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Tax Perspectives

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Please note that these publications may not be up-to-date as taxation matters are subject to frequent changes.


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Fall 2003
Volume 3, Number 3

The information in Tax Perspectives is prepared for general interest only. Every effort has been made to ensure that the contents are accurate. However, professional advice should always be obtained before acting and TSG member firms cannot assume any liability for persons who act on the basis of information contained herein without professional advice.


Setting up in China

By P.Y. Ng, ACCA
Thomas Lee & Partners (Hong Kong)

Following China's entry into the World Trade Organization (WTO) in 2001, China has continued to be a major market for the inflow of foreign capital. Foreign investors wish to tap the relatively low cost of labour and resources and sometimes the huge domestic market.

In this brief article, I shall provide a basic overview of the business structures in China and the taxation system governing the operations of these entities.

Nationwide Investment Policy

In order to encourage the earning of foreign currency and modernization, China has classified industries as "Encouraged," "Restricted," "Prohibited" and "Permitted."

The wholesale and retail of general commodities fall into the "Encouraged" category. However, the wholesale and retail of certain special products (e.g., agricultural products including tobacco, chemical fertilizers, pesticides, etc.,) is classified as "Restricted" and will not be open to foreign investors until a future date. Certain activities are "Prohibited" and are not open to foreign investors despite the accession of China to the WTO. These include the newspaper, broadcasting and film industries.

Foreign investors should take into consideration the investment priorities of the Chinese government, and match them with their own investment strategies in China.

Fewer restrictions are placed on the establishment of joint ventures than on wholly foreign-owned enterprises because of local involvement and less stringent approval requirements. More favourable tax incentives are placed on the "Encouraged" category. On balance, projects that introduce new technology, and those that are export-oriented, are most likely to receive approval and tax incentives.

Form of Legal Entities in the PRC for New Business

There are various forms of legal entities that may be established in the PRC, as follows:

1. Equity Joint Venture (EJV)

An EJV is a separate legal entity, and takes the form of a limited liability company registered in China. The parties have joint management of the company, and the profits and losses are distributed according to the ratio of each partner's capital contribution. However, the foreign participant is not able to recover the original investment until the termination of the joint venture.

The EJV also brings together the respective skills and technologies of each party. The participants share profits, risks, and losses in proportion to their respective contributions to the registered capital of the EJV. The capital subscribed by the foreign investors should not be less than 25% of the registered capital.

All EJV's are governed by Law on Joint Ventures using Chinese and Foreign Investment, which was promulgated in 1979 and amended in 1990. There are also a number of other laws and regulations that affect the joint venture's operations relating to such matters as taxation, employment and foreign exchange.

2. Cooperative Joint Venture (CJV)

A CJV may operate under a structure similar to that of a western-style partnership, or the parties to the venture may apply for approval to have the company structured as a separate legal entity with limited liability. For a CJV that has obtained legal entity status, the investment contributed by foreign investors should not be less than 25% of the registered capital. The profit and loss distribution ratio is defined in the contract and may vary over the contract term, unlike the Equity Joint Venture above.

The foreign investor in a CJV may repatriate his original investment prior to the expiration of the joint venture. This kind of partnership structure is less often used than an EJV.

All CJV's are governed by the Law on Sino-Foreign Cooperative Enterprises that was promulgated in 1988.

3. Wholly Foreign-Owned Enterprise (WFOE)

A WFOE is established exclusively with the foreign investor's capital. It is similar to a corporation with share capital and incorporation documents. It may be wholly owned by foreign investors.

All WFOE's are governed by the Law on Sole Foreign Investment Enterprises that was promulgated in 1986 and amended in 2000.

4. Representative Offices

Foreign enterprises are permitted to open representative offices in China (i.e., branches). Legally, these are to be established purely for liaison purposes, and their activities are limited to the provision of services that do not give rise to earnings. The permissible activities of representative offices include the following:

  • Investigating and collecting market information;
  • Providing introductory services to potential buyers and sellers;
  • Assisting in making arrangements for trade visits to China;
  • Coordinating with the parent company and other associate companies or affiliates.

Such a representative office is exempt from business tax and enterprise income tax, but a representative office of a foreign company is technically not permitted to perform profit-making activities. Any other services performed beyond the approved scope of a representative office's business will render it subject to business tax and enterprise income tax on an actual or deemed income basis.

Choice of Location

Foreign investors must be sensitive in the choice of location for the enterprise. Tax incentives vary by location, which may greatly favour one place over another.

Post Approval Requirement for Setting Up

After getting the approval to set up, the entity must apply for the registration with the Administration of Industries & Commerce to establish its legal existence. Other procedural matters such as tax registration, customs registration and financial registration have to be completed within a reasonable time before the entity may become operational.

Capital Injection

The law does not set out the minimum registered capital of EJV's and WFOE's. However, the minimum capital should also take into account the operating capital requirement of the proposed business investment since borrowing locally is restricted. For an investment below US$3 million, the registered capital should be at least 70% of the total investment. In addition, the capital requirement will be higher in Special Economic Zones because of the various tax incentives offered.

No less than 15% of the registered capital must be contributed within three months of the issuance of the business licence and the rest should be made within three years.

China Tax Regime for Foreign Investment Enterprise (FIE)

All FIE's (including EJV's and WFOE's) are subject to various PRC taxes such as Foreign Enterprises Income Tax ("FEIT"), Business Tax, Value-Added Tax ("VAT"), Customs Duty, etc. FIE's of different forms are nevertheless all taxed in the same way.

Apart from the above taxes, FIE's may also be subject to other local taxes and charges.

Customs Duty

Import tariffs vary, depending on the existence of preferential tariff arrangements between the PRC and the country of origin, and the nature of the goods. The average import duty rate was around 12% in the year 2002.

Business Tax

Business tax is imposed on various types of services as well as the transfer of intangible assets and immovable properties in the PRC. Transportation, construction, telecommunication, cultural and sports industries are taxed at 3%. Entertainment services are taxed at rates from 5% to 20%. Banking, insurance, leasing, hotels and tourism, the transfer of intangible assets and immovable properties, and other service sectors are taxed at 5%. Business tax is usually paid by the user of the service, and, unlike the VAT, is not refundable to businesses.

Value-Added Tax

VAT is imposed on the supply of goods, the provision of certain services, and on imports into the PRC. VAT is charged at the standard rate of 17% of the taxable value, which is reduced to 13% for certain necessary goods and special equipment. In addition, there are certain tax exemptions and zero-rated supplies. VAT payable on the purchase of goods ("input VAT") is deductible from the VAT payable on sales. Input VAT may be refunded on export of goods.

Income Tax

FIE's are subject to income tax on their worldwide income. The standard tax rate is 33% (30% national tax and 3% local tax). However, FIE's may enjoy reduced tax rates of 15% to 24%, depending on their business location, industry, registered capital and term of operation. They may also enjoy a period of tax-exempt status or payment at half rates. The table below summarizes the incentives.

Individual Income Tax (IIT)

The employment income of both Chinese and foreign employees in China are subject to tax at progressive rates from 5% to 45%. The individual income tax is calculated month-by-month and is determined by the residence status and the length of stay in the PRC. The employer is required to withhold and pay tax on behalf of its employees. Foreign persons working in the PRC for less than five years may obtain an exemption on non-Chinese source income.

Conclusion

An understanding of Chinese government investment policy and the China tax regime is important to the effective establishment of a business in the PRC. Foreign investors should keep abreast of the latest developments in Chinese investment policy and taxation, and obtain professional advice before beginning the process of establishing a PRC business.