Way forward - China Procurement and Distribution Strategies
FOREWORD
Since the new Enterprise Income Tax Law (“EIT law”) became effective on January 1, 2008, the Chinese government
has issued extensive supplementary rules and regulations to govern the enforcement of the new EIT law. The new law
adds much emphasis on compliance, which clearly demonstrates that the Chinese government is committed to improve
the tax environment to one that would conform more closely to international tax practices. Many Chinese enterprises are
already reviewing their current China business structures and are examining whether adjustments are required in
response to the new business and tax rules and regulations in China.
This article highlights some of the major issues that enterprises engaged in the procurement and distribution activities in
China may need to consider, which may involve establishing new business structures in order to implement their China
strategies more effectively and to mitigate potential tax exposures.
Is Representative Office (“RO”) structure still optimal?
Before the promulgation of the Measures for the Administration of Foreign Investment in the Commercial Sector (“the
Commercial Measures”), most foreign investors were not allowed to conduct direct trading in China. They relied heavily
on setting up Representative Offices (“RO”) in China to conduct the necessary “supporting services” for their
procurement or distribution activities. These “supporting services” were narrowly defined and were strictly limited to
liaison and coordination services with their Chinese vendors / customers as ROs are not allowed to carry out any trading
business in China.
In practice, it is not uncommon that a RO may have performed services of a more substantive nature beyond its
“supporting services” role. For instance, the RO may have extensively and regularly engaged in negotiating and
concluding business and trading contracts for the overseas head office. Over time, the RO by its acts can potentially
trigger a taxable presence in China for the overseas head office, apart from exposing itself to regulatory risks of
performing outside the scope of its restricted services. According to our understanding, the Chinese tax authorities have
penalized numerous ROs for non-compliance such as violation of business scope and under-reporting of taxes in China.
In fact, the Chinese State Administration of Taxation has issued a ruling in late 2006 (“RO ruling”) affirming that where
a Hong Kong company has created a permanent establishment (“PE”) in China, then all of its profits attributable to the
PE should be subject to EIT in China.
A further point to note being that a RO does not have the import/export right to facilitate the local distribution of goods
in or procurement of goods from China. Accordingly, apart from the potential hidden tax or regulatory exposures as
described above, foreign investors have encountered a lot of operational constraints by relying on the RO to facilitate
their procurement or distribution activities in China. Alternative structure for their China business is called for.
Is Foreign Invested Commercial Enterprise (“FICE”) a better structure?
Foreign investors are allowed to establish a Foreign Invested Commercial Enterprise (“FICE”) to conduct activities
permitted under the Commercial Measures including commission agency services, wholesaling, retailing and
franchising. A FICE is usually formed as a 100% foreign owned legal subsidiary in China and can engage in trading
activities as a buy/sell principal and directly import/export and provide related services. Alternatively, a FICE can
function as a commission agent to provide sale support and agency services in China in return for an arms length
commission service fee. If the foreign investor has established a manufacturing subsidiary in China, it may apply to
expand the business scope of the subsidiary to include the activities allowed under the Commercial Measures.
Cont’d…/P. 2
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The capitalization of a FICE is generally determined by the scale of its operation as approved by the approving authority.
As an indication, the PRC Company Law specifies a minimum registered capital of RMB500,000 (USD64,000) and
RMB300,000 (USD38,000) for a company engaged in wholesaling and retailing business respectively.
A FICE can effectively function as a regional sale centre to centralize and coordinate all the procurement and distribution
of goods in China. It can trade with related or unrelated parties both in China and overseas. Upon obtaining approval as
a Value-Added Tax (“VAT”) taxpayer, the FICE will be able to issue invoices directly with the vendors/customers. A
FICE is not subject to the restrictions imposed on the RO and can engage in direct trading business activities.
The following diagram illustrates some sample transactions that can be undertaken by a FICE either as a buy-sell
principal or commission agent:
Principal
 Supply of
 Sale
Non-PRC
proceeds
 Import goods

PRC
Finished
goods
Liaise
services
 Payment
FICE

Local distribution of
goods

PRC customer
Sale
proceeds
 Liaise
services
 Procure finished
goods in PRC
 Payment
PRC supplier
Flow of goods
Flow of money
Flow of services
Cont’d…/P. 3
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Major PRC tax implications
While a RO is generally taxed on a cost-plus basis, a FICE is taxed on its net profit and will not incur tax liabilities if it
has no taxable profits. Tax losses incurred by the FICE can be carried forward for utilization in the following 5 years. A
trading FICE would also be subject to 17% VAT on sales or importation of goods in China. Export VAT mechanism is
generally complicated and a FICE may be allowed to recover part of the input VAT incurred upon export. A FICE
engaged in commission agency service would be subject to a 5% Business Tax on the service income.
Depending on the holding structure of the FICE, and given that China has entered into a wide treaty network with many
other jurisdictions, the relevant treaty may be utilized to provide tax planning opportunities to minimize PRC tax costs
on the repatriation of dividends, royalty and interest income received from the FICE. On the basis that the FICE will
earn a reasonable profit for the activities performed in China, the exposure of triggering PRC tax exposures to the
overseas head office according to the RO ruling could be minimized upon careful tax planning.
Closing remarks
Monitoring China tax development is always a difficult task; devising an optimal and tax efficient structure is even more
challenging. For the last few years since the implementation of the Commercial Measures, FICE has proved to be a
viable and practical solution helping many foreign investors to tap directly into the procurement and distribution market
in China. It generally provides a better legal and tax protection over the traditional RO model. While it is always
advisable to check with the local practice before submitting the FICE application, the set up process of a FICE is
generally straight forward.
However, there are other important post-formation issues to consider in order to ensure that the FICE can become
effective in achieving the intended objectives. One being that the FICE would need to have a proper set up of financial
records to make sure that the invoicing mechanism and compliance requirements are fully observed. The export VAT
refund regime applicable to FICE under the different trading scenarios may easily confuse investors if there is
insufficient understanding in advance. From a tax standpoint the formulation of an arms length pricing between the
FICE and the related parties, and accordingly the functions and risks analysis of the parties concerned with proper and
adequate supporting documentation in place would also be prominent according to the latest requirements issued under
the transfer pricing regulations released in China.
If you require further assistance on your personal or corporate tax affairs, Eddy Yeung ([email protected] or
+852 2110 5350), Steven Kwan ([email protected] or +852 2110 5271) or Johnny Ma ([email protected] or +852
2110 5282), at HLB Hodgson Impey Cheng Taxation Services Limited will be more than happy to talk to you.
Disclaimer
This information is of a general nature only and is not intended to be relied upon, nor to be a substitute for, specific professional advice. No
responsibility for loss arising from acting on or refraining from action as a result of any of this information can be accepted. No reader should
act on the basis of this information without obtaining independent professional advice with regard to their particular circumstances.