April/May 2009

Although China's economy is experiencing a year-on-year slowdown with exports falling in March this year by around 16.4 percent, the country's economy is still strong compared to many other countries in the world. For this reason Foreign Invested Enterprises (FIEs) continue to either have an interest in expanding to the China market or placing more focus on their existing China business. Although sourcing in China has slowed and the consumer market is weakening, many companies are looking, particularly in this year, to make an investment in China in order to be ready for 2010. With real estate prices dropping and skilled human resource available it is a good time to make such an investment, particularly in trade.

Types of Trading and Distribution Companies

Since 2005, China implemented new regulations that permit foreign companies to establish fully operational trading companies that can buy and sell in China, without using an Import/Export agent. These new regulations for foreign enterprises apply for the following five activities: retail, wholesale, representative transactions on the basis of provisions (i.e. as an agent / broker), franchises, as well as import/export. In addition existing manufacturing companies are able to distribute themselves as well.

In China there are two possible options to establish a trading entity.

Wholly Foreign Owned Enterprise (WFOE)
Establishing a trade and distribution entity in the Free Trade Zone (FTZ):
This type of entity is the "old" trading structure (prior to 2005).The advantage of establishing in the FTZ is that goods can be imported and remain in the FTZ until they are being further "imported" into domestic China. No VAT (Value Added Tax) or customs duty has to be paid when the goods are shipped from overseas into the FTZ. VAT and Customs Duty are only paid upon delivery to the clients (on consignment basis for example), allowing for a more flexible cash flow structure.

Depending on the level of registered capital and whether an official customs agent is employed by the company, the entity must go through an Import/Export agent when importing into domestic China from the zone (as the FTZ is considered "outside of domestic China"). The I/E agents generally have a service fee of approximately one percent of the sales invoice value in order to help with the necessary paperwork, customs clearance and initially to help issue the VAT invoices. A further disadvantage of this structure is that the VAT invoices must be controlled and issued by the Bonded Commodity Market in the Free Trade Zone.

A WFOE can only be operated within the scope of business approved by the authorities and is limited to one product line. Additionally the office would need to be registered in the FTZ (however an office can also be rented in the downtown business districts).

Foreign Invested Commercial Enterprise (FICE)
Establishing a trade and distribution entity in domestic China:
A FICE is actually a WFOE, however with an Import and Export license. The advantage of establishing a FICE is that the company is given the freedom to register the office address anywhere in domestic China. Additionally, the company is not required to use an Import/Export agent and it can issue VAT invoices without being tied to a Bonded Commodity Market. In this situation once the goods are imported from overseas, VAT and Customs Duty are paid upfront.

Similar to a WFOE, a FICE can only be operated within an approved business scope. However, the FICE offers greater flexibility and business can be done within five different product lines.

Requirements for a Limited Trading and Distribution Company

Registered capital requirements
The registered capital requirements vary from entity to entity and also on a regional basis. Wherever the WFOE / FICE is based basic investment criteria remain the same. The government will look at the general viability of the project and a reasonable cash requirement for a particular type of investment. It is stipulated in China that at least RMB 1 million is required for a trading / distribution company, should the company be planning to apply for the General Tax Payer Status, which allows the entity to issue VAT invoices.

Registered capital and total investment figures are both required during the application procedure. The total investment is what is necessary to realize the company's operations, while the registered capital is the equity pledged to the local authorities. Limited liability is recognized by the amount of registered capital injected into the WFOE / FICE. Registered capital can be contributed in cash or in kind, the latter normally being imported equipment, which may be needed for testing or showrooms etc.

It is important to measure Registered Capital amounts (the investment) against the businesses cash flow needs and not against minimum qualified amounts issued as guidelines. The term is used by local governments as a guideline only, as the WFOE / FICE 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 WFOE / FICE runs out of operational capital - and this is a huge problem not easily rectified. There are additional issues with local governments, seeking foreign investment, not being fully aware of tax and customs requirements - too low capital can mean issues such as refunds on export VAT can be problematic and so on. It is vitally important to address the registered capital need against the businesses operational requirements and not against 'minimum' specified amounts mentioned elsewhere. It is an operational cash flow issue, not a regulatory licensing matter.

Taxes Imposed on Trading and Distribution Companies

Profits Tax
The profits tax rate of 25 percent has been implemented for both foreign and domestic companies in 2008 and is paid on a quarterly basis.

Business Tax
Business Tax is imposed in relation to transactions on services provided by enterprises. An example would be after-sales services, quality control services, installation of equipment, etc.

Business tax is levied on gross turnover at rates between 3 percent and 20 percent. The most common rates are either 3 percent or 5 percent and it is paid on a monthly basis.

Value Added Tax (VAT)
The Chinese government rules that all enterprises and individuals that are engaged in the sale of goods, provision of processing, repairs and replacement services, and import of goods within China have to pay Value Added Tax (VAT). In China, companies are divided into two categories depending on their registered capital and revenue earned.

1. General Tax Payer Status
The benefit of having the General Tax Payer Status is that it gives the company the right to issue VAT receipts to its clients in China. The General Tax Payer Status is usually important for FIEs that trade in industrial related products and not so much when trading in consumable products to individual customers. In January 2009 the requirements for the application for a General Tax Payer Status changed, in that now the company has to have a registered capital of at least RMB 1 million and an annual sales turnover of RMB 800,000 (previously this was RMB 1.8 million). The general VAT rate for general taxpayers is 17 percent. The General Tax Payer will usually purchase goods during the course of doing business. The VAT paid is known as Input VAT. The Input VAT can be deducted from the Output VAT which has to be paid when selling products. The VAT Payable is calculated on a monthly basis using software provided by the tax bureau.

General Tax Payer Status - Export of Goods
When a trading / distribution company exports goods from China to overseas, it can apply for a refund of the initial 17 percent VAT. The amount of the refund depends on the goods that are being exported. Export companies must follow a formal approval process to apply for a VAT refund. They have to submit a series of documentation (most importantly the customs document and foreign exchange certificate) to their responsible tax authorities for the approval. As a result, if a company cannot complete the VAT filing for export sales within 90 days after exportation these sales must be deemed as local sales and are taxed with 17 percent VAT.

General Tax Payer Status - Import of Goods
When goods are being imported by a General Tax Payer, customs duty and VAT of 17 percent have to be paid on the imported goods. Should the goods go into a Bonded Logistics Park or Free Trade Zone (in case of a WFOE for example), these payments only occur once the goods are being imported into "domestic China". For further domestic sales in China, 17 percent VAT will be added onto the invoice.

2. Small Scale Tax Payer Status
Small Scale Tax Payers are companies where the annual taxable sales value falls below RMB 800,000 and the registered capital is below RMB 1 million. The current VAT rate for Small Scale Tax Payers is 3 percent which has been reduced from 4 percent since 2009. Small Scale Tax Payers cannot deduct Input VAT.

Small Scale Tax Payer Status - Export of Goods
When goods are being exported from China there is no VAT implication for Small Scale Tax Payers. However, as mentioned above should the company fail to submit all documentation in time, the sales will be considered as a domestic sale. In this case, the company would be liable to pay 3 percent VAT.

Small Scale Tax Payer Status - Import of Goods
When goods are being imported by a Small Scale Tax Payer, customs duty and VAT of 17 percent have to be paid on the imported goods. Should the goods be delivered into a Bonded Logistics Park or Free Trade Zone (in case of a WFOE for example), these payments only occur once the goods are being imported into "domestic China". For further domestic sales in China, 3 percent VAT will be added onto the invoice. This means that the initial 17 percent paid on the import cannot be offset and has to be considered as a cost.

Accounting and Tax Filing, Tax Exemption Applications and Annual Audit Requirements

A Limited Trading Company is liable for filing and paying the above mentioned taxes as well as Individual Income Tax for the employees, Stamp Tax and potentially a series of other taxes. It is therefore required that the company has an approved accounting software system to conduct monthly bookkeeping, and to create all government required financial statements and tax declarations.

Annual Audits and Annual Inspections are necessary for Limited Trading Companies and must be submitted before May each year. The annual audits must be conducted by a local Certified Public Accounting firm.

Additional Requirements for Limited Consulting Company's

If there are any changes associated with the Company, such as change of office address, change of Legal Representative, change in business scope, these must be approved by the original approving authority and all certificates associated with the Company must be changed.

Besides an annual audit, Limited Companies also have to submit a range of other documents and licenses to the authorities for checking and renewal if necessary. The so-called annual renewal is a bureaucratic process, but also a good time to take stock and ensure all paperwork is up to date. The Audited Financial Report, the Foreign Exchange Audit Report, and the Annual Report must be submitted to seven government departments. These documents must be submitted before June 30th each year.

Consideration for Ease of Operation

Outsourcing Administration Functions
Many companies look to outsource their administrative functions, such as accounting, tax filing, payroll and other corporate governance functions to external consultants. This benefits the investor in two ways:

1. Professional advisors often provide a "new set of eyes" or they can predict what problems may arise and they offer a greater level of understanding of the corporate environment; bringing experience and best practice across all business functions - from finance, accounting, legal and IT
2. They can act as independent "Administrative Managers" making sure that the Limited Company is in compliance in all aspects of operations. This can be an asset for investors who want to only focus on the company's day-to-day activities and alleviate any financial and business risks.

Protection of the Parent Company by having a Holding Entity
Many foreign companies feel it is a risk to establish an entity in China. The establishment may not require a high capital investment but there can be a risk factor. Due to these aspects, more and more investors are establishing offshore companies to act as a holding entity for their China investment and thereby creating a buffer layer to take over the full liability for the Chinese operation from the parent company. The establishment of many of these offshore companies is an easy process and due to an uncomplicated tax system and accounting requirements, simple to operate. Double taxation agreements have been drafted and implemented between China and many of these offshore jurisdictions, which adds an additional benefit.

Conclusion

Generally for domestic sales in China a trading / distribution company is necessary in order to sell in RMB currency and to have stock available when needed. However for export business depending on the type of export terms, the overseas client and the currency being used, an alternative solution would be to establish a trading entity outside of China. A trading company in Hong Kong for example has numerous advantages, such as lower risk, a more developed trading infrastructure, as well as a free currency in and outflow. With a Hong Kong company it is possible to sell directly from Hong Kong to worldwide clients without involving the headquarters, and without goods burdening the warehouse. As a result, lower Freight On Board (FOB) Asia prices can be offered. In addition, a bank credit is not required since clients could open a transferable Letter of Credit. This frees up capital and improves the cash flow. Furthermore Hong Kong offers a lower profits tax (16.5 percent or 0 percent when the business has been done outside of Hong Kong) and most importantly can also be operated with minimal cost.

With all these options available, it is important for a company to evaluate its best entry strategy when it wants to do trade or distribution in China and / or Asia and to consider which option fits their profile most.

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.