China RO vs. FICE

May 9, 2012 Posted by China Briefing Reading Time: 4 minutes

Op-Ed Commentary: Chris Devonshire-Ellis

May 9 – Recent changes to China’s tax treatment of representative offices (ROs) have started to infringe on the viability of using an RO as a vehicle for “investment” into China in terms of increasing financial pressure. While often stated as being an “investment” vehicle, alongside wholly foreign-owned enterprises (WFOEs) and foreign-invested commercial enterprises (FICE), the reality is that ROs have never been considered as a vehicle for foreign investment in the strictest sense.

Firstly, there is no capitalization requirement (and therefore no “investment” by the foreign owner), and secondly, they are not permitted to trade. Instead, ROs have over the past 15 to 20 years been used as a type of “getting to know you” vehicle, whereby foreign companies, perhaps feeling their way in China, could establish a presence to see what the market conditions are like. China used to also be wary of letting foreign companies enter the China market en mass. Early ROs could only be established for example in specific, security-controlled Chinese-owned hotels, and were not originally permitted to rent genuine office space. This is why, in many second-tier cities and older hotel buildings, you can still see hotel floors devoted to small offices. ROs were originally even more confined than they are today.

However, the use of the RO in China by foreign investors has fallen into some disrepute. By clever – if still illegal – use of offshore billing, many ROs are able to conduct trade and source income for their parent company. Often they will conduct actual work in China, yet avoid taxes by having an offshore, Hong Kong or other holding company invoice for services carried out in China. There have been moves by the Chinese State Administration of Taxation to combat this, however dealing with traceable, taxable income overseas has proven difficult. Hence a situation arises where work is carried out in China, but no proper tax treatment is applied as regards China-derived income and the applicable income tax.

Accordingly, the SAT has placed ROs under increasing domestic tax pressure to conform, by raising the tax rates for ROs last year. The new regulations, which came into effect from March 2011, have effectively raised the tax burdens of an RO from around 9 percent to around 11 percent of total expenses, as well as imposed more requirements on the documentation needed on set up and stricter annual inspection procedures. This has now developed to the extent whereby for many foreign investors, a FICE structure may now be a more valid vehicle for trade in China. ROs are now subject to increased amounts of tax, and are unable to obtain certain licenses that FICE may adopt. Therefore, it is pertinent to examine the differences between ROs and FICE from the trading perspective as follows:

Most ROs are taxed based on their expenses. This means, for any salary, rent, traveling costs, telephone bills that are related to the RO, taxes have to be paid. The current tax rate is from a minimum of roughly 11 percent (subject to local surcharges), therefore potentially making an RO very expensive. If your expenses for example amount to US$100,000 per month, you would need to pay roughly US$11,000 in taxes which is quite a burden because they have not been permitted to trade.

A FICE is taxed differently. If you are a general value-added taxpayer you are allowed to reduce your input VAT against the output VAT. This means that your tax burden could be very low. Furthermore, while you will have to pay corporate income tax, this will only be applied on profits as you are allowed to deduct expenses. In addition, you are allowed to hire staff directly, to trade, and to issue local RMB invoices (fapiaos). Therefore it may be worth considering setting up a FICE, especially in light of China’s recent regulatory changes to the RO laws.

In terms of establishing sourcing offices or import-export businesses, in addition to service companies, the FICE structure offers a reasonably inexpensive way to get legal, obtain import-export licenses of your own, and obtain the crucial ability to offset VAT. These are important considerations that should certainly be taken into account for businesses wishing to newly set up in China, and also for existing ROs whose overheads may now become a burden considering their previous advantages.

Chris Devonshire-Ellis is the founding partner of Dezan Shira & Associates – a boutique professional services firm providing foreign direct investment business advisory, tax, accounting, payroll and due diligence services for multinational clients in China, Hong Kong, India, Singapore and Vietnam. The firm specializes in assisting foreign enterprises establish and operate legal entities in China such as ROs and FICE. For advice, please email china@dezshira.com, visit www.dezshira.com, or download the firm’s brochure here.

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