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Business> Legal-Ease
UPDATED: December 15, 2006 NO.49 DEC.7, 2006
Faulty or Inefficient Business Applications (VI)

Important tax issues that are commonly misjudged

VAT treatment

There is still one commonly held misconception about the "VAT Exemption on Exports." If the refund rate is lower than the levy rate, the company must bear the additional VAT cost on exportation. The VAT cost is calculated as follows:

Manufacturing company:

VAT cost = (export cost - free duty imported raw material cost) x (levy rate - refund rate)

Trading company:

VAT cost = cost of local purchased raw material x (levy rate - refund rate)

Generally speaking, the levy rate is 17 percent, while the refund rate is 13 percent.

Customs deposit on imported raw materials to be subsequently exported

We often hear the misconceived statement: "There is no VAT and customs duty levied on imported raw materials used for manufacturing goods locally if they are then finally exported 100 percent." It is incorrect. Actually, newly established foreign-invested enterprises (FIEs) must still make a tax deposit to the customs for VAT (at around 17 percent) and remit duty on the initial importation, for a period of time of generally six months. Many new businesses do not budget for this as initial working capital to be contributed as part of registered capital, leaving them short of operating cash later on.

Enhanced profits repatriation-reducing profits taxes in your business

This is a tax issue, and applies to all FIEs that sell services or products in China. If no structural changes are made to your FIE articles, you will spend 4-13 percent of your total turnover on profits tax payments. FIEs, as mentioned earlier, are not just simple licensing applications, and if you treat them as such, you will end up with an inefficient business.

Enhancing your China profitability by reducing your profits tax burden is essentially a matter of introducing into the business a series of allowable service contracts between the FIE and its parent company back home. These services can include:

· Management expertise;

· Royalties such as for trademark and patent use;

· Interest and administration on loans made to the FIE; and

· Other services as required.

These services rendered to the China FIE generally attract a withholding tax rate of 10 percent if based in a free trade or similar zone and 20 percent if based elsewhere in China. This means, for an invoice of $1,000 sent to the China entity by the parent, the China entity will have to deduct and pay to the local tax bureau either $100 or $200, depending upon their locale, and remit back home the balance, being either $900 or $800 respectively.

However, this compares favorably against the profits taxman at the year-end. If the money is left in the company, the profits taxman will levy rates of 15 percent (if in a free trade zone), 24 percent (if in a municipality) and 33 percent if elsewhere (tax holidays excepted). That means payments in profits tax of $150 if in a free trade zone, or $240 if in a municipality or $330 if elsewhere, obviously being less competitive in tax treatment.

Accordingly, to take advantage of this, an enhanced profits repatriation structure needs to be built into the FIE articles and inserted (they do not appear in normal drafts), and a series of contracts need to be agreed between the parent and the FIE and registered with the tax authorities in China for assessment.

Establishing a local company by using local staff's name

Some foreign investors don't wish to go through the required FIE registration process to set up their operations, for reasons such as having to part with higher amounts of registered capital, or that certain industry sectors restrict foreign investment. However, a local company under local staff's names is not your company, even if foreign investors funded the capital of the local company. If there is any dispute with such staff, the foreign investors in it will have no legal mechanism to protect their assets.

Additionally, domestic companies, even if indirectly invested by foreigners, have no rights to transfer profits overseas, as the money is earned by a local company and is subject to local taxes and regulations restricting the movement of such companies' money out of China.

Chris Devonshire-Ellis is a senior partner of Dezan Shira & Associates, Business Consultants www.dezshira.com

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