Representative Offices held by a Hong Kong company may still be a cheaper option for setting up a mainland China sourcing operation. This article explains why:
Op-Ed Commentary: Chris Devonshire-Ellis
Jan. 20—We recently ran a piece on upgrading representative offices on the basis that the changes due this March will largely render them uneconomic to operate. While true for many investors whose businesses have evolved to trading with China, there are still circumstances when incorporating a representative office makes perfect sense—and is a cheaper option.
Essentially, the question boils down to the function of possessing an entity in China and whether or not that entity needs to bill in RMB. Or, to put it another way, if the investment intends on acquiring clients based in mainland China. The new regulations, which come into effect on March 1, do however spell out exactly what a representative office can do. The "Regulations on the Administration of Registration of Resident Representative Offices of Foreign Enterprises" states the business scope that ROs can be involved in includes "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."
Fast forward to a client meeting yesterday, where an investor from the Middle East wanted to establish a structure with a Chinese partner that would permit him to assist buyers from the region source Chinese products. In short, a sourcing office with a Chinese partner to assist.
The China office was to be based in Beijing. On first sight, the obvious choice given a Chinese partner is involved is to go for a joint venture. However, that JV would have to bill clients in China, where there is a 25 percent income tax rate. In addition to this, China levies a 5.5 percent turnover tax each month based upon the business cashflow. For the foreign investor, an additional 10 percent dividends tax would have to be paid in order to repatriate any profits back home. At this point it is also prudent to note that dividend taxes can often be reduced by 50 percent for investors whose country of origin has a double tax treaty with China (to check whether this applies to you, please refer to the Dezan Shira & Associates complimentary DTA download). However, the overall impact of these taxes is that collectively they begin to erode attainable profit margins and can make companies operating in competitive industries with narrow margins—such as sourcing—uneconomic in China.
This structure is now starting to make the China route expensive, especially as all the investor really intends to do is assist clients with sourcing activities—a function that falls under the permissible "market research" and "domestic procurement" functions of a representative office. Accordingly, we proposed establishing a limited liability company in Hong Kong, and to divide equity with his Chinese partner in that company. The Hong Kong company would then apply for a license to set up a representative office in Beijing.
The reasons this structure is appropriate are as follows:
Hong Kong/RO structure
Hong Kong income tax: 16.5 percent
China representative office: Deemed profit rate of 15 percent (based on actual overheads)
Corporate entity (FICE, WFOE, JV)
Monthly business (turnover) tax: 5.5 percent
China income tax: 25 percent
Dividends (repatriation) tax: 5 to 10 percent (depending upon DTA status)
Essentially, the Hong Kong/RO structure keeps the entire business out of mainland China's tax reach. While it is true that ROs are now subject to a deemed profit rate of 15 percent, this is against the actual operating expenses and as such can be controlled. Increased profitability from the structure need not impact on the deemed profit rate due from the China RO.
Representative offices therefore still have a place for investment into China, and especially for businesses who are purely sourcing, or conducting market research on behalf of clients who wish to do so. In many instances, the holding of a China representative office by a Hong Kong limited company and billing through that entity to take advantage of Hong Kong's low income tax rate of 16.5 percent continues to make a great deal of commercial sense.