On December 8, 2011, the Ministry of Commerce (MOFCOM) and State Administration of Foreign Exchange (SAFE) issued the circular Shangzihan [2011] No. 1078 (Circular 1078), which sought to clarify issues relating to the use of RMB income by Chinese Holding Companies (CHCs) to reinvest in existing subsidiaries or establish new companies in China.

We examine Chinese Holding Companies as a vehicle for foreign investment and outline how the new regulations will affect their operation.

Chinese Holding Companies

Company registration in China for foreign invested entities (FIEs) requires approval by SAIC (State Administration for Industry and Commerce) of intended business scope as described in a list of narrowly defined categories. For MNCs with a range of business lines, this can present a strategic disadvantage with local competitors as they can be forced to separate their operations into several separate entities.

The CHC offers one solution, providing a vehicle for companies with at least one Chinese subsidiary to share services and sell products manufactured by investees – albeit attracting a higher tax rate, with high registered capital requirements (USD 30 million) and complex transfer pricing issues. In recent years, the Chinese government has issue a number of regulations to encourage the use of CHCs as a draw card for large scale foreign investment, including relaxed rules on the borrowing ratio against capital.

Background

In March 2011, the SAFE released Circular Huizihan [2011] No. 7 (Circular 7) stating that CHCs wishing to reinvest legitimate RMB proceeds in their Chinese subsidiaries must first convert the funds to registered capital by applying for a capital increase. This requirement raised new tax implications for foreign investors: the use of after-tax profit to increase registered capital would be deemed as a distribution of dividend and thus attract withholding tax within China, while concurrently raising the possibility of dividend tax implications in the home jurisdictions of foreign investors.

Circular 1078 addresses these issues by providing other options for reinvestment and outlining administrative procedures.

Key Points of Circular 1078

• CHCs are allowed to reinvest directly into their Chinese subsidiaries using RMB profits, return on investment, liquidation proceeds, and share transfer proceeds as well as other legitimately obtained proceeds within China upon approval from their local SAFE.
• The Circular confirms that CHC income can be used not only to increase its own registered capital but also contribute to the capital of other CHCs.
• CHCs may not make a reinvestment in subsidiaries with domestic loans.
• The approval procedure requires submission of the following to SAFE:

1. Written application
2. Foreign Exchange Registration IC Card
3. Ministry of Commerce approval document issued on the CHC domestic investment
4. Supporting documents that verify the RMB funds source
5. Most recent capital verification report and audited financial statements

• Following SAFE review and approval, RMB funds may be wired directly to the recipient entity’s bank account or to the final entity via the bank account of the CHC.

S.J. Grand Notes

In general, this Circular moves in a positive direction for investors considering a CHC structure. Circular 1078 provides an option for reinvestment that avoids costly withholding tax by allowing CHCs a direct route to investment in subsidiaries without dividend repatriation and registered capital increase.

CHCs in the process of increasing their registered capital in line with earlier circulars or considering a reinvestment should discuss the issue with their local SAFE office to ensure compliance and avoid any unnecessary withholding tax.

For further information on the tax benefits of Chinese Holding Companies, contact S.J.Grand