Do's And Don'ts Of A China Investment

Everyone who is anyone is going into China. Opportunities are plentiful. However, pitfalls are just as plentiful, if not more.

Although some of the issues raised in this article appear basic, if they are not properly addressed could cost you time, money and more importantly, lose real opportunities. What follows are three examples of common pitfalls.

Some Businesses in China ‘lower’ the value of imports in order to lower the Value Added Tax (“”VAT””) and Custom Duty. Should you follow suit?

China levies VAT at 17% and Import Duty in varying percentages, on the value of imports. This increases the cost of imports. Businesses will also have to find the funds to pay for these taxes while awaiting the goods to be sold and receivables collected from customers. To reduce this expense and improve on cash flow, some businesses under-declare the value of imports. Although this solves the above, it gives rise to its own problems.

Under declaration of the value of imports would mean that the costs of sale would be artificially reduced. This means higher profits and hence higher Income Tax on such profits.

Although the importer would still benefit from the delay in payment of Income Tax as opposed to payment of VAT and Import Duty at the time of import, under-declaration of the value of imports may lead to investigations and the resulting financial penalties.

The imposition of financial penalties for an incorrect payment of VAT and Import Duty does not allow the taxpayer to re-file its Income Tax and make a claim for a refund of overpaid Income Tax. The taxpayer thus would have incurred the financial penalties for the incorrect payment of VAT and Import Duty and still pay the higher Income Tax arising from the under-declaration.

The taxpayer who under-declares the value of imports will also have to constantly ‘watch his back’ as unscrupulous or disgruntled employees or business partners may use the situation to their own advantage.

Have you been financing your investments in China with funds from abroad? If so, can you repatriate these funds from China?

Many businesses that invest in China will require more funding than the paid-up capital of their Wholly Foreign Owned Entity in China (“”WFOE””). Additional funding is usually made by remitting funds into China from outside China by the holding company. Such remittances are often made on a regular basis, as and when funds are needed in China.

Notwithstanding that the financial statements of both the WFOE and its holding company respectively reflect the parties as borrower and lender, the parties may not be able to repatriate funds to repay this foreign loan. This is because many foreign investors do not properly register these foreign loans with the Foreign Exchange Bureau in time. Failure to do so will jeopardize the WFOE’s ability to obtain foreign exchange approval for the remittance of funds for the loan repayment.

Where foreign investors use loans to finance their China investments, they have to properly register the foreign loans so that loan repayments can be effected with minimal problems. It is also prudent to have proper loan documentation to evidence the existence of the foreign loan. Such documentation can be used as additional support when approval of the Foreign Exchange Bureau is sought for repatriation of funds.

If you have a Chinese Joint Venture (“”JV””) partner, how best to structure the investments in China?

Have a properly structured Joint Venture Agreement suitable for your investment in China. Don’t just replicate the same structure used in your home country.

Using a Manufacturing & Distribution Joint Venture as an example, many investors use a single entity for the manufacturing of products and for the distribution of the manufactured products in their home country.

If this is replicated for their investments in China, this will mean that the investor and their Chinese JV partner are invested in one JV vehicle which activities will include both the manufacture and the distribution of manufactured products. This is not prudent risk management, especially when the JV relationship is new.

Often, the Chinese JV partner is selected because they bring valuable contribution by way of business contacts and market intelligence for the distribution of products. In a majority of cases, the Chinese JV partner has little to contribute in the manufacturing of the products as the manufacturing know-how often belongs to the foreign investor.

In such a situation, the foreign investor should consider structuring its investment in China using two entities. The first entity is a WFOE for the manufacturing aspect of the business. The second entity is a JV with the Chinese partner. The JV purchases products manufactured by the WFOE and distributes these in the China market. This structure will isolate the Chinese partner to that unit of the business (ie the distribution) that will benefit from their contribution. If the JV fails for whatever reason, the manufacturing portion of the business will not be seriously affected, if at all.

Conclusion

The above gives only three illustrations of the many problems an investor may encounter when they journey into China. For businesses to be successful in China, there is a constant need to remain vigilant and guarded, so as to avoid the many pitfalls in this significant journey. Proper professional advice is a crucial element for success.