End of 2010 – Time to Upgrade Your RO to a WFOE

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Op-Ed Commentary: Chris Devonshire-Ellis and Rosario DiMaggio

Dec. 13 – As we approach the end of 2010, annual audits loom for all foreign invested enterprises in China. The State Administration of Taxation employs a fiscal year to denote reporting requirements, and this then makes it an excellent time to consider the future of your business if still using a representative office in China.

China’s State Council recently issued new regulations to “strengthen” the administration of resident representative offices (ROs) of foreign enterprises in China. The new regulations require ROs of foreign enterprises to provide audited accounting information on a regular basis, prohibit them from conducting profit activities, and specify the relative penalties for foreign enterprises that violate the rules. As we previously advised in March, tax structuring of ROs has also changed, with ROs now being liable for deemed profit rates of 15 percent. These regulations affect foreign investors setting up representative offices in China, as well as ROs already established on the mainland as they touch on the establishment, management, permitted activities and staffing of ROs.

The main changes as affect existing representative offices are as follows:

Representative offices cannot employ in excess of four foreign staff, including the chief representative.

From this year onwards, representative offices will not be permitted to apply for tax exemption as has occasionally been the case in the past. Additionally, the SAT increased the “deemed profit tax rate” from a fixed 10 percent to a variable 15 percent to 30 percent. This has increased the amount of tax liabilities ROs usually have to pay on the sum of their costs from an average of 8.7 percent to a new minimum rate of 11 percent, depending on the specific case. Additionally, this new variable rate is determinable by the tax bureau and not by the RO, meaning that ROs are potentially at risk of the tax authorities increasing their deemed profit tax rate without prior notice. Although this is dependent upon a number of variant factors on a case by case basis, it is very likely that under the new conditions, an RO with more than 8 to 10 employees involved in quality control and/or market research is now paying more taxes then a service WFOE or a FICE involved in the same activities.

RO operations
It should be remembered that representative offices may also not engage in any profitable activities. This has been rather loosely monitored by the government in the past, however over the course of this year, ROs are being increasingly monitored for trading activities. If you are using your RO illegally for trading purposes, you will get caught. Punishment, which includes the serious category of tax evasion, can be severe. The China tax bureau has the power to fine up to five times any amount due, plus additional penalties for non-compliance. Foreign chief representatives should be aware that amounts due in excess of RMB10,000 in China can be classified as a criminal offense, and be subject to jail time if sufficiently serious or should fines be unpaid. The current regulatory climate in China towards foreign investors also dictates that this is not a time to be playing with the prospect of being hit with fines or jail time. It is the time to be considering getting out of such possibilities by getting into compliance.

The new guidelines for what ROs can actually do come into effect on March 1, 2011. The “Regulations on the Administration of Registration of Resident Representative Offices of Foreign Enterprises” were issued this year on November 19, and state:

“The RO cannot engage in any profit activities except for those activities which China has agreed on in international agreements or treaties. The activities ROs can be involved in include market research, display and publicity activities that relate to company products or services, contact activities that relate to company product or service sales, domestic procurement and investment. ROs will have to pay an RMB50,000 to RMB200,000 penalty for profit activity involvement, and RMB10,000 to RMB100,000 for exceeding the activity scope mentioned above.”

The new regulations reveal special concern over the degree of business undertaken by ROs as well as their valid financial records. They call for the availability of RO accounting books and forbid ROs from using the accounts of other enterprises, organizations or individuals.

If you require your China operations to directly buy and sell, have its own import/export license, and legitimately trade in China – you will need to change your current RO structure to that of a foreign invested commercial enterprise (FICE) or wholly foreign owned enterprise (WFOE) in order not to fall foul of these new regulations concerning the use of an RO.

Why change now?
There are five main reasons:

  1. China is clamping down on the use of ROs for trading activities and has issued directives effectively banning this
  2. ROs are now more expensive to operate than a FICE or WFOE
  3. The alternative structures of FICE and WFOE are now relatively inexpensive to set up
  4. To close an RO requires an audit. It is the end of 2010 and ROs have to submit audits for this year’s activities in any event. You can use your annual audit as the base for your RO closure and move to a FICE/WFOE structure without the need to go through a second audit for closure
  5. FICE and WFOE also have tax advantages, especially as concerns the ability to reclaim and offset VAT, and book profits/losses, which ROs are not able to do

What do I need to do?
There are two procedures to carry out, which can be handled concurrently. First of all, the existing RO needs to go through its annual audit. This is a statutory obligation and you must go through this process. Audits need to be submitted by the end of March (sometimes an extension can be granted). At this juncture, the RO needs to settle up all taxes and all liabilities assessed. This can be carried out not just for the statutory requirement, but also with a view to closing the RO. Such closures also require an audit to be submitted as part of the closure process, using the annual audit to do this means you don’t have to be audited twice. The full closure procedure may take some time (up to 12 months) to complete, however, acceptance by the government of the closure audit then triggers the termination of the RO license, closure of bank accounts and so on, which then releases the foreign investor from ongoing tax and operational liabilities for the RO. This procedure can usually be enacted within three to four months from start to finish. It means it is effectively possible to get out of your RO structure and liabilities by April 2011 if you act now.

Concurrently with this, a new structure needs to be put in place. Whether this is a FICE or a WFOE depends upon the nature of the business activities, and whether you wish to expand them beyond the previous activities of the original RO structure.

Use of foreign invested commercial enterprises (FICE)
These are typically used for the following business activities:

  • Import-export and distribution
  • Retailing: selling goods and related services to individuals from a fixed location, in addition to TV, telephone, mail order, internet and vending machines,
  • Wholesaling: selling goods and related services to companies and industry, trade or other organizations
  • Agencies, brokerages: representative transactions on the basis of provisions
  • Franchising

Use of wholly foreign owned enterprises (WFOE) in the services industry

  • Consulting, other professional services
  • Quality control, after sales services, product design, technical support, sampling (although minimum amount permitted)

It should be noted that some industries are off limits (such as publishing) and others may require additional licenses to fully complete your administrative obligations. In certain circumstances, both a FICE or a service WFOE may be suitable; your advisors will be able to advise you on the differences between the two as applicable to your specific situation.

WFOEs may also be used for manufacturing. In which case, what is now an RO may be upgraded to a fully-fledged manufacturing unit, lessening dependence upon Chinese suppliers and placing the entire manufacturing and sales operations under your control. Registered capital requirements are higher for manufacturing WFOEs than for services WFOEs, but may provide an option for some RO operations wishing to take advantage of the ability to sell directly to the China market. The trend is there – China is moving to a more consumer based economy and the government is committed to providing cheap credit and loans to domestic consumers to ensure this happens. Aside from services, the sale of products to the newly created class of Chinese domestic consumers is now very much a growth area and foreign investors should consider enhancing what is now an RO into either a FICE, a service WFOE, or a fully-fledged manufacturing and sales WFOE. The choices are all there.

Your legal advisor will be able to advise on the suitable structure for you depending upon your specific needs. Your business strategy – what you want to accomplish – should determine the business structure.

It should be noted that the establishment of both a FICE and a WFOE are rather more complex than an RO, and should not be treated (as many consultants regrettably do) as pure licensing applications. As most FICE/WFOE will be involved in trade of some sort, considerations over VAT, customs and other issues that can affect the financial obligations of the business must be taken into consideration. These will add more to the legally required “minimum registered capital” and should be worked out in advance in order for you to both plan your business financing properly and to make it as tax efficient as possible. However, the minimum registered capital requirements are far less than they used to be. Essentially what now needs to be injected is the operational working capital – something that should be easy to evaluate for ROs that have already been operational. Upgrading from an RO to a FICE/WFOE in any event is a procedure of increasing operational efficiency, attention to detail should also be taken when structuring the new corporation to maximize financial and tax effectiveness upon the regulatory need to upgrade.

The structuring and application of the new FICE/WFOE can be combined at the same time as the RO closure. Staff and other assets may then be moved over to the new structure – possibly without even having to leave your premises (although a new lease in the name of the new company will need to be arranged). For other ROs, moving to a more appropriate FICE/WFOE structure provides a new lease of life to your China operations, as it permits legitimate trading, is now less expensive to run, and gives options over the accessibility of a vastly superior scope of business activities.

Dezan Shira & Associates are a one stop shop when it comes to the closure of representative offices and the incorporation of suitable FICE/WFOE replacement structures. The practice maintains 10 offices throughout China and can assist with annual audit and closure audit procedures, in addition to the legal and tax structuring of FICE and WFOEs. Please contact the firm at info@dezshira.com, visit the practice at www.dezshira.com or download the firm’s brochure here.

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