Why Representative Offices in China are Now Less Attractive to Foreign Investors
Introduction
Foreign investors that are entering the China market are often faced with a threshold question, do they form a representative office (RO) or will the scope of business that they anticipate require that they form a wholly foreign owned enterprise (WFOE) incorporated under China law? Recent regulations enacted in China earlier in 2011 provide new insight on activities often engaged in by ROs that China regulators have now clarified can only be engaged in by a WFOE. Furthermore, China regulators have also recently provided guidance on certain tax treatments applicable to ROs that also make an RO less attractive for the foreign entity.
ROs have been allowed to exist in mainland China since China’s economy opened to the world at the end of the 1970s. An RO is often a good choice for an initial Chinese presence when a foreign company seeks supplier relationships as compared to direct investment in the Chinese market, but feels it needs to do more market research before it can decide on a long-term strategy for entering the China market. ROs are simple to set up and relatively easy and less costly to maintain. They have played an important role in bridging the gap between foreign and Chinese businesses, especially in those times when WFOEs were not prevalent or even allowed.
New Regulations Impacting ROs
However, it is now the general view in China that ROs are falling out of favor because of recently enacted unfavorable laws and policies. The Chinese government passed these laws in an attempt to crack down on many foreign enterprises that are using their ROs improperly in profit making activities to avoid paying taxes. The recent policies have also had the effect of decreasing RO presence in China. Therefore the following key limitations and drawbacks should not be ignored by an investor when evaluating how to enter the China market.
I. Limited Activities Under the Law
The law has limited an RO to act only as a liaison office for the overseas company, not an independent legal entity; therefore, the RO is not allowed to engage in direct business activities, unless the bilateral treaty existing between the two countries allows for direct business operations of a certain type of RO. This limitation has effectively set the ultimate nature of an RO. The newly enacted Regulation on the Administration of Registration of Resident Representative Offices of Foreign Enterprises (the Regulation), effective on March 1, 2011, elaborates on the allowed activities to include only business liaison for overseas companies product sales or service provision, Chinese domestic purchasing and investment, market research, product presentation and promotion, etc.
II. Employment Issues
ROs are not permitted to directly hire their employees (usually Chinese employees, excluding representatives). All hiring of Chinese nationals must be done indirectly through a Chinese human resources service agency such as Foreign Enterprise Human Resources Service Co., Ltd. (FESCO). FESCO acts as the formal employer, with the responsibility of maintaining personnel files and withholding individual income tax and benefit plan contributions. The fees that FESCO or a similar agency asks for are on a monthly, per employee basis. This may be cost effective for a small RO operation, but if the number of local employees grows or the overseas company establishes more than one RO in China, the cost may no longer be reasonable. The Regulation now places restrictions on the number of representatives a RO may have—up to four representatives, including one chief representative appointed by the parent overseas company.
III. Tax Issues
Tax considerations raise increasingly important issues for ROs. Formerly, ROs would pay taxes based on a deemed revenue even though they were not allowed to engage in direct for-profit business activities. The estimated tax rate is approximately 10% on an RO’s gross expenses.
The recent tax regulation, Provisional Measures for Tax Collection and Administration of Representative Offices of Foreign Enterprises, effective retroactively to January 1, 2010 (The Measures), released by China’s State Administration of Taxation (SAT) is significantly different from the previous tax rules. The changing rules can include higher administrative costs and create uncertain tax liabilities. The following aspects in the Measures potentially make ROs unattractive:
- Scope of ROs and Tax Exemption: The Measures cover most ROs, including those set up by the enterprises in Hong Kong, Macao and Taiwan. It invalidates the former tax circulars governing various taxation treatments for ROs under the former Foreign Enterprise Income Tax regime. Specifically, there are no more tax exemptions for ROs and the local tax bureaus are required to eliminate any previously approved exemptions. As a possible alternative for better tax treatment, ROs may resort to double tax treaties, if any, between China and countries or regions where ROs’ parent companies are tax residents. To claim such benefits, ROs need to follow the relevant administrative procedures set out in the SAT Circular No.124 of 2009, which addresses the procedures for claiming treaty benefits by non-residents.
- Change of Tax Filing Basis: The Measures now emphasize ROs should file their tax returns on an “actual basis”. It appears that the SAT has a presumption that ROs are set up for the objective of carrying on taxable activities and should therefore keep accounting books and records in order to determine their revenue and profits. Consequently, they should be able to report tax on an actual basis. Unless the tax bureau in charge examines and agrees that a RO has failed to keep complete or accurate books, or is unable to calculate and file its tax obligations on an actual basis, the RO must file on an actual basis.
- Raising the Deemed Profit Rate: The deeming methods, in particular, the Expense-plus Method, were widely adopted as tax filing methods for existing ROs. ROs now face a heavier tax burden with the deemed profit rate raised from 10% to a minimum of 15%. The new deemed profit rate of 15% is not simply a fixed rate, but rather is set as a minimum. This suggests that the local tax bureaus have the discretion to set the profit rate, which may be higher than 15%. This change serves to deter ROs from continuing the use of deeming methods, and thus push them to report actual revenues and profits.
Conclusion
Before selecting the appropriate business form for entering the China market, a foreign investor should be well-informed. The ultimate reason to choose one entity over another relates to the purpose and goal of the foreign investor. Thus, a thorough evaluation of the company’s strategy and business plan is strongly recommended. The investor should also give careful consideration on how the ever changing regulatory landscape in China may impact its decision.
For more information regarding this alert, please contact Gary Biehn (215.864.7007; biehng@whiteandwilliams.com) or Chunsheng (Tony) Lu (215.864.7006; luc@whiteandwilliams.com).
