August 2009

Profit repatriation is a delicate subject under China's foreign direct investment regime. Various regulatory, formality and tax factors surrounding the issue make it worthwhile for investors to define carefully their repatriation strategies, so as to entail tax and profit outcome that they should be legally entitled to. These strategies may not necessarily be complex or costly, while their effects could be substantial: in certain cases meaning a tax saving of up to 15% of the turnover. It is advisable that such mechanisms be written into your China entities articles of association and approved by the local government at the application stage. Below are some commonly used strategies that may help to optimize profit repatriation out of China.

Mandatory funds allocation and dividends

Enterprise Income Tax (EIT) for Foreign Invested Enterprises (FIEs) is set at 25% under the new national law which was implemented on 1st of January 2008. Previously rates could be reduced even further to 15% and manufacturing companies could enjoy the 2-year holiday and an additional 3-year half tax commencing from the year they start to make profits.

Before distributing after-tax profits, FIEs are required to make up any losses carried forward from previous years. Additionally FIEs are required to allocate a certain rate of after-tax profit, determined by the board of directors, to reserve funds, enterprise development funds, staff incentive and welfare funds.

1. Reserve Funds are used to cover any losses suffered by the FIE.
   
   
2. Enterprise Development Funds are used to expand the operation and increase investment with approval from the local bureau of Foreign Trade and Economic Cooperation.
   
   
3. Staff Incentive and Welfare Funds are an irregular reward to employees and other collective staff welfares (for example, allowances to employees for purchasing, constructing and repairing their houses, etc).

Wholly Foreign Owned Enterprises and Foreign Invested Commercial Enterprises (WFOE and FICE) are required to allocate 10% of their after-tax profit to the reserve fund and cannot reduce this rate until the fund reaches an amount equivalent to 50% of the registered capital. There is no development fund and staff incentive and welfare fund needed to be allocated for these types of entities. For an Equity or Cooperative Joint Venture there is no minimal or maximal limit on the amount allocated to these funds, which should be setup by Joint Ventures. The board of directors can decide the allocation ratio on their own initiative.

The remaining part is distributable profits from which board of directors may declare dividends to the investors in proportion to their contribution of the registered capital. For foreign exchange dividends, FIEs could remit directly from their bank accounts or purchase convertible foreign exchanges with banks by presenting a valid board resolution on profit distribution.

At present, China does impose withholding tax on the dividends distributed to the foreign investors. The withholding tax is 10% on the dividends and this new regulation was implemented as of January 1st 2008. It has been decided by the Chinese tax authorities to grant a special concession to waive the withholding tax on dividends arising from the FIEs' pre-2008 retained earnings in order to facilitate a smooth transition from the old tax regime to the new EIT regime. However, the FIEs' profits arising in year 2008 and beyond to be distributed to the foreign investor as dividends shall be subject to withholding tax according to the EIT Law.

Under the double taxation agreement (DTA) between Hong Kong and China top rates for withholding tax for dividends received by a Hong Kong resident from investments in PRC enterprises is reduced from 20% to 10%, and a Hong Kong business from 10% to 5% providing that the Hong Kong business holds at least 25% of the capital of the PRC enterprise. This will attract more overseas investments into the PRC through Hong Kong

Alternatives of profit repatriation

Foreign investors may charge fees, interests or royalties' by entering into transactions with their FIEs in China so that profit repatriation would be partly realized before EIT. While the foreign investors must pay Withholding Tax and / or Business Tax on their incomes arising from such associated transactions, the taxable income base of the FIEs could be reduced. Therefore a thorough analysis on the regulatory settings and tax consequences of various possible transactions is essential for strategic planning purposes.

Royalties

Manufacturing royalties used to be capped at 5% and retailing royalties at 0.3% by the Ministry of Commerce (MOC) under its obsolete regime of approving technology transfer and commercial retailing enterprises. The maximal royalty charging term was limited to 10 years. Since 2001 (State Council Order No. 331), a file for record system has been adopted for most of the cross-border technology transfer, which replaces the pre-approval process. As a result, the commercial terms and conditions for technology transfer such as the royalty level and payment term are no longer subject to the screening by the authority, unless the royalties are so excessive that the transaction could be at arm's length and thus trigger transfer pricing issues with the tax authorities. In 2004, a new regulation (MOC Order No. 12) on retailing and distribution activities greatly reduced the entry barrier for the sector. Accordingly the former 0.3% cap on retailing royalty was abolished in the call of a more liberal market framework.

Nevertheless foreign IP owners are required to present necessary documents before royalties could be remitted out of China, as part of the formalities for foreign exchange control that is still in place in China. These include the inter-company agreements that set out the terms of IP transfer, the registration certificates issued by the competent authorities and the tax clearance certificates issued by in-charge tax bureaus. MOC is the responsible body for registering cross-border technology transfer agreements. When it is concerned with trademark transfer, such agreement will need to be filed with the State Administration of Industry and Commerce. Remittance of patent royalties must be accompanied by a return receipt issued by the State Intellectual Property Office.

Royalties are subject to both a 10% Withholding Tax and a 5% Business Tax.

The recent DTA states that royalties received by your Hong Kong Holding Company from the China entity attract in China a business tax of 5% and a withholding tax of 7% (totaling 12%). Other Holding Company jurisdictions would have a business tax of 5% and a withholding tax of 10% (totaling 15%).

This compares favorably against China's tax on profits of 25% which means that savings of up to 13% of your total net profit in China can be achieved.

That said, these require profit repatriation structures to be built into the Articles of Association of your China entity together with supplemental agreements and contracts. It is recommended that these be written inside at the time of incorporation.

Service Fees

Foreign investors could provide services and thus get paid under service agreements with their FIEs in China. It is not requested to register or file service agreements with authorities. To remit service fees is therefore subject to less paperwork requirement under forex control in comparison with royalties' remittance.

Fees paid by FIEs to their parents for services rendered onshore are subject to a 5% Business Tax. In addition where the servicing period is long enough (more than 6 months in any 12-month period) to constitute a Permanent Establishment (PE) in China, a 25% EIT will be charged on the deemed profits, which vary from 10 to 40% of the income arising from onshore service. If PE could not be established, EIT is theoretically not applicable. In practice, tax authorities would treat the fees as loyalties and levy a 10% Withholding Tax. Service fees at arm's length are normally deductible for FIE's EIT purposes. However "management fees" charged by parents on the basis of inter-group cost sharing is not deductible.

Interests

Loan interests paid by FIEs to their parents are subject to a 10% Withholding Tax, but with no Business Tax exposure. Such interests paid are deductible for FIE's EIT purposes.

Much attention should be paid to the regulatory requirements on loan arrangement between a FIE and its foreign parents. China imposes mandatory equity / debt ratio on FIEs. With a given amount of the registered capital, loans that a FIE is permitted to raise are capped. Loans granted by foreign parents will need to go through the foreign-debt registration procedure with the State Administration of Foreign Exchange (SAFE). The remittance of interests is also subject to the approval of the SAFE. Thus, foreign investors should plan the capital structure carefully in advance if it is the intention that debt finance will be provided by the parent company.

R&D cost sharing arrangement

Under a R&D cost sharing arrangement (R&D CSA) participants share the worldwide R&D expenses in proportion to the anticipated benefits each participant might obtain. Each participant would acquire its own piece of IP rights developed within the local jurisdictions. China did not recognize CSA until the State Administration of Tax (SAT) issued in 2004 a private ruling letter, which endorsed an international R&D CSA for a particular FIE. The letter states that a FIE is able to participate in a CSA provided that certain pre-requisites and formalities could be satisfied including:

1. the FIE would receive specified IP rights and benefits;
2. no royalties would be charged; and
3. documentation for cost sharing pool, allocation mechanism and method adopted should be lodged to SAT for review, etc.

Once the clearance with SAT is obtained, a FIE may effect the payment under the R&D CSA and deduct such payment for its EIT declaration. More importantly, such payment will not be treated as royalties and thus no Withholding Tax or Business Tax is chargeable. Needless to say, this new tax policy, even though not formulated as an official regulation, does present an important opportunity for profit repatriation and tax optimization. However as a R&D CSA would move IP rights into China, companies may consider to restrict the application only to their wholly-owned operations or to take appropriate measures to protect their IP in China.

Conclusion

It should be noted that the tax authorities will investigate on companies that tend to have the following characteristics:

1. Significant amounts or numerous types of related party transactions;
2. Long-term losses of low profitability or fluctuating patterns of profit and loss;
3. Below average profitability than industry standards or profits that do not match the companies functions;
4. Business dealings with companies established in tax havens
5. Absent or incomplete transfer pricing documentation; and
6. Obvious violations of the arm's length principle

Many problems in Foreign Invested Enterprises (FIEs) can be traced back to their initial establishment and the project's structure. The items listed above should be already considered in this initial stage and therefore it is recommended to seek advise on how to implement these strategies into the company's structure prior to filing the company setup application.

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.