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Winding Road to the China Market

Chinese mainland authorities recently announced tighter regulations on foreign representative office  

Chinese mainland authorities recently announced tighter regulations on foreign representative offices on the mainland (photo: iStockphoto.com)

 
Representative offices (ROs), once among the most popular corporate vehicles used by foreign firms for initiating business on the Chinese mainland, seem to be fading from favour among small- and medium-sized (SME) trading companies. 

What was a minimally regulated means of accessing the mainland market since the 1980s became misused over time, say observers, and the strong corrective medicine of tighter regulation and more comprehensive taxation might not be what foreign traders can stomach. 

Under regulations jointly announced by the State Administration of Industry and Commerce and the Ministry of Public Security last January, ROs must comply with annual rather than tri-annual renewal of registration certification, as well as notarised obligations of the foreign head office for new RO setups. There are also restrictions on the number of representatives among other new administrative measures. (Please see chart below)

  New measures for foreign representative offices
  New measures for foreign representative offices
At issue is whether ROs, which are currently numbered in the hundreds of thousands, continue to be useful, as their business scope remains limited. At the same time, they could face a higher tax burden and administration requirements. 

Some senior legal, tax and trade professionals see the RO as a bygone vestige of the last century. But there are also those who view this hybrid corporate vehicle, which is banned from taking part in revenue-taking activities, as still playing a key role liaising with mainland firms and facilitating international supply chains. 

Choice of Vehicle

Much depends on the size and operations of the foreign company. Large retail players are already far advanced in building extensive revenue-taking networks. For them, the RO is a device that has served its purpose already.

For smaller entrants, newly formed regulations for ROs are proving more difficult to work with for lack of full definition. Further official explanation of how the modified RO will operate is due at any time. 

Large, successful players have moved on from ROs to access the Chinese mainland market  

Large, successful players have moved on from ROs to access the Chinese mainland market
(photo: iStockphoto.com)

 
For these smaller foreign firms, Hong Kong-based corporate entities seem to have been gaining in popularity, not only for the relative simplicity of their legal framework and ease of setting up, but also for their accessibility to financial services. Also, Hong Kong-based entities may be eligible for the preferential tax treatment under the existing arrangement on the avoidance of double taxation, on income arising between Hong Kong and the mainland in respect of mainland operations. 

In particular, withholding tax on dividend repatriation may be reduced from 10 per cent to five per cent for Hong Kong firms with mainland operations. Elizabeth Thomson, President of corporate financial services firm ICS Trust (Asia) Ltd, says she invariably advises trade clients – many small- and medium-sized, capitalised at between US$10 million and US$500 million – to use Hong Kong’s jurisdiction to provide a holding structure in its well-regulated legal environment. ICS Trust has itself been established in Hong Kong for 30 years. “Based in Hong Kong, a lot of people are happier, with easier travel options and continuing to be in touch with people on the mainland.” 

Ms Thomson says this is also why her company offers integrated “one-shop” solutions in Hong Kong, primarily to avoid exposure to risks existing for mainland entrants, particularly new ones. Anthea Wong, a partner for China Tax and Business Advisory Services with accountancy firm PricewaterhouseCoopers (PwC) in Hong Kong, advises clients – whether large multinationals or mid-sized firms – to take what she calls “a holistic approach” when planning their China investment structure.

Investing in Hong Kong is not contradictory to investing on the mainland, she says. The two structures can actually be complementary if the roles and functions between the entities in both jurisdictions are carefully designed. This could help investors capitalise on Hong Kong’s sophisticated banking system, tax regime and legal structure, while having a mainland-based entity to penetrate the China market. “You have to look at both angles; if the client is expanding in the mainland market, there would be a need for a presence [on the mainland],” says Ms Wong. 

ROs and Other Species

  Many foreign firms prefer to go straight to becoming revenue-handling entities
 

Many foreign firms prefer
to go straight to becoming
revenue-handling entities
(photo: iStockphoto.com)

ROs were set up in the 1980s as part of an array of foreign-invested enterprises, which included different types of ventures. Of the other categories, the most often used are wholly foreign-owned enterprises (WFOEs) and joint ventures (JVs). 

Lawyers agree WFOEs are comparatively flexible corporate entities that allow manufacturing and services firms to set up on the mainland, provided they are not under restriction in so-called state “strategic sectors.” The uncertainty lies in the fact that what is “strategic,” can change. 

The main advantages for foreign investors are in the fact that WFOEs are independent, allow freedom of management and operation, invoicing in Rmb and IP protection. 

Comparatively, some believe JVs with mainland partners offer the attraction of a shared investment risk, as well as good market access and intimate knowledge of the country. But partners have to offer the right fit; there’s plenty of potential for disagreement. 

There are still other, more specialised vehicles that may not be suitable for smaller players. Of these, strategic alliances are said to have the benefit of flexible operation, but lack the stability of a formal corporate structure. Relatively new licensing agreements require both branding and a large-scale operation to generate the profits that foreign firms expect of a mainland investment. 

Passive and Active

ROs are structured as “passive investment” entities, mainly to lay out foreign companies’ long-term goals and oversee mainland operations. In turn, these foreign-manned corporate units were popular with multinationals striving to make an impact on a largely unknown but seemingly lucrative Chinese market. 

Times have moved on and a proportion of ROs is said to have been “too creative” with their manning and operations, leading to this year’s thorough shake up. 

William Soileau, Senior Associate with UK-based law firm Pinsent Masons in Shanghai, says that mainland ROs are an “historical anachronism.” But since China joined the World Trade Organization in 2001, a number of ROs have been “used in a sloppy fashion” by firms, with lax oversight and inadequate bookkeeping. Indeed, there’s trade talk of so-called “credit card factories” grouped as ROs, with their only function being to pay for goods destined for export, using credit cards to hide what are real revenue flows. 

The overall effect of the mainland regulation was seen by some as cracking down on the exposure of ROs to tax after they were revealed to be carrying out physical trades. According to one account, this even involved foreign teachers and traders that formed the easy-to-establish ROs and bypassed mainland employment regulations. They’re now subject to tax, assuming they have the right to work on the mainland. 

Mr Soileau says Pinsent recommends a Hong Kong company as a “special-purpose vehicle,” establishing bona fide residence for the foreign entity on the mainland, whichever one is chosen. 

The law firm tends to prefer WFOEs to either ROs or joint ventures, unless the latter are situated in the Guangdong special economic zones of Shenzhen or Zhuhai. That’s because the cultural and operational differences between foreign and mainland enterprises vary significantly according to region, with consequences for the success of the joint venture. For her part, Ms Thomson says she advises clients to look closely at whether they need to set up an RO or a WFOE. Some indeed adopt the RO, due to the type of businesses they operate. 

For example, one client is involved in selling auto industry parts to a US-based car producer. The company’s RO is responsible for finding the factories on the mainland and negotiating contracts for shipment of the parts back to the United States. In this case, the RO acts as a facilitator for all aspects of the contract, which is usually directly drawn between the US and Chinese firms. 

Ms Thomson believes some aspects of the new regime are intriguing, including the registration certification for ROs, which ran for three years. Under the regulatory change, this has been reduced to one. “A lot can happen to a company in three years,” Ms Thomson says. 

From PwC, Ms Wong admits that the new regulatory framework doesn’t fully answer how the “new” RO will fit into a modern supply chain that assumes revenue flows through different entities to achieve efficient business models; this is required by most foreign traders on the mainland. 

But she still insists there will be foreign companies that prefer to enter the mainland intending to “look first before trading” (therefore opting for an RO), even though the process of dismantling this and forming a WFOE is a cumbersome one. It’s still not possible to “transform” a mainland RO. A new WFOE will have to be separately established, whereas the RO may be de-registered if it is no longer useful. 

As for the income tax of ROs, most were taxed on a deemed basis at the profit rate of 10 per cent in the past. However, from this year, ROs are requested to compute tax on an actual basis or on a deemed basis at the rate of no less than 15 per cent. This could conceivably result in some ROs paying more in tax than previously, under some circumstances. 

Ms Thomson of ICS Trust (Asia) hopes to see “a new RO take the place of the present one,” believing that an improved model can emerge from the mainland’s regulatory work in progress. It would be wise not to pronounce the RO dead quite yet. 

For more  details, please see the June issue of HKTDC Trade Quarterly, which can be ordered at: www.hktdc.com/bookshop.

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