Against the backdrop of the China Australia Free Trade Agreement (“CHAFTA”) an increasing number of Australian businesses are investing in the Chinese market, especially in the growing area of professional services. Traditionally one of the biggest challenges for foreign investors into China has been getting profits and payments past the labyrinth of China’s financial, taxation and exchange regulations. In recent years there has been a significant reduction on those regulations and with careful planning it is possible for Australian businesses to establish a successful profit and payment repatriation structure.
Recently, Moulis Legal hosted a business breakfast for small and medium Australia businesses exploring investment opportunities in China. In this China Messenger and China Podcast, Moulis Legal’s Christopher Hewitt and Macky Markar examine China’s financial repatriation rules and the repatriation strategies discussed at Moulis Legal’s business breakfast.
Money flows from China are controlled, but less than you may think
The flow of money across Chinese borders – both physical and virtual borders – is carefully controlled by the Chinese Government. The most important institutions for the repatriation of money to Australia from China are the State Administration of Foreign Exchange (“SAFE”) and the State Administration of Taxation (“SAT”).
Traditionally, foreign investors in China have found the repatriation of funds to be a complex and time consuming process. SAFE has maintained a large number of complex regulations and required foreign investors to navigate a long administrative process before allowing money to be transferred offshore by Chinese banks. SAT has similarly complicated the repatriation of money though a relatively complex taxation regime that requires various financial allowances prior to allowing profits to be repatriated. If an investor has not considered these complexities prior to investment, the investor will often find they do not have the appropriate structures to facilitate the efficient repatriation of funds. Poor planning can result in excessive taxation liabilities, unexpected fees and charges, and even the complete inability to transfer funds out of China.
This problem is colloquially known as the “Cash Trap” and it is far too common amongst foreign investors in China. However, in recent years there have been a number of positive developments in the regulation of money transfers out of China, which have reduced the complexity and time.
For example:
- On 1 September 2013, SAFE replaced 49 separate regulations governing inter-company charges with a single regulation.[1]
- SAFE have delegated authority for approving and processing foreign exchange remittance applications to local banks. This allows businesses to deal directly with their bank in China to repatriate funds to an overseas parent company or related business. This process is closely monitored and SAFE conducts regular audits of the activities of banks.
- Remittances under USD50,000 generally do not require SAFE approval or detailed documentation to be provided to the bank before completing the transfer.[2]
- Remittances over USD50,000 do require documentation evidencing the purpose and justification for the transfer, although SAFE approval is no longer required in most instances.[3]
The loosening of these regulations has allowed for a more streamlined and efficient system for the repatriation of payments and profits from China to Australia. However, there are still multiple examples of Australian business being caught in the so-called “Cash Trap” because they have not followed the regulations, they have failed to establish a defensible repatriation strategy, or because of bureaucratic problems (despite improvements problems still exist!).
How Australian businesses get caught in the cash trap
Foreign investors in China still face a number of internal and external challenges when seeking to repatriate payments and profits. Some challenges are imposed by regulators. Other challenges are self-imposed.
The regulatory challenges that need to be overcome include the complexity of foreign exchange regulations; differing interpretations and practices between local and regional branches of SAFE; and different practices between local banks. While there has been significant reductions in regulations and restrictions, the local banks strictly impose the requirements for complete applications and supporting documentation. SAFE regularly audits local banks to ensure they are complying with the terms of their delegated authority and this can result in some unnecessary delays to certain offshore transfers. Administrative issues and delays are sometimes unavoidable, although they can be minimised by having a well-documented and defensible money transfer process in place. Where possible (and appropriate), communication with the relevant authority may help a business to understand the requirements imposed by the regulator and make the remittance process simpler, saving a business both time and money.
The self-imposed or internal business issues we see most frequently include:
- businesses not having sufficient commercial justification for overseas payments and assuming that they can simply transfer money from a Chinese bank account to an Australian bank account;
- businesses having little or no supporting documentation for a remittance application;
- failing to complete prerequisite applications for a remittance;
- not having a transfer pricing policy or necessary documentation for inter-company charges; and
- the structure of the corporate group not be conducive to inter-company charges and payments.
Foreign investors that are unaware of the rules imposed on their business in China may not have appropriate processes in place to facilitate repatriation. Necessary structures and contractual documentation should be developed at time of the initial investment and should be part of the investment planning phase.
How to spring the (cash) trap
In order for a Chinese business to transfer money from China to a business in Australia a remittance application must be completed and approved by the local Chinese bank. Depending on the size and type of the remittance certain supporting documentation may be required. In our experience, three key principles must be followed when completing remittance applications, regardless of the type of payment:
- the remittance must be reasonable and have a valid commercial justification;
- the remittance must be authentic; and
- the remittance must be supported by all relevant documentation.
Inter-company charges: service and royalty fees
Companies doing business in China can use a variety of inter-company charges to facilitate before tax distribution of funds, including service fees and royalty fees. Service fees are typically charged by an Australia parent or related company to company in China for services. Royalty fees are related to the provision of specific know how, intellectual property or technology by the Australian company to the Chinese company. Critically, it is a requirement that the relevant royalty agreement be pre-registered with the China Trademark Office in order for it to be used for a remittance application.
Service fees are a particularly important part of a comprehensive remittance strategy because they can be considered a deductible for Chinese Company Income Tax purposes if they relate directly to the Chinese company’s field of business and have been charged at market rates.[4]
The streamlining of the remittance process, including the delegation of authority to local banks, has facilitated the greater usage of service fee and royalty fees as a mechanism for pre-tax repatriation. The removal of the requirement to provide documentary evidence for most transfers of under USD50,000 in value in a single transaction has allowed businesses to simplify offshore service fee payments. However, foreign investors have sometimes been tempted to split a larger sum into several smaller remittances in order to circumvent the evidentiary requirements – this practice is prohibited and the company may face a penalty of up to 30% of the remittance amount.
As with all inter-company charges, the payments should be structured in order to minimise taxation obligations in China and Australia. Most inter-company charge payments will be subject to Business Tax and/or Value Added Tax in China, and if the payments are not structured appropriately they may also be subject to Foreign Enterprise Income Tax. All inter-company charges should be properly documented through proper contractual documents to demonstrate the commercial justification for the offshore payments.
Inter-company loans
An inter-company loan between members of a corporate group – with corporate members located in both China and Australia – can be a useful repatriation method provided it is properly structured and documented. The two most basic forms of investment related loans are when:
- the Australian parent or related company lends to the Chinese company who must make repayments, with interest, to the Australian company; or
- the Chinese company loans funds directly to the Australian company.
In the first type of loan the interest payments by the Chinese company will usually be subject to Business Tax and Withholding Tax by SAT in China. Subject to the structure of the inter-company loan and the relevant debt to equity ratio, interest payments may be tax deductible.
In the second type of loan, the interest payments received by the Chinese company may be subject to Company Income Tax and Business Tax in China. Traditionally these loans have been heavily regulated in China, although recent changes by SAFE have simplified some of the processes, including allowing for loans for a period of more than three years. Despite these developments there are still limitations on the amount that may be loaned by the Chinese company.
Dividends
The most common form of after-tax repatriation is dividends declared and paid by the Chinese company to foreign investors. While the payment of dividends is a relatively straightforward process it is not always the optimal solution for companies. Foreign Invested Enterprises in China are required to be audited annually, and dividends cannot be declared and distributed until after the company’s profit has been audited. This means that, in practice, an Australian parent company or investor will be forced to wait a year between receiving dividend payments.
Additionally, in most cases a company can only distribute dividends out of its accumulated profits and will not be allowed to distribute dividends that exceed the company’s net income in any given year. In practice this means that prior accumulated losses must be offset by profits over the life of the company, before declaration of any dividends.
The company in China will generally need to make various accounting provisions prior to declaring a dividend, including Company Income Tax and a contribution to the company’s reserve fund. In some instances funds will need to be reserved for Withholding Tax, and contributions may be required into the company’s Staff and Workers Welfare Bonus Fund and its Enterprise Expansion Fund. These accounting provisions are cumulative and can result in a substantive reduction in the dividend that may be declared by the Chinese company. After accounting provisions are made, the company may declare a dividend from the remaining distributable profits and remit them to the overseas parent company or investor.
Moulis Legal advises Australian and Chinese companies in their trade and investment between the two countries. Moulis Legal’s investment team includes lawyers with training and experience in advising foreign companies in China on all aspects of their investments and business operations. For more information, please contact Charles Zhan (charles.zhan@moulislegal.com) or Macky Markar (macky.markar@moulislegal.com) on +61 2 6163 1000.
This memo presents an overview and commentary of the subject matter. It is not provided in the context of a solicitor-client relationship and no duty of care is assumed or accepted. It does not constitute legal advice.
© Moulis Legal 2015
[1] Circular on Printing and Forwarding the Regulations on Foreign Exchange Administration for Trade in Services, (People’s Republic of China) State Administration of Foreign Exchange (Huifa No. 30 [2013])
[2] Circular of the State Administration of Foreign Exchange on Further Improving and Adjusting Foreign Exchange Administration Policies under the Capital Account, (People’s Republic of China) State Administration of Foreign Exchange (Huifa No. 2 [2014])
[3] Circular of the State Administration of Foreign Exchange on Further Improving and Adjusting Foreign Exchange Administration Policies under the Capital Account, (People’s Republic of China) State Administration of Foreign Exchange (Huifa No. 2 [2014])
[4] EY, China’s State Administration of Taxation issues views on service fees and management fees on Global Tax Alert (News from Transfer Pricing) (12 May 2014) EY (http://www.ey.com/GL/en/Services/Tax/International-Tax/Alert–China-s-State-Administration-of-Taxation-issues-views-on-service-fees-and-management-fees)
