12 Mar 2012

Investing in China – a changing landscape

Investing in China has been made easier by a series of changes in the business and tax environment. Nick Farr, head of China Britain Services Group at Grant Thornton, considers the likely impact

China is often seen as a huge opportunity, but corporates do have concerns about investing in the region, due to perceived complexities. The good news is that recent changes have just made entering into China easier than before.

There is much hyperbole surrounding China; "China will be the biggest economy by ..2040...or 2030...or 2020 ", "by 2014 China will have 19,000km of high-speed rail", or "China is expected to be the world's largest luxury goods market for the next decade".

As with all hyperbole, there is an element of truth, but it is not the whole story. China is certainly a very exciting emerging market offering excellent opportunities, but companies need to ensure the finance structure is right at the outset to avoid the pitfalls.

When structuring operations in China, there are equally many pre-conceptions.  To name but a few, these include that you should set up a Wholly Foreign Owned Enterprise (WFOE), should invest via Hong Kong, or that Renmimbi (RNB –the Chinese currency) cannot be taken out of China.

Once again, whilst there may still be some truth in these comments, the landscape is rapidly changing, with significant changes to Chinese domestic law and a new tax treaty with the UK.

This has significantly improved the landscape, changing the options available to UK businesses trading in China.

Business model – what is the right route?

A key first structuring question is to determine the preferred business model for China. Companies may sell into China directly, potentially with a Chinese Representative Office providing local support.

Alternatively, if they wish to have greater presence on the ground, a WFOE (a subsidiary company in effect) or an equity joint venture is the preferred route.

Historically many companies have been forced into setting up a WFOE. RMB could not historically be taken out of China – so companies selling directly would have to be paid in dollars or sterling, which is not always acceptable to Chinese customers.

This has changed. UK companies can now set up offshore RMB bank accounts in London – which makes it much easier to sell directly, receiving RMB payments direct to a UK bank account, where it can be freely converted.

For service companies, there are further improvements.

Withholding tax on service fees charged by the UK into China has now been reduced to nil under the new double tax treaty. As a result, it is worth service companies revisiting their China business model.

Service companies should also consider where they operate. Shanghai has stolen a march over the rest of China, by introducing a scheme from January 2012 to replace business tax with VAT. Business tax, levied at around 5.6% on services, is not recoverable - it is therefore a very real cost for service businesses, such as architects or IT consultants. VAT is in many instances recoverable, so operating in Shanghai can now significantly reduce the cost of doing business in China.

Holding company structures – should Hong Kong and Singapore still be used?

It has been common to invest via an intermediary holding company in Hong Kong or, to a lesser extent, Singapore. In some instances groups set up shell companies in these jurisdictions.

Historically this resulted in a reduced 5% withholding tax on dividends, and potentially reduced taxes on exit.

Several years ago, however, China introduced substance requirements which had to be met for intermediary holding companies to benefit from the tax advantages, so shell structures became redundant.

Recent changes to the double tax treaty with the UK, effective from 1 January 2012, mean direct dividend payments to the UK are now also subject to the lower 5% withholding tax rate.

So direct investment from the UK will in many instances be favourable to investment via a dormant intermediary company, and unwinding shell intermediary structures may be beneficial.

Does this mean that Hong Kong and Singapore are now redundant? Not necessarily.

The tax incentives associated with cash repatriation may have disappeared, however where real substance is planned in these jurisdictions, there may well be good commercial and tax benefits for continuing to invest via Hong Kong or Singapore. Additionally, if entering into a joint venture in China, routing this via Hong Kong or Singapore should make setting up, varying or unwinding the structure more straightforward.

Location of IP in China – is it safe?

Many companies have historically been reluctant to put intellectual property in China, fearing it would be plundered.

Whilst caution is still essential, an improved legal environment means this is less of a concern than hitherto, and a number of leading UK businesses – AstraZeneca and Unilever to name two – have set up innovation centres in China, to take advantage of the growing research capability of the region.

It is worth noting potential tax incentives. As well as research and development and other tax credits, companies achieving hi-tech status are entitled to a reduced 15% tax rate and potentially tax holidays, not just in less developed western regions but even in certain special economic zones in Shanghai and Beijing.

China is no longer necessarily a high tax jurisdiction.

Extracting funds – how to avoid trapped cash?

Surplus cash is of course a reflection of a profitable Chinese operation, but returning those funds to the UK is a key issue facing many businesses at the moment. Not only can there be incremental withholding taxes, but government regulations and practice can restrict the ability to actually remit funds in the first place – for example, high levels of royalties may be rejected by the Ministry of Commerce, irrespective of whether the rates are OECD-compliant.

The key is to be flexible as to methods of returning funds to the UK, using a mix of working capital and supply chain solutions. Critically, documentation needs to be in place in advance – forward planning is essential.

The new UK-China treaty has reduced withholding tax rates on dividends, royalties and service fees, which certainly helps tax efficient extraction of funds from China.

Closer relations between the UK and China is one factor which is encouraging burgeoning trade with China – exports grew by 20.8% in 2011.

The changing business and tax environment is another factor. Whilst investment in China, as for any emerging economy, is not without risks, the landscape is becoming more straightforward. With careful structuring many of the downside risks can be substantially mitigated.


Nick Farr is head of China Britain Services Group at Grant Thornton