October 2009

The worldwide economy may be in a trough but the manufacturing sector in China still expanded for a sixth straight month in August of this year to a 16-month high. The economic recovery has continued and this also affects the Foreign Invested Enterprises (FIEs) that continue to either have an interest in expanding to the China market or placing more focus on their existing China business. With real estate prices dropping and skilled human resource available it is a good time to make such an investment, particularly in manufacturing.

Types of Manufacturing and Distribution Companies

Since 2005, China implemented new regulations that permit foreign companies to establish fully operational manufacturing companies that manufacture and distribute in China, without using an Import/Export agent.

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

Wholly Foreign Owned Enterprise (WFOE)

Establishing a manufacturing entity in a Trade Development Zone:
A manufacturing company that is exporting 100% of their goods overseas should consider the Trade Development Zones due to the facilities and services on offer. As the company is not selling onto the local market but is using China as a manufacturing base, components can be imported duty free and then processed. China components can be added on duty free and then be re-exported while claiming VAT back on the China-sourced components.

Foreign Invested Commercial Enterprise (FICE)

Establishing a manufacturing and distribution entity in domestic China:
A manufacturing FICE is actually a manufacturing WFOE, however with an Import and Export license, allowing it to greater flexibility to do trade business outside of the product category being manufactured. Additionally a manufacturing FICE does not have to be in a Trade Development Zone, providing the company freedom to register the manufacturing site anywhere in domestic China.

Finding the Best Location for Manufacturing Companies

For companies that are looking to invest in China, finding the best location for their investment is one of the initial issues to deal with as each province and city have different investment policies that could affect the market entry. Investing in China does not automatically imply that one must setup their operation in the first tier cities, such as Beijing, Shanghai, Guangzhou or Shenzhen. It is advisable to look at all available options. There are four main economic regions in China which are being promoted by governmental incentives: the Pearl River Delta, the Yangtze River Delta, the Bohai Sea and the West. It is recommended to have a closer look at the developing second tier cities in these regions as alternative solutions.

Industrial Property

Similar to the commercial sector, the industrial property market is also becoming a market of increased choice. Although the location of industrial premises in China is limited to government approved zones, there are already more than 150 industrial zones and parks in the greater Shanghai area alone, and costs can vary significantly from zone to zone. Apart from the price differential and location, zones have also traditionally been differentiated by the tax concessions that they have been able to offer occupiers. Since January 2008 however, the income tax system has been unified all over China and this means that all entities are liable to pay 25% profits tax no matter in which zone they are established. However, zones can be differentiated by whether they are State, Municipal/Provincial or Township zones, depending on which level of government issues approval and according to their industry focus.

The choices available in industrial real estate are now much more varied. The market, which was once solely the domain of government-owned development zones, is now expanding to include private sector developers from both China and abroad. While foreign manufacturing companies that entered the market early tended to build and own their facilities, the current trend is increasingly towards renting or sale and lease back arrangements. This has mirrored the trends in North America and Europe where companies prefer to utilize their capital in their core business as opposed to the real estate market.

Many manufacturing firms require a more customized building than these standard offerings of the development zones. Therefore, development zones generally also offer acceptable quality ¡§build-to-suit¡¨ programs with buildings constructed specifically to meet the requirements of the occupier, and sold or rented to the client for longer-term rents of five-to-ten years. But a number of zones are now running low on capital and their criteria for offering such a build-to-suit solution will usually depend on the size of the client¡¦s registered capital.

This has presented an opportunity for private developers to build industrial parks within development zones and also provide their own build-to-suit programs. Many of these park developers are local manufacturing companies who purchased land for their own use and have decided to develop industrial parks to take advantage of China¡¦s economic growth. The rates charged by these local developers tend to be relatively inexpensive, but the quality of the facilities they provide can vary dramatically.

This issue of quality is now being addressed by a small number of specialist international firms that are developing high quality build-to-suit solutions. Their costs are higher than those generally charged by the local developers, but they often offer more flexibility, less risk due to their expertise and international operations, and the higher quality of facilities they provide are very much in line with what foreign occupiers want. They also may offer sale and lease back arrangements enabling clients to free up capital.

As foreign companies in China expand, merge with others, are acquired or close down, their local operations or facilities may come onto the market. Consequently, there is now a developing secondary market in industrial property that may present opportunities for a company to find facilities that match its needs at a more attractive price. There may also be a significant time saving for the company in getting its facility into production.

Business Park Concept

The success of the business park concept overseas in which custom-built premises are set in attractive landscaped parks has largely been lacking as an option for international firms looking to setup in China. That is now about to change with the addition of more and more such parks as for example the Shanghai Business Park to the country¡¦s set of commercial property options. The Shanghai Business Park for example is a joint venture with the highly successful Caohejing High Tech Park and Arlington. Arlington is Europe¡¦s largest business park operator with 23 parks in operation in Europe, including a collaboration with EuroDisney outside Paris.

Typically, business parks suit clients looking for long-term quality premises, such as corporate headquarters, R&D and IT centers, that require a high degree of customization and quality of construction to meet their intended purposes.

The Build-to-Suit Option

The key decision confronting firms wishing to set up their industrial site in China has traditionally been between buying (or leasing) existing premises or constructing their own site. Although leasing may reduce the amount of capital outlay and allow a firm to move more quickly into operation, in practice finding an existing industrial building in the right location that will fit all the needs of the company when converted is not easy. As a result, many firms find the build-to-suit option more appealing. The property can be tailor made to meet exactly the requirements of the company, thus ensuring maximum efficiency and productivity. Available sites are generally more numerous, giving the company greater flexibility in its choice.

However, the challenge for many firms wishing to take this option is a practical one. They will want to negotiate a good deal on the land and on the construction terms in what is probably a new market for the company. There is also the problem of finding a local contractor that can build to the international requirements they may have, and upon whom they can rely to deliver the premises to specification and on time. Then as already mentioned there is still the drawback that the company is tying up its capital in non-productive industrial real estate: a sector that has a poor secondary market.

But there are now a small number of international firms in the market that are positioned to address these issues. These companies are seeking out Build-to-Suit projects that they can operate on a sale and leaseback basis.

Requirements for a Limited Manufacturing 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, the 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 1,000,000 is required for a manufacturing company, although this should be checked with the local Administration of Industry and Commerce to see whether they have any local government requirements.

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, 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. 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.

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

A Limited Manufacturing Company is liable for filing and paying profits tax of 25% 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 Manufacturing 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.

Health Checks and Internal Audits

Although manufacturing companies in China are not required by law to perform internal audits, more and more FIEs are becoming aware of the importance of it as an effective tool to ensure the companies are operating in an effective and efficient way, the financial reports submitted to the government authorities and public are reflecting the true position and performance of the companies and most importantly that the companies are in compliance with the relevant laws and regulations.

It is also advisable for foreign investors to conduct internal audits through an external company (outside perspective) regularly in a year, for example on a quarterly basis before tax filing occurs. It is a good tool to keep updated on the company¡¦s standing. Additionally, background checks on staff in management positions can be conducted. Internal audits often assist in discovering anomalies which lead to further discoveries. However, it is impossible to guarantee that all secrets will be disclosed through an audit.

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. Should the FIE additionally use the Hong Kong Holding company for all (offshore) export trading business, the profits tax can be as low as 16.5 or 0 percent.

Conclusion

With the manufacturing sector still strong, it is a good opportunity for foreign companies to enter the Chinese market now that there are lower leasing prices and skilled staff available. For a manufacturing company it is even more important than for any other business to find the right location and facilities that suit the company¡¦s needs (and are affordable). It is recommendable to do a thorough market research to find the best location and have consulting staff on board that can help in the decision making process.

It is not uncommon that FIEs are "tricked" into setting up in certain regions as they get promised by the local government bureaus lower tax rates and other such preferential treatments. However, once the company is established, these government officials have forgotten their promises and the beneficial treatments originally offered are no longer valid. This is why it is essential to obtain all information provided by local governments in writing and to obtain tax advice prior to the establishment phase in order to understand the requirements of operating a manufacturing structure in China and also how to remain in compliance and avoid basing company decisions upon false information.