Legal Operating Structures in China Changing with Country’s Economic Development

June 24, 2010 Posted by China Briefing Reading Time: 6 minutes

Jun. 24 – These days there is virtually no wholesaler, retailer or original equipment manufacturer in the industrialized world that is not sourcing some, and in most cases all, of its products from Asia and China in particular. The advantages of a low-cost production site for export, a competitive cluster of second and third-tier suppliers, and the ever-lasting potential of a fast-growing domestic market has created opportunities for entrepreneurs all along China’s coast.

Hong Kong and Taiwanese businessmen were among the first to move their operations to China as increasing manufacturing costs in their homelands and a more competitive global marketplace were squeezing margins and profits. Multinational corporations followed swiftly, taking advantage of China’s low-cost production base and started to outsource some of their mass-market manufacturing operations in the early 1990s. Since the late 1990s international forward-looking small and medium-sized enterprises (SMEs) have also started sticking their nose out of their domestic turf and have been scouting out manufacturing opportunities in China. Having said that, it is only in the last few years that SMEs have increasingly and proactively been looking to internationalize their operations as mounting cost pressure combined with a lack of innovation, research and development back home and a shrinking local customer base were forcing them out of their developed countries in order to sustain competitiveness.

Some considerations need to be made about the main reasons behind the new wave of SME arrivals in China:

Lack of competitiveness in the Euro zone determined by a dearer selling price in Euros for local export-manufacturers (although the situation has recently changed due to the appreciation of the RMB giving some much-needed oxygen to struggling EU exporters)
Many European companies have been delocalizing their production to Eastern Europe as a cheaper and relatively closer manufacturing base since the late 1990s. After these countries joined the EU and attracted a strong influx of SMEs, production cost and wages have risen sharply making it less appealing as a current manufacturing base (although this is still widely use as “close” to home and due to the high investment in fixed assets made in the previous years)
Lack of human resources in certain sectors both in the United States and the EU (tanneries and leathers artifacts, textiles factories, woodwork productions to name a few)
Margins in mass-market productions are at minimal levels in the West and, due to a general lack in innovation and research to upgrade products design and manufacturing capabilities, suppliers are having to move to lower cost industrial areas like China
The advantage of the PRC labor force: not necessarily the cheapest in term of costs (Vietnamese and Indian workers wages are lower) but more productive and efficient
Availability of a cluster of first, second and third-tier suppliers providing components to manufacturers lowering the total cost of production.
Being close to clients and end users in China (the global economic dynamo is moving to Asia and the recent financial crisis accelerated the shift to these emerging economies) and an active globalization process to sustain growth and face off competition
A passive pull-in factor determined by existing clients already in the mainland which now want to be supplied with the same quality products, just in time and at lower costs
To face off Chinese competitors; Chinese manufacturers are not only good at copying (in some instances of course, we do not want to generalize this statement) products/equipments and designs but are also getting better at improving existing machineries and products. With the recent encouragement by the local government to “go global” more and more Chinese companies will start to look beyond national borders and sell in overseas markets. This process is already happening.

Types of investment

There are several forms of foreign investment enterprises international investors can choose from when it comes to investing in manufacturing operations in Mainland China: generally speaking, the most commonly used direct investment vehicles included wholly foreign-owned enterprises (WFOEs) and joint ventures (JVs). OEM (original equipment manufacturers) contracts with third local parties and processing agreements (PA) have also, historically, been very popular forms of investments, especially in the South China region since the late 1970s.

During the early years of China’s economic reform many foreign investors decided to profit from China’s lower labor cost and “appointed” a local manufacturer (Chinese company) to produce industrial finished or semi-finished goods on their behalf. In some cases, these goods were additionally dispatched to other processing factories or even WFOEs for additional processing with the end products then exported 100 percent. Investors were generally contributing equipments (which could be imported in exemption of value added tax and customs duty) and cash for the initial funding while a local Chinese company contributed factory space and labor. These operations became famous and known as Lai Liao Jia Gong (LLJG). An LLJG is able to process and assemble imported and supplied materials or parts. An LLJG factory does not normally have a legal person status, instead, it is a contractual arrangement between a Chinese partner (“party A”) and the foreign investor (“party B”). Usually, but not necessarily, party B provides equipment free of charge to party A to be used in the manufacturing process. All raw materials/parts supplied by party B are considered “bonded” when imported into the China factory and thus do not attract VAT and custom duties. The end-products must be exported 100 percent within the term of the production contract. No domestic sales are allowed for LLJG factories which receive a processing fee from the foreign investor which includes the profit element recognized to the local manufacturer. This form of investment has been widely used by early-days investors as it did not require setting up an entity on its own, and it was good enough to entrust a local factory to manufacture products for export with supplied raw materials and equipments.

In the present day, however, PA are not encouraged any longer by the government and also present some restrains and complications for those who wish to sell domestically and tap into the Chinese market. Some of the obvious disadvantages are:

Corporate Income Tax is assessed by the tax bureau on the processing fee amount and this may give rise to potential foreign exchange creative arrangements and additional paperwork to offset local official tax liabilities. With more and more stringent checks by the authorities this model is continuously under attack.
Most of VAT paid by the local Chinese manufacturers is not recoverable (as no local sales in China are allowed by subsequent/separate company) so it increases the overall tax burden.
No domestic sales allowed; exportation and re-importation can be done but would add costs to final price;
Bonded goods and operations are closely monitored by authorities
Rely on good relationship with the Chinese party which could break down any time
Rigid and complicated structure creating cumbersome administration procedures and customs problems

As you can imagine by reading the above, many companies are trying to get out of the PA “lock” and set up on their own or restructure their operations.

Another factor pushing more and more PA investors to switch to wholly or partially owned subsidiaries is the fact that as some of them are now in the country for a long time and there are less restrictions and costs in dealing with the equipments invested into the local manufacturing plant at the beginning then they feel that it is less burdensome set up fully-fledged WFOES or JVs. In fact when the supervision period expires (normally five years) the equipment/machinery shall be released from customs supervision and can be exported, transferred or sold.

Transforming LLJG operations into WFOEs

As previously addressed, LLJG investments will not allow you to sell your products domestically and this may not be ideal especially now that China’s internal demand is picking up and locally foreign invested or Chinese companies are also demanding local sales of components and parts. To overcome this problem and avoid lengthy and logistically expensive movement of goods to Hong Kong or other bonded logistics parks and back, you would have to convert your LLJG operation into a fully-fledged WFOE or JV.

If your plans are to both sell domestically and still benefit by the tax advantages of importing materials and then export the finished goods 100 percent then you can still use your WFOE or JV in a tax efficient way. Using the company’s handbook, raw materials can still be imported in exemption of VAT and CD (deposits are required with customs in many cases) for that part of your final production which will leave the country after the local assembly or manufacturing process is finished. The raw materials, in this case, would normally be purchased by the WFOE itself and not temporarily “consigned” by the foreign party.

Generally speaking, the transformation from an LLJG factory into a WFOE can be arranged through two stages. The first step is to set up a new WFOE either at the same location of the existing LLJG factory or in a different area. The second step would involve the deregistration of the LLJG factory license. A temporary termination agreement is normally signed between the parties to kick off the procedure.

Do take into consideration at this stage that the local government may try to persuade you not to move away from the current premises and keep the existing workforce on your new WFOE books. In the end it is your decision but take into account a certain degree of meddling by the local officials. Other issues to note would be related to customs and especially the de-registration of the customs handbook.

While deregistering the LLJG factory, the raw materials/parts and equipment can be transferred onto the WFOE’s customs handbooks or alternatively can be exported back to Hong Kong or elsewhere. The equipment released from customs supervision or purchased domestically can be moved into the WFOE.

Alberto Vettoretti is the managing partner for Dezan Shira & Associates in China and the current chairman of the European Chamber of Commerce South China. He is based in the firm’s Shenzhen office, and has lived and worked in China for 13 years. The firm has a significant manufacturing and OEM client base in South China, with three regional offices in Guangdong Province (Guangzhou, Zhongshan and Shenzhen) and one in Hong Kong. Dezan Shira & Associates can advise on LLJG, OEM and corporate establishment in the China trade area from both the legal and tax perspectives. Please e-mail china@dezshira.com

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