For multinational corporations operating in China, repatriating cash from their subsidiaries has always been an important but challenging issue.
China maintains a strict system of foreign exchange controls, meaning funds flowing into and out of China are tightly regulated. Laws and regulations – such as the Company Law, relevant tax regulations, as well as China’s transfer pricing rules – impose additional barriers to profit repatriation. In this environment, businesspeople need to understand and incorporate a profit repatriation strategy from the very beginning to ensure access to the profits earned.
There are several ways to repatriate profits from China:
- The most common is for the company’s China-based entity to pay dividends directly to its foreign parent company. However, this is subject to certain prerequisites; or
- As an alternative, many multinational corporations use intercompany payments, such as service fees or royalties, to remit cash from China; or
- Other Chinese subsidiaries remit undistributed profits by extending a loan to a foreign related company with which it has an equity relationship.
Below, we introduce and analyze the pros and cons of each method to provide investor some initial references for their planning.
Remitting profits as dividends
Remitting profits as dividends is the most direct and common way to distribute profits. However, this is subject to certain prerequisites:
- A FIE can only repatriate profit after its registered capital has been injected within the time limits as set out in the company’s Article of Association;
- An FIE can only repatriate profit once a year after the annual audit and tax compliance process. This is to ensure a 25 percent CIT had been paid up with regard to the profit to be distributed;
- No profits can be distributed before the losses accumulated in the previous years have been made up. The FIE can only distribute dividends out of its accumulated profits, the accumulated losses from the previous year must be more than offset by the profits;
- Not all profits can be repatriated after tax clearance. For example, companies have to place 10 percent of their annual after-tax profits into a mandatory surplus reserve fund until it reaches 50 percent of the company’s registered capital. Besides, the investors usually allocate a portion of after-tax profits to the staff welfare and incentives fund, though these are not mandatorily required; and
- The dividend is subject to additional 10 percent withholding CIT when repatriating to foreign investors, with limited exceptions. If a double tax treaty (DTA) is available, and the parent company qualifies as the beneficial owner, a preferential withholding CIT rate of five percent or even lower may apply. And if non-resident enterprises decided to re-invest the dividends derived from FIEs into projects not prohibited by the country, the withholding CIT on this part of the dividends can enjoy deferral treatments by fulfilling certain conditions.
In the below table, we provide an example to demonstrate the tax implication and reserve requirements of repatriating profits by dividends.
|Tax Implication and Reserve Requirements on Dividends|
|CIT||(2) = (1) ×25%||25.00|
|Net profit||(3) = (1)-(2)||75.00|
|Mandatory surplus reserves||(4) = (3) ×10 %||7.50|
|Maximum dividend||(5) = (3)-(4)||67.50|
|Withholding CIT||(6) = (5) ×10 %||6.75|
|Net Payment||(7) = (5)-(6)||60.75|
*Suppose there is no accumulated losses, and other pre-tax deductible items
Paying intercompany fees to foreign investors
Many multinational firms repatriate profit from China through intercompany payments when faced with the requirements of remitting dividends. Often, they attempt to achieve this by charging for supporting services (such as human resources, information technology, or financing) or intangible assets (such as trademark, patent, or know-how) provided to Chinese affiliates.
In comparison with remitting dividends directly, profit repatriation through intercompany payments has some advantages for some investors.
- Intercompany payments are often an easy way to repatriate profits due to less prerequisites. For example, the FIE can make intercompany payments without going through the annual audit and tax compliance process.;
- The company can make intercompany payments when needed, rather than once per year for dividend remittance; and
- Remitting money through intercompany payments are more tax efficient as well. Although the intercompany transactions are subject to turnover taxes and possible withholding CIT, these intercompany payments can be deducted from the CIT taxable income by fulfilling certain requirements.
Despite these many advantages, profit repatriation through intercompany payments bears more risk for tax investigation. Tax authorities put special scrutiny on intercompany service fees and royalties paid by Chinese enterprises to the overseas related parties, because they regard the practice as a tool for avoiding tax and shifting profits.
The anti-avoidance rule empowers Chinese tax authorities to make reasonable adjustments where an enterprise implements an arrangement without reasonable business purposes to reduce its taxable income or profit.
According to the CIT Implementation Guidelines, “an arrangement without reasonable business purpose” refers to an arrangement which has the main purpose of obtaining tax benefits such as the reduction, elimination, or deferral of tax payments.
The Implementation Measures for Special Tax Adjustments (for Trial Implementation) (Guo Shui Fa  No.2) provided a stronger regulatory basis for disregarding a special purpose vehicle (SPV) that lacked economic substance.
The areas specified for anti-avoidance investigation include:
- Abusing tax treaties;
- Avoiding tax via tax havens;
- Abusing corporate organizational structures; and
- Other arrangements without reasonable business purposes.
Instead of having a single defining factor, the STA Announcement  listed out a number of elements that may contribute to the transaction having a reasonable commercial purpose. These factors are:
- Whether the main value of equity in the foreign entity is made up of taxable assets in China;
- Whether the assets of the foreign entity are mainly comprised of investments in China, or whether its income is mainly sourced from China;
- Whether the corporate structure has economic substance, from the point of the functions the foreign company is performing, and the risk it is bearing - this is commonly assessed by looking at the related companies’ equity structure, assets, staff arrangements, income, and other operational information;
- The length of time the foreign company’s business model, shareholders, and organizational structure have been in existence - tax authorities will look for “traces of a plan” to avoid tax by indirect transfer, such as an intermediary company being set up shortly before the indirect transfer, which would be a clear red flag that the investor is trying to evade tax by using foreign corporate structures;
- Whether foreign tax is being paid on the transaction - the tax authority will assess whether the transaction is resulting in cross-border tax advantages by looking at both the party transferring and the party receiving the shares. If the tax burden is less than what would have been paid in China, this will get flagged by tax authorities;
- Whether the transaction could have been substituted by a direct transfer - the tax authorities will consider a variety of matters to determine whether not transferring assets directly serves a reasonable business purpose, such as market access, the need for a review of the transaction, compliance requirements for the transaction, and the goal of the transaction;
- Whether China has a DTA with the states in question, or other tax reducing arrangements relevant to the case; and
- Other matters deemed relevant.