An Overview of Profit Repatriation

By Richard Hoffmann, ECOVIS Beijing China

Using the right strategy to optimize profit repatriation from China can result in significant cost savings. The most obvious way is to repatriate dividends from China to another country.

Before any dividends can be distributed, losses carried forward from previous years have to be made up, and the Enterprise Income Tax (EIT) of 25% has to be paid .  Unless the reserve fund’s capital is equal to 50% of the reserve capital,  Wholly Foreign Owned Enterprises (WFOEs) and Foreign Invested Commercial Enterprises (FICE) also have to allocate  10%  of their after tax income to their reserve fund (used to cover any losses). Also Joint Ventures should allocate money for enterprise development funds (for investment purposes), welfare funds and staff incentives. However, the exact percentages can be determined by the Board of Directors. If the dividends are distributed to foreign investors, a withholding income tax is imposed (in most cases 10%). Without an audit profit repatriation won’t be authorized.

The conventional process is:

There are a variety of alternatives to repatriate funds. In all cases the general idea is that the FIE in China pays the parent company for receiving a service, royalties or R&D benefits. Although these transactions will be subject to turnover tax and possibly withholding income tax, the advantage is that such fees are deductible before EIT.  These profit repatriation structures should be supported with proper legal documents, such as the Articles of Association, service contract etc.

In the following paragraph an overview of three different alternatives to repatriate funds are shown.

Service Fees:

If the parent company charges a service fee to the FIE (as stipulated in a service contract) money can be transferred legally out of China. This can lower the taxable income for the FIE. However, only service fees and not management fees charged are deductible for EIT purposes.  To be compliant and to avoid transfer pricing issues with Chinese laws all fees have to be charged at arm’s length basis.

Depending on the service provided, a VAT of 6%, 11% or 17% applies. However, in most cases this rate is 6%.. The service provider is the liable party for such tax, and the service recipient is a mandatory withholding party. If the FIE is a VAT general tax payer it can claim input taxes to decrease the tax burden. For certain services a company might be subject to business tax at 5%.

China is currently undergoing a VAT tax reform with the aim of gradually replacing its business tax (BT) system with a VAT system. Therefore great attention should be given to the service scope and the most recent reform changes.

Either way, this alternative of repatriating profits compares favorably against China’s tax on profits. The service fee is subject to a withholding income tax at 10% if the service is provided in China.  The 10% rate applies for most countries having a tax treaty with China. However, for certain cases (e.g. Hong Kong) it might be different.

The service fee is usually exempted for withholding income tax if the service is rendered outside China.  Such exemption is subject to approval according to tax treaties China enters with other countries.

Royalties:

The parent company can charge the FIE for royalties used.  The rate for the royalty has to be reasonable and at arms length basis. Foreign IP owners need to provide the authorities with the necessary documents, including the inter- company agreements that set out the terms of intellectual property (IP)  transfer and the registration certificates issued. Measures should be taken to protect individual property transfers in China accordingly.

Royalties are subject to VAT at 6% and surcharges as well as withholding income tax.

R&D Cost Sharing agreement:

This means that partner companies share research and development costs according to the  expected benefit for each party.  However, certain requirements have to be fulfilled to be able to be part of a R&D cost sharing agreement. This includes that no additional royalties can be charged and the foreign invested enterprise would obtain intellectual property rights.

Given the fact that intellectual property rights are transferred into China companies need to be careful to protect their IP rights appropriately.

Payments for R&D costs sharing agreements are not treated as royalties and therefore not subject to withholding income tax, business tax or any other tax.

Hence, aside from the risks of intellectual property violations in China, this can be an effective way to save costs for a FEI.

 Conclusion:

Choosing the right method to repatriate profits from China can be very cost effective for a FIE. However, many factors should be considered before making any decisions. Also, if any of the above methods are used, tax implications for parent companies need to be recognized.

The following might raise red flags with Chinese authorities and should be avoided when considering alternative methods to transfer money from a FIE to the parent company.

• A very large number of inter-company transactions.
• No documentation of transfer pricing activities or violation of the arms length principle.
• Long-term losses and low profitability

A strategy for profit repatriation should be developed on a case-by-case basis.

Ecovis China can help you to develop a tax effective strategy to repatriate profits from China.