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Taxation Planning and Profit Repatriation in China
Five China success factors – taxation planning, inter-company agreements and how to repatriate profits from China.
A number of foreign companies make excellent business and are very profitable in China. However, often these companies report that they have challenges and problems with the Chinese taxation regime and issues in repatriating China-made profits to their home countries. China experienced companies have solved their tax optimization and profit repatriating issues using a variety of legal ways. Here we look at some of these key methods of making profit repatriation easy and in-line with global tax optimization practises and OECD rules of profit erosion and double taxation restrictions.
Experience has shown three levels of taxation planning and profit repatriation approach which are both flexible and tax effective presented below.
One – Conventional Methods of Profit Repatriation as Dividends
For foreign investors repatriating profits from China can be complicated and challenging issue in the event of pre-planning for profit repatriation has been neglected upon incorporating phase of the foreign invested company.
China practises very strict system of foreign exchange control and the flow of capital out is tightly controlled by authorities but a number of ways exist which foreign investors may choose to be built into their own business structures, taxation planning and profit repatriation plans.
For a foreign company operating in China, the most used method for profit repatriation is to pay dividends from the China company directly to its foreign parent company. However, this conventional profit repatriation method is subject to certain restrictions. Investors are well advised to understand Chinese taxation and foreign exchange regime and incorporate additional profit repatriation strategies into incorporation stages and document preparation to ensure access to the profits earned.
Foreign investors should note that China established companies are only allowed to repatriate profits as dividends after its registered capital has been fully contributed. In China, accounting year is always a calendar year and companies can repatriate profit only once a year after the annual audit, tax compliance process and proof of proper tax payments.
According to Chinese taxation regime, corporate losses incurring in a tax year are deductible from income before tax and can be carried forward up to five years, but losses must be recovered before any profit distribution. Therefore, profits are not allowed to be distributed before all earlier losses accumulated in the previous years have been fully recovered. Profitability of China operation is subject to success of the market entry and often a few operative years are running on a loss. Therefore, regulations requiring losses to be covered often delay all money remittances from China to home countries.
In addition, foreign investors should note that not all profits can be repatriated even after-tax clearances since foreign companies are required to place certain percentages of annual after-tax profits into mandatory surplus reserve funds until it reaches 50 percent of the registered capital. Foreign companies are also required to allocate a portion of after-tax profits to the staff welfare and incentives funds as ruled at localities.
Two – Profit Repatriation Using Inter-Company Agreements
Foreign investors may use a variety of taxation planning methods and Inter-Company Agreements to repatriate profits from China as an alternative of conventional dividend payment method.
Companies are allowed to charge China establishment business entity inter-company payments in forms of technology transfer, training, service fees and royalties to receive funds from China or remit undistributed profits in forms of loans to a foreign equity related company with which it has an equity relationship.
However, inter-company agreements require from investor China expertise and much initial planning since not all arrangement are approved by the Chinese government and taxation authorities. Inter-company agreements and related payments are often made to cover costs for a variety of supporting services such as SAP system compliance, IT technology installations and usage rights, financing, human resources training as well as technology transfer and patent rights, trademarks and knowhow provided to China entities.
Chinese taxation regime accepts such foreign exchange payments, but all these transactions must be very well documented and follow arm’s length principles and priced in accordance with global business practises. Such provided and invoiced services must be relevant to China company’s business and beneficial to company development and expansion and approved by relevant authorities.
Inter-company agreements are for foreign investors an easy way to repatriate profits at any time without going through annual audit and tax compliance process, however, such agreements shall be planned and prepared upon incorporation phase of the China subsidiary.
Moreover, Inter-company payments are more tax efficient than repatriation profits by dividends since they are subject only to withholding taxes and surcharges, which typically can be deducted from the CIT taxable income.
Foreign companies repatriating profits by inter-company agreements shall maintain transaction documents as detailed as possible to be able to explain the nature of payments and demonstrate results in the event such payments are later challenged to Chinese tax authorities.
Three – Taxation Planning, Inter-Company Loans and Cash Flow Issues
Foreign companies are well advised to study these above referred channels for tax optimitization for betterment of investment return and flexibility of invoicing profits out from China entities at any given time.
Conventional remitting profits as dividends is straightforward but subject to many restrictions as explained above and available only once per annum. Inter-company agreements are a convenient and tax efficient alternative, however, all such actions must be planned well beforehand and documented properly.
Foreign companies should be aware that inter-company agreements, payment and related service fees are subject to Chinese VAT tax as well as other surcharge taxes, such as construction and maintenance tax and education surcharge fees. Royalty remittances are first subject typically to 10 % withholding tax and, thereafter, 6% VAT together with surcharges as above making tax burden in proximity of 16 % in China, which taxes must be paid before remittances outside China are allowed.
Foreign investors may also remit undistributed profits by extending loans to foreign equity related companies. Such arrangements are possible but are subject to scrutiny from the State Administration of Foreign Exchange. Chinese regulations stipulate the overseas loans are possible only after the company has been established for one year and has a good record in complying with the foreign exchange rules. Lending is limited to 30 % of the investors equity as shown in the latest financial report and repayment period should not be longer than 5 years.
Making money in China is a challenging issue, however, repatriating profits to home countries will be even more challenging unless expertise exists at company incorporation stages.