How to avoid the Cash Trap?
Strategies to repatriating profit from China in 2014
Investing in China should never be decided on an impulse. One should consider its advantages and drawbacks, so as to be prepared for the worse and make the best out of the money invested. China’s cash trap represents one of the biggest obstacles on the way to profits. In this document, S.J. Grand provides you with a full description of the options at your disposal to avoid this trap and get the best out of your investments in PRC.
Cash Trap: What is it?
Profits generated in China are difficult to repatriate due to multiple barriers. They are raised by different factors: taxes, laws, regulations and heavy administration control.
The profit made during one year can’t be distributed directly. Foreign Invested Enterprises (FIE) such as Wholly Foreign Owned Enterprises (WFOE), Joint Ventures (JV) and Representative Offices (RO) are required to be audited annually. Only the profit that has undergone the audit process can be redistributed.
However, what can be paid to investors is not only determined by this year’s profits. It is based on the accumulated profit, i.e. the sum of profits and losses of the whole history of the FIE. Only if its profits outnumber its losses can the FIE distributes dividends.
Dividends can still not be paid directly on the accumulated profit. The company first needs to pay the Corporate Income Tax (CIT) on this one, which is 25% of its value. The FIE should then place 10% of what’s left into a reserve fund, until this fund reaches 50% of the FIE Registered Capital (RC). Note that it means that an amount of your profit, equivalent to half your RC, will be stuck in China forever. After allocating this part of the profit, the amount left is the Maximum Distributable Dividends. However, it is good to keep in mind that dividends paid to a foreign investor are subject to 10% withholding tax (in most situations, unless there is a preferential tax treaty between China and the foreign investor’s home country).
* Audited Profit equals 2014 profit less non-audited profit. Accumulated profit equals audited profit less losses of the previous years. In this chart, non-audited profits and losses of the previous years have been chosen arbitrarily, so as to illustrate their impact on your profit evaluation.
In the hypothesis of a 2014 profit fully audited, a null accumulated profit for the previous years and no reserve fund, we can estimate that about 45% of the profit made in 2014 will have to stay in China. As a consequence, companies have no choice but to diminish the profits made in the country, transferring money to their parent company. This can be achieved thanks to several levers:
Service fees have the great advantage of being deductible for CIT purposes, when they are directly related to the field of business of the company and charged at normal market rates. They are subject to the following taxes: Business Tax (BT) or Value-Added Tax (VAT) depending on the type of services, CIT if the company is a Permanent Establishment (PE), Urban Construction and Maintenance Tax (UCMT), Education Surcharge (SE) and Local Education Surcharge (LES). All calculations done, between 80% and 95% of the payment will be received by the parent company.
However, tax authorities will check that the service invoicing is legitimate and not over-priced. As a consequence, we advise you to edit a contract detailing the services provided and to prepare to explain their purposes if required by the tax authority.
Service fees can be regarded as royalties when the service is linked to the introduction of a specific know-how or technology. Be careful that Management fees are not deductible.
Royalties are another way to repatriate profits to the parent company. They are also deductible for CIT purposes when directly related to the business of the company and charged at the normal market rate. They are subject to the following taxes: withholding CIT, VAT, UCMT, ES and LES. Taxes on royalties are taken at the source of income. For royalties, it is up to 85% of their value that you can get out of PRC.
So as to be able to receive royalties, the parent company has to get registered with the trademark bureau so as to be recognized as “Beneficial Owner”.
Another way to transmit money to the parent company is through loans. There are two ways: either by contracting one with the parent company and paying interests, or by lending money to the parent company.
- Repayment of shareholder loan
The company pays back the money lent by the parent company, for example at its registration in China. The interests paid by the Chinese subsidiary are subject to withholding tax on interests.
The debt to equity ratio can’t exceed 2:1, in the wake of the “thin capitalization principle”. If the required ratio is maintained, the interest is tax deductible; however, if the debt exceeds the ratio, the interest to be paid for debts over the ratio will be subject to corporate income tax. Note that the critical ratio can be lower when setting up a company, depending on the amount of money invested.
- Offshore lending
The Chinese subsidiary lends money to the parent company. The interest income generated is then subject to 25% CIT and 5% BT. CIT paid in China can be used to offset income tax liability in the parent company country.
The procedure has been recently simplified, removing the necessity of the State Administration of Foreign Exchange (SAFE) approval and enabling overseas loans to cover a period longer than 2 years. However, the offshore lending is limited to 30% of the owner’s shares in the WFOE. SAFE approval is still needed if a larger loan is needed.
The 5 methods previously exposed have their own forces and weaknesses. We can assess that Service Fees is the easiest and most effective way to get profits out of China, assuming you can justify the services invoiced. Royalties come second, since they require the company to be registered as beneficial owner. Loans-based solutions are trickier to implement, especially when it comes to lending offshore.
There are some other methods to repatriate profits, but they are far less common and hard to implement. If you want more information about them, please contact one of our consultants.
You will find a comparative table of the 5 methods introduced below
Repatriating Profits: Hong-Kong and Singapore
Most of the previous tools are subjected to taxes that can be alleviated thanks to Double Tax Agreements (DTA). Hong-Kong and Singapore have very interesting DTA with China, unlike many other countries, making service fees, royalties and loans techniques more efficient.
Moreover, both cities are very business-friendly. Taxes are low, legislation is sound, economy is stable and investments are highly encouraged.
You can find more information about Hong-Kong and Singapore in the following S.J.Grand documents:
S.J. Grand consultants can help you make the best out of your investments in China. For further information about how we can help you, please contact us.