November/December 2009

There are various structures available to companies looking to source effectively in China. The individual options vary in terms of investment, risk, commitment, control and time frames. For the export out of China customers generally have two options:

1. Exporting from China without any local representation or
2. By establishing a sourcing presence in China

It is important for companies to understand what strategies are available and how these structures could fit into their existing business models.

Outsource all export activities in China

Sourcing with no representation
Many foreign companies may feel that in today's global economy, it is vital for their business to be present in the rapidly growing Chinese market. Not every company, however, has the resources to immediately set up their own entity or send expatriate staff to China. At the same time they may not feel complete loyalty from the local suppliers, trading agents and logistics providers.

A foreign company has the option of establishing a network of logistics providers all around China to assist in the export of goods as suppliers are located in various regions of China. Sourcing in China without any local warehousing facility is naturally the first step for many, but if any company wishes to expand and use the full potential of the China market, a local presence may be unavoidable as consolidated shipments may be required to customers all around the world.

Looking for an appropriate agent
The greatest challenge for foreign buyers is to find dedicated, reliable, professional and credit-worthy agents. A long-term, focused and consistent strategy is needed to access and profit in the market. An agent could be a manufacturer who is in a similar field as the foreign company or an import/export company that is well established in the field and has connections and an extensive network with suppliers. Agents both buy and sell the products, or they act as commission agents receiving a sales commission.

A first step towards a buying representation in China would be to identify an agent who will search for reliable suppliers on the Chinese market; however this is not always a recommended method as the agents can be in conflict due to sister companies which produce similar products.

Outsource your "Buying Office"
Service providers have developed services where the foreign company can utilize outsourcing services in order to establish their own buying and consolidation network without having to set up their own entity with fixed cost, or loose control over the order transactions to a local agent or logistics provider. As a second step, companies with their own representation can also outsource their local sourcing, invoicing and warehousing.

This effective outsourcing solution provides the foreign company with a customized outsourcing service for a smooth and trouble-free market entry. The foreign company may continue to utilize the service providers for as long as they wish. Usually, after a few years, clients have gained significant experience and access to the market, and are ready to set up their own entity. At this point it will also be possible for the foreign company to then take over the employees, which so far have been working for them in China within the service provider's structure.

Establishing a Hong Kong Trading Company

Establishing a Hong Kong Company for purchasing activities with China and the rest of the world has many advantages. When buying from the Chinese and/or Asian market, the Company can enjoy significant tax and operational benefits - with or without a China mainland entity. The Foreign Company can use a Hong Kong Company as a re-invoicing center for purchases from China and other Asian countries and accumulate profits at favorable tax rates. The regular tax on profits is 16.5%, but if the profits of a Hong Kong Company are generated through offshore business, they are tax free.

Every year once the company has been audited, the tax return to the Hong Kong Inland Revenue Department has to be filed. If the company has only conducted offshore business, a 0% tax rate can be applied for. In order to be able to justify "offshore business" the company should:

- have no employees in Hong Kong
- do not issue or receive any invoices to and from other Hong Kong companies
- shipments should not go through Hong Kong
- business decisions should be done outside Hong Kong

There are two common possibilities to structure the Hong Kong Company. It can either be a subsidiary of the overseas company or a person can be the shareholder of the Hong Kong Company.

Once the Hong Kong Company has made profit, and the annual audit and tax return have been completed, the dividends can be remitted. Dividends in Hong Kong are tax free. If the company in Hong Kong is held by an individual, the profit can be repatriated to the home country; however it will most likely be taxed on the profits in the home country.

Establishing a Hong Kong Trading Company with a Representative Office in China

Nevertheless, if the Company decides to hire mainland Chinese staff in China, in addition to having a trading company in Hong Kong, a legal entity would need to be established. A Representative Office (RO) is the easiest and most economic way of setting up a legal presence in China. It is an office of a foreign enterprise set up for the purpose of liaising with Chinese businesses and customers on behalf of its parent company. A RO is not considered to be a separate legal entity and it can not carry out direct revenue earning business activities, i.e. it cannot enter into purchase/sales contracts and cannot receive payment for products or services, issue invoices or repatriate monies overseas. A RO is restricted to conduct only "indirect operational activities", such as:

- Business liaison
- Introduction of products
- Market Research
- Technology exchanges

By law the Chinese staff must be employed by a Chinese entity in China. Together with their gross salary, the company must provide social insurance to each employee. As social insurance is owed to the State and not the individual, it is recommended that this be done in a legal way so as to not incur any difficulties with the Labor Arbitration Committee and other government bureaus in China.

There are many foreign companies in China that do not monitor the daily business of their local employees in their RO, allowing many of these employees the opportunity to engage in activities not allowed by the RO. The consequence is often that the parent company becomes blacklisted by the Chinese government. A further advantage of a Hong Kong company would be that it takes this liability away from the parent company.

There are no capital contribution requirements for a RO. Establishing a RO is therefore largely a matter of complying with the prescribed application procedures. A RO, although indirectly operational, is liable for filing and paying Business Tax, Foreign Enterprise Income Tax and Individual Income Tax based on your expenses. You will pay approximately 10% of your expenses in the form of Business Tax and Enterprise Income Tax. There is an additional called Stamp Tax which is required for all signed contracts - Therefore your lease contract will require a Stamp Tax (approx. 0.01% of the rent total).

In summary, the Hong Kong Trading Company can handle all purchase issues with the supplier and the customer. The RO would act as the sourcing and quality control liaison office, making sure that the negotiations, contracts, production and quality control issues are all being taken care of.

Establishing a Hong Kong Holding Company with a Limited Company in China for Export and Warehousing Purposes

If the Company wishes to act as the exporting agent from China as well as have its own independent warehousing facilities, a Limited Company would need to be established. A Wholly Foreign Owned Enterprise (WFOE) / Foreign Invested Commercial Enterprise (FICE) is a limited liability company wholly owned by the foreign investor(s). WFOEs / FICEs allow foreign investors to manufacture, process, assemble, trade, distribute or deliver services in China, without joining together with a Chinese partner. Setting up a Limited Company does not necessarily mean that you can engage in any sort of activities, as may be the case in the West and certainly in Hong Kong. WFOE's / FICEs can only be operated within the scope of business as approved by the authorities. If, at a later date, the WFOE wishes to add other activities, these are subject to further approval by the relevant government authorities. It is therefore very important from the onset of your establishment to determine what will be the functions of the WFOE.
The difference between a WFOE and FICE is that the FICE is able to have distribution rights (ie. import and export rights) included into its business scope.

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.

The Hong Kong Company can act solely as a Holding Company to the China Limited Company. The Hong Kong Holding Company would then be fully liable for the China investment and protects the existing parent company. Also, dividends received by the Hong Kong Holding Company are tax free, but incur a 5% withholding tax in China compared to 10%-20% from other countries and can be used for further investment.

The main disadvantage in establishing a Limited Trading Company in China to handle the export business is that the existing suppliers will now be conducting local sales in Renminbi (RMB) when selling to the new China Trading Company and as they are no longer exporting from China will not be receiving the VAT Refund any longer potentially causing an increase in prices. Not to mention the larger investment requirement and higher risk involved when establishing a Limited Company.

Establishing a Hong Kong Trading Company with a Limited Joint Venture in China for Production Purposes

A Company may want to go into partnership with an existing supplier in China in order to have exclusive production rights for the products they are designing. The main reason is to take control of all production capabilities of the supplier and to have more of a legal right in production processes and delivery times within the factory. The Company could then either export these products internationally via a Hong Kong Trading Company keeping a profit margin in Hong Kong and/or sell domestically on the local Chinese market.

For any Joint Venture partnership it is highly recommended to at least establish a Hong Kong Company as a holding entity for the Joint Venture so that all liability remains in Hong Kong instead of the parent company in case of failure with the Chinese party. The Hong Kong Company can also be used for international export trade purposes and profit accumulated for further investment. Additionally profits from the purchase of goods build up in the Hong Kong Company can also be used for re-investment. It is important to make sure that all transfer pricing issues between the Hong Kong Company and the production facility in China are being well taken care of.

An alternative solution when wanting to build a partnership with a local supplier is to setup the Joint Venture with your Chinese partner in Hong Kong as it would be based on Hong Kong Law. Additionally it would be much easier to exit this Joint Venture in the future and it would be advantageous to receive your dividends from China in Hong Kong due to the favorable Hong Kong Tax Laws. From this Hong Kong Joint Venture, you can then establish a Limited Company (WFOE or FICE) in China (based on one shareholder which is then your Hong Kong Joint Venture).

Recommendation for ease of sourcing activities in China

For export business, depending on the type of export terms, the overseas client and the currency being used, an most effective solution would be to establish a trading entity outside of China. A trading company in Hong Kong 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 with lower Freight On Board (FOB) Asia prices. 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 time it may then be required to employ staff who are on the ground and based in China in order to supervise production processes, quality control issues as well as delivery times. In this regard only a Representative Office would be needed allowing saving on larger and more riskier investments.

Conclusion

With all these options available, it is important for a company to evaluate its best China sourcing strategy and to consider which option fits their profile most. There is no reason for foreign investors to be nervous or hesitant about establishing a Hong Kong and/or China operation. The key for many investors is to make sure they do not become excessively complacent and to avoid any fraud or non-compliance issues. It is advisable to obtain advice and assistance through a consulting company or law firm in relation to the requirements, regulations and related activities.

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

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.