Since July, China has liberalised its foreign exchange system to allow most current account transactions to be convertible. This policy has recently been reaffirmed publicly by a formal undertaking given to the IMF by the Governor of the People's Bank of China, Mr Dai Xianglong. One side-effect of this liberalisation appears to be a change in the approach adopted by the foreign investment approval authorities (Moftec and its agencies) to the undertakings required of foreign-invested enterprises (FIEs) in respect of their 'export sales ratios'.
In the past, the authorities have insisted on FIEs undertaking to maintain a minimum percentage of export sales to total sales (the export sales ratio), or in other words limiting their access to the domestic market to a percentage of their total business. However, in recent applications for approval, there has been a relaxation of this requirement with the fixed export sales ratio being replaced by a general undertaking to keep the FIEs self-balancing in terms of foreign exchange. The approach might be varied for individual circumstances, but any FIEs should bear this in mind in seeking approval.
VAT export refund
The system for making and restricting refunds has continued to cause much uncertainty for many people.
Since July 1995, exporters have suffered a VAT penalty in respect of their exports. It is now clear that for all FIEs registered on or after January 1, 1994, what has effectively been introduced is not so much a restriction on VAT recovery as a fixed irrecoverable levy of 8 per cent of the value added in China when exported.
There are cash flow differences in the method used to collect the VAT depending on whether the FIE in question agreed a method before or after January 1, 1995. Broadly, the latter have to pay VAT on exports and claim a refund (which can take 60 days) and the former, while not having to pay VAT on exports, have their input tax recovery restricted and claim any over-restriction by way of refund. The overall burden is, however, the same for both categories.
This levy on export sales comes as something of a shock to businesses used to a European Union model VAT system where if sales are exempt from VAT, some input tax recovery may be impaired, but no levies made on sales. The differences are particularly pronounced if the business is labour intensive so there is little VAT paid on inputs but may be substantial value added in China.
It will not be surprising if this change has contributed to China's fall in exports during 1996 as businesses have reassessed the economies of exporting.
The State Administration Office of Taxation has announced a crackdown on the collection of tax from representative offices of foreign enterprises. Some activities of a rep office are not subject to tax, such as market research or information gathering activities for its foreign 'parent'. However, it is easy for a rep office to overstep the mark, for example by providing services to third parties or even members of the foreign group other than the direct parent. Such services are taxable.
It is believed that a large number of rep offices are either not registered at all for tax or have been involved in taxable rather than exempt activities. There is therefore a programme under way in tax offices throughout the country to review all rep offices by June 30, 1997 and collect back tax due.
As rep offices are often the precursor of more substantial operations, foreign companies are advised to regularise their tax. The tax cost of running the rep office will generally be far outweighed by the longer term benefit of maintaining good relationships with approval authorities, including tax authorities.
There have been recent international developments which affect how foreign investors might wish to structure their investments in tax effective ways to cater for:
* losses in China, perhaps in the early stages of a new venture
* remitting profits
* selling their investment.
Losses The US have published draft regulations which, if confirmed, will allow US companies to treat most of their foreign subsidiaries as transparent for US tax purposes, so that the US company will be able to deduct its share of an FIE's loss against its other profits. This would reduce the cost of losses but limit the benefits of Chinese tax holidays once the FIE starts to make profits.
Remitting profits: The UK and China have recently published a variation in the tax treaty between the two countries, confirming the continuance of 'tax sparing' for a further 10 years. Tax sparing arises where profits of a Chinese FIE which have benefited from a tax holiday exemption are paid out as a dividend to a UK company which owns at least 10 per cent of its voting power. The UK company can offset against UK tax on the dividend not only any tax actually borne on the profits of the Chinese company out of which the dividend has been paid, but also any tax which would have been paid but for the tax holiday. Since UK and full Chinese taxes are charged at similar rates, this can lead to profits being exempted in full in China and bearing no UK tax on remittance to the UK investor.
Gains on disposals: Mauritius is becoming a popular location for owning foreign group investments in Chinese companies. This is because a 20 per cent tax is usually withheld in China on gains from disposal by a foreign investor of shares in an FIE. The double tax treaty between China and Mauritius is, at present, unique in eliminating this – charge for Mauritius companies leading foreign investors to interpose Mauritius companies, between themselves and their Chinese FIEs.
Foreign investors will need to use some ingenuity to combine the benefits of these structures.
This update was prepared by Charles Norris, Ernst & Young's Chinese Liaison Partner in the UK using information provided by Ernst & Young's offices in China and Hong Kong. For more information, please contact either Charles on (44) 171 931 4147 or Alfred Shum, Executive Partner of Ernst & Young's China Division in Hong Kong on (852) 2846 9959.