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China Company Taxes: Don’t Let the Tail Wag the Dog.

China tax laws

Excellent post on the China Tax Insight Blog, based largely on a couple of comments on our blog. The post is A Seeming Solution to the China PE problem [link no longer exists] and it relates to foreign companies trying to avoid having a business presence in China for tax or other reasons.

A few years ago, a pretty successful US based international company came to my firm regarding an ownership dispute regarding one of its overseas companies. This US based company is a mid-sized company (maybe USD$600 million or so a year in business) with on the ground operations in five countries. It had at least fifty companies and about ten companies relating to the particular country in which it was having the dispute. I asked them how things were working for them with so many companies and they said, “not well.” Over the years, their accountants and lawyers had formed new companies as a solution for just about everything and now their situation was unwieldy and expensive. I asked if it was saving them money on their taxes and they said, they doubted it. We counseled them on what we thought they should do, which was to reduce their “empire,” to six companies with one holding company.

We did that for them and they thank us just about every time we see them.

When small or start-up company comes to us with grand ideas for elaborate corporate structures to avoid taxes or liabilities, I become very skeptical their business will make it. The tail is wagging the dog for these people. Their initial focus should be on building a solid but simple corporate foundation and on making money. It should not be focused on acrobatic and expensive gyrations to avoid taxation on money that may never come in the door.

That’s sort of what Matthew over at China Tax Insight says as well. He starts out his post by saying how we wrote a post, entitled,The China Representative Office (RO). Got WFOE? on “the representative office problem in China” that did not raise any tax issues. He then notes the following comment left on our China Rep Office post:

One of the thoughts was that not only would there be a flight to WOFE but that arrangements whereby foreign companies aren’t carrying on business in China or don’t have a permanent establishment for tax purposes will become more prevalent. On review, it may be be that foreign companies do not now require a presence in China and ‘agency’ or similar arrangements with Chinese companies may be sufficient.

Matthew then notes how the first sentence in this comment “only looks at the Chinese tax impact of a China investment,” while completely ignoring the overall tax rate, which will likely include the company’s home country. As Matthew so nicely points out, the result of not setting up operations in China may result in little to no tax savings, while at the same time it will likely mean incurring the”risk of penalties and interest” from China.

Matthew then comments on how the second sentence of this comment is even “more problematic because it suggests an agency relationship can remove a permanent establishment risk.” He then does a nice (and somewhat complicated) analysis of why this is not correct and points out how because the agent will need to make a profit too, such an arrangement will not usually make business sense either.

I completely agree.

I cannot tell you how many times people have come to my law firm’s China corporate lawyers with convoluted schemes to avoid having to establish a WFOE or Joint Venture in China. Within about two minutes, we are usually explaining to them why their plan will end up costing them more in both the short term and the long term, and saddle them with much greater risk than if they just did things the right way.
The reality is that Chinese tax and company laws are quite sophisticated and the Chinese authorities generally understand (and do not appreciate) the various methods foreign companies employ to try to escape from Chinese taxes and jurisdiction. It is time  foreign companies start realizing that China now has relatively sophisticated tax laws and good mechanisms in place for catching foreign companies that try to dodge those laws.

What do you think?

6 responses to “China Company Taxes: Don’t Let the Tail Wag the Dog.”

  1. Having practiced in both the US and China, I would say that foreign companies are treating China’s tax laws exactly the same as they treat the tax laws in their own countries. The problem of companies becoming dangerously inefficient and unwieldy through complex corporate structures is not unique to China. I think nearly every large company would benefit from your advice to trim down.

  2. Interesting post. I think you have given the right advice to your clients. Would be interesting to also read more details about the fundamentals of taxation and company laws as practiced in China.

  3. Annual revenue of US$600 mn but with fifty companies in the structure? Holy cow.
    Everytime I have come across a structure that I did not understand in a corporate deal, it was tax-driven, but this is extreme.
    I think the take-away for foreign investors is: respect ALL Chinese laws and authorities. And do not underestimate the sophistication of the people you’re dealing with in government bureaux.
    As a side point, actually, in the Chinese tradition, the best and the brightest have gone onto careers in government.
    That may be changing, but still many extremely accomplished university grads opt for this career path. It might well serve many foreign investors to keep this in mind.

  4. EJ,
    Comments like yours are why I never leave a CLB post without checking out the comments.
    Geraldine Johns-Putra,
    Your side point has provoked so many thoughts in my mind I don’t know where to begin. I’ll just ponder over them more and thank you for the food for thought.

  5. What makes me sad is the pulling out of Google out of China. Both parties have the point and I think its a loss-loss situation, if only they talk of better solution..

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