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Legal-Ease
Business> Legal-Ease
UPDATED: April 18, 2008 NO.17 APR.24, 2008
Nurturing SMEs (ii)
Practical financial, tax and accounting issues affecting international SMEs during the early stages of investment
By CHRIS DEVONSHIRE-ELLIS
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Tax invoices and foreign currency control

Small manufacturing enterprises (SMEs) usually need to almost immediately purchase equipment, rent offices, buy raw materials and hire local staff within China. All these expenses should, in an ideal world, be paid from the company's local bank account and not from any other sources (e.g. holding company's money or investor's cash). What's more, the company should give clear instructions to its staff in order to obtain legal tax invoices from Chinese local vendors. Anything other than an official invoice (the famous fapiao) would not be booked into the Chinese accounts.

When asking local suppliers to provide legal value-added tax (VAT) invoices, some may demand more money, i.e. an additional 6 percent of the total amount (VAT applicable to small tax payer suppliers), while others may even refuse to provide legal VAT tax invoices. SMEs usually find it difficult to explain to the tax authorities where this money has gone under such conditions, and the company may face a tax penalty in the future. Therefore, what foreign companies need to remember is that they should make clear whether the price quoted by the local suppliers is tax-inclusive or tax-exclusive.

Mixing up of different subsidiaries' or business units' accounting operations

Many foreign investors do set up different entities at the same time or within a close period of time as they see many opportunities arising while they do business in China. For example, a typical structure to perform trading activities would include a Hong Kong incorporation and a China representative office or a trading company; most manufacturers who set up in south China will also likely include a Hong Kong holding company for various strategic, financial or protection reasons. During the initial period, it often happens that money from different companies' accounts is mixed for financing operations without a clear allocation based on cost. Companies should try to build up a clear financial model and flow from the beginning to avoid problems.

Differences between total investment and registered capital

We keep on mentioning this subject in our articles as it seems that SMEs still do not pay enough attention to the proper structuring of their investment. Foreign capital accounts are still restricted in their operations in China (do not assume what you can do in Hong Kong or in your home country applies in China as well) and borrowings of any kind need to be applied for. It is very important to get the ratios right between the total investment and the registered capital and understand the fundamentals behind this allocation.

If you are required to obtain a loan from the mother company or a banking institution to solve initial cash flow problems or to pay Chinese local suppliers to finance production, according to the policy of the State Administration of Foreign Exchange, a subsidiary in China is not allowed to get a loan from the mother company if their total investment is equal to their registered capital and no gap had been considered during initial setup stages. Because of this, it is important to structure investments correctly from the beginning by paying attention to the necessary start-up capital required and the borrowing options which may be considered should the need arise. It should also be noted that the registered capital amount should be based on the businesses' specific cash flow needs to operate it until it develops its own cash flow to support it, and not be based on any minimum amounts-otherwise you simply run out of money. "Minimum guidelines" should be treated with caution and the amount actually required based on your practical financial needs.

Scarce knowledge of tax planning opportunities

Many foreign SME investors do not know how to use the present advantageous Chinese (or international) tax policies to structure an efficient and effective global tax planning. The right amount of attention should be paid to the following in order to properly alleviate the ultimate tax burden (where tax exemptions still apply):

a) Use imported production equipment for tax planning purposes as part of registered capital if your business sector is encouraged and allows for tax exemptions.

b) Establish Chinese entities and companies in other jurisdictions if your operations require an international or Asian presence so as to benefit from lower tax rates in different countries.

c) Move selected functions from your internal vertical operations to lower tax jurisdictions in order to benefit from different lower corporate tax rates.

d) Use double tax treaty arrangements between Chinese and foreign individual income tax policies to structure IIT (individual income tax) planning.

e) Use double tax treaty arrangements between China and other jurisdictions to lower withholding and dividend taxes.

f) Use bonded areas or export processing zones to do tax planning for VAT if your operations involve processing for re-exportation activities elsewhere in Asia and the world.



 
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