Repatriating profits from China can be complex but there are a number of options, writes Valur Blomsterberg of accountancy Integra Group
China has long maintained strict foreign exchange controls over funds entering and leaving the country, which means that foreign investors face a series of compliance challenges before they can move funds out of the country. With the current pace of regulatory changes and with banks adopting various anti-money laundering procedures, many foreign investors are naturally concerned about their ability to move funds and, most importantly, repatriate profits from China.
Foreign investors in China are advised to use the various methods available to them to optimize the tax liability that will result from funds leaving the country. This article examines the four primary ways that Foreign Invested Enterprises (FIE) can repatriate profits from China as well as the application of transfer pricing.
Profit Repatriation (Dividends)
Dividends to shareholders are the most common method for FIEs in China to repatriate profits to foreign entities despite being a fairly costly method of profit repatriation. Companies must first pay corporate income tax (CIT) on its profits and then, of the gross income from dividends paid to overseas entities, a withholding tax of 10 percent is paid to the relevant tax authorities unless a preferential rate has been granted under a Double Tax Agreement. In addition, FIEs who wish to repatriate profits must place at least 10 percent of net profits in a reserve account, up to a specified limit, for later reinvestment in the business.
Profit repatriation is also a lengthy process. It can only begin after annual tax reports have been filed and CIT paid – usually by the end of June in the following fiscal year. If applicable, it can then take up to two months to apply for a preferential tax rate under a Double Tax Agreement and to register the application with the State Administration of Foreign Exchange (SAFE). Additionally, the company must first fully top-up the registered capital and settle any accumulated losses carried forward from previous years before it is eligible to pay dividends to shareholders.
Another method FIEs have of repatriating profits is through service agreements. Certain functions may be carried out at the group company level, or by a related party in exchange for a service fee. These functions, such as accounting, HR, information technology, and marketing can be charged by the group company in order to repatriate funds overseas.
In general, VAT and other surtaxes must be withheld by the FIE, in addition to a 25 percent CIT on deemed profits of 15 to 50 percent which must be paid before remittance can be made outside of China. While CIT exceptions and other preferential treatment for intercompany service agreements exist, these are only available on a case-by-case basis and are subject to pre-approval by the relevant tax authorities. Businesses are advised to plan ahead.
It’s important to note that service agreements signed with foreign entities must be registered with the tax authorities within 30 days. The authorities also reserve the right to question the validity of these service agreements, scrutinising two areas in particular:
- Were services actually delivered and where?
- Were service fees calculated in accordance with the arm’s length principle?
Given their potential for misuse, service agreements between related parties have become a focus of tax authorities. It’s important that the necessary steps be taken to ensure such agreements are done in compliance with PRC law.
Fees paid to an overseas entity in relation to the use of intellectual property are similar to service fees in that they are both tax efficient and relatively convenient for the business. As with service agreements, 6 percent VAT and 10 percent CIT must be withheld by the FIE and paid to the relevant tax authorities before remittances can be made. Royalty agreements must also be registered with the trademark bureau and detailed royalty agreements provided, including the rationale for calculating royalty fees.
Foreign Loan Interest Payments
The final method of repatriating profits overseas is through foreign loan interest payments. According to PRC law, the total investment of an FIE in China can exceed its registered working capital by between 30 to 70 percent, depending on the size of the investment. The difference between the two figures can then be registered as a foreign loan on which the FIE pays interest to its parent company at a rate not exceeding the official interest rate provided by the Bank of China. FIEs are required to withhold VAT at 6 percent and other surtaxes, as well as a 10 percent CIT on such interest payments.
Businesses can decide how much of the difference between total investment and working capital they wish to register as a foreign loan with the State Administration of Foreign Exchange.
How Transfer Pricing works
Transfer Pricing is an accounting practice that relates to intercompany payments made in exchange for good or services. Transfer pricing allows for tax savings as companies can redistribute earnings amongst groups or related parties. However, due to the potential for misuse, the tax authorities will often carefully examine both parties involved in such transactions, in particular, focusing on:
- How each party benefited from the transaction
- The necessity of the services in question
- The rationale for determining the price
- In the case of royalties, how much value the company derived from using the intangible assets
Thus, it’s important that intercompany transactions are accompanied by detailed supporting evidence and are carried out in compliance with PRC law should they be challenged by the tax authorities.
When choosing methods of profit repatriation, FIE’s should consider the options available in their unique business situations, and keep in mind that the tax authorities in China reserve the right to question the validity of many of the methods discussed. It’s also important that the business conducts thorough cashflow forecasts before repatriating profits in order to avoid potentially increasing its working capital in the future should it need additional funding.
It’s also worth mentioning that China provides qualified non-resident foreign entities a special deferral of withholding tax for profits derived from resident companies in China should they be invested in industries outlined in the Catalogue of Encouraged Industries for Foreign Investment. To take advantage of the full range of profit repatriation methods available and achieve an optimal tax liability, foreign investors are encouraged to plan ahead.