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Bull Housser & Tupper has been helping clients in China for over 20 years. We have had offices in Shanghai, as well as in Hong Kong and Taipei, and as such have built up some considerable expertise as well as an infrastructure of contacts in China who assist us and our clients. This memorandum will contain a general overview in connection with carrying on business or investing in the People’s Republic of China (“the PRC” or “China”). This memorandum should be considered an introduction and of a general nature only and is not intended to be advice on a specific proposal. Many aspects of the law and practice surrounding certain matters referred to herein, and particularly the tax issues, are subtle and not always clear. We should therefore review any proposed arrangements when the details of those arrangements have been more fully worked out. In addition, as Bull, Housser & Tupper LLP is not authorized to practise law in the PRC, our comments about Chinese legal and tax matters are based on our experience in advising clients doing business in that country but should not be regarded as legal advice for any specific transaction which should be sought from the appropriate lawyers or tax accountants in China. We work with such Chinese lawyers and accountants and believe that we are able to ensure that the legal and tax assistance that will be needed will be as seamless as is possible. Part I deals with the business entity in China from a Chinese legal standpoint; Part II comments on some Chinese tax issues, and Part III touches on some practical issues in doing business in China. Finally, in Part IV there is included some very preliminary comments on structuring from a Canadian tax perspective.
One of the threshold issues is whether you or your company will be providing services, know how or other intellectual property or other property for a fee or selling goods to entities in China, or whether you or your company will be carrying on business in China and will therefore be required to register or be incorporated in, or form a joint venture in, China. This will depend to a large extent whether your company or its subsidiary will have employees in China or will have an office of some kind, or whether it is intended that you are to have an equity participation in the Chinese venture. It may be that there will simply be a contract in place with no requirement for a Chinese legal status. It should be noted that under Chinese law, in order to open a bank account with a Chinese bank in the name of a company, that company must provide the bank with evidence of its legal registration in China. Assuming there will be need for legal status in China, the issue will be how should your company, or its subsidiary, be structured from a PRC legal perspective, that is to say how should you be registered to do business in China. There are three main types of business entities available in the PRC for a foreign enterprise, namely, (i) a Representative Office, (ii) a Wholly Foreign-Owned Enterprise (a “WFOE”), and (iii) a Joint Venture (a “JV”) (which can be either an Equity Joint Venture or a Contractual (or Co-operative) Joint Venture). There are other types of business entities, but these three are the main types of business organization in China. A Rep Office is an office of a foreign enterprise set up in China solely for liaison with Chinese businesses and customers on behalf of its parent company. A Rep Office may be opened for consulting. Joint Ventures are relatively time consuming (and therefore expensive) to set up in terms of the negotiation of terms and approval by the Chinese authorities, the feasibility study requirements, the requirement for the payment of capital to the venture (which may be know how), and generally are for joint equity participation by the parties. One reason that a joint venture may be chosen is that there may be tax holidays available for a joint venture not otherwise available. This memorandum will not deal with the procedures to obtain approval of JVs, except to say that the Letter of Intent and Feasibility Study are important documents not to be passed over lightly or left to the Chinese side to deal with. Assuming that you require legal status in China because you have an office and employees there, if a JV is not required, a WFOE may be the preferred legal structure. The Chinese law does not expressly require minimum capital contribution when setting up a WFOE, however, a minimum amount of capital contribution is required by some local authorities. The WFOE would enter into the agreement with the Chinese side. It should be noted, that every WFOE must appoint a "legal representative" who has the legal authority to bind the WFOE and who may also be held personally liable for civil or criminal claims against the enterprise. If Chinese legal status is not required, your existing company or its
Canadian subsidiary, or indeed a company incorporated in some third country
may be used as the contracting party, perhaps with a Rep office opened
in China to provide consulting services. The Chinese taxes are Income Taxes, a VAT tax, a Business Tax and a Consumption Tax, as well as Customs Duties. As for income tax, all companies (including Joint Ventures) are taxed at a flat corporate rate of 33% (as at the time of this writing). It may be possible to negotiate a waiver of the local surtax, reducing the overall rate. Canada has a tax treaty with China which means that Chinese taxes are not paid unless your company, or its subsidiary, has a “permanent establishment” in China, and, if payable, the treaty seeks to avoid double taxation (see below under Part IV “Tax Structuring Issues”). One reason that a joint venture may be chosen over another structure is that depending on the type of business the joint venture carries on, there can be tax holidays and/or rebates. The Business Tax is a turnover tax payable by taxpayers based on their gross revenues of services or proceeds from the transfer of intangible and immovable properties. The Business Tax and the VAT are mutually exclusive. The Business Tax is computed based on the turnover value of a business or the gross proceeds of a taxable transaction. However, in certain cases, the Business Tax is to be computed based on the net revenues after deducting certain charges. The Consumption Tax is a tax imposed, where applicable in addition to VAT, on categories of luxury goods and is imposed before the levy of VAT. Of the three taxes, namely, the Business Tax, the Consumption Tax and VAT, VAT has the widest scope. It covers the sale of all tangible goods (except real estate properties) and utilities, together with the provision of repair services and goods processing servicing. Special rules are in place for small-sized taxpayers. While at first blush, the VAT system seems to be relatively straightforward, we are advised that it may be more complicated for foreign investment enterprises and therefore some potential tax relief may be available for foreign JVs. It is to be noted that China's VAT system does not incorporate both goods and services. As stated above, most services will be subject to the Business Tax but not to the VAT. As a result, Business Taxes paid by VAT taxpayers cannot be recovered under the VAT system and the VAT paid by business taxpayers are also not recoverable. It is important that the VAT be understood and that proper accounting and invoicing records are kept for VAT purposes and that the proper amount of VAT is paid to the tax authorities and on time, as the penalties are severe.
The Partners As in any commercial transaction, it is important to determine as best you can whether the proposed partner is the best and the most appropriate in all the circumstances. In the PRC, this is particularly true as the legal system is not as transparent as it is in Canada, is not as fully developed and the enforcement of rights is not always as impartial as it is in Canada. In China “who you know” may be just as important as having proper legal agreements. Therefore your partner is crucial. There may be various entities that may be involved in the negotiations in China in addition to the Chinese party directly involved. The appropriate ministry and the Ministry of Foreign Economic Relations and Trade, the requisite Municipal Authority, and perhaps some state-run trade enterprise may all have to be present during or at some stage of the negotiations, and indeed the Ministry responsible or its delegated authority may have to approve the agreement under regulations specific to a particular industry. It is important to try to get a clear picture of where these various entities stand and what their agendas are. It is also important to get to know the PRC partner and find out what its goals and agendas are. If these are different from yours, can they be balanced? With respect to the question of authority, you must be clear that the company in the PRC that you are doing business with is in fact a legal entity capable of entering into contracts and in addition, that such company has the authority to negotiate with foreigners and enter into the contract. Due diligence on these kinds of issues is very important. It will be important to find out whether the person you are negotiating with on the PRC side has the power and authority to bind the enterprise. This is often a puzzling issue, as the idea of "apparent authority" does not exist in China. That is to say, a person with a particular title or particular responsibilities may not be able to commit the enterprise. The power of a person within the enterprise and his or her legal authority may not be the same. You should follow the rule of insisting on chopped and notarized powers of attorney in favour of the person who signs the negotiated letter of intent and JV contract. Therefore, adequate and full due diligence is crucial. As you may expect the negotiation of any kind of agreement in China often takes much more time than it would in Canada or another western jurisdiction. The Letter of Intent While the letter of intent is a non-binding agreement, it is an important document. It sets out the broad parameters of transaction and is part of the approval process. The letter of intent should be as specific as necessary but provide for flexibility for later variation depending on the results of the feasibility study or for other reasons. In addition, to the usual matters (business scope, corporate control structure, foreign exchange issues, source of materials and know how), it should deal specifically with any applications for investment and tax incentives or custom duties reductions on imports. It will be difficult to deal with these matters later unless they are set out in the letter of intent. Letters of Intent almost always precede a joint venture agreement and are a very common way of commencing a commercial transaction in China. However, there is no reason in law why a letter of intent cannot be dispensed with enabling you to go directly to the negotiation of your final agreement. Trade and Finance Matters The Chinese currency is Renmimbi (RMB “the People’s money”) which is denominated into Yuan and pegged by the Bank of China. RMB cannot be remitted abroad since it is a not a freely-convertible currency according to the laws of China. When Chinese domestic payers make payments abroad, they must, unless they have their own forex fund, purchase forex in RMB from Chinese banks upon approval of the State Administration for Foreign Exchange (SAFE) which is located in Beijing, and then remit the exchanged forex abroad. Therefore, where the Chinese party does not have its own foreign exchange, any contract that involves the payment in hard currency must be approved by SAFE, other than contacts for the importation of goods into China in the normal course of business where Foreign Trade Corporations (FTCs) are normally involved. The sale of goods in the course of normal business operations would constitute a "current account" transaction and as such would not normally require SAFE approval, so long as the Chinese contracting party has its own foreign currency or deals through an FTC. The large FTCs have foreign currency accounts with Chinese banks and the banks are pre-approved by SAFE for remitting forex abroad from the FTC's current accounts, that is the accounts used for normal trading transactions. Invoices and basic documentation will have to be provided to the bank. It is therefore important that the Chinese side have the obligation of ensuring that foreign exchange is available for the payment of any agreed fees. You should know at an early date whether forex is available and how it is to be obtained. This will be one of the many due diligence subjects. Letters of Credit need to be considered to secure payment of fees. The choice of the PRC bank issuing the LC is important, unless the LC is to be confirmed by a Canadian bank, which we recommend. LCs usually expire each year and therefore the agreements must provide for a “rollover” mechanism. Under PRC law, imported goods as well as goods manufactured by foreign invested enterprises in China cannot currently be distributed directly to retailers or consumers in China. Rather, FTCs licensed to conduct various import and distribution business must be involved in the transaction. There are presently some 40,000 of such companies, and their involvement does lead to some increased cost and complexity. Under the World Trade Organization commitments given by China, this trade restraint is to be relaxed over the next period of years so that foreign goods may be imported by foreign companies and sold directly in China. Dispute Resolution Laws are not evenly enforced in China in some court systems. Accordingly, one cannot always count on the Chinese courts to protect a foreigner’s legal interest. One should, for example, assume that know how, trade secrets and even patented intellectual property may be used by others without compensation to you or your company, with no or little recourse. This also means that disputes should be handled outside China by way of arbitration. The issue of the resolution of any disputes between your company and the Chinese side should be set out in the your agreement. We suggest that rather than leaving the matter silent, in which event any dispute (unless otherwise agreed at the time of the dispute) would have to be handled in the courts of the PRC, you consider having such disputes settled by arbitration in a neutral jurisdiction, such as New York, Stockholm or Vancouver. There are many different international bodies having their own arbitration rules, such as the International Chamber of Commerce based in Paris, the International Centre for Settlement of Investment Disputes (CSI), the American Arbitration Association (ASA), the London Court of International Arbitration, or an ad hoc arbitration under the United Nations Commission on International Trade Law. The Vancouver International Commercial Arbitration Centre may also be considered but may not be acceptable to the Chinese party. Choice of site, law and enforcement of the award are probably the three most important considerations at this time. However, it should be noted that some PRC laws relating to certain industry sectors require that the contracts be subject to arbitration in the PRC. As to enforcement of an arbitrator's award, China has acceded to the New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards. This provides a mechanism for the enforcement in China of Awards made in other contracting states. The China International Economic and Trade Arbitration Commission (CIETAC) is China's international arbitration organization. It has a very large case load and is gaining in popularity. CIETAC operates under the auspices of the China Council for the Promotion of International Trade (CCPIT), which, amongst other things, is responsible for appointing the panel of arbitrators for CIETAC.
In addition to tax driven structuring issues, the issue of licensing know how or other intellectual property to a Joint Venture, as opposed to contributing the same by way of a capital contribution, often arises. The Chinese party will often want the latter whereas the foreign party may be concerned about an outright grant of intellectual property. Issues of intellectual property valuation in terms of the relative capital contributions are sometimes the matter of some debate, with the Chinese party putting a high value on rights to land and a low value on the foreigners non cash contribution. Ensuring that the Chinese party to the JV has in fact the rights to any land that may be involved is not always easy to determine. It may be that the named Chinese party to the JV does not have the rights to the land, or that such rights are not clear. In such circumstances a third party may have to be brought into the negotiations. Again, proper due diligence is crucial. IV TAX STRUCTURING ISSUES It is not practicable in this memorandum to highlight all of the tax structuring issues to be considered, however the following matters may be noted. As a resident of Canada, a company or its subsidiary will be taxed in Canada on its worldwide income computed under the Income Tax Act (Canada). It will be important, therefore, to structure and conduct the business of your company and its subsidiaries to minimize Canadian and foreign income taxes to the extent permitted under
The tax rules in brief. (a) Canadian mind and management If a company is a resident Canadian taxpayer, which is the case if it is incorporated in Canada or its “mind and management” is in Canada wherever incorporated, then it is taxed in Canada on its worldwide income, subject to any applicable tax treaty. If a company controlled by a Canadian taxpayer is incorporated in a country that has a tax treaty with Canada although the mind and management of such controlled company is in Canada, the residency “tie breaker” rules may take the tax residency of such company to the offshore jurisdiction in which event the active business income would not be taxable in Canada. However its investment or foreign accrual property income (known as “FAPI”) would still be taxable in Canada. If resident in the offshore jurisdiction for the purposes of the applicable treaty the company would be taxed in the treaty jurisdiction. If the “mind and management” of a controlled foreign affiliate is not in Canada, its active business should not be taxable in Canada, but its FAPI will be taxable in Canada. Therefore, if the Chinese affiliate is controlled by a Canadian company in terms of shareholdings, but its directors or a majority thereof are non Canadian residents, its directors meetings are not in Canada, and it is not in fact managed or controlled in Canada, then its active business income should not be taxable in Canada. (b) Active business There are restrictions on what is and what is not “active business”. “Services” are deemed not to be active where the foreign affiliate provides services and the amount paid in consideration for such services is deductible by the Canadian taxpayer, unless the service are provided in connection with the purchase and sale of goods. (c) The Canada – China Tax Treaty and Exempt Surplus As a result of the treaty the active business income of the foreign affiliate carried on through a permanent establishment in China can be repatriated to Canada without Canadian tax as “exempt surplus”. However Chinese withholding taxes would have to be paid at the treaty rate of 10%. (d) Permanent Establishment To the extent covered by the Canada-China Tax Treaty, a Canadian company, or its Canadian resident subsidiary, will not be required to pay Chinese income taxes on the profit from carrying on a consulting business in China unless the Canadian company has a “permanent establishment” in China or has Chinese source property income . Generally, a fixed office or place of business will constitute a permanent establishment, whereas if an office is made available to the entity on a temporary basis, Chinese income tax might not be payable. However, if a company or its Canadian subsidiary has its own employees in China, and those employees provide services to the same project, or a connected project, for a period or periods which aggregate more than six months in a twelve-month period, then the provision of services by the company or its subsidiary will be deemed to be a permanent establishment. There are special rules relating to the issue of warehouses and agents. If a permanent establishment is found to exist in China, then only those profits of the Canadian company which are attributable to that permanent establishment can be taxed in China. (e) The Tax Treaty and Royalties The Tax Treaty provides that China may also tax any royalties arising in China however the Chinese Tax Treaty limits such taxation to 10%. Dividends and interest are also so taxable. As our clients are sometimes licensing intellectual property in China, special mentions should be made to royalties. The term “royalties” for purposes of the Treaty is defined in the treaty as consideration for the use of copyright, patent, know how, trade mark, plans, secret formula or process, or for the use of described equipment, or certain information. The earning of fees for performing services within the ambit of what is ordinary business is not usually regarded as royalties. (f) Transfer Pricing Issues If the Canadian company is to transfer a business to or sell services
or products to its Chinese subsidiary or affiliate, consideration will
need to be given to the transfer pricing rules under the Income Tax Act.
This may be particularly so if one of the reasons for establishing in
China is to effect Canadian income tax savings.
the consideration, or the nature of the transaction, will be deemed to be that which would have been entered into had the parties been at arm’s length. These rules, which adjust the commercial transaction for Canadian income tax purposes, apply with respect to transactions between persons not dealing at arm’s length. What is meant by “arm’s length” is a question of fact and the Income Tax Act (Canada) stipulates that certain relationships are deemed not to be at arm’s length, specifically related persons and companies as defined under the Act. These transfer pricing rules impact any assets, including goodwill, which is initially transferred from a Canadian corporation to a non-resident corporation as well as transactions respecting goods or services which take place on an ongoing basis. The Canada Customs and Revenue Agency ("CCRA") may adjust the pricing if it thinks that the transfer price would be different from a price agreed between two unrelated (arms length) parties. A change in the transfer price would affect the profits of the Canadian business subject to tax in Canada. In order to establish that the consideration paid in a transaction is equal to an arm’s length amount, the parties to the transaction must keep extensive information to demonstrate to the CCRA that the consideration is equal to an arm’s length amount and must continually update that information. There is normally a cost in complying with these transfer pricing rules which must be factored into any cost benefit analysis on establishing an offshore foreign affiliate.
If you are interested in further information please contact Bill Gooderham
directly at the number listed below. Bull, Housser & Tupper LLP
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