August/September 2008

Over time many foreign invested companies (FIEs) change their China strategy due to the growth within their company and within their industry or due to unexpected obstacles that can arise in China. An increasing number of FIEs have re-structured their initial China entity by either expanding their existing operational business scope, becoming fully operational entities, increasing their investment capital or purchasing the shares from their Chinese Joint Venture to become a 100%-owned FIE. Companies have different motives for changing their structures and there are benefits and disadvantages that should be taken into account.

Reasons for Re-structuring

FIE's have been entering the China market for over 50 years, many starting with a simple Representative Office structure. However, over the years, as these companies' industries have expanded and developed, they have become confident to further invest and eventually establish fully functional Limited Companies or even participate in Joint Venture structures.

Additionally China can be a rather unpredictable place and over time a company's structure or business plan may no longer suit the needs and business requirements of the company. In order to stay competitive the company may need to change its primary strategy. As a result it may need to expand its business scope, upgrade from a Representative Office to a Limited Company, change its shareholder structure or even add branch companies in other locations.

Furthermore the Chinese laws and regulations have changed, opening the market to new industries and allowing companies to expand their operations. Furthermore, the requirements and procedures have become more simple and straightforward so that companies are willing to take on the challenge of staying in the China market and moving forward.

Possible structural changes for FIEs

Representative Office (RO) to a Service / Trading / Manufacturing Entity
Should the investing company be interested in selling their products into the China market or sourcing in the China market, they may find that a RO will be sufficient considering that all contracts and payments will be made directly between the parent company and the customers / suppliers in China. However, there may come a time where the investing company decides that it would be more cost efficient and effective to either produce their products locally and /or to begin to sell locally and invoice in Renminbi (RMB). As a consequence a RO might feel the need to establish a trading or manufacturing entity after studying and researching the market possibilities.

It is a very common mistake by FIE's to think that it is feasible to "convert" a Representative Office into a Limited Company; however this is not possible in China. Should a company be interested in expanding its business scope and being able to function as an operational entity (i.e. by being able to issue VAT invoices, for example), it is important for the company to decide whether it is worthwhile to keep the RO or close the RO down and open a Limited Company. It is recommended to initially find an office location, establish the entity and then transfer all fixed assets and employees to the new entity, before closing down the RO.

Closure of a Representative Office (RO)
In order to close down the RO one should make a "health check" to see whether there are any outstanding debts and / or tax liabilities. Should there be any debts / liabilities the company will be responsible for clearing all outstanding tax payments and may potentially be fined for late tax payment. However if the company has conformed to all the local and national rules and

regulations by proving that it has no tax liabilities, which can be verified via its bookkeeping records, certificates and receipts issued by the local and national tax bureaus, then the company only needs to submit the required documents to the government. The tax bureau will still require that the company go through a tax audit report signed by an official Certified Public Accountant, which would also be submitted to the government bodies. The procedure can take between three to six months.

Increase of Registered Capital / Change in Business Scope / Change in Employee Structuring for Limited Companies
It should be noted that the Registered Capital is the amount of capital that is required by the business to operate until it can break even. There is a great deal of confusion over the term 'Minimum Registered Capital'. The term is generally used as a guideline only, and as mentioned, the Limited Company needs funding via its registered capital until it is able to support itself from its own cash flow.

If this does not occur, then the Limited Company may run out of operational capital - and this is a huge problem not easily solved. There are additional issues with local governments, seeking foreign investment, not being fully aware of tax and customs requirements. It is vitally important to address the registered capital need against the business's operational requirements and not against 'minimum' specified amounts given out elsewhere. It is an operational cash flow issue, not a licensing matter.

A company could, over time, also decide to increase its registered capital as a way of financing its expansion plans, such as renting a larger factory space, hiring more employees or developing the business scope to add further activities. The process of increasing the registered capital can be quite tedious and it is recommended to take short and long term plans into account when making the cash flow analysis for the company. The application process takes approximately two months before the registered capital can be remitted in.

Should a FIE need a prompt increase in their registered capital or in foreign funds the simplest way to gain financing is by borrowing money from its parent company or from banks overseas. The law states that the maximum loan amount should not surpass the difference between the total investment capital and the registered capital. The foreign debt option is the only legal way a foreign company can inject money into its entity in China (outside of the registered capital amount, which must enter the company). It should be taken into consideration, however, that should the FIE want to have a larger foreign debt amount; the registered capital would need to be higher. As a consequence the liability for the company would then also increase.

Should the FIE wish to make any further changes associated with the existing structure, such as change of registered office address, change of Board of Directors, Supervisory Board or Legal Representative, addition to the business scope, etc, these variations must be approved by the original approving authority and all certificates must be updated. Similar to the increase in registered capital, the application process takes approximately two months.

Establishment of Branch Companies
After a Limited Company is established and operating, and its total amount of registered capital is injected, it might consider opening branch offices around China to further expand its business.

An Operational Branch Company is a fully functional branch of the parent Limited Company. It is permitted to conduct invoicing in the name of the branch company and all accounting functions can be consolidated with the parent Limited Company in China. A Non-Operational Branch Company is similar in function to a Representative Office in that it cannot do invoicing, however it acts as a liaison between the parent Limited Company and the suppliers / customers in its region.

Branch companies can be established anywhere in China and the procedure is very straightforward, however an approval process is required, and it should take about two to three months. No supplementary investment is required into the Limited Company to establish the Branch Company.

Re-structuring the Investing Company

Investing into China is still a risk for many foreign companies and for this reason an increasing number of international companies are now willing to reorganize their existing Chinese companies and hold them under an entity in another jurisdiction outside of their home country. An example would be to restructure the China entity and to have a Hong Kong Company be the new shareholder. The Hong Kong Holding Company would be fully liable for the China investment and would protect the parent company or individual from all liability. There are additional incentives and benefits to have Hong Kong as the Holding Entity, such as dividends received by a Hong Kong Holding Company are tax free, but incur a 5% withholding tax in China compared to 10%-20% when paid out to other countries and can be used for further investment.

Holding Companies can also be in Singapore, Macau, and other "offshore jurisdictions". Hong Kong, however, is an excellent location in which to set up a business, as it offers important tax and operative advantages. The taxation for the earned profit of the company in Hong Kong is 16.5% or if it is considered as offshore, profit tax can be exempt, and all operational functions can be outsourced if needed.

Conclusion

Upgrading an entity in China is a complex procedure, in which taking the required amount of time for planning and understanding will determine the success in the future operations in China. The administrative effort involved might be rough and sometimes complex with a variety of tax and legal concerns to take into consideration when establishing operations or developing new ones.

Nowadays the Chinese Government is moving to facilitate and standardize all the procedures, which an FIE will have to go through, in order to update their entity. This situation will incite many companies to take the final step to switch their corporate structure and consequently be more competitive in the market.

If you require assistance with the above subject, please contact us at This e-mail address is being protected from spambots. You need JavaScript enabled to view it with your detailed questions.

All information in this report is verified to the best of our ability and is assumed to be correct at time of release; however, Klako Group does not accept responsibility for any losses arising from reliance on the information provided within.