Despite the recent global economic downturn, China is still a powerful magnet for foreign investors. On a recent trip to Japan, our electronics clients told us that while they were trimming back their investments in Japan and the US, they were expanding heavily in China. The reason is simple: China is the most cost-effective place in the world to manufacture. Those companies that want to export their VCRs, cameras, copiers and other products find that China offers an unbeatable combination of high-quality labour, low wages, tax incentives and a stable environment.
Pressure on prices
Of course, companies also invest in China to sell to the potential 1.3bn domestic customers. Here the story is more mixed. On one hand, these companies will also continue to invest heavily because China is perceived as the last growth market. But they are often in a loss position. The Chinese market is hyper-competitive and no one wants to quit first. This results in price-cutting, promotions and other give-aways that can force prices below costs.
As one angry manager told me: "I don't know how these guys do it. The price in China is less than half the world price." Pepsi-Cola recently admitted that it had lost money during the 20 years it has been in China, because of low margins in the soft drinks sector and heavy spending on advertising and promotion.
As they seek to expand domestic sales, many multinationals are considering setting up a China holding company (CHC). The most important reason for doing this is that the CHC allows multinationals to undertake certain crucial activities that would otherwise be difficult, if not impossible. This creates a strategic advantage over competitors who find themselves blocked from such actions.
However, setting up a CHC is an expensive proposition and there are only a few multinationals willing to make the investment. It requires a minimum registered capital of US$30m, which should be paid up within two years. There are also significant tax and operational burdens. For example, a CHC will pay tax at the full statutory rate of 33 percent while other types of FIEs will be taxed at a far lower rate. Despite this we are seeing more interest in the CHC. This article explains why.
There is less than one CHC for every 1,000 foreign investment enterprises (FIEs) in China. However, while the list of companies that have CHCs is quite small, it does include some of the best known names in the world, including BASF, Caterpillar, GM, IBM, Microsoft, Nestl?, Ericcson, Sony, Coca-Cola and General Electric.
In certain industries, it has become the norm for companies to have a CHC. For example, nine of the 14 semiconductor companies in China have established CHCs, including Toshiba, Philips, Sanyo, Samsung, Motorola and NEC. All of these CHCs are located in Beijing.
PwC has found that almost 90 percent of CHCs are located in either Beijing or Shanghai. While Beijing still outranks Shanghai, it should be noted that many Beijing CHCs actually conduct a fair amount of their activities from their Shanghai branch.
CHCs, like other FIEs in China, are granted approval by the Ministry of Foreign Trade and Economic Co-operation (Moftec). In April 1995, Moftec promulgated provisional regulations that lay down the basic guidelines for those foreign investors wishing to establish a CHC. It sets out the qualifications (such as minimum worldwide assets of US$400m), application requirements and procedures, and the allowable business scope.
In 1999 and 2001, Moftec issued new guidelines that expanded the scope of permissible activities available to CHCs. Today, they can do just about everything except manufacture or freely import.
What are the benefits?
National selling Restrictions imposed on businesses in China mean that an FIE that has been licensed to manufacture shoes cannot later start to sell socks. Nor can it sell shoes manufactured by another FIE. Thus, a consumer goods company with FIEs scattered across China uses multiple sales forces to sell to the same customers.
A CHC allows a multinational to get around this problem, as it is permitted to buy and sell the products of its investee companies. This allows the CHC to sell the products manufactured by all the FIEs, be they socks or shoes. Thus the CHC can present a single face to the market and employ a single sales force, brand name, invoicing system and so forth.
A multinational with five FIEs in China would not want to have five information technology, finance or human resources departments. Ideally, it would like to create a single department to serve all five FIEs, and a CHC can do so through a shared services centre. Such a centre can yield the following benefits: significant cost savings, knowledge sharing, standardisation of systems across business units and greater focus on operations for the business unit. Almost all holding companies in China provide some type of shared services to their investee companies.
Other functions A CHC can perform purchasing, R&D and a range of other useful services. For example, a CHC can source materials in China from third parties that can then be exported to related parties overseas. In addition, we have seen multinationals that use the CHC to set up a China design centre to customise global products to better meet the tastes and budgets of the China market. Since the CHC has a much better understanding of the local market, it makes business sense to consolidate group R&D functions at the CHC level to achieve efficiency and cost-effectiveness.
Political liaison Government relationships are relatively important in China because new initiatives generally require approval from the authorities and the criteria for such approval is not always clear. The CHC is a good vehicle through which to conduct government relationships.
Financial and tax planning Even though a CHC pays tax at a higher rate than a manufacturing FIE, there can still be financial and tax benefits. In China, multinationals are not allowed to consolidate tax returns, meaning that they cannot offset the high profits of one FIE against the losses of another. A CHC allows the multinational to blend these income streams and thus utilise the losses. There are also mechanisms the CHC can use to reduce its business tax consumption taxes.
Reputation Having a CHC puts a company in an exclusive club. This can have obvious benefits in China.
Despite these advantages, the decision to set up a CHC is not an easy one to make, particularly in such a complex and competitive market. Some major multinationals have decided against setting up such a structure. The costs and benefits must be weighed up carefully.
This article was written by Glenn De-Souza, PhD, economist and national transfer pricing director of PricewaterhouseCoopers based in Shanghai. The above information is not intended to be comprehensive or final. Professional advice is strongly recommended before entering into any arrangements that are discussed in this article. He can be contacted by email at email@example.com.