China WFOEs: It’s Not Standard Law, It’s Getting the Finance and Tax Right

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By Chris Devonshire-Ellis and Richard Hoffmann

Oct. 22 – One of the frustrating issues about advising corporate clients in China is how many of them, prior to seeing our firm, are so often badly advised on the China establishment procedures. Far too often, assumptions are taken that setting up a wholly foreign-owned enterprise (WFOE), for example, is a standard application procedure. We’ve even seen “cookie-cutter” models used both by lower end firms and even China government investment departments keen on making it as easy as possible (for them) to secure your consulting fees and investment dollars.

The truth is that setting up a WFOE properly is not an easy, standard procedure at all. The legal administration aspects of the process are relatively straightforward, however the real trick with WFOEs, and one that requires actual on-the-ground China experience in both law and tax, is getting the financing right and the tax planning in place. In this regard, all WFOEs are different, and all require specific attention to detail to get right. Otherwise, serious post-incorporation problems can arise that can affect the very credibility of the business operations and, at the very least, cost you considerably in wasted monies and additional financing. In short, structuring a WFOE in China is less of a legal issue and far more of a tax and finance issue. In this article we provide details of some of the common mistakes that are made when adopting a “standard cookie cutter” approach to a WFOE application.

Pre-incorporation for foreign-invested enterprises: Faulty license applications and tax structuring problems
The scenarios and problems below apply to wholly foreign-owned enterprises, foreign-invested commercial enterprises and joint ventures, but for sake of convenience we have used the term foreign-invested enterprise (FIE) to cater for all.

Sending start-up funds to somebody else before FIE is ready
It takes normally four to six months to complete the FIE application, however, some foreign investors can’t wait that long and try to send the start-up funds to their local agent or local staff to cover the cost for the initial office fit-out, overhead or even equipment purchases. The problem is that these funds, as paid for the FIE setup, cannot be recognized as part of your capital injection once the business license is issued, as the capital injection has to be transferred by the foreign investor from their overseas account to the nominated capital account directly, and not via any third party.

We have previously had clients remitting up to US$200,000 to their local supplier asking them to pay for rental and purchase equipment prior to the license being issued, with them subsequently finding it very difficult for them to pursue the balance and show such purchases as part of their capital injection. Rather, it is better to open a temporary capital account right after the name registration is completed. Here’s the deal if you don’t handle this properly – the Chinese tax department will assume it is earned income and it will be subject to income tax of 25 percent.  That is a very expensive way to fund a business.

Registered capital issues: undercapitalization
One of the most common, and most serious, problems with FIE applications, especially for small businesses, is the issue over registered capital. This is a much misunderstood area. Confusion exists, and many ill-advised investments are made in China due to misinterpretation of the local governments term “minimum registered capital.” This is not supposed to be a ruling on how much you need to invest. Actually, the amount of registered capital needed in the business depends on a number of different factors.

Location – Some regions in China apply different levels of capital requirements than others to reflect their lower or higher regional operational costs.

Scope of business – For certain industries or services, the applicable registered capital amount can be quite high. This is sometimes used as a protectionist tool to discourage foreign investment, and is sometimes used to ensure that only the right standard of international business can enter the market to ensure the quality of the applicant. Note that if some existing businesses wish to expand their current scope of business, it may be required to increase the amount of registered capital.

Cash flow – This is critical and often overlooked. Registered capital is also required to fund business operations until it is in a position to fund itself. Generally speaking this should be catered for in the feasibility report – a business plan type document that is submitted to the authorities as part of the application process. In the rush to attract new investments many government agents do not pay much attention to details of this report. Often the happy foreign investor will naively assume he’s gotten a great deal due to “minimum amounts” being identified as all that is required. However, the business can come to a shuddering halt if the registered capital amount is insufficient to support the operations cash flow. It is also not just a simple matter of wiring additional funds to China.

The procedures to be followed include:

  • Application to increase the registered capital with the original licensing authority
  • Application to the State Administration of Foreign Exchange to transfer funds into China bank to fund transfer
  • Capital verification
  • Reissuing of business license reflecting above; this is important as the registered capital amount is also the limited liability status of the business

These steps take between six to eight weeks to fulfill. If you have already run out of operational money, you by now have not paid your staff, your suppliers, and possibly your utilities for two months. In effect, your business has been throttled before it even had a chance to breathe. It is vital you properly capitalize your business in China in accordance not just with government guidelines over “minimum registered capital,” but also with regards to pure economic and operational realities.

Businesses can and do go broke in China because of this issue, and unscrupulous consultants may not always advise on the matter as they seek to gain more fees from you in terms of sorting the problems out when they arrive, or because they are just in the business to make a quick buck out of handling your registration processes without putting any thought into the business aspects of your operations.

The catch here is that if you do run out of cash flow due to undercapitalization, you can wire money to the businesses capital account. In doing so, China’s tax bureau will regard this as taxable income, meaning you incur an additional tax bill purely for refinancing your business. It’s an obvious waste. Calculating the required registered capital properly in advance will save a lot of headaches and an unnecessary loss of capital later on.

Lower registered capital amounts affecting VAT general taxpayer status
Many people are aware that the MOC has reduced the minimum registered capital amounts to establish WFOEs and FICEs. However, adhering to the “minimum registered capital” amount figure can cause additional problems when applying for VAT general taxpayer status.

The benefits of having general VAT payer status is that it gives the VAT payer the right to issue VAT receipts to their clients, which allows them to deduct the input VAT from purchases when it pays output VAT for sales.

For the FICE or WFOEs who deal with clients that need VAT receipts – such as industry-related producers – they normally will require VAT general taxpayer status. If the FICE is only engaged in trading consumable products to individual customers, this is probably not necessary.

In March, the State Administration of Taxation issued a notice stipulating that if VAT taxpayers’ annual taxable sales pass the level of the small-scale taxpayer set by the Ministry of Finance, they shall apply to the tax authorities for the general taxpayer qualification.

That threshold has been set at RMB500,000 for enterprises engaged in the production of goods or the provision of taxable services and RMB800,000 for enterprises engaged in wholesaling or retailing.

Tax authorities will approve the general taxpayer qualification for taxpayers who have fixed production or operation sites, comply with the standard national accounting regulations, and can provide accurate complete tax records. It should be noted that over the past year, the authorities have been very lenient in the granting of VAT general taxpayer status to companies that do not quite meet the requirements listed above.

The application documents for VAT general taxpayer status are as follows:

  • Written application
  • Established contract and property rental agreement
  • General taxpayer certificate
  • Identification of the legal representative and accounting staff and accounting certificate
  • A photograph of the person who purchases the invoice
  • Temporary/formal confirmation for general taxpayer
  • Other relevant documents and information as required by the local tax authorities
  • Annual financial record

As all FICE are related to trading, usually a FICE needs to apply for VAT general tax payer status for the purpose of a deduction of input VAT.

Certain trading WFOEs also need to bear this figure in mind. Without attention to detail here, especially with agents and consultants with no tax experience, it can cause cash flow problems to the company.

Accordingly, the issue of VAT general payer status needs to be dealt with as a pre-incorporation issue, and the financial implications of this thoroughly understood. The VAT issue must be taken into consideration prior to incorporation.

Maintaining currency consistencies in the articles and business license
When applying for your business license, it is important to pay attention to detail when completing the application and cross-referencing this against the articles. If, for example, the capital amount to be registered on their business license is shown in RMB, it can cause issues if the AOA identifies this amount in euros or U.S. dollars.

Consequently, if the exchange rate fluctuates, the injection verified by the local CPA firm as is required to prove the registered capital transfer, may no longer match the figures on the business license. The registered capital converted into RMB may be less than their promised capital amount. So, the client has to transfer again, bearing the uncovered missing amount caused by currency fluctuations into their capital bank account. They also have to complete another capital verification, which is an annoyance and wastes the investor’s money and time.

Keeping the legal and operational address of the FIE the same
Many smaller consultants and agents in China may advise investors that it is permissible for the FIE to register in one location (in a small office building for example), but then have its manufacturing facility setup in a different location (rural country side). This may be to take advantage of better profits, tax rates or other incentives in the office location area, yet effectively operate from a different location. If so, this does cause trouble for post-registration procedures such as environmental appraisal and VAT application.

This point is often missed by consulting firms and certain lawyers who do not provide post-registration work. It can have serious effects on the client and possibly make their business unworkable.

Important tax issues that are commonly misjudged
VAT treatment
There are many common misconceptions as concerns to VAT exemption on exports. If the refund rate is lower than the levy rate, the company must bear the additional VAT cost on exportation.

The VAT rate for general taxpayers is generally 17 percent, or 13 percent for some goods (see table).

For taxpayers who deal in goods or provide taxable services with different tax rates, the sale amounts for the different tax rates shall be accounted for separately. If this is not done, the higher tax rate shall apply
The VAT cost is calculated as follows:

VAT general taxpayers
The VAT payable shall be the balance of output tax for the period, after deducting the input tax for the period. The formula required:

VAT payable = output VAT – input VAT

Output VAT is calculated based on the value of the taxpayer’s sales, namely Output VAT = A × B, where A = sales value and B = tax rate

VAT small scale taxpayers
As we mentioned earlier, the sales threshold for small scale taxpayers is RMB500,000 for enterprises engaged primarily in the production of goods or the provision of taxable services; RMB800,000 for enterprises engaged in the wholesaling or retailing of goods (it was reduced in 2009 from RMB1 million and RMB1.8 million respectively).

Non-enterprise units and entities that normally do not engage in taxable activities were given the choice whether or not they are taxed as small-scale taxpayers while individual (natural person) taxpayers with business turnover exceeding the threshold shall continue to be taxed as small-scale taxpayers. The current VAT rate for small scale taxpayers is 3 percent.

Such taxpayers cannot deduct input VAT, so the formula is as follows:

VAT payable = sales value × tax rate (3 percent)

For the sale of goods or taxable services, VAT is incurred on the date when the sales sum is received, or documented evidence of the right to collect the sales sum is obtained. For imported goods, it is incurred on the date of import declaration.

VAT on imported goods is collected by China Customs on behalf of the tax authorities.

VAT on articles for personal use brought or mailed into China by individuals is levied at the same time as customs duty. The takeaway point from all this is that you need to ensure, during the application procedure, which VAT payer status you are going to fall into. It affects whether you are subject to 13 percent or 17 percent and also whether or not you need to lodge a deposit with customs.

Customs deposit on imported raw materials to be subsequently exported
We often hear the misconceived statement: “There is no VAT and custom duty levied on imported raw materials used for manufacturing goods locally if these are then finally exported 100 percent.” It is incorrect. Actually, newly established foreign-invested enterprises must still make a tax deposit to the Administration of Customs for VAT (at around 17 percent) and remit duty on the initial importation, generally for a period of six months.

Many new businesses do not budget for this as initial working capital to be contributed as part of registered capital, leaving them short of operating cash later on.
Enhanced profits repatriation: reducing taxes in your business
This is a tax issue, and applies to all FIEs that sell services or products in China. Foreign-invested enterprises, as mentioned earlier, are not just simple licensing applications and, if you treat them as such, you end up with an inefficient business.

A company can significantly enhance profitability by reducing profits tax burden by essentially making sure to introduce into the business a series of allowable service contracts between the FIE and its parent company back home. These services can include:

  • Royalties such as for trademark and patent use
  • Interest on loans
  • Rental income

Royalties, interests and rental income rendered to the FIE in China generally attracts a withholding tax at a rate of 10 percent. That means, if the income derived from above mentioned activity is US$1,000, a foreign-invested enterprise located in China will withhold US$100 income tax.

This compares favorably against the profits tax authorities at the yearend, who can be more avaricious. If the money is left in the company, the profits tax authorities will levy rates of 25 percent corporate income tax.

To take advantage of this, an enhanced profits repatriation structure needs to be built into the FIE articles and inserted (they do not appear in normal drafts), and a series of contracts agreed between the parent and the foreign-invested enterprise, and registered with the tax authorities in China for assessment.

Other post-registration procedures
The paperwork does not stop there. You still have quite a bit to do before you have a fully functioning FIE. This additional work consists of:

  • Approval for making chops by Public Security Bureau
  • Enterprise code registration with the Technical Supervision Bureau
  • Office inspection by the tax bureau
  • Tax registration
  • Opening an RMB bank account
  • Customs registration for import-export license
  • Commodity inspection with Commodity Inspection Bureau
  • Registration with the State Administration of Foreign Exchange
  • Opening foreign capital bank account
  • Injection of capital and capital verification report
  • Renewal of business license by SAIC after capital has been injected
  • Financial registration
  • Statistics registration
  • Application for general tax payer status

Note that many consultants and law firms do not regard post registration procedures as part of their scope of work when processing clients’ applications, so either shop around for a firm that does or ensure you have this vital component catered for elsewhere. Not following through correctly on these procedures can lead you to non-compliance and government penalties later on.

As can be seen, tax and finance are therefore an important part of any application for a WFOE in China. Other aspects can also crop up, such as location issues, use of free trade zones, bonded warehouses, labor law, and we haven’t even begun to discuss the articles of association yet. China also has numerous double tax treaties in place with an increasing number of countries that may also impact favorably on WFOE tax planning, while subjects such as holding company structuring should also be considered as part of the tax aspect. Inter-company aspects such as reducing profits tax in China through structuring royalty agreements and so on should also be considered. The provision of simple applications or standard documentation for WFOE applications is not going to be enough when wanting to professionally establish a business capable of operating to its complete financial potential in China. Attention to detail must be paid to finance and tax, and ignoring or discounting the importance of these issues leaves the investor with a crippled corporation.

Chris Devonshire-Ellis is the principal of Dezan Shira & Associates, Richard Hoffmann is a senior legal associate with the firm. The practice have been operational in China since 1992 and provide legal administration, establishment and tax planning services, in addition to ongoing compliance and maintenance issues with customs, tax and labor law to investors in the China market. The firm has 10 China offices. Please visit firm’s web site, e-mail the firm for advice on China WFOE structuring at, or download the firm’s brochure here.

Chris also contributes to the Asia Briefing publications India Briefing, Vietnam Briefing, and

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