HOW TO AVOID PROFITS FROM BEING STUCK IN CHINA FOR MULTINATIONALS
Setting up operations in China is challenging for foreign firms. Indeed several barriers prevent multinationals to repatriate some of the profits linked to their profitable operations in China, such as:
Since the Chinese economy is still developing, the regulation system is very strict. It is therefore important to manage correctly registration and approval procedures. Incorrect management can lead to the cancellation of remittance by making it illegal. Several strategies can be implemented to avoid this.
Distributing dividends to foreign investors:
Before distributing its yearly profits, foreign, invested firms must satisfy legal reserve requirements: profits can only be distributed if they are more than equal to losses.
Moreover, dividends cannot be paid directly:
Foreign actors see this strategy as the safest although 50% of the profits are stuck in China forever.
Under Chinese accounting standards, depreciation and amortization are considered as expenses thereby decreasing operational profits. This can significantly reduce profits of foreign invested firms with a high amount of fixed assets and intangibles. On the other hand, it can be an option to reduce the amount classified as “profits” and therefore taxable. As a result many firms implemented implicit policies to minimize their profits and capital injections in China. Liquidities are now transferred to parent companies or subsidiaries.
For taxation, corporate income taxes of subsidiaries can be reduced if they are deemed as expenses. Excessive taxation is due to permanent establishments in China for foreign entities; they should be entitled to their home country taxation system only.
Service fees to overseas parent firms:
Service fees aren’t subject to Corporate Income Tax and are charged at normal market rates, if directly linked to the commercial activity of the company.
Taxes applicable to service fees:
- Business tax
- Corporate income tax if it is a permanent establishment in China
- Urban construction and maintenance tax
- Self-employment tax
However, firms must go through the tax clearance process before being able to remit profits abroad.
Management fees are controversial since they aren’t exempted of corporate income tax under PRC laws but remain undefined. Moreover, since the authorities are checking them very closely, firms must provide very detailed contracts with the purpose of each payment between both entities. The only way for management fees to be exempted from corporate income tax is to be filed as specific know-how or technologies.
Before 2008, the “markup method” was used to assess intercompany charges between subsidiaries and foreign entities: a 5% profit margin could be used in order to assess the service fee charges against the foreign entity. However, the introduction of the arm’s length principle in the process in 2008 excluded the 5% markup convention thereby threatening the “safe harbor” status of the latter convention.
The payments received should include income and turnover taxes as well as VAT. Both income and turnover tax may be applicable depending on the payment type:
|Type||Corporate Income Tax||Turnover Tax|
Service fee with PE in China
Service fee with no PE in China
|Licensing fee / royalty||Yes||Yes|
|Licensing fee involving a transfer of technology||Yes||No|
In certain areas, such as Shanghai, a VAT Pilot program was launched meaning VAT can replace BT on certain types of services. Beijing is on its way to adopt a similar program. For instance, in an operation involves technology transfers, the firm is not entitled to BT.
In theory, the service fee recipient must assess whether a permanent establishment would be created due to the provision of the service involved. If the overseas service provider is located in a country with a tax treaty with China, the need of a permanent establishment will be assessed under this treaty. In practice, services provided don’t establish permanent establishment if they manage to defend their position to the SAT bureaus in China by carrying out some reporting for instance.
Service fees under $30,000 are exempted of the tax clearance process. This is a heavy process, as it requires tax clearance from the SAT and the local bureau.
If successful, the following must be submitted by the entity paying service fees to the SAFE:
- Original agreement / contract between the two parties
- Original invoice issued by the overseas service provider
- Tax payment / exemption certificate issued by the PRC tax authorities.
Like service fees a maximum of 80-85% of the profits can exit China since the same taxes apply to them. In addition, the Chinese affiliate must be recognized as the “beneficial owner” and be registered at the trademark bureau. The foreign invested firm must provide:
However the status of “beneficial owner” isn’t always favorable for parent companies as activities and control are limited, royalties are low, assets are much smaller than incomes and more than 60% of the incomes are remitted 12 months after receiving the royalties.
If royalties are linked to know-how or a technology, the both entities must be registered at the local branch of the Ministry of Commerce. If they are used for trademarks, the trademark owner or user will have to register at the State Administration of Industry and Commerce. It is important that due diligence is carefully performed for both parties for other approvals and registrations to be determined accurately.
Loans as interest expense payments to foreign partners:
The SAFE can approve them after they have submitted a tax clearance certificate on the interests of the loans submitted. They must comply with the following rules:
|The maximum debt to equity ratio according to the “thin capitalization rule”|
It cannot exceed 2:1 àif it does, the interest tax is subject to corporate income tax.
However, if the loan is made according to the arm’s length principle, a deduction may still apply.
|Repayment of a shareholder loan|
|The interests paid by a Chinese subsidiary are subject to withholding tax.|
The income generated is subject to:
However, since the SAFE doesn’t approve loans anymore, the income generated is now limited as 30% of the WOFE’s shares.
|Total investment||Part of registered capital in total investment|
|< $3 million||70%|
|$3 million < x < $10 million||>50% or $2.1 million|
|$10 million < x < $30 million||>40% or $5 million|
|>$30 million||>33.33% or $12 million|
Intercompany payments require a complete mastery of the PRC regulatory requirements, taxation and transfer pricing rules and are made from subsidiaries. Therefore, they require efficient structuring planning and must be very adaptable since the Chinese regulatory environment is constantly evolving.
Investors and foreign invested firms must therefore carefully assess each strategy as they all have their advantages and disadvantages. Distributing dividends to investors is the easiest way to repatriate cash from China but the less efficient. Service fees or royalties for foreign entities aren’t as simple but much more efficient overall. Loan repayment is an alternative solution in terms of easiness and efficiency. Hong Kong and Singapore can be interesting countries as they are business friendly and have interesting relationships with China.