As the top recipient of foreign direct investment (FDI) in 2014 (source: UNCTAD), China is unarguably an important destination for investment. Nevertheless, China's regulatory environment and implementation procedures continue to present a challenge for foreign investors.
It is important not only to consider the different vehicles available when investing in China, e.g. a wholly foreign-owned enterprise, joint venture or representative office, but also the jurisdiction through which a Chinese investment is held.
Hong Kong has always been and continues to be the preferred jurisdiction for structuring both China inbound and outbound investments. Last year, close to 72% of investments into China were through Hong Kong, which far exceeded direct investments into China by any other country. Singapore, China's second largest investor, accounted for less than 5% of China's inbound FDI (source: Investment Promotion Agency of MOFCOM).
Below are five of the main reasons why Hong Kong is favoured over any alternative.
1. Protection for the foreign parent company
The most common and efficient structure for foreign investment into China is a Hong Kong holding company. This holding company can be used as parent to the Chinese foreign investment enterprise as well as to structure other investments into the region.
The private limited company is the most common type of entity to be registered in Hong Kong. It is governed by the Hong Kong Companies Ordinance, has its own independent legal personality and liability is limited to a shareholder's subscribed capital.
As a holding company of the Chinese investment, this structure may offer foreign investors more protection than a direct shareholding in a Chinese company and significantly more protection than creating a joint venture (JV) in China, where ownership is shared with a local Chinese partner. If a JV is used, structuring it at the Hong Kong level may offer greater flexibility and less risk for investors than setting up the JV in China.
2. Legal benefits
Many investors in the region prefer their contracts and disputes to be governed by Hong Kong law and subject to the jurisdiction of the Hong Kong courts.
This is because Hong Kong has a stable, mature and accessible legal system, based on the familiar concept of English Common law and supported by a fully independent judiciary. All laws are in English and proceedings can be held in English on request.
Hong Kong is also a leading centre for international arbitration. Hong Kong's courts are renowned for upholding arbitral decisions, and awards granted under Hong Kong arbitration are consistently recognised in jurisdictions around the world.
Another attractive feature of Hong Kong's legal system is the protection offered to intellectual property (IP). This is more extensive and enforceable in Hong Kong than in China, and many businesses operating in China may wish to register their IP rights through a Hong Kong holding company to ensure infringements are dealt with appropriately.
While Hong Kong has long been a popular jurisdiction for resolving Chinese-foreign disputes, it has not always been easy to enforce Hong Kong court judgments in China. This changed in 2006: although the Hong Kong and China legal systems remain separate, an arrangement between the two jurisdictions now enables the reciprocal enforcement of court judgments. The arrangement applies to final and conclusive financial judgments and to arbitral awards. Consequently, businesses that choose to use the Hong Kong courts may have more confidence that judgments will be upheld in China.
3. Additional flexibility
Transferring or restructuring shareholdings in a Chinese vehicle is a lengthy process that requires compliance with Chinese regulations and cooperation of government authorities as well as extensive documentary approvals. These are not always forthcoming and transactions may be delayed as a result.
Corporate restructuring at the level of a Hong Kong holding company, however, is a straight forward process of registration and filing. Although some reporting may be required in China for the change of shareholding of a Hong Kong holding company, it is easier and more efficient than restructuring a Chinese vehicle directly.
Hence, for businesses that operate in Mainland China or across the region, a Hong Kong company is an effective regional holding platform, streamlining the investment and disposal process of entities in North and South East Asia.
4. Potential tax benefits
When investing in China through a Hong Kong company, certain advantages may be granted by the double tax agreement (DTA) between Hong Kong and China, which is one of the most well-established and familiar tax agreements to Chinese authorities:
a) Dividends: Dividends paid by a Chinese company to a foreign investor are subject to withholding tax at the rate of 10% unless reduced under a DTA. Under the DTA between Hong Kong and China, dividends paid by a Chinese company to a Hong Kong parent are subject to withholding tax at the reduced rate of 5%, provided the DTA conditions are met.
b) Interest and royalties: Interest and royalties received by a Hong Kong parent company from a Chinese subsidiary also benefit from the DTA – the maximum rate of withholding tax on both is reduced to 7%. This compares favourably with direct payment from China to other jurisdictions where the current withholding tax rate is 10%, unless otherwise reduced under a DTA.
It must be noted that to take advantage of the DTA, the Hong Kong company must be able to demonstrate business substance in Hong Kong.
In addition, Hong Kong adopts a territorial system of taxation where a tax exemption may be granted for profits that are not of a Hong Kong source. Profits derived in Hong Kong are only subject to a corporate tax rate of 16.5%. Hong Kong does not charge tax on dividends received by a Hong Kong company or withholding tax on dividends paid to shareholders (local or overseas).
5. Simple, efficient and cost-effective administration
From an administrative perspective, incorporating a company in Hong Kong is quick, easy and cost-effective. It can be completed within 24 hours and requires only one individual director (additional corporate and individual directors may be appointed). Although the company must have a local secretary and a Hong Kong registered office, directors do not need to be resident in Hong Kong.
With the modernisation of foreign investment policies in China and its neighbouring countries in the region, investing directly has become significantly easier in recent years. Nevertheless, many foreign investors still opt to invest via an investment holding vehicle based in a country that offers better protection, familiarity and flexibility as well as accessibility when entering new markets.
In 2014, Hong Kong was the second largest recipient of FDI in the world, while China held the top spot. Hong Kong also ranked second in terms of FDI outflows behind only the United States and ahead of China (source: UNCTAD). These rankings are strong indicators that Hong Kong plays a vital role as a 'super-connector' and a conduit for investment between Asia and the Western world.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.