China to Crack Down on Use of Hong Kong Shelf Companies?

September 3, 2013 Posted by China Briefing Reading Time: 5 minutes

ChinaWhys scandal could impact upon use of shelf companies with no Hong Kong assets

Op-Ed Commentary: Chris Devonshire-Ellis

Sept. 3 – A result of part of the investigation into the ChinaWhys scandal and the continuing incarceration of the company’s directors in China could be a shift in attitude towards the use of shelf companies in Hong Kong to hold China assets. As part of the investigation into ChinaWhys, the Chinese PSB official interviewed on state TV about the case commented that the PSB had gone to the extent of looking at the overall ChinaWhys corporate structure. Describing the business as a Hong Kong “shell company,” he implied it held no material assets in Hong Kong, although it can reasonably be assumed the company held a bank account there. The implication then is that in China, the ChinaWhys business was operating either as a representative office (RO) or as a wholly foreign-owned enterprise (WFOE) as its primary place of business, and not Hong Kong.

China has already clamped down on the use of Hong Kong companies to apply for RO licenses on the mainland, and corporations applying for such entities are now expected to be a minimum of two years old, and a bank reference letter may also be required. However, it is possible to purchase such aged companies (suppliers such as Dezan Shira & Associates’ Hong Kong office maintain a stock of such entities specifically for this purpose).

The use of Hong Kong companies for setting up WFOEs or FICE, however, is not yet required to follow this two years’ existence guideline. While China is not looking beyond the two year “qualification” period for such Hong Kong company activities in China at this moment, that could potentially change if the likes of more scandals involving the use of shelf Hong Kong companies come to light.

One example the Chinese are sure to have taken note of is the Indian government, and their recent closure of the tax loopholes into investing in India exploited by the use of Mauritian incorporations. Just as Hong Kong has been for China, Mauritius has been for India. The Mauritian DTA with India has allowed for Mauritian companies holding assets in India to be exempt from capital gains tax.

Consequently, many local Indians promptly established Mauritian corporations to hold assets, including property in India as well as entire functioning business operations – a status that lead to the faintly ridiculous position of tiny Mauritius (population 1.25 million) being the largest single investing nation in India for each of the past 10 years. Finally fed up with the abuse of its capital gains tax laws, India has recently clamped down, and Mauritian companies doing business in India are now required to demonstrate they possess “significant” operations in Mauritius to qualify for future corporate gains tax relief.

While China is unlikely to retroactively impose such a regulation, they could insist that Hong Kong companies in the future show a similar track record of operations in the territory prior to being allowed permission to set up in mainland China. That would be a move that would upset Hong Kong and damage its use as a trading hub for China. But if more scandals such as the ChinaWhys use of a Hong Kong shelf company to project illegal trading activities on the mainland come to light, it remains a scenario that is within the realms of possibility. Should China wish to extend its anti-corruption drive to weed out weak Hong Kong entities and permit established businesses with track records only, it could do so as follows:

Insist all Hong Kong companies are a minimum of two years old (already in place for ROs)
Insist all Hong Kong companies provide bank references showing a minimum balance on account (already in place for ROs)
Insist all Hong Kong companies provide certified copies of their last annual audit
Insist all Hong Kong companies submit local employment records
Insist upon a minimum trade history including financial records for the previous two years in Hong Kong

The Chinese tax authorities are already becoming quite aggressive with the Hong Kong DTA with China and the reduction of withholding and dividend taxes to 5 percent under this treaty. If the Hong Kong entity cannot prove it has legitimate operations in Hong Kong, the treaty benefits may be disallowed. We have seen cases where this has already occurred.

China has a habit of making adjustments to its regulatory environment as concerns foreign investment into the country, and especially so in the wake of scandals involving foreign-invested businesses, as ChinaWhys was. It remains to be seen whether China will react to the use of Hong Kong companies with no tangible assets in Hong Kong continuing to be allowed to invest in the mainland. However, the televised interview does demonstrate that the Chinese PSB is aware of the issue – and that means it is certain to come up as a matter for debate concerning the creation of additional layers of security when it comes to the use of Hong Kong shelf companies holding assets in the mainland yet with nothing tangible in Hong Kong.

Chris Devonshire-Ellis is the founding partner and principal of Dezan Shira & Associates – a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in emerging Asia.

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