FINANCING OPTIONS FOR FOREIGN-INVESTED ENTERPRISES IN CHINA
As China moves from an export-driven economy to a more sustainable consumer-driven economy growth model, it will place greater emphasis on domestic demand to boost consumption, and at the same time, reduce reliance on foreign investments and export. This development is important from the growth perspective of foreign-invested enterprises (“FIEs or Chinese subsidiaries”) in China. Amidst these broad structural reforms, there will be greater foreign capital control mechanisms in place requiring Chinese subsidiaries to review their financing situations for future operations in China more carefully.
For an FIE to finance through debt within China may not be as easy as it is back home. FIEs are subject to stringent financing regulations which are strictly applied by the examination and approval authorities in China. The debt is limited by the FIE’s registered capital and the worth of an FIE is only as much as the worth of cash it is holding in China. This inhibits the ability of the FIE to use financing for its growth in China. Besides, local banks would require security arrangements, such as bank guarantee or guarantee from Mother Company which may get in the way of easy financing.
This newsletter provides an overview of the options of financing available to FIEs established in China and the potential limitations in exploring these options.
FINANCING FROM OVERSEAS
Generally foreign investors raise fund for their direct investment or acquisition in China from sources outside China, and then inject the funds into China as:
- Equity financing (i.e., paid-in capital),
- Debt financing (i.e., related party loan), or
- A combination of both.
• Equity financing:
Equity financing from overseas investors is one of the ways of raising funds for Chinese subsidiaries. Usually, an FIE will convert the injected capital into RMB which will then be used for developing its business in China. However, the foreign capital can be used only for the specified purposes and within the approved business scope of the FIE.
If an FIE is set up in China with an excessive amount of registered capital, it will require huge timely investments in a relatively short time; needless to mention the difficulties that follow in repatriating the excessively injected amount from China afterwards. And, if the FIE is set up with minimum registered capital and requires more funding at the later stage, additional capital can be committed only after approval has been obtained from the relevant authorities to increase the company's legal capitalization. The whole process of approval is quite lengthy and may take about 3-4 months for clearance and approval. Thus, the timing when the financing will be available is beyond the FIE’s control leaving no choice but to consider other alternatives for financing as discussed in the following section.
• Debt financing:
Generally, debt financing refers to a loan which funds a business without conferring ownership of rights. An FIE is required to maintain the minimum ratios of registered capital to its total investments (also known as debt-to-equity ratio). The difference between total investment and the registered capital is the maximum amount the FIE can finance by offshore borrowings, including foreign bank loans and related party loans as shown in the accompanying table:
The loan applied for within China might also be subject to borrowing gap rule as stated above. Like capital increase, a loan request in foreign currency also requires the approval of the Chinese authority before every cash injection in China. This procedure can take up to 2 to 3 months.
If it’s a related party loan, the arm’s length principle must be followed under transfer pricing rules. If theeffective tax rate of the borrowing enterprise is higher than that of the domestic lending enterprise, then the interest will not be tax deductible.
The interest is tax deductible as long as the debt/equity ratio of is no higher than 2:1. (5:1 for financial Institution), and therefore, follows the thin capitalization rule provided by the PRC corporate income tax regulation.
• Equity financing Vs. Debt financing:
As compared to equity financing, debt financing is more preferred alternative for raising funds for the following reasons:
• Ownership:As against equity financing, debt financing does not require the sacrifice of any ownership interest of the business in exchange for the funding as the fund will be repaid.
• Financing costs:Cost of debt financing is more or less fixed and foreseeable due to fixed interest rate, and thus, less risky.
• Less time and cost consuming:Debt financing is relatively less time and cost consuming as compared to equity financing which requires more investor involvement, higher level of monitoring and more stringent regulatory requirements.
• Tax efficient: Interest charged on the debts is generally tax deductible; whereas dividend as cost of equity financing is not tax deductible.
• Flexible: Once the capital is injected in Chinese subsidiary, it is difficult to get approval from PRC authorities to withdraw/ reduce injected capital and repatriate to home country. If a foreign investor intends to pull out of investment in China in the future, financing the FIE through debt would be a better choice.
A foreign investor is contemplating his options for setting up an FIE in China:
Option #1: Equity investment, i.e., injecting paid-in capital to fund the business.
Option #2: Debt financing where the foreign investor extends a loan to the FIE in addition to the paid-in capital, which will incur annual interest of RMB 200,000.
Comparison of two options:
• Mixed financing:
The combination of debt (shareholder loan) and equity (registered capital) financing may be considered
as it might provide for higher returns. Preparation for financing requires careful planning to prevent cash shortages. The overall taxes on interest are normally lower than the tax on dividends as shown in the example above. Before choosing a mixed financing one’s must follow the following checklist:
• Tax treaties and taxation of revenue from interest and dividends
• Potential tax credit on dividends and interest in the home country
• Reduced CIT rate for specific activities or within certain region
Further financing options may be discussed with your bank in the PRC. PRC intra-group transactions may be financed in various ways, such as through the use of entrusted loans and cash pooling.