Finnish SME motivations for holding in HKG

Finnish SME motivations for holding in HKG Jari Makkonen, Eric Cheng Finpro Asia Version 15.1.2013

CONTENTS 1 Executive summary... 2 2 Introduction... 5 3 Conclusions... 6 3.1 Taxation......6 3.2 Regulation...8 3.3 Currency and capitalization related...8 3.4 IPR...10 3.5 Other....10 4 Reference readings... 11 Appendix 1: Corporate tax and withholding tax... 13 Appendix 2: Some Finnish related lawyers in China or for China... 13 Appendix 4: Finnish Chambers in China and Finchi... 13 Appendix 3: Comments of Borenius... 13 Editors Jari Makkonen, Senior Consultant, Finpro Shanghai - Project Manager Eric Cheng, Senior Consultant, Finpro Hong Kong - Team member Jari Hietala, Vice President, Finpro Asia Advisory board to this project Region China and East Asia, Operations & Network For contact information see www.finpro.fi. Advisors in legal, financial and taxation matters were used. Taxation matters related charts were commented and amended by a Chinese tax consultant. Enclosed parties commented particularly the legal and financial aspects: Antti Oksala, Senior Relationship Manager, Nordea Shanghai Sha Wang, Borenius Attorneys, Helsinki 2

1 Executive summary Finnish companies find currently lot of interesting business opportunities in mainland China. Also many Tekes projects focus often on China mainland market place. As well, Team Finland will most probably pay lot of attention to the growth markets, hence interest to the present study. Companies entering China mainland market have various options in doing so. Reason for having a legal entity in mainland China can typically be: to have legal status to sign contracts, to be enrolled into the mainland China system for VAT management and to have company customs ID code for importation and exportation of goods, amongst all. In order to have the a.m. opportunity any Finnish company has to establish either WOFE or JV in mainland China. Basic scope of this Tekes financed study was, if there is somehow automatically need to establish a holding company in Hong Kong between the mother company in Finland and the future daughter company in mainland China. This seems to have been kind of paradigm in Finland in the past even though big Finnish companies have nowadays mostly organized their ownership structure directly between the Finnish mother company and the China mainland daughter companies. This document is addressing mostly economical and tax related factors of company establishment in mainland China. Potentially there might be some implications of having a holding company in Hong Kong or elsewhere in Asia for regional hub or such, but also in this case the eventual benefits should be possible to express in terms of P&L and improved balance sheet, should there be such a structure necessary. M&A and investment into third entities do not normally make part of the Finnish SME activities in Asia and they are not particularly considered in this report. As a matter of fact, Finpro has not found any tangible and reliable evidence, why a Finnish SME having a mother company in Finland and evaluating market entry to mainland China - should establish an additional holding company structure in Hong Kong automatically and without studying its implications at the level of business plan and concrete monetary benefits on P&L (improved profit, other) and company s overall performance. Closer Economic Partnership Arrangement 1 (CEPA) regulations and their development might one day change the scene between mainland China and Hong Kong, or then not. However, also this case should be documented and verified before using it as some kind of automatic good practice platform for improved performance and success in mainland China operations. At the same time other countries prepare similar agreements (e.g. Taiwan) and hence there 1 CEPA is the first free trade agreement between the mainland and Hong Kong, signed on 29 June 2003. Other similar agreements are supposed to be established in the future, e.g. between Taiwan and the mainland. 3

are or in some cases will be same level playground for several countries, Finland included. After presenting the draft report of the current report, Finpro has received from Hong Kong some concrete reference cases on Finnish and European SME companies having their regional hubs and similar in Hong Kong. However, at the same time tangible advantage of such a structure at the level of company profitability was not demonstrated. Hence, the reference cases were not conclusive. We also conclude that most benefits listed in having a holding company structure in Hong Kong promoted e.g. by various HKG based consultants - are often referring to the situation of Chinese mainland companies working on outbound investment to other parts of the world. Alternatively, misconception of having to establish a HK holding structure might be the old habit of establishing rep offices in mainland China and controlling them from Hong Kong. More comments on this in the appendix of Borenius attorneys. One real-life case about holding structure needed between Mother Company and China mainland company was found and hence it is described on the page 10 (example Finnfund, relative to foreign debt quota). Hong Kong definitely is competing as location for holding company with locations such as Cayman Islands, Luxembourg, and Netherlands and other. On the other hand, mainland China is opening more and more and as consequence Hong Kong has to re-invent its position in the future. More on this topic see appendices from KPMG and South-China Morning Post (published in Hong Kong). It is also true that lot of FDI is channeled through Hong Kong to mainland China even today. However, the benefits of doing so for Finnish SME are anything, but self-evident. Some Finnish SME and big companies might have their mother company operations elsewhere in the world than in Finland (Hong Kong, Luxembourg, other), which might reflect more choice of having left Finland for tax planning or other purpose. This practice is not encouraged by Finpro or Tekes as financier of this study. We have departed with the idea that Finnish entities will pay their dividends in Finland, they own the IPR in Finland and so on. So, this document is not any handbook of tax planning, or similar. Waiver: First of all; this document is only for reference on some of the important topics on operations establishment in mainland China. It does not replace good business planning of each individual company case with relevant experts. Such considerations might be also industry specific, hence very different between each other. Secondly, the situation in an emerging country like China changes constantly. Hence, Finpro or advisors to this document encourage companies to discuss their individual cases with one or more experts before proceeding with company establishment. Thirdly, regional hubs were not focus of this study. Should someone want to establish such a structure to Hong Kong, they should also evaluate other locations such as Singapore etc. and also in these cases have a solid business case with actual figures at hand before proceeding. 4

2 Introduction Tekes has several programs developing business of Finnish SME companies in mainland China. The said companies have normally their mother company structure on the Finnish territory. The said companies need to establish their possible China and Asia operations in a logical and economically viable way in order to create growth, jobs and profits both in Finland and globally. In relation to China market entry, there seems to be in Finland a general belief about advantages of a holding company structure established in Hong Kong. However, nobody seems to know exact economical and tangible reason for using such structure in Hong Kong even though several HKG sales pitches list a lot of reasons, why to do so. In order to advice companies in a concrete and realistic way Tekes has ordered the present study to clear some concepts of this topic so that good advice is possible to give all Finnish SME companies developing their presence in mainland China. This study is not about tax optimization or similar, as such. It is about possible reasons to have an extra layer of holding company in Hong Kong instead of using the Finnish mother company as holding of the current or future China mainland commercial and industrial operations. This document is done with the idea of a Finnish legal entity paying its dividends in Finland and hence accumulating the profit also in Finland. For purpose of improved understanding Finpro has interviewed financial management of some leading Finnish machinery producers. The rational of this has been to interview parties, who truly have both opportunity (and interest through big volume of business) for tax optimization and resources to buy advisory in this topic. Finpro has also interviewed Invest in HK for improved insight about benefits working in Hong Kong. Finpro has studied, if a holding company in Hong Kong can - reduce corporate income tax paid in the mainland China - help to repatriate the profits of the mainland China operations - reduce withholding tax on interest, royalties and dividends on profits made in the mainland China operations - reduce other taxes paid on the mainland China operation 5

- help companies to solve legal disputes generated in the business in mainland China - lower financial cost of the operations in the mainland China - improve management of liquidity between operations in mainland China, holding company in HK and mother company in Finland - permit improved management of RMB based funds in and outside mainland China - permit companies to invoice their customers in mainland China in RMB - permit companies to defend better their IPR in the mainland China all the above mentioned relative to commercial and industrial operations in mainland China. 3 Conclusions No evidence was found supporting automatic need of a holding company in Hong Kong. Through written business plan done case by case and demonstrating tangible reasons on level of P&L and balance sheet such structures could and should be considered. 3.1 Taxation Table 1 illustrates the People s Republic of China corporate tax and withholding tax implications for holding company established in different jurisdiction. This table shows how much a Finnish SME will have to pay for their China mainland operations (percentage providing that a Finnish company owns at least 25% of the paying company). Between the cases of having mother company in Finland or in Hong Kong there seems to be only one basic difference at the level of eventual WHT on interest (see below). This might or might not be significant on the level of P&L and balance sheet. China base case refers to a foreign holding company incorporated in those jurisdictions other than Finland or Hong Kong and which holds a subsidiary company in mainland China. Tax treaty between China and that jurisdiction is not taken into consideration. 6

Table 1 Holding company in Finland vs. Hong Kong Holding company in Finland or Hong Kong savings Type of tax China base case Finland holding Hong Kong holding Corporate income tax in mainland China 25% no saving, you pay in mainland China 25% no saving, you pay in mainland China 25% Withholding tax dividends 10% Withholding tax, interest 10% could be reduced to 5% 1) no saving, you pay 10% could be reduced to 5% 1) could be reduced to 7% 1) Withholding tax, royalties & licences 2) could be reduced 10% 7%/10% to 7% 1) Withholding tax, capital gain 10% 10% 10% Distributable dividends out of profit; 10% to be put into BS of China mainland company 90% 90% 90% Note: 1) The holding company needs to apply for and pass a beneficial ownership test with China tax authorities so as to enjoy the reduced withholding tax rate. Otherwise, 10 % will apply. 2) Finland holding company shall be the beneficial owner to enjoy 7 % withholding tax rate on royalty derived as a consideration for the use of industrial, commercial, or scientific equipment. Otherwise, 10 % will apply. Finpro has studied, if a holding company in Hong Kong can help a Finnish company to transfer its profits from mainland China instead of transferring the said profits directly to Finland. No evidence was found supporting need of a holding company in Hong Kong, it is exactly so easy or difficult to third countries, as well. Should a Finnish company build a relevant (rather big) company structure in Hong Kong, which would have in mainland China legal entities working on materials received from this type of Hong Kong holding company (and supplied back for sales of products from Hong Kong), then probably the resulting profits could be accumulated in Hong Kong and certain savings would be made for example on corporate income taxation (Hong Kong corporate income tax 16, 5%). However, this would require a business case calculation, which would eventually confirm the possible savings, if any. Obviously a relevant size of company structure would require its higher level of cost in Hong Kong than it would be in mainland China and hence it is not self-evident that this would be beneficial. 7

Holding company in Hong Kong might facilitate, however, management of net working capital in a way that a holding company in HK can loan money to mother company in Finland without PRC regulation, which makes this in practice impossible. The same applies to dividends. If a mainland China company pays dividends to mother company in Finland and runs suddenly to cash flow problems, the money cannot be returned to mainland China in a flexible way, to Hong Kong yes. To have these benefits one has to have a certain volume of business and business case (to be verified in each particular case). However, it seems that very few (if anybody) in Finland has really made the above mentioned company structure between Hong Kong and mainland China or at least it is not made public. Should there however be some relevant transfer of profits done through transfer pricing to Hong Kong, this might result subject to challenging it by the China mainland tax man. Small holding company structure in HK for tax optimization and gaming with transfer pricing will most probably result relatively risky. 3.2 Regulation Also operational benefits of having a holding company in HK were addressed. Using a holding company in Hong Kong as an instrument for increased flexibility to buy and sell companies in mainland China might seem like an interesting option. This is especially the case of bigger companies having aggressive politics towards their portfolio of businesses. This is not certainly the normal case of a Finnish SME. If the mainland China company changes ownership and China mainland tax man discovers that the operation has been done in the name of a holding basically working on paper or being minuscule in Hong Kong, this might lead to tax consequences on WHT on capital gain tax and similar. 3.3 Currency and capitalization related Since RMB is not freely tradable internationally, it is normally considered than a Finnish legal entity cannot invoice its customers in China in RMB, unless having a legal entity with relevant business scope in mainland China doing so on its behalf. The same basically applies to any legal entity in Hong Kong. Cross-Border RMB is officially administered by People s Bank of China (PBOC), whereas trade-related payments are controlled by SAFE (State Administration of Foreign Exchange). Hence, there are two overlapping regulations, as such. 8

Contrary to common belief, it is possible for Finnish companies to pay and receive RMBs without being present in mainland China. However, the payments in and out are subject to local restrictions and ultimately even approvals from SAFE, which might have different rules at the provincial levels in various parts of the mainland China. As well, if Finnish company has competitors, who do not force their customers to use this option, then this might be feasible, otherwise not. As well, it might be a question of credibility for a Chinese customer, not being willing to work with companies, who do not wish to have legal entities in mainland China. Once the registered capital of a company is determined, it cannot be changed freely. It is in practice very hard to get approval of decreasing the registration capital. However, it is acceptable in increasing it for the purpose of enlarging the business scope, business scale, etc. The procedure of doing so is taking time, at least 4-6 weeks in Shanghai (for example). The steps in general are: - Get approval of the application for registration capital increasing, from Foreign Economic & Trade Committee - Get approval of company s foreign currency quota increasing, from Administration Bureau of Foreign Exchange - Remit at least 20% of the increased amount for the first time, and make capital verification report accordingly - Revise the Business License. Surprisingly and against common belief, a non-resident Finnish company can in reality open RMB account in mainland China. The company though cannot get said RMB out of the country and interest rate is very low. However, the account can be used for buying services and goods from China mainland partners. Opportunity of using this kind of RMB account must be studied case by case there is no rule of thumb on this, either. Finnish SME company mainland China operations can easily run into difficulties in terms of under-capitalizing them. The said operation cannot get foreign debt outside of its foreign debt quota (quota calculated in function of registered capital and total investment varies between 33 and 66%). Registered capital in these terms means real money paid-in, total investment is instead of a plan for the purpose of authorities and similar. Basically there are the following options, if the local mainland China operations run out of cash: - increase stock capital (Chinese authorities have to formally accept the eventual increase) from sources of mother company in Finland or in any other country, including Hong Kong - accumulated profits registered into capital (Chinese authorities have to formally accept the eventual registration) from the balance sheet of the mainland China company itself 9

- intragroup loan in RMB or other currency, if within the quota - organize RMB or other currency related finance on-shore. When organizing RMB related finance, local Chinese banks require collateral guarantee and normally a Finnish SME does not own land rights, buildings or similar. Foreign bank guarantees would result the local company going out of its foreign debt quota and hence it is easy to run into the initial question of sufficient quota (or not). In Hong Kong or e.g. in London there is offshore platform for RMB. CNH (offshore Renminbi) is a virtual currency. CNH is freely traded currency. BOC (Bank of China) in Hong Kong acts as an agent for payments to and from China. The conversion rate is 1/1. CNH spot rates follow CNY (mainland China RMB) rates closely. Finnish company case I: Finnfund or other financing body might participate in the capitalization of the mainland China operation. However, the Finnish company would like to be 100% owner of the mainland China operation and would not like to use their foreign debt quota as from the day one. Hence, the Finnish mother company might want to organize a company between the Mother Company and China mainland company. The said ( holding ) company could be established either in Finland or in Hong Kong (and financed by Mother Company and Finnfund). More about Finnfund related countries, please refer to http://www.finnfund.fi/yritys/fi_fi/kohdemaat/ Finnish company s case II: Finnish company not having legal entity in mainland China. They buy materials from China in CNY (trade in goods). Makes currency deal in Finland, makes clearing of the payment through HK or directly to the supplier of goods in mainland China. No legal entity in Hong Kong is needed, as such. 3.4 IPR Finpro has studied, if a holding company in Hong Kong can help a Finnish company to protect its IPR in mainland China. No evidence was found supporting need of a holding company in Hong Kong for this purpose. However, there was a common understanding that one needs to locate IPR outside China for logical transfer of royalties and license fees to the mother company. IPR protection of brand, trademarks in mainland China is hugely important task. Finpro has listed in the annex some contact of Finnish related lawyers to China. Basic data on IPR protection can be obtained from EU SME Helpdesk http://www.china-iprhelpdesk.eu/ 10

There has lately been also development in relationship between Chinese and Finnish patent authorities about improved work on IPR protection. Press release on this topic, see appendix 5. 3.5 Other Hong Kong is often used as legal platform and site of arbitration between a foreign and Chinese (mainland) company. However, this is not a viable solution, when working on a basis of a Finnish owned mainland China Company and its mainland China customer. The site of solutions of legal disputes must be on the territory of mainland China, often in Beijing or in Shanghai. Other type of clause of contract would result void in mainland China. Attracting important talent might be effectively easier to Hong Kong than in mainland China, but there are today big concentrations of expats and high-level services to them also e.g. in Beijing or Shanghai. Personal taxation might result in HK much more interesting than in mainland China, but this probably will not be the key factor of locating business operations. There is one interesting consideration about the future financial centre of Asia. The Chinese government is pushing for Shanghai to become such. However, Shanghai does work under mainland China legislation, which does not result too predictable from the point of the view of international investors. In this sense Hong Kong, having British based legal system will maintain its important position in Asia for a long period to come. However, Hong Kong does have to re-launch its reason-d etre as per the enclosure containing the article of South-China Morning Post (November 2012). Currently Chinese authorities solved VAT related development by doing a pilot project in Shanghai in 2012 and now enlarging the pilot to Beijing and probably soon to the rest of the country. It remains to be seen, how China will liberate financial movements of capital including free convertibility of RMB on the global scale. 4 Reference readings KPMG 2008: Hong Kong Tax Competitiveness Series: Hong Kong as a Holding Company Locaction. Audit - Tax - Advisory. PwC Tax facts and figures: http://www.pwccn.com/home/eng/cn_tax_facts_figures_2012.html (China) http://www.pwchk.com/home/eng/budget2012_tax_facts_figures.html (Hong Kong) 11

Seewald Leo 2005. The advantages of structuring PRC investments through Hong Kong. The Asia Pacific Antitrust & Trade Review. Väänänen Riitta 2010: Suomalaisyrityksen etabloituminen Kiinan verotuksen näkökulmasta. Jyväskylän ammattikorkeakoulu, opinnäytetyö. 12

Appendix 1: Corporate tax and withholding tax Table 2 Corporate income tax and withholding tax Tax rates on foreign corporations and non-residents Type of tax China Finland Hong Kong Corporate income tax 25% 24.5% 16.5% Withholding tax 10% 0-28% 0%/4.95% Dividends 10% 10* ) /28% 0% Interest 10% 5* ) /28% 0% Royalties 10% 10* ) /28% 4.95% Withholding tax is dependent on whether it is on dividends, interest or royalties and which is the country of the recipient. * ) When the recipient is Peoples Republic of China Source: PricewaterhouseCoopers, Worldwide Tax Summaries 2011/12 The withholding tax (WHT) rates in mainland China, Finland and Hong Kong vary according to the subject. Additionally, in China, some sectors/industries, that fulfil the necessary criteria, have a lower corporate income tax rate available. In China, foreign enterprises without establishments or places of business in China are subject to 10% WHT on gross income from dividends, interest, lease of property, royalties and other China-source passive income unless reduced under a tax treaty. For Finnish companies this means for example that if the beneficial owner of e.g. the dividend is a company that directly owns at least 25% of the capital of the paying company, the lower rate may apply. In Finland, The Finnish corporations paying certain types of income are required to apply a 28% withholding tax on payments to foreign corporations and non-resident individuals, but according to the domestic legislation, interest paid to a non-resident is usually tax exempt in Finland. In Hong Kong, there is no withholding tax on dividends, interest or royalties. However, the 4,95% tax on royalties received by non-residents is in effect similar to WHT. 13

Appendix 2: Some Finnish related lawyers in China or for China Borenius Ms. Sha Wang (Helsinki) +358 44 317 2567 sha.wang@borenius.com Hästö & Salingre Oy Mr. Max Jussila (Shanghai) +86 1368 182 1380 max.jussila@hastolaw.com Vinge Mrs. Katarina Nilsson (Shanghai) +86 138 1715 3712 katarina.nilsson@vinge.se Local lawyers available e.g. at Finchi softlanding site in Shanghai: Ms. Kristal Li (Shanghai) +86 159 2100 0893 kristal.li@finchi.cn 14

Appendix 3: Finnish Chambers in China and Finchi Finnish Business Council in Beijing Seppo Selkälä, Vice Chairman, Tel: (+86) 1350 1158 905 Email: seppo.selkala@fbcbj.org http://www.fbcbj.org/ Finnish Business Council in Guangdong Mika Tavast, Chairman, Tel: (+86) 13600446910 Email: mtavast@genford.com Finnish Business Council in Shanghai Markku Hakala, Chairman Email: fbcs@fbcs.fi http://www.fbcs.fi Finnish Chamber of Commerce Hong Kong Arto Mäkelä, Chairman, Tel. +852 2121 1302 Email: info@finncham.com.hk http://www.finncham.com.hk/ Finchi, Shanghai: Kristal Li, General Manager, Tel:+86 21 6104 2222 E-mail: kristal.li@finchi.cn http://www.finchi.cn/ 15

Appendix 4: Comments of Borenius HK ltd+ Mainland RO (representative office) a different structure The structure of overseas company having a Hong Kong limited liability company ( HK ltd ) plus a representative office in Mainland China ( Mainland RO ) used to be widely applied and was of great popularity in foreign investments into China this is different from the structure discussed herein, i.e. overseas company having a HK holding company and then a limited liability company in Mainland, but it could be a major contribution why the threefold structure of Finland-Hong Kong-Mainland China sound so familiar and common to Finnish investors. The HK ltd+ Mainland RO structure was popular for a reason: Compared with establishing a limited liability company, establishing an RO is much easier and faster way of setting up a presence in mainland China as there are fewer approval authorities involved and fewer documents required. Also setting up a Mainland RO is cheaper than setting up a limited liability company in China, as Chinese laws do not have requirements on the registered capital of RO. However, it should be noted that, unlike limited liability Company, RO is not an independent legal entity but merely a liaison office of the HK ltd, therefore RO is not eligible to carry out direct revenue-generating business activities such as entering into purchase and sales agreements, or to receive payment or issue invoices under its name. RO s main functions lie in assisting its overseas company with business liaison, product promotion, and market research, etc. Since China is a challenging and different market, many foreign investors have used Mainland RO as the spearhead into China to conduct liaison and research work, therefore this overseas parent company- HK ltd subsidiary Mainland RO has gained its popularity in the past. However, it is worth mentioning that the HK ltd+ Mainland RO structure is nowadays also witnessing increasing difficulty and decreasing popularity, as the Chinese authorities have added more regulatory requirements on the setting up and operation of a Mainland RO, for example, currently it is required that HK ltd must have been incorporated for two years to set up a Mainland RO. It is also believed as a trend that Mainland RO system will be closed one day and all ROs will have to be changed into limited liability companies. Taking into consideration of the above increasing inconveniences and the restrictions on RO s functions, setting up a limited liability company directly may be a more efficient way for foreign investors. HK ltd + Mainland China legal advantages PRC does not in practice enforce foreign judgments without a reciprocal enforcement of judgment treaty with the relevant foreign jurisdiction. HK and Mainland China signed in 2006 a Mutual Legal Assistance Agreement to make civil and commercial judgments delivered in each other s courts enforceable on both sides of the border, while Finland does 16

not have such treaty with PRC so court decisions made in Finland are not automatically enforceable in PRC and vice versa. However, both Finland and PRC are signatory states of the New York Convention (i.e. The Convention on the Recognition and Enforcement of Foreign Arbitral Awards), which enables arbitral awards made in Finland to be enforced in PRC and vice versa. As a matter of fact, Borenius has just successfully advised a Chinese company in enforcement of a Chinese arbitral award in Finland, where the recognition of an arbitration award was challenged by the counterparty for undue procedure in the arbitration process. Therefore, in our view this 2006 a Mutual Legal Assistance Agreement is not really a decisive factor for Finnish companies to build a HK holding mainland China WOFE structure, if the main concern here is to enable the dispute resolution results to be enforceable both in and out of mainland China. Arbitral awards made in Finland and China would be enforceable in the other country anyway Finnish companies just need to remember to agree on arbitration as the dispute resolution mechanism in their agreements with Chinese companies. 17