Home > California CPA Magazine > March/April 2009 > Going Global: Doing Business in China

Going Global: Doing Business in China

China’s economic juggernaut continues to be an engine of growth for Asia and the West. Here’s a guide to operating a business within China’s borders.

 

By Brian Rowbotham, CPA

As we begin the Year of the Ox, China’s economic juggernaut, while slowing down, will continue to be an engine of growth for Asia and the West for decades to come. While lower-cost labor still is available for U.S. businesses expanding into China, the better reasons for having a presence there are the opportunities for growth, being positioned in what will be the largest economy in the world and access to a highly motivated and educated workforce.

There is no cookie-cutter approach for a U.S. business looking to expand into China due to the fluid nature of tax and legal issues, and industries that are subject to special tax concessions. The Cultural Revolution essentially banned scholars, lawyers and capitalists until they were welcomed back in the late 1970s. As one lawyer from China recently told me, you will not find many lawyers in their 60s and 70s, which means strategies that are well established in the West are still in their early stages in China.

The following is intended to provide a general familiarization with the legal forms of doing business in China and the existing tax system and rates.

Legal Forms of Doing Business in China
The representative office is considered to be part of the foreign parent, similar to a branch, and often restricted in the range of business activities that it can conduct. It is often used to manage and coordinate operations, marketing and research and development, and generally is not permitted to undertake activities that generate a profit. Restrictions apply with respect to hiring local Chinese labor. Because a representative office is not a separate legal entity, it must hire staff through authorized state-owned employment agencies, which ensures that local staff’s rights and interests are respected. Representative offices generally pay tax on a deemed profit basis, with the total tax liability amounting to about 11 percent of expenses.

An equity joint venture is formed for joint ventures and must have at least 25 percent foreign investment. A key requirement is that profit distributions among joint venture partners must be proportional to their equity contribution, unlike a cooperative joint venture (discussed below). An equity joint venture is a separate company that pays tax in its own name.

A cooperative joint venture was traditionally used on short-term projects, such as developing property for sale. More recently, they have been used for fund establishment by firms in the private equity sector. The terms of the cooperative joint venture determine how profits are to be allocated, which may differ from the ownership.

In typical cooperative joint ventures, a foreign investor will provide the capital while the local owner will provide labor, materials and local management of the operation. There are two types of cooperative joint venture: (1) a legal person or corporate venture, which will pay taxes in its own name; or (2) a non-legal person venture, essentially a partnership, in which each party pays tax in its own name.

A wholly owned foreign entity is very similar to a local subsidiary in the United States that is owned by a foreign parent. A wholly owned foreign entity is taxed as an entity, and payments out of it are subject to a second level of dividend withholding. These are the most commonly used business entities for foreign companies in China and can include manufacturing, service and trading activities. They are relatively easy to form, and a Chinese partner is not required, as they are with an equity joint venture or cooperative joint venture. Ownership of patents and trademarks are considered more secure in a wholly owned foreign entity since there will be no Chinese business partner that may assert greater rights or compromise the security of the intellectual property.

For U.S. tax reporting purposes, regulations regarding entity classification were adopted in the United States in 1997. The default rules for foreign entities provide for corporate treatment of a foreign entity (i.e., no pass-through reporting like a partnership) if all the owners have limited liability. In some cases, a cooperative joint venture can have unincorporated status or specify unlimited liability in its documents, so pass-through status would apply. IRS Form 8832 can be used to make a “check the box” election to override or change the status of the entity to avoid uncertainty regarding tax status.

The corporate tax rate through December 2007 was 30 percent, with a 3 percent surcharge added by local tax authorities. However, many foreign-owned businesses paid a much lower rate due to tax holidays (suspension of taxes for a period of time) and tax rate concessions provided to new companies in China. The reduced rates that were used to attract foreign companies to establish operations in China are no longer seen as necessary, however, and are changing.

Given China’s standing in the global business community, businesses are no longer moving to China solely due to cheaper labor and tax concessions. The government also recognizes that the lower tax rates for foreign investors were creating a significant disadvantage for locally owned businesses.

New Tax Regime
Effective Jan. 1, 2008, the new regime of the Chinese Enterprise Income Tax established a standard corporate tax rate for all businesses at 25 percent on net income (gross income less permitted expenses). Concessions and holidays that were granted to foreign-owned businesses slowly are being phased out through 2012. Lower rates are still in effect for certain industries that the government wants to continue to grow including:

• High technology: 15 percent.
• Agriculture: May be either exempt or 12.5 percent, depending on the crop or activity.
• Low-profit enterprises (industrial enterprises with annual income not exceeding RMB 300,000, fewer than 100 employees, and less than RMB 30 million in assets: or other enterprises with annual income not exceeding RMB 300,000, fewer than 80 employees, and less than RMB 10 million in assets): 20 percent.
• Other preferred industries identified by the government.
• Central and Western China have continued tax rate concessions for encouraged industries.
• Venture capital from outside the country is strongly encouraged by China so regulations still permit significant deductions for investing in new startups.

While foreign-owned businesses will feel the biggest impact of the new 25 percent tax regime, these increases have been expected for some time. For business restructurings, there may be an emphasis on keeping existing structures in place and maintaining lower tax rates that will be grandfathered for the few years until phased out.

There is also a new dividend withholding tax of 10 percent that is applicable to all profits generated after 2007. This may be reduced by treaty to 5 percent. Other passive income also is subject to withholding tax at 10 percent, though treaty reductions may be available as well.

Life for accountants in China will be increasingly complex going forward. Last year, new related-party transaction forms and rules for contemporaneous transfer pricing documentation were issued. Exemptions for small businesses exist, e.g. the documentation rules do not apply to inter-company transactions, such as sales of tangible goods for less than $30 million per year. For now, new startups formed in China by U.S. investors may be able to breathe easy for the short term.

VAT and Business Taxes
In addition to income taxes, there are indirect taxes that apply to businesses in China. A value-added tax of 17 percent applies to imports and sales of tangible goods. However, some exemptions and reduced-rate concessions exist. For example, there is no value-added tax on basic food and necessities. Business taxes of 3 percent to 20 percent apply to certain service industries. A 3 percent rate applies to telecommunications, construction and transportation. A 5 percent rate applies to general services, banking, finance, hotels, restaurants, leasing and advertising. Entertainment—including nightclubs, karaoke bars and golf—can be subject to the higher range of taxes.

Other business-related taxes that may apply include:

• Individual income taxes for U.S. residents working in China.
• Payroll deductions for pensions, unemployment insurance and housing.
• Stamp duties on commercial transactions.
• Real property tax.
• Vehicle, deed taxes.
• Resources tax.
• Land appreciation tax (which is considerable).

Issues Unrelated to Tax System
U.S. enterprises or investors doing business in China need to consider a range of issues unrelated to China’s tax system. An income tax treaty exists between China and the United States, which often reduces the local tax exposure for a U.S. company expanding into China. Withholding taxes on China source dividends, interest and license fees generally impose a 20 percent tax at source, but this rate can be reduced under the U.S.-China Income Tax Treaty.

The U.S. reporting regime in the cross-border arena is getting more complicated each year. The IRS recently announced that it will assess automatic penalties for U.S. companies that file delinquent IRS Form 5471, Information Returns With respect to Foreign Corporations. This report provides detailed information, including the profit and loss and balance sheet of the China-based company. The penalty for a late-filed Form 5471 is $10,000 per year for each company omitted. Other IRS forms that may be required include 8865, 8858, 926, and Treasury Form TDF 90-22.1 to report signature authority or a financial interest in a foreign bank or financial account.

U.S. taxpayers that own or control a foreign corporation must contend with a set of rules—referred to in the Internal Revenue Code as Subpart F provisions—that include IRC secs. 951-960. In many instances, these rules create a deemed dividend of profits generated in a foreign subsidiary even if not remitted to the U.S. parent company.

While inter-company balances, such as receivables and payables, are a common practice with a domestic consolidated group of companies, under the IRC Subpart F provisions, such loans and inter-company balances may create significant U.S. taxes due to these deemed dividend rules. In addition, U.S. companies need to maintain contemporaneous documentation to support transfer pricing between affiliates or face a potential 40 percent penalty on tax assessments under transfer pricing regulations.

These complexities should not restrain anyone from pursuing new business opportunities in China. Such complexities can be handled by the right professionals to avoid the punishing penalties allowing the enterprise to benefit from the China market. However, dealing with the additional complexity should be factored in to one’s budget since the costs of initially setting up business in China can be significant, as multiple entities may be involved in creating a tax efficient structure.

Foreign Holding Structures
Many foreign businesses still conduct business in China through a headquarter company in Hong Kong for both business and tax reasons. Hong Kong has a corporate tax rate ranging from 16 percent for unincorporated businesses to 17.5 percent for corporations. However, the United States still views Hong Kong and China as separate legal jurisdictions. The U.S. treaty with China does not apply to Hong Kong, and there is no U.S.-Hong Kong treaty.
New U.S. venture funds are being formed for acquiring interests in China-based companies, but there is no standard approach. Fundamental questions about investing in China keep coming up, such as:

• What’s the “best” holding structure?
• What rights will the general partner have over local limited partners?;
• Can the fund invest in portfolio-type companies in China and sell their interests without overly burdensome regulation?
• Can the investors (Chinese and foreign) move their profits out of China or will exchange controls force general and limited partners to reinvest into other
• local opportunities? 
• How can one best negotiate with the local authorities and guarantee their friendly support, and will the fund be able to exercise control over portfolio companies? The laws and how to apply the taxes are still evolving in this area.

All of these issues should be addressed and handled in speaking with tax professionals before setting up the new investment structure. Cayman Island limited partnerships are commonly used to acquire interests in new portfolio companies in China. This is because Cayman partnership rules are similar to U.S. rules, and the use of a Cayman holding structure is very common in China. Cayman and British Virgin Island corporations are also used to own the shares in China-based companies because they are relatively easy to set up and maintain, have zero taxes in their own country and Cayman companies can go public on the Hong Kong exchange.

Companies in China considering going public usually want to list on the Hong Kong Exchange. Only companies incorporated in Bermuda, Cayman Islands, China and Hong Kong can list on the Hong Kong exchange. Caution should be exercised when structuring investments offshore.

First, there is no reduction in the dividend withholding tax to 5 percent in tax havens such as the British Virgin Island, Bermuda and the Caymans—as there would be if investing through many other countries or regions, such as Hong Kong, Singapore or Ireland (the U.S. rate also remains at 10 percent).

Second, China’s new tax law does include an anti-avoidance provision, so investing through treaty countries may have its own risks of being subject to the higher withholding taxes particularly if trying to escape capital gains tax by taking advantage of the Mauritius treaty, for example.

Use of entities established in a treaty country, engaging in transactions without a “reasonable commercial purpose” may nevertheless not be granted treaty benefits. This underscores the need for the foreign entity doing business to have a commercially defendable position.

Locally incorporated businesses often will have one or two levels of British Virgin Island companies interposed between the China operating company and the foreign parent even if there is no intention of going public. One reason is to avoid the difficult task of re-registering the ownership company in the event of a sale or merger.
A foreign buyer can more easily acquire the shares of a British Virgin Island company that owns the China subsidiary rather than stock in the China company directly. This can avoid complications in registering the ownership of the China company and possible stamp duty costs.

Local tax advisers in China or Hong Kong always should be consulted whenever a U.S. enterprise forms a new business in China, since effective tax planning can only be implemented when the tax rules in China and the United States—in conjunction with the U.S.-China Income Tax Treaty—are integrated. In this Year of the Ox, coordinated planning is the only way to avoid being gored on either or both sides of the Pacific. 
Brian Rowbotham, CPA is managing partner at Rowbotham & Company LLP. John Lo and Stephen Nelson, partners based respectively in the Hong Kong and Beijing offices of King & Wood, contributed to this report.