Tax and Finance
There are many reasons why setting up a Representative Office (RO) in China is beneficial for a company, with the simplicity and low cost of the registration process being among the most attractive. If a company is beginning its venture into China or only wants a research/support post then an RO is a great way to get started.
There certainly are uses to an RO but at some point in a company’s development, either if it wishes to expand or the expenses are too high, it will mature beyond the scope of the RO and from that point on the RO no longer becomes cost efficient. One must keep in mind how tax on an RO works. ROs are taxed on their expenses which can be quite considerable if companies consider rent, salaries and other variable costs.
ROs in China are highly restricted. They cannot conduct any profit making activities or issue invoices. This has a detrimental effect on the tax of the RO, which results in an effective rate of about 12 percent on expenses. There is no way to change this, the effective tax remains constant, there is no scaling and efficiency in the isolated concept of the RO. Are the tax costs justified by the revenue that is achieved through the RO outside of China? So what options are available to companies?
One of the most viable options for companies who have an RO already registered is to convert this to a Wholly Foreign Owned Enterprise (WFOE). One of the core differences between the two, is that a WFOE is a separate legal entity under Chinese law, whereas the RO is not. It is merely seen as an extension of the foreign company. The process isn’t exactly a ‘conversion’ as the RO has to be fully de-registered, and the WFOE must be fully established. However, these steps can be completed in any order to offset delays.
Since the effective tax rate on the RO is roughly 12 percent of costs, using the RO to funnel monies to cover operational costs in China can be more expensive than funding operations by means of a WFOE, where a lower effective tax rate can often be achieved. The WFOE can deduct expenses from revenues generated from business activities specified in the business scope ranging from providing services, trading goods to manufacturing products.
The tax savings achieved by using a service agreement between the WFOE and headquarters would be based on the fact of the difference in the deemed profit rate between the two structures. The RO has a relatively inflexible 15 percent deemed profit, whereas the WFOE is taxed at 10 percent of actual profits.
Of course there would be some expense associated with setting up such a service agreement mechanism, but that could very well be offset and overcome by the tax savings. An actively trading WFOE/FICE would offer even greater flexibility to manage revenue and expenses to minimize corporate income tax (CIT), whereas the RO would continue to be inflexible in that respect.
ROs cannot develop and expand to become more tax efficient and save you capital in the long run. Having a Wholly Foreign Owned Company however will allow companies to have access to many more business opportunities. Further, if the company wishes to expand into trading, the Service WFOE can expand its business scope to include this.
Also, if the WFOE’s services to overseas companies fall under the scope of “logistics auxiliary services” and “general offshore outsourcing services” the company can apply for a VAT tax exemption status, with the latter being from the financial years 2014-2018 which, coupled with the lower tax on profits, could amount to significant savings for a company. Based on Dezan Shira& Associates’ calculations, and assuming varying factors, a company with high yearly expenses through an RO is poised to save a minimum of 12 percent on their tax each year.
Since its establishment in 1992, Dezan Shira& Associates has been guiding foreign clients through Asia’s complex regulatory environment and assisting them with all aspects of legal, accounting, tax, internal control, HR, payroll and audit matters. As a full-service consultancy with operational offices across China, Hong Kong, India and emerging ASEAN, we are your reliable partner for business expansion in this region and beyond.
By Stephen O’Regan Dezan Shira& Associates
For inquiries, please email at email@example.com.
Further information about our firm can be found at: www.dezshira.com
Apr 26, 2015