Articles by Practice Area
- 中华人民共和国个人所得税法修改 - 对您的潜在影响及所需的即时行动
- Excellent Client Feedback from Asialaw Profiles
- Hong Kong has commenced exchanging financial account information with other jurisdictions for tax purpose
- China is Reforming Its Individual Income Tax Rules – Are You Ready?
- OLN Nominated for Four Awards in the ALB Hong Kong Law Awards 2018
在8月31日，中国全国人大常委会审议并通过了新的个人所得税法（以下简称《新个人所得税法》）。除了相对瞩目的税收居民定义的修改外（详情请参阅我们的文章“China is Reforming its Individual Income Tax Rules – Are You Ready?”），以下两项修改也很值得关注，特别对高净值资产人士而言：
此外, 第六条第（八）项列出 「财产转让所得，是指个人转让有价证券、股权、合伙企业中的财产份额、不动产、土地使用权、机器设备、车船以及其他财产取得的所得。」
另外，以信托形式管理资产仍可实现递延税项(Deferred Taxation)、资产保护(Asset Protection)及继承计划(Succession Planning)等好处和目的。因此，虽然在新修订生效后可能要为馈赠资产缴付税项，以信托形式管理资产依然是利多于弊。
We are very pleased to receive excellent client feedback from Aisalaw Profiles for our Partners Vera Sung and Stephen Chan. Below are the comments:
Stephen Chan “He is very good and responsive.”
Vera Sung “Vera understands how to deliver legal solutions to European clients. She is very commercial, has a keen eye on finding solutions. Clients are very impressed with her work.”
Vera Sung and Stephen Chan “They are very commercial, responsive and provide excellent legal support with competitive pricing, and are a pleasure to work alongside. I would have no hesitation recommending them and the firm.”
Congratulations to both of them and we believe that they will keep up the great work in the future!
By Anna Chan
With Hong Kong being a signatory to the Multilateral Competent Authority Agreement on Automatic Exchange of Financial Account Information (“MCAA on AEOI”) and the Convention on Mutual Administrative Assistance in Tax Matters (“Convention”) entering into force in Hong Kong, Hong Kong has started exchanging financial account information with 41 jurisdictions commencing from 1 September 2018, including United Kingdom, France, Germany, Australia, Canada, Singapore and Japan.
This means the information of account holders who are subject to taxation as a resident in other jurisdictions other than Hong Kong including interest income, dividend income, gross proceeds from the sale of financial assets would be provided to the tax authorities of the other jurisdictions under the Automatic Exchange of Financial Account Information (“AEOI”) regime. Please refer to our Article “Is your personal data at stake because of the increased transparency in tax administration through Automatic Exchange of Information?” for a detailed discussion of the AEOI regime.
How it works?
(1) The Hong Kong Inland Revenue Department (“IRD”) has established a dedicated platform, i.e., the AEOI Portal, for reporting financial institutions (“FIs”) to electronically submit notifications and furnish Financial Account Information Returns for reporting the required information of reportable accounts.
(2) The IRD will exchange the financial account information collected from the reporting FIs with relevant jurisdictions via the Common Transmission System established by the OECD.
In the past Hong Kong had relied on a bilateral approach which involves signing bilateral Competent Authority Agreements (“CAA”) for AEOI with other jurisdictions that already have a comprehensive avoidance of double taxation (“CDTA”) or a tax information exchange agreement (“TIEA”) with Hong Kong. As at 13 September 2018, Hong Kong had 40 CDTAs and 7 TIEA, and signed 16 bilateral CAAs for AEOI. Hong Kong’s move of being a signatories to MCAA on AEOI and having the Convention entering into force in Hong Kong has demonstrated Hong Kong’s commitment to enlarging the scope of the exchange of tax information in the international community and to comply with the OECD’s requirement to have the first exchange of AEOI with a wide network of partners by September 2018.
With the continuous trend of the exchange of tax information between the tax authorities, taxpayers, in particular for the taxpayers that have presence in various jurisdictions, should carefully assess their tax obligations to ensure compliant with the tax laws of the relevant jurisdictions.
OLN is equipped to advise clients on tax issues arising from various jurisdictions. If you have any questions regarding the above or on any tax issues, please contact one of the members of the tax advisory team.
Major amendments to China’s Individual Income Tax Law (“IIT Law”) were proposed by the Standing Committee of the 13th National People’s Congress in June 2018 and after a period of public consultation which ended in July, the Draft Amendment (“Draft”) will likely take effect in October and be fully implemented in January 2019.
The key reforms include:
- New definition of tax residency with revised criteria for determining tax residency status for foreigners
- Augmenting current system of taxing individual income
- Revised tax rates and reshuffling of taxable income brackets
- Expanding standard basic deduction and introducing additional specific deductions
- Introducing new anti-avoidance rules for individuals
- Implementing a taxpayer identification system
Changes to Tax Residency
The Draft introduces the concept of resident and non-resident for IIT purposes and will reduce the threshold for tax residency from 1 year to 183 days. This means that any foreign individual who has stayed in China for 183 days or longer in any tax year will be considered a resident, with income sourced within or outside China subject to IIT.
This shortened tax residency will, if passed, repeal China’s longstanding "5-year tax rule". Under the 5-year tax rule, a foreign resident’s worldwide income only becomes subject to IIT after the resident remains in China continuously for five years. Foreign individuals were able to avoid having their overseas income subject to IIT by temporary absences from China prior to the 5-year threshold.
Reclassification of Taxable Income
Under the current IIT Law, all income received by individuals taxable was lumped together for IIT purposes. The Draft designates 4 categories of employment-related income (including income from salary and wages), income from independent personal services, income from author’s remuneration and royalties, as “Comprehensive Income”. These will now be subject to one set of progressive tax rates in determining the IIT payable on them. All tax residents will be taxed on an annual basis for these while non-residents will continue to be taxed on a monthly or as and whenever taxable income arises.
Income from business operations conducted by self-employed taxpayers will now be reclassified as "Business Operations Income", and all income from contractual/leasing operations will either be treated as Comprehensive Income or Business Operations Income depending on the circumstances.
Income from interest income, dividends, income from property leasing, income from transfer of assets, incidental income and other income will continue to be taxed separately at the rate prescribed for those categories.
Revised IIT Rates & Tax Brackets
In an effort to alleviate the IIT burden on low and middle-income earners, the Draft consolidates certain taxable income categories and revises both the rates of IIT and tax brackets that will apply to these income categories, as illustrated in the 2 tables below:
|Under Current IIT Law||Under the Draft|
|Categories||Tax rates||Categories||Tax rates|
|Income from wages & salaries||
|Classified as “Comprehensive Income”||3%-45%|
|Income from remuneration for personal services||
|Income from authorship||
|Income from royalties||
|Income from operations by individual and commercial households||
|Classified as “Business Operation Income”||
|Income derived from contractual or leasing operations||
|treated as either Comprehensive Income or Business Operation Income|
|Income from interest, dividends & bonuses||
|Income from lease of property||
|Income from sale/transfer of assets||
|Comparison of Tax Brackets for IIT|
|on Monthly & Annual Taxable Income|
|Bracket||Amount (RMB) under Current IIT Law||Amount (RMB) under Draft||IIT rate (%)|
|1||up to 1,500/month||up to 3,000/month||3|
|up to 18,000/yr||up to 36,000/yr|
|7||over 80,000/month||over 80,000/month||45|
|over 960,000/yr||over 960,000/yr|
IIT payable by lower and middle-income earners will be significantly reduced under the reforms. So, for example, a resident national with a taxable income of RMB 40,000 per month currently paying RMB 8,195 in IIT will see her tax burden fall to RMB 6,090 or less depending on which specific deductions she and her family qualify for.
Augmented Statutory Deductions
The standard basic deduction (i.e. the first part of the salary that is not subject to IIT) is to be increased slightly from RMB 3,500/month for Chinese employees (and RMB 4,800/month for foreigners) to RMB 5,000/month for both.
Arguably the single most important amendment to the IIT Law is the long overdue augmentation of deductible expenses for Chinese taxpayers. Under pre-existing implementing rules, expatriates have long been allowed to deduct 5 categories of expenses from IIT but since the Draft is silent about several of those categories, it is uncertain whether or not all of those expenses can still be claimed after the Draft becomes law. If not, the new IIT rules will significantly increase the tax burden of expatriates working in China。
The new categories of expenses that the Draft does allow as deductions are as follows:
- Children’s education expenses
- Expenses for taxpayer’s own continuing education
- Health care expenses for serious/major illness
- Mortgage interest (on principal residence)
- Rental expense (for principal residence)
These new deductions are in addition to those that Chinese taxpayers can already claim for social insurance and housing fund contributions and commercially-sourced medical insurance.
Those familiar with HR practices in China will know how time-consuming it is to track, account and make filings for employee deductions, many of which vary from month to month. In the coming months, employees will need to work closely with their employer's finance / HR departments to ensure that all claimable special deductions are taken into account.
New Anti-avoidance Rules for Individuals
Under the current IIT Law, the collection and administration of IIT is governed by the Administrative Law of the PRC on Tax Revenue Collection. These are being reinforced by provisions contained in the Draft which address, among other issues, tax evasion/avoidance. In particular, Article 8 of the Draft introduces General Anti-tax Avoidance Rules (“GAAR”) for individuals which gives tax authorities wide latitude for reviewing situations under which individuals are seeking to reduce their IIT burden. Unless a justified business-related purpose can be demonstrated for those arrangements, they may be disallowed.
Art. 8 also outlines specific scenarios which are liable to challenge by China’s tax authorities (e.g.: non-arm’s length transactions; business arrangements channeled through tax havens; arrangements deriving tax benefits but lacking reasonable commercial substance, etc.).
The new GAAR are only the most recent step that China is taking to step up tax enforcement efforts and tax authorities are, no doubt, hoping to rely on the tax agreements that China has put in place with 103 countries including the USA, the UK and Canada.
To avoid expensive tax audits and penalties, resident taxpayers should review their sources of income and obtain whatever professional advice they need to ensure their arrangements comply with the new rules.
New Administrative Arrangements
The Draft outlines new administrative arrangements aimed at, among other things, modernizing the collection process and incentivizing/penalizing taxpayers.
Under the new system, all taxpayers will be allocated unique identification numbers to facilitate IIT collection and internal administration arrangements.
The Draft also includes measures aimed at streamlining the tax refund claim process. In situations where taxpayers have paid too much IIT (e.g.: due to under-reporting of deductions), they can file claims and (hopefully) be paid out after the annual tax reconciliation on March 31st.
These reforms are some of the most important and comprehensive since the passing of the original IIT Law in 1980 and will impact nearly all working age individuals in China.
Expatriate residents should expect to be paying significantly more IIT and their overseas income will be subject to far greater scrutiny. At the same time, the tax burden of millions of local working class and middle-income taxpayers will experience a windfall as their IIT burdens are reduced.
Since employers remain statutory IIT withholding agents for their employees, the reforms will certainly impact the payroll/finance operations of every company in China. Given the scope of the reforms, adapting to them will require complex adjustments that will require months to implement properly.
The new tax rates and brackets will be effective from October 1, 2018. Foreign companies with operations in China will then have only a few months to review their payroll and IIT declaration processes and communicate whatever changes are needed with their expatriate and local employees to ensure a smooth transition. Tax equalisation arrangements with expatriate employees need to be reviewed and to the extent that any of these employees incur additional taxes due to loss of deductions, employers will need to formulate a policy and plans for addressing these.
In the meantime, all taxpayers with outside sources of income and/or expenses to claim should begin gathering together supporting documents and obtaining whatever professional advice they need to prepare for these reforms.
OLN is pleased to have been shortlisted as finalist in the following four categories:
Young Lawyer of the Year - Anna Chan
Firm of the Year categories:-
- Civil Litigation Law Firm of the Year
- Intellectual Property Law Firm of the Year
- Labour and Employment Law Firm of the Year
Congratulations to the teams!
by Anna Chan
The State Administration of Taxation of China (“SAT”) recently released Public Notice  No. 9 (“Public Notice 9”) which provides additional guidance in assessing the beneficial ownership for treaty purposes to be aligned with the international standards.
Impact of Public Notice 9
Public Notice 9 replaces Guoshuihan  No. 601 (“Circular 601”) and Public Notice  No. 30 (“Public Notice 30”) and has come into effect from 1 April 2018. The impact of Public Notice 9 are as follows:-
(i) Amendments to the unfavourable factors as listed in Circular 601
(ii) Extension to the Safe Harbour Rule for dividends as listed in Public Notice 30
Distribution of income: The recipient of the income is obligated to distribute more than 50% of such income (as opposed to 60% as stated in Circular 601) to a resident(s) of a third jurisdiction within 12 months after the receipt of such income.
In addition, the term “obligated” is now more broadly defined as “including having contractual obligation or actual payment even if no contractual obligation”
the following recipients of China-sourced dividends will automatically recognized as beneficial owners without the need to undergo an assessment based on the unfavourable factors:-
(1) Government of the contracting state (an extension from Public Notice 30);
(2) Company that is a resident of the contracting state and listed in the contracting state;
(3) Individual who is a resident of the contracting state (an extension from Public Notice 30); and
(4) Recipient that is directly or indirectly wholly owned by one or more parties listed above. In cases of indirect ownership, the intermediary shareholders must be either Chinese residents or residents of the contracting states (unless it falls into either the “same country rule” or “same treaty benefit rule” as detailed below).
Substantive business activities: Public Notice 9 now broadly states that it would be an unfavourable factor if the business activities conducted by the recipient of the income do not constitute substantive business activities, which is determined based on the functions performed and the risks assumed by the recipient
No tax in residence jurisdiction: Same as Circular 601, the income is not subject to tax or it would be taxed at a very low effective tax rate in the residence jurisdiction of the recipient
Existing of another loan agreement: Same as Circular 601, in addition to the relevant loan agreement of which interest is derived, the creditor has another loan agreement or deposit agreement with a third party with similar terms such as the loan amount, interest rate and date of execution
Existing of another agreement regarding ownership or right to use: Same as Circular 601, in addition to the relevant agreement in relation to copyright, patents or technology etc. of which royalty is derived, the recipient of the royalty has another agreement with a third party regarding the ownership or right to use the relevant copyright, patents or technology etc. (this factor remains the same as the one listed in Circular 601)
Our observations and application
The extension of the safe harbour rule provides more certainty to dividend recipients without the need to undergo the assessment based on the unfavourable factors as SAT considers that there should be less risk in treaty abuse.
For example, entities / individuals can now enjoy treaty benefits under the introduction of the “same country rule” or “same treaty benefit rule” as detailed below:-
(1) Same country rule
(2) Same treaty benefit rule
However, the unfavourable factors now have more stringent requirements in place. For example:-
- the percentage of the income to be distributed has now dropped from 60% to 50%;
- the term “obligated” is explicitly defined in Public Notice 9 as “including having contractual obligation or actual payment even if no contractual obligation”; and
- replacing the factor that “the recipient conducts no or very few other business activities” to “do not constitute substantive business activities”.
Entities / individuals with China-sourced passive income should carefully review their existing investment structures to ensure that they could enjoy or continue to enjoy the treaty benefits under Public Notice 9.
OLN provides a full range of tax advisory services. If you have any questions regarding the above or on any tax issues, please contact one of the members of the tax advisory team.
A relaxation of longstanding restrictions on hiring residents of Hong Kong, Taiwan and Macau (“HTM”) was among a list of official changes approved by China’s State Council on August 3, greatly expanding their employment opportunities in China.
Under the pre-existing system, mainland employers had to obtain approval from three separate government agencies before they could hire staff from any of these regions, a process that normally took more than a month to complete.
The restrictions continued after employment commenced, since the work permits were valid for only two years and were non-transferable. Employees wanting to change jobs would need to find employers willing to go through the approval process. As a result, many HTM residents worked illegally in China which meant that they were not eligible for social insurance benefits such as state-subsidised medical insurance.
The State Council decision means that such employees will now be entitled to the same employment freedoms as local residents and are more fully able to obtain social insurance coverage. Under the new arrangements being implemented in cities across China, employees simply apply for jobs in China and if hired, their new employer handles all of the filings needed to register for social security and other benefits. No vetting is required.
These changes only apply to Chinese nationals and will not impact expatriate HMT residents.
So far, most commentary about these new arrangements has been focused on their supposed economic benefits, pointing to, for example, opening up China’s vast employment market access to fresh talent, particularly in knowledge-based industries. However, for HMT residents, the benefits are more personal and potentially life-changing.
First, working in the mainland, in an industry of their choice, is now finally viable since employers there will be less likely to reject these candidates on the basis of overly complicated administrative procedures. Second, these changes level the playing field for HMT residents since they are now free to seek employment elsewhere and any time without having to wait for a new employer to obtain approval.
Benchmark Litigation Asia-Pacific has announced that OLN is ranked as a Recommended Firm of 2018.
This is excellent news for the firm, as we are ranked for the first year of Benchmark Litigation arriving in Asia-Pacific.
Congratulations to our following Practice Areas:
Commercial and Transactions - Tier 3
About Benchmark Litigation
Benchamark Litigation was first published in 2008 covering the litigation and disputes markets in United States and Canada and has broadened its coverage to include Asia - Pacific this year.
To succeed with your startup, you have to find ways to monetize your ideas that comply with the law and use the law to protect your business, all without letting it become a distraction.
Here are five startup law issues that you need to know about, at least at some level:
1. Business Formation
There are many reasons you should form a business entity for your startup rather than operate as a sole proprietorship. In Hong Kong, in most instances, that will mean a limited company. Limited companies can protect the founders and investors from corporate liability, own property, open bank accounts, have different types of shareholders (holding common and preferred shares), sue and be sued, and carry on business both in and outside of Hong Kong.
It is important to form your company early and to document the formation, the ownership, and the agreed arrangements among the shareholders. All of this can be done cheaply by professional corporate service providers but if you want to make sure that it is done properly, taking into account the current and future needs of the business, as well as the preferences of the founders (and investors), you should speak to a startup lawyer first.
2. Intellectual Property & Confidentiality
As a startup, your most valuable asset will likely be your intellectual property Trademarks protect your name and branding, trade secrets protect certain kinds of confidential business information, and patents protect any inventions your startup will use. All of these require registration to enjoy protection from outsiders. Copyrights protect creative works such as songs, literary works and computer code but are automatically protected and normally do not need to be registered.
If you like most startups, you will also need to design a website and register a domain name for it. Like the other intellectual property created for the startup, steps will need to be taken to transfer ownership of your domain name to the startup itself and you will need to seek advice from a startup lawyer on this.
There is no one-size-fits-all time for registering IP but as a rule, before settling on a name for the startup, you should have a trademark search and companies search carried out to ensure that no one else is already using the name.
To avoid disputes and ensure everyone knows what their role and responsibilities are, you will need suitable written agreements in place with all of your co-founders, employees, and contractors, that make it expressly clear that the startup owns all IP and not the individual creating the IP. In addition, you should have a standard non-disclosure agreement (“NDA”) for third parties to sign that prohibits them from disclosing and/or using your confidential information.
3. Securities Law
Although crowdfunding laws in the US may eventually evolve to the point that it is relatively easy to approach investors funding, here in Hong Kong, there are longstanding legal restrictions on raising capital from “members of the public” and these can make it illegal for you to approach potential investors for funding. However, there are exceptions that allow startups to raise money without breaking the law.
You should know that the most popular and useful exceptions require you to only raise money on a private placement basis or from professional investors (a narrowly defined group of individuals). You should always speak to a startup lawyer before raising money for your startup, even if you are just raising money from family and friends. This can avoid unrealistic expectations on the part of investors and unwittingly tying an unrealistically low valuation to the startup.
4. Employment Law & Commercial Law
Employees and contractors are treated differently under the law, with employees given greater protection.
Before engaging individuals and/or vendors to perform services for your company (eg: app developers), you need to speak to a startup lawyer about what they are going to do, who is responsible for what, how they will be remunerated and, most importantly, who will own any IP they might create in the process. You can then work with your startup lawyer to create a suitable agreement to govern the relationship. In all likelihood the startup will only need a few of these to begin with.
5. Contract Law
Wherever possible, you should use written contracts when dealing with third parties. Oral agreements are normally enforceable in Hong Kong but proving what was agreed on can be complicated (read: expensive).
If limited time or resources prevent you from preparing written contracts, send out a binding letter of intent or, at the very least, a follow up email and send it to all everyone concerned to document the key terms of your agreement. That way, if a dispute arises, you will have some evidence of what was agreed.
These are the basics. For any given startup, a dozen or more legal issues may surface within months of launching but failure to obtain sound legal advice on any of these could lead the startup down the wrong track.
If you need advice in relation to these or any other legal issues, please feel free to contact our startup partners:
By Dan Harris on January 6, 2012.
We lawyers are known as deal-killers. Most lawyers get offended by that moniker and vehemently deny it. Me, I am more than willing to own up to it. Clients go to lawyers all excited about a deal and it is the lawyer’s job to point out the risks and to explain which of those risks can be mitigated and which cannot. I am proud of the deals I killed because my killing the deal meant I was doing right by my client. In other words, I was just doing my job.
I have put the kibosh on many a China acquisition and that is what this post is about. The following is actually an amalgamation of many such potential acquisitions, but for ease of explanation and to camouflage the identities of those involved, I have amalgamated a bunch of them into one. Trust me when I say that the following is incredibly typical, including the retirement of the owner precipitating the need for the deal.
The potential deal was for a US manufacturer that had been receiving its product from the same China manufacturer for about fifteen years. The Chinese manufacturer had been providing about 90 percent of its product output to this one US manufacturer and the two companies had a “fantastic” relationship. The owner of the Chinese manufacturer had done very well over the years and he now wanted to retire and sell his China manufacturing business to the US manufacturer.
In theory, this made complete sense.
The US manufacturer told me of its plans to buy and we briefly discussed some terms and “the numbers.” They said that the Chinese company was clearing about “a million a year” but that was not why they were buying it. They were buying it because they wanted to be sure they would be able to keep getting the product.
I then told laid out the likely reality of what was to come. I told them that if they bought the Chinese manufacturing company their profits (if any) would likely be considerably lower. I proceeded to explain why this would probably be the case.
I said that there is a good chance the Chinese manufacturer is paying half of its employees completely under the table and reporting to the government only half of what it was paying the other half. I then talked of how there is also a good chance the Chinese manufacturer is underpaying its taxes and of how its rent also may be paid under the table. I then said that this sort of thing may be all well and good for Chinese companies, but that if the US manufacturer were to buy this Chinese manufacturer, it would need to do so as a WFOE and it would then immediately be on a “whole ‘nother level” with respect to China’s various tax authorities.
I then told the US manufacturer that if it were to buy the Chinese manufacturing business, it would need to bring every single employee onto the payroll and that would likely mean the payroll expenses would be close to doubled. I then gave my estimated numbers. All of the wages now being paid under the table would need to be paid above the table and that would mean that the US manufacturer would, in turn, need to pay all sorts of employer taxes, pensions, and insurance. I told the US manufacturer to figure that these items would be about 40% of all wages. So if you have an employee who is now getting $1000 a month under the table and you then report to the government that you are paying that employee $1000, you should figure on needing to pay about $400 on that to the government.
But it gets worse. Much worse.
You see, that employee who is receiving $1000 under the table is usually quite happy to be getting paid under the table. So when you tell that employee that you are now going to be reporting his or her wages/income to the government, that employee is going to demand a raise. You see, that employee has been able to avoid having to make his or her various employee contributions and to pay his or her income taxes and your now reporting his or her income will end all of that.
You should expect needing to raise employee salaries by maybe 40 percent. So now the employee who was getting $1000 is getting $1400 and you as the employer are going to need to pay an additional 40 percent on that, which equals around $560. So all of a sudden the employee that cost the Chinese manufacturer $1000 a month is going to cost you pretty close to $2000. In other words, double.
And let’s take rent. The Chinese manufacturer is probably paying the landlord under the table and the landlord is not reporting it. Heck, there is a very good chance the landlord is not even legally able to lease out the property, but for the sake of the numbers, let’s assume that the landlord is actually authorized to lease it. If you are going to buy the Chinese manufacturer’s company you are going to have to do so as a WFOE and to get a WFOE approved at all, you are going to need to have a legitimate lease. That means that before you buy this Chinese manufacturer, you are going to need to go to the landlord and tell it that you need to get your landlord-tenant relationship “on the grid” and that the landlord is going to need to register the lease with the appropriate authorities.
The landlord will likely call you an idiot (trust me on this) and initially balk. You will then need to explain that you absolutely must get on the grid and that you are prepared to cover the landlord’s increased costs to do so. Figure on this raising your rent by around 25%. Again though, this assumes that your being able to stay at this facility is even possible.
Okay, so now that I have explained how the above will eat into your numbers, let’s talk about income taxes. You are going to have to pay income taxes on the money you make, even though the Chinese manufacturer maybe never did. Figure 25% of your profits will go to income taxes. And if you are now thinking that you are not going to have any profits, let me tell you that is likely going to matter less than you think for Chinese income tax purposes. You see, if you have no profits, the Chinese tax authorities will figure that is because your Chinese WFOE is intentionally under-pricing the product it is selling to your United States operations and it will then impute a profit to your Chinese WFOE. It’s a transfer pricing thing.
You need an accountant who understands China to look over the Chinese manufacturer’s books and to run the numbers to see if this deal is going to make sense.
A few months later, I received the following (doctored) email from our US manufacturer client:
Here is where we stand:
Our accountant is in the process of re-modeling the business from a top-down perspective, in an effort to clarify what the numbers would be for our China WFOE, while complying with the rules. We have good history on the revenue and most of the operating costs.
As you guessed, we will need to apply roughly a 2x factor to the labor costs that the Chinese manufacturer is showing, so as to properly book all of the official upcharges.
Also, as you suggested might be the case, the landlord of the factory space is not properly registered, so we will be increasing the booked rental costs as well.
The reality is that we probably will not be purchasing the Chinese manufacturing company did not sit well with its owner. He was offended when I reiterated my stance that I wouldn’t operate the business in the same manner as he has. He lost face.
A few weeks after that, I received the following email from the client (again doctored):
it is now clear that we shouldn’t consider buying [the Chinese manufacturer]. He [the owner of the Chinese manufacturer] had previously indicated that there were “a couple” more issues related to the accounting procedures. I pressed him to explain if there were any others. Of course, you know the answer to that.
In summary, it is becoming clear that we cannot be profitable in China if we follow all the rules. It is not completely clear this is really the case, since we can’t tell if [the owner of the Chinese manufacturing company] really understands the rules. What is certain is that the numbers on which we had been basing our valuations are simply not valid. The “profits” that the Chinese manufacturer was claiming to have achieved are not valid under our business model.
Amazingly enough, the US manufacturer and the Chinese manufacturer came up with a great solution which ended up working like a charm. The manager of the Chinese manufacturer bought the Chinese business and continued running it just as before and the US manufacturer and the Chinese manufacturer have maintained their “fantastic” relationship. All is well, except my law firm made a lot less money than if the deal had gone through.
To read the original China Law Blog article, please click here.