Foreign investors in China are advised to use the various methods available to them to best optimize the tax liability resulting from funds leaving the country. In this article, we discuss the four primary ways for foreign invested enterprises (FIE) to repatriate profits from china as well as application of transfer pricing.
Profit Repatriation (Dividends)
Dividends to shareholders are the most commonly utilized method for FIEs in China to repatriate profits to foreign entities despite being a fairly costly method of profit repatriation. First, companies must pay corporate income tax on its profits. Of the gross income from dividends paid to overseas entities, a withholding tax of 10% should be paid to the relevant tax authorities – unless a preferential rate is granted under a Double Tax Agreement. Additionally, FIEs who wish to repatriate profits must place at least 10% of net profits in a reserve account, up to a specified limit, which can later be reinvested in the business.
Profit repatriation is also a lengthy process. The process can only begin after annual tax reports have been filed and CIT paid – usually by the end of June of the following fiscal year. It can then take up to two months to apply for preferential tax rate under a Double Tax Agreement, if applicable, and register the application with the State Administration of Foreign Exchange (SAFE). Additionally, the company must first fully top-up the registered capital and settle any accumulated losses carried forward from previous years before it is eligible to pay dividends to shareholders.
Another method FIEs have of repatriating profits is through service agreements. Certain functions may be carried out at the group company level, or by a related party in exchange for a service fee. These functions, such accounting, HR, information technology, and marketing can be charged by the company’s group company in an attempt to repatriate funds overseas. In general, VAT and other surtaxes must be withheld by the FIE, in addition to a 25% CIT on deemed profits of 15% to 50% must be paid before remittance can be made outside of China. While CIT exceptions and other preferential treatment for intercompany service agreements exist , these are only available on a case-by-case basis and subject to pre-approval of the relevant tax authorities. Businesses are advised to plan ahead.
It’s important to note that service agreements signed with foreign entities must be registered with the tax authorities within 30 days. They reserve the right to question the validity of these service agreements, scrutinizing two areas in particular;
- Were services actually delivered and where?
- Were service fees calculated in accordance with the arm’s length principle?
Given their potential for misuse, service agreements between related parties have become a focus of tax authorities. It’s important that the necessary steps be taken to ensure such agreements are done in compliance with PRC law.
Fees paid to an overseas entity in relation to the use of intellectual property are similar to service fees in that they are both tax efficient and relatively convenient for the business. Like with service agreements, a VAT of 6% and a 10% CIT must be withheld by the FIE and paid to the relevant tax authorities before remittances can be made. Royalty agreements must also be registered with the trademark bureau and detailed royalty agreements provided, including the rationale for calculating royalty fees.
Foreign Loan Interest Payments
The final method of repatriating profits overseas is through foreign loan interest payments. According to PRC law, the total investment of an FIE in China can exceed its registered working capital by between 30% – 70%, depending on the size of the investment. The difference between the two can be registered as a foreign loan on which the FIE pays interest to its parent company at a rate not exceeding the official interest rate provided by the Bank of China. FIEs are required to withhold a 6% VAT and other surtaxes as well as a 10% CIT on all interest payments made on foreign loans.
Businesses may decide how much of the difference between total investment and working capital they wish to register as a foreign loan with the State Administration of Foreign Exchange.
How Transfer Pricing works
Transfer Pricing is an accounting practice related to intercompany payments made in exchange for good or services. Transfer pricing allows for tax savings as companies can redistribute earnings amongst groups or related parties. However, due to the potential for misuse, the tax authorities will often carefully examine both parties involved in such transactions focusing in particular on;
- How each party benefited from the transaction
- The necessity of services in question
- The rationale for determining price
- In the case of royalties, how much value the company derived from use of the intangible assets
Thus, it’s important that intercompany transactions are accompanied by detailed supporting evidence and are carried out in compliance with PRC law should they be challenged by the tax authorities.
When choosing methods of profit repatriation, one must consider the options available to their unique business situations keeping in mind that the tax authorities in China reserve the right to question the validity of many of the methods discussed. It’s also important that the business conducts thorough cashflow forecasts before repatriating profits to avoid needing to further increase its working capital in the future should it need additional funding.
Its also worth mentioning that China provides qualified non-resident foreign entities a special deferral of withholding tax for profits derived from resident companies in China should they be invested in industries outlined in the Catalogue of Encouraged Industries for Foreign Investment. To take advantage of the full range of profit repatriation methods available and achieve an optimal tax liability, foreign investors are encouraged to plan ahead.