specific location you have in mind CHIEF REPRESENTATIVE A Chief Representative must be appointed by the parent company. This person will be responsible for the activities of the RO and is considered the "legal face" allowing him to sign all related government forms and any documents required by government offices. This person can also have automatic authorization on bank accounts. The Chief Representative will be liable to make a declaration of income tax in China, even if not residing in China. If not residing in China, then personal income tax may be paid on the worldwide salary and based on the number of days spent in China for a specific month. Should the person be based in China, then tax will be paid on a monthly basis based on the salary income in China ACCOUNTING AND TAX FILING, TAX EXEMPTION APPLICATIONS AND ANNUAL AUDIT REQUIREMENTS A RO, although indirectly operational, is liable for filing and paying Enterprise Tax on the yearly expenses made. This may sound strange to many Foreign Invested Enterprises (FIE), especially as a RO is non-profit-making. However the Chinese government does require that tax be paid as they consider that by having such an office in China, profit is being made in the parent company at least. State Administration of Taxes (SAT) increased the deemed profit tax rate from a fixed 10 percent to a variable 15 percent to 30 percent. It is therefore recommended to keep a series of accounts based on all the expenses of the RO and also keep all original receipts for a minimum of five years, according to the PRC Law. Annual audits and annual inspections are compulsory for RO's and must be completed before May each year. 6

9 Resident representative offices are required to submit an annual report to the registration authority, providing information on lawful existence of foreign enterprises, ongoing business activities of the RO, and its income and expenses audited by its accounting agency. Failure to submit an annual report within the specified timeframe will result in a penalty of RMB10,000 to RMB30,000, while providing false information will be fined with RMB20,000 to RMB200,000. Fraud may also lead to license revocation EMPLOYMENT OF MAINLAND CHINESE AND FOREIGNERS A RO is not permitted to hire their mainland Chinese staff directly. A RO must employ local staff through an employment organization. A maximum of four foreigners can be employed by an RO. Only under certain circumstances can this quota be extended. Practically, in Beijing for instance, it is required that the maximum number of foreign representatives working for the RO shall not exceed four. In addition, the number of foreign representatives cannot exceed the total number of local Chinese staff hired through the licensed employment organization. (e.g. RO employing 2 local staff can have a maximum of 2 foreign representatives). The new regulations also require that for every registered foreigner in the RO, at least one mainland Chinese is employed. E.g. a RO with only one foreigner as employee might not get a work permit & required visa without first hiring a local employee through an employment organization. Those regulations came into place due to the frequent misuse of the RO as a vehicle for foreigners to gain an employment visa through a dormant RO PROTECTION OF THE PARENT COMPANY BY HAVING A HOLDING ENTITY Some foreign companies feel although the establishment may not require a high capital investment it is a risk to set up an entity in China and are establishing offshore companies to act as a holding entity for their China investment and thereby create a buffer layer to take over the full liability for the Chinese operation from the parent company. The establishment of many of these offshore companies is an easy process and, due to an uncomplicated tax system and accounting requirements, simple to operate. Double taxation agreements exist between China and many of these offshore jurisdictions, which adds an extra benefit. However, it costs money to maintain the structures set up to manage the DTA and this may therefore make sense only for a certain size of company. In addition, the transfer pricing in China has become much more regulated and may have taken some of the lustre away from the DTA. The mother company should also check with their Board of Directors if they want/need to consolidate their accounting with a HK/China entity. All this will yearly cost money and extra accounting fees ADMINISTRATIVE BURDEN The State Administration for Industry and Commerce (SAIC) has increased the administrative burden over recent years on new and existing RO s, including but not limited to the following: The parent company must have been in existence for two years; In addition to the incorporation certificate, a bank reference letter also will need to be notarized and legalized; Setting up in China March

10 The registration certificate for an RO is now only valid for one year rather than three years; all existing ROs will have a one-year valid registration license when they renew their current registration certificate; Every year when an RO renews its license, a notarized and legalized incorporation certificate of the parent company will need to be provided; Foreign representatives of an RO, including the chief representative, cannot exceed four; for existing ROs with more than four foreign representatives (including a chief representative), the SAIC will not require the RO to decrease their number of representatives but will not approve any additional foreign representatives; Existing ROs will have to be gradually scaled down to 4 foreign representatives. How gradually hasn't been defined; The local branch of the AIC will verify all the information of the RO including its registered address within three months after the RO obtains its registration certificate; Visa policy towards foreign representatives will be enforced according to the new rules and limitations. This should make it more difficult for foreigners to get Z-visas (employment) through this channel KEEP IN MIND Many think that the future of the RO as a cheap way to set up a China presence is now coming to an end. Increased tax burdens, an inability to offset expenses against these, and restrictions on activities, staff and size are all taking a toll. Operating an RO as a trading company by using third party bank accounts will also come under scrutiny, and if caught, will inevitably lead to fines over unpaid income tax. 8

11 2.2 BRANCH OFFICE OF AN OVERSEAS COMPANY An easy option for a locally registered company. Subject to approval by, and registration with, the relevant authorities INDUSTRIES PERMITTED TO SET UP A BRANCH OFFICE Prospecting for, and extracting, oil & mineral resources Contractor for engineering projects Contractor to operate Foreign Invested Enterprises (FIE) Branch office of foreign banks Branch office of foreign insurance company Other production or business activities as permitted by the State LIABILITIES OF A BRANCH OFFICE Is not an independent legal person under Chinese law Head office (mother company) will therefore be responsible for all civil liabilities and obligations Head office is required to allocate funds to the Branch Office based on the minimum requirements and commensurate with the business activities carried out by the Branch Office Setting up in China March

12 2.3 FOREIGN INVESTED ENTERPRISE [FIE] Is an independent legal person Is legally entitled to directly conduct business in China Most usual option for manufacturing, trading, retail and logistics MOST COMMON TYPES OF FIE: WFOE EJV CJV FICE WFOE [Wholly Foreign Owned Enterprise 100% foreign owned] EJV [Equity Joint Venture] Limited liability company jointly incorporated by foreign and Chinese investors. Profits allocated and risks distributed in accordance with their respective contribution to the capital CJV [Contractual Joint Venture] Are joint-ventures jointly incorporated by foreign and Chinese investors. Rights and obligations are subject to the JV agreement. This type of JV is often set up for oil exploration & extraction, minerals, etc. (as investment here is often high and it takes too long for a decent return under an equity agreement). FICE [Foreign Invested Commercial Enterprise 100% owned by foreigners] Can be set up from the start or can be the result of a conversion of a FIE into an FICE. Currently one of the most commonly used means for trading in China by foreign investors. Similar to a WFOE, a FICE can only be operated within an approved business scope. A FICE can be engaged in the following activities: commission agency, wholesale, retail and franchise. However, trading activities face restrictions (including a cap on foreign equity share) in the following areas: books, periodicals, newspapers, automobiles, medicines, salt, agricultural chemicals and crude oil. The list of restricted products should be consulted before establishing a FICE. Legally the minimum registered capital of a FICE shall be the amount in foreign currency equal to RMB 30,000. However, the foreign investor must pay attention to a fact that most major local banks are reluctant to open a bank account for a company with such a small amount of registered capital. Therefore, such a FICE with a registered a registered capital less than RMB 250, ,000 may not have a chance to establish its bank account with a local bank. Basically this means that the company will never be able to operate as there s no possibility to transfer the registered capital into a valid company bank account. In addition one should realise that running an operation in China might take some time before a positive cash flow is generated. Since increasing an existing registered capital is 10

13 time consuming & getting approval for an intercompany loan or bank loan is not easy to obtain, it is best, from the start, to set up a company with enough registered capital to avoid serious cash flow problems during the start-up phase of the company. Note on JVs: A number of local consultants and legal advisers do not encourage even warn against setting up a JV in China if the law allows a WFOE. A joint venture with a local partner has proven to be challenging for many foreign entities operating in China. Long term strategies do not always coincide, with foreign shareholder value maximization often not a priority for the local partner. Long term strategy, exit strategy planning, and potential arbitration solutions should be agreed upon prior to entering into any JV. The JV laws are very much in favour of the Chinese partner. Even if one is a majority shareholder, one should not underestimate this or be blinded as the sad reality is that many JV end up in wrecks LIABILITIES A WFOE and an EJV will always take the form of a limited liability company. The shareholders liability is limited to their respective capital contributions, the company liable for its debts to the extent of its entire assets. With a CJV, there can be other forms of liability QUALIFICATION AS A SHAREHOLDER A Chinese individual cannot establish a CJV or an EJV with a foreign investor. He may establish a Chinese company to act as a shareholder of an investment vehicle, but this company s participation in the JV will be subject to approval by local authorities. Chinese laws contain no limitations on foreign investors, whether they are individuals, legal entities or other types of organizations BUSINESS SCOPE OF FIES It is impossible for a foreign investor to apply for approval to operate a FIE with a general business scope. Chinese law requires the foreign investor to detail the activities (under the headings of manufacturing, trading or provision of services). As usual, any business scope will be subject to approval from local authorities. The life time of a FIE can be no more than 50 years and renewal is subject to approval by local authorities MINIMUM REGISTERED CAPITAL Limited liability company (limited by equity) CNY 30,000 Limited liability company with sole shareholder (For a Chinese Citizen) CNY 100,000 Setting up in China March

14 Company limited by shares CNY 5,000,000 Holding company USD 30,000,000 The percentage of equity interest held by the foreign investor in the registered capital of a JV is very important. Chinese law requires such interest to be no less than 25%. If it is less, the company will still be deemed to be a JV but will receive less favorable treatment (e.g. no tax holidays ) compared to other JVs REGISTERED CAPITAL REQUIREMENTS The registered capital requirements vary from entity to entity and [!] also from region to region 4. However, no matter where the WFOE/FICE is based, basic investment criteria remain the same. The government will look at the general viability of the project and a reasonable cash requirement for a particular type of investment. Registered capital and total investment figures are both required during the application procedure. The total investment is what is necessary to realize the company's operations, while the registered capital is the equity pledged to the local authorities. Limited liability is recognized by the amount of registered capital injected into the WFOE/FICE. Registered capital can be contributed in cash or in kind, the latter normally being imported equipment, which may be needed for testing or showrooms etc. However, one should never focus on the minimum capital requirement only. Very often the operational cost of a manufacturing or service company over a period of 1 year will be higher than the minimum capital required. The business plan should reflect the cash flow one requires otherwise one will get into trouble. It takes time & paper work to increase the company's Capital. It's also not always easy to arrange overseas loans to cover the lack of cash flow during short periods of time: This has to be mentioned in the company's by-law to get approval. (Forget about a Chinese bank giving you short term loans for daily operations, in practice this will not happen). Minimum capital will also depend on: The region where the WFOE is registered. (e.g. Beijing authorities will try to attract large manufacturing or innovative companies and try to keep the investment high (± 200,000). In case it doesn't fit the investment strategy of the region, a company will not receive a licence, irrespective of how high the investment may be. (e.g. if one wants to go into a polluting industry, very often one will hit a wall, unless one wants to invest in the West of China... The consequences of this, however, are the huge logistical problems, power failures, transport infrastructure, qualified manpower, etc...) 4 according to the requirements and approval process of the local authorities. 12

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16 2.3.7 FIES COMPARED EJV Form/Legal status & business scope Limited liability company as legal person Investment method Each party contributes in cash, in kind, with IPRs or land use rights, etc. Share of profits/risks Shared in accordance with the ratio of the equity interests of each party. Profits may only be distributed in the form of cash Management The board of directors is the highest organ of authority CJV Limited liability company as legal person or an incorporated CJV as a non-legal person The parties may provide for conditions of cooperation such as sales channels or special licenses Shared in accordance with the terms of the JV contact. No need to share in proportion to the parties contribution to the CJV The board of directors or joint management committee is the highest organ of authority WFOE Limited liability company as legal person Same as EJV Shared between the investors as per the articles of incorporation The sole shareholder or the shareholders meeting is the highest organ of authority FICE Limited liability company as legal person The promoters may contribute in cash, in kind, with IPRs or land use rights, etc. Same as EJV The shareholders meeting is the highest organ of authority 14

17 2.3.8 FIES, REPRESENTATIVE OFFICES AND BRANCH OFFICES COMPARED FIEs Main feature PROs CONs Legal person (except for some CJVs) Can engage in direct business activities More complex and time consuming establishment procedures. Strict requirements for capital contributions and debt-equity ratios Rep Office Non-legal person. Liability is borne by the foreign parent company. Usually set up by a foreign company wishing to acquire local knowledge of the market prior to establishing full operations in CN Simple and expeditious procedure for establishment. Need not meet stringent requirements for e.g. capital contribution and debt-equity ratios Strictly limited business scope. Only allowed to engage in indirect business activities Branch Office Non-legal person. Liability is borne by the foreign parent company. Mostly option chosen by banks or insurance companies Same as Representative Office Same as for Representative Office except that a Branch office is allowed to engage in profit-making business Setting up in China March

18 2.3.9 OUTSOURCING ADMINISTRATION FUNCTIONS Many companies look to outsource their administrative functions, such as accounting, tax filing, payroll and other corporate governance functions to external consultants. This benefits the investor in the following ways: 1. Professional advisors often provide a "new set of eyes" or they can predict what problems may arise and offer a greater level of understanding of the corporate environment; bringing experience and best practice across all business functions - from finance to accounting, from legal to IT. 2. They can act as independent "Administrative Managers" making sure that the Limited Company is in compliance with all aspects of operations. This can be an asset for investors who want to only focus on the company's day-to-day activities and alleviate any financial and business risks. 3. A law firm can provide input on the fast changing legal and regulatory environment in China. 2.4 FOREIGN-INVESTED PARTNERSHIP A new vehicle for doing business in China 5 On November 25, 2009, the State Council published the long awaited Administrative Measures on the Establishment of Partnership Enterprise by Foreign Enterprises or Individuals ( Measures ). The measures (which will take effect on March 1 st, 2010) allow foreigners to establish foreign-invested partnership (FIP) enterprises in China either by themselves or with Chinese partners. Unlike the traditional Three Forms of FIE (Sino-foreign equity joint venture, Sino-foreign cooperative joint venture and wholly foreign-owned enterprise), FIP can be set up merely through a registration process without out the need to obtain prior approval. It should however be noted that FIP is still subject to the same China industry guidance for foreign investments. The foreign companies or individuals are requested to submit an explanation to the registration office demonstrating that the investment complies with China foreign investment policies; furthermore, if project approval is required for a foreign investment, such project approval prior to partnership registration must be obtained. Unlike joint venture companies and whole foreign-owned enterprises, partnerships offer a number of advantages. Such advantages include the possibility of flexible flows of capital and flexible profit distribution (e.g. capital contribution/increase/reduction and profit sharing can be determined by free agreement). Under the existing tax rules partnerships can enjoy pass-through tax treatment. Foreign partners are taxed directly in China, and hence 5 Content supplied by Deloitte 16

19 there should be no withholding tax on the profits distribution from a partnership under these rules. However, the possible negative attributes of a partnership are worth to be considered further, for instance the unlimited liability of general partners for the debts of the partnership, the ineligibility of tax incentives and limitation on loss utilization. Setting up in China March

20 3 ACQUISITIONS Under the present Chinese law, an overseas investor can acquire Chinese companies. This includes both domestic companies and FIEs but different laws and regulations will apply. There are two ways to carry out an acquisition: equity acquisition or asset acquisition 3.1 EQUITY ACQUISITIONS A foreign investor can either acquire equity or subscribe to a share capital increase in the target company. All of the target company s rights and liabilities are attached to the equity. Hence, the importance to obtain a due diligence report ADVANTAGES Continued existence of the target company Lower tax burden More simple procedure compared to Asset Acquisition DISADVANTAGES Need for a comprehensive due diligence report Need to agree on specific rules and mechanisms for the handover of control in order to allocate duties and responsibilities to all parties involved. 3.2 ASSET ACQUISITIONS A foreign investor either directly purchases the assets of a target company and uses these to set up a FIE or establishes a FIE and uses it to purchase the assets of a target company. As it involves the purchase of assets (only), none of the target company s liabilities will be transferred with the purchase ADVANTAGES Easier control of the risks Possibility of partial acquisition of the target company, excluding the unwanted parts None of the liabilities will be transferred DISADVANTAGES Higher tax burden Incorporation of a FIE is required and more time consuming Any tax benefits enjoyed by the target company cannot be transferred with the acquired assets RESTRICTIONS 18

21 A FIE will only enjoy incentives if the foreign investor holds more than 25% of the share capital after the acquisition APPROVAL Is the same as for establishing a FIE: the acquisition must be approved by MOFCOM (or its local offices at the provincial level) DUE DILIGENCE The process can be challenging and time consuming in China. Advisable to carry out due diligence in four areas: legal, tax, financial, reputation LEGAL DUE DILIGENCE The legal status of a target company is of utmost importance as rights and liabilities, regulatory compliance, third party claims and ownership of assets will determine the value of the deal. The following are important in the legal due diligence process: Property ownership (buildings, trademarks, other IPR) Land ownership (owned collectively, by the State, by the Army?) Contract risks (any risks attached to any contracts the target company may have? Any guarantees given? Any change of control clauses?) Potential debts (any debts not recorded?) Shareholder structure and business scope (has the company been operating within its business scope?) Employment contracts for an Equity Acquisition can hide serious liabilities and could have consequences for the cash flow of the company if employees will be fired after the acquisition takes place TAX DUE DILIGENCE Since tax liability in China can have severe consequences, it is important to pay attention to: Payment of taxes Tax withholding obligations Transfer pricing (has the company been complying with transfer pricing regulations?) Preferential tax treatment (does the company fulfill the requirements?) Real estate tax (have all been paid?) Other tax obligations (has the company been complying with statutory obligations related to tax registration, invoice usage, etc..?) Setting up in China March

22 FINANCIAL DUE DILIGENCE Can be extremely difficult. It is not uncommon for Chinese companies to have several sets of accounting records, if they have one at all: one for the tax authorities and another set for internal use. Advisable therefore to cross-check between legal, tax and financial due diligence REPUTATION DUE DILIGENCE Purpose is to identify possible off-balance sheet risks. This due diligence focuses on key people and the entities involved in transactions or joint-ventures, etc. 20

23 4 OTHER WAYS OF DOING BUSINESS IN CHINA Foreign companies can still conduct other activities in China such as sourcing, subcontracting, etc. This does not (necessarily) require setting up a FIE. 4.1 SOURCING Foreign companies can import from China and enter into international purchasing contracts. If, however, a regular presence of the foreign company is required, then the foreign company may incorporate a FICE to buy locally and export afterwards. 4.2 SUBCONTRACTING (ASSEMBLY, PROCESSING, ETC) Materials and parts will be supplied by the foreign company and subsequently sold back to the foreign company after assembly or processing. 4.3 FRANCHISING Chinese law allows local companies or local individuals (the franchisee) to establish a business using the franchising method and paying a franchise fee to the franchisor in accordance with the franchise contract. Note that the Franchisor must have three operational shops in China before being able to start licensing. Setting up in China March

24 5 HONG KONG HOLDING COMPANIES Source: Moore Stepens 6 As China started to unthaw its relations with Western countries under Deng Xiaoping in the late 1970 s, Hong Kong became once again the port of entry for Western economies to the Chinese market. Today Hong Kong has a tax code that offers very competitive rates when compared to most other countries. This in combination with the existence of a solid legal and regulatory framework, the lack of foreign exchange restrictions and an abundant supply of financial liquidity makes Hong Kong the preferred home to many corporations doing business in Asia. Hong Kong applies a (territorial) tax regime in which tax is only levied on income generated in Hong Kong (onshore). This means that income derived from offshore activities are not taxable in Hong Kong. There are some conditions that need to be satisfied in order for an offshore claim on trading profits to be accepted by the Inland Revenue Department (IRD) of Hong Kong. For example, the customer or supplier should be a non-hong Kong company and goods cannot be stored in, or enter Hong Kong. Also all relevant documents (invoice, purchase contract, shipping document) should be prepared outside of Hong Kong. Business activities deemed as onshore will be taxed at a flat rate of 16.5%. A number of European countries have tax treaties with Hong Kong to avoid double taxation (including Belgium). Structuring a Hong Kong company in between the Chinese entity and the foreign owners could be a structure that provides a number of fiscal benefits. The foreign entity would own 100% of a Hong Kong company, which in turn owns 100% of the Chinese entity. This structure also offers greater flexibility in the transfer of company ownership. Transfers of ownership in the Chinese entity can be accomplished by buying or selling shares in the Hong Kong entity. This allows for reduced administrative burden in the transfer (no government approval needed in Hong Kong) and reduced taxation on the gains realized of the transfer of ownership. This said, Chinese tax code includes anti-avoidance regulation, allowing the tax authorities to adjust the total tax liability in China if a tax-reducing transaction has been used and is determined to have no other purpose but to reduce, avoid, or defer the payment of taxes. Based on recent precedent it would appear the Chinese tax authorities will be applying this regulation more stringently, effectively leaning more towards applying the substance over form approach. Tax avoidance through the usage of tax havens or structures set up with the single purpose of benefitting from tax favorable treaties is subject to certain reclassification or adjustment

25 of applicable tax liability. The usage of a Hong Kong structure therefore needs to have economic purpose aside from the reduction in tax liability. In addition, the usage of holding company structures to transfer offshore equity interest that represent ownership in Chinese entities has come under more scrutiny from Chinese tax authorities, resulting in Chinese capital gains tax liability. At the same time, there is still a lot to be gained from a China structure that involves an offshore holding company. Even with the increased level of restrictions from the Chinese tax authorities, the Hong Kong route will often lead to a reduction of total tax liability, and allow for less administrative burden on the transfer of ownership. In addition, due to the favorable tax treaties Hong Kong has with Belgium, dividend and royalty distributions from a Hong Kong Holding to a Belgian residual owner (company) enjoys a very favorable tax treatment. Setting up in China March

26 6 TRANSFER PRICING Source: Moore Stepens 7 A large portion of world trade takes place within multinational enterprises, when branches or subsidiaries of the enterprise exchange goods or services. All aspects of the intercompany pricing arrangements between these related parties are referred to as transfer pricing. When the prices of transactions between related parties are artificially reduced or increased, taxable profits can shift from one jurisdiction to another. An example of such strategy would be the following: A company would set up its production in China and its sales in Hong Kong. Produced goods can be sold at production price from the Chinese entity to the Hong Kong entity, thus creating a break even income in China and avoiding to pay enterprise income tax there. Next the goods are sold from the Hong Kong to the consumers globally at a margin. The net income has not shifted to Hong Kong, and will be taxable at a (lower) enterprise income tax. Recently we have witnessed greater alertness around this process at different tax authorities worldwide. New reporting requirements on cross-border transactions have been introduced, numerous information exchange agreements are being signed in different countries, transfer pricing audits are performed on more regularly basis and larger penalties for non-compliance are being imposed. The Chinese tax authorities have also increased documentation requirements and require significantly more disclosure around intercompany transactions. Transfer pricing regulations tends to be overlooked when foreign companies set up their Chinese business, and it is important to be aware of all regulatory and fiscal aspects of international related party transactions. Correct transfer pricing application is not only important for a big multinational, SME s should also take the increased vigilance of tax authorities into consideration and manage transfer pricing risk accordingly. Analysis of the current transfer pricing methodology and development of sound documentation policies and processes could provide a defensible approach to safeguard against non-compliance penalties and other exposures. This should enable the company to avoid or prepare for any future transfer pricing disputes or examinations. Transfer pricing should not only be seen as compliance burden. A well-executed transfer pricing strategy can provide sustainable effective tax rate benefits

27 7 CORPORATE & INDIVIDUAL TAX IN CHINA Source: Moore Stephens 8 In China there are five types of tax that foreign entities may need to pay. There is corporate income tax, business tax, withholding tax, value added tax (VAT) and individual income tax. 7.1 CORPORATE INCOME TAX This is the effective taxation on profits. In China the standard rate is 25%. For small and low-profit entities a 20% reduced rate may be applicable. Certain incentives may also be applied for advanced technological service enterprises and encouraged high tech entities. 7.2 BUSINESS TAX This is a flat revenue based tax on service income. The applicable rate is dependent on the scope of the services. Most services are levied at a 5% rate. Examples of exceptions are construction, transportation, post and telecommunication, and culture and sports, which are liable for a 3% rate. 7.3 WITHHOLDING TAX A withholding tax is applicable for foreign entities operating in China, when remitting payments to a foreign entity outside of China. This withholding tax is applicable on paying out dividends, interest, royalties, management fees, rent, capital gains from equity sales, and on payment for services to foreign enterprises. The withholding tax should be withheld prior to payment. A growing number of countries have double taxation treaties with China that limit withholding tax rates. In the current Belgium Chinese tax treaty, the payment of dividends, interest, and royalties are subject to 10% withholding tax. Capital gains arising from the sale of substantial shareholding (25% or more) is not subject to withholding tax. A new tax treaty was signed between China and Belgium in 2009 but has not yet been implemented by the respective tax authorities. The new treaty reduces withholding tax rates to 5% on dividends and 7% on royalties. We expect this treaty to be implemented over the course of the next few years. 8 Setting up in China March

28 7.4 VALUE ADDED TAX (VAT) The Chinese tax code is currently undergoing it s biggest reform as of yet, with the gradual transition of a revenue based fixed tax to a value added tax system. Following the VAT test project that was successfully implemented in Shanghai early 2012, the following provinces have also adopted the a switch from a Business Tax system to a VAT based system. As of the publication date of this paper, the following provinces are levying VAT instead of Business Tax: Beijing (from Sep 1st, 2012), Jiangsu Province (from Oct 1st, 2012), Anhui Province (from Oct 1st, 2012), Fujian Province (from Nov 1st, 2012), Guangdong Province (from Nov 1st, 2012), Tianjin (from Dec 1st, 2012), Zhejiang Province (from Dec 1st, 2012) and Hubei Province (from Dec 1st, 2012), while other jurisdictions have indicated they will follow in implementing this program. Value-Added Tax (VAT) is a tax charged on the private and public consumption of goods and services. It is levied at all stages of production and distribution, and paid to the state on the basis of the value added at each stage. In general, VAT must be paid by taxable traders. In principle, every such trader charges VAT on its sales and is (in principle) entitled to deduct from this amount the VAT paid on his purchases. Ultimately, the tax is borne by the "final consumer", who cannot deduct VAT paid on purchases. VAT is calculated based on the difference between output VAT (charged to customers) and input VAT (paid to suppliers). The difference between both is subject to tax. The flat VAT rate is 17%, with a number of exceptions for small entities, certain special goods and certain exempt goods. Typically VAT refunds are entitled for exports, but this tends to depend on local tax authorities willingness to comply. These export rebates tend to fluctuate depending on the government s willingness to stimulate exports or slow them down. The rebate can be as large as the entire applicable VAT, or it can be only a small percentage. Companies with annual turnover of less than RMB 5 million are classified as small taxpayers and will pay a reduced VAT rate equal to 3% on turnover, but cannot deduct VAT paid on inputs. Small scale taxpayers have the option to file under the normal VAT system, provided they have sound accounting systems which can provide accurate tax filing information. 7.5 INDIVIDUAL INCOME TAX (IIT) Individual income tax is often subject of misinterpretation and confusion amongst foreigners in China. Chinese tax authorities seem to be more proactive in ensuring compliance with IIT regulations in recent years. Digital processing of immigration records has allowed the tax administration to allow comparison between declared presence in China and actual presence, should they chose to do so. Chinese IIT is levied on a monthly basis. For individuals with income exceeding RMB per year, an additional annual return disclosure is required by the end of March. As soon as the individual is absent from China during either 30 consecutive days or 90 days in total the requirement is waved. Both annual as well as end-of-the-month declarations should be made at the local tax bureau. 26

29 Foreigners with presence of over 183 separate calendar days are subject to IIT on their entire income related to activity in China, regardless of where they are employed and where this income is paid. Note that for foreigners from countries that have not entered into an income tax treaty with China, this can be reduced to 90 days. Foreigners, who are employed in their foreign country as well as in China, will be subject to China IIT based on the actual amount of days the individual is physically present in China per month. Those foreigners who are employed by a Chinese entity are subject to IIT upon commencement of employment. All income related to the activity in China should be disclosed in China. Having part of the salary being paid in the foreign country does not exclude it from being subject to Chinese IIT. Non declaration of this income will constitute a violation of Chinese tax code by both the individual and the employer, and is subject to fines. Also for these individuals we note that double taxation should be avoided based the respective foreign tax code. Typically income subjected to IIT in China will either be exempt from taxation in the foreign country (example Belgium), or the Chinese IIT will be credited against foreign ITT liability (example US). Foreign individuals who are present in China for more than 5 years will be subject to IIT in China on their global income. This can be relatively easily avoided, since as soon as the individual is absent from China during either 30 consecutive days or 90 days in total, the individual is no longer be considered present in China any given year. The Standing Committee of the National People s Congress (the highest legislator of China) passed new revisions to China s IIT Law in June The final revisions the IIT-rate are the following: Applicable Tax Rate Min Income (RMB) Max Income (RMB) 3% % % % % ,000 35% % The Chinese tax code does provide significant income tax planning possibilities. Certain expatriate living allowance benefits are in fact non-taxable if documented properly. These living allowance benefits should be structured in the employment agreement as part of the non-salary compensation package. The following allowances are typically claimed: Housing allowance, meal allowance, laundry allowance, relocation allowance, travel allowance (twice per year to country of origin, as well as reasonable business travel), language training, child education and health care, and social security coverage when required by the employer s country. It is advisable that these expenses are handled directly by the employer, instead of utilizing a cash allowance system. A system of actual reimbursements is also possible, but this will create more administrative burden. Note that classification of this compensation will ultimately still be subject to the local tax bureau s judgment. Setting up in China March

30 7.6 SOCIAL SECURITY In September 2011 the Ministry of Human Resources and Social Security of China released a decree to request all foreign employees working in China to start participating in Chinese social security programs as of October 15, These include pension benefits, medical benefits, work related injury insurance, unemployment benefits and maternity benefits. According to the decree the insurance premiums are born by both employer and foreign employee. The decree did not mention more detailed participation arrangements, leaving significant room for interpretation on the municipal level (which may lead to implementation and enforcement levels varying per region). In addition there continues to be uncertainty on the contribution percentages and basis used for calculation of contributions. It is expected that further detailed implementation measures will be released by the respective local social security authorities at municipal level. Due to this level of uncertainty, one can expect that social security participation will not be required and may even not be possible. 7.7 OTHER TAXES Other applicable taxes include property tax (1.2% purchase price, payable twice a year), land appreciation tax, stamp tax (small tax applicable upon closing certain contracts), customs duty, certain resource exploitation taxes, vehicle tax, urban construction tax, and the education surcharge. There is also additional taxation on consumption of luxury goods (cars, jewelry, gasoline cosmetics, yachts, golf balls) and on goods deemed harmful to health (tobacco, alcohol and firecrackers). As noted, certain tax incentives can be applicable for entities operating in specific high tech industries, agriculture, public infrastructure investments, environmental protection and conservation, offshore outsourcing, small scale entities with low profitability and for entities operating in certain ethnic autonomous regions (pending government approval). 28

31 8 ACCOUNTING PROCEDURES AND PRACTICES Source: Moore Stephens 9 Unfortunately there is a large administrative burden to manage when conducting business in China. The annual audit requirement is one of them. Regardless of the size or type of enterprise, each foreign enterprise in China has a burden to disclose annual audited financial statements. Management will be held accountable for the truthfulness and completeness of the financial statements in accordance with Chinese accounting standards. Such audit needs to be conducted by an audit firm registered with the Chinese institute of certified public accountants. The auditor s report and financial statements needs to be disclosed by the end of April each year. Only after completion of the annual audit and tax settlement may a foreign entity repatriate funds to shareholders abroad. The audited financial statements must contain a balance sheet and income statement, and be in conformity with CAS (Chinese Accounting Standards), Chinese company law, and Chinese tax law. The mandatory audit is often limited in time, in scope and in resources, making it far less comprehensive than it is in most other countries. Shareholders, management, and the board of directors need to be aware that the basic mandatory audit performed by a local accounting firm will typically provide little assurance as to the overall picture of the entity s performance. Consolidation of the financial statements (prepared in accordance with CAS) with the financial statements of the foreign owner in accordance with IFRS can be challenging at times. Internal controls that limit the risk of material misstatement are not as widely implemented or tested as they tend to be in some other countries. Levels of internal independence, systems of checks and balances between departments, proper corporate governance rules, and the creation of a general control environment tend to be overlooked. 9 Setting up in China March

32 Flemish companies considering setting up a representative office in China could consider doing so in a service centre (Dienstencentrum) in Beijing or in Shanghai. The service centers in both Beijing and Shanghai are operated by a third party but recognized by Flanders Investment & Trade. This allows Flemish companies to apply for a subsidy. For more information and criteria, please go to the chapter <Dienstencentra> on (W) 30