China: Changing Representative Offices into Wholly Foreign Owned Enterprises (WFOEs)?

Last Updated: 27 December 2012
Article by Maarten Roos


Since new regulations on representative offices came into effect in March 2011, cities such as Shanghai and Beijing have seen many such offices being replaced by wholly-owned subsidiaries in consultancy or trading. This trend is in part a direct result of the tightening of the supervision on activities that employees of the representative office may engage in. Rep. offices are only permitted to engage in non-operational activities such as marketing and liaison only, with the penalties on operating beyond this approved business scope greater than ever.

An even more important consideration has been the increased legal and practical disadvantages, administrative burden and fiscal cost of continuing to operate a rep. office.

At the same time, alternative structures are now establish to establish and simple to operate. Sourcing companies for example often only need their Chinese staff to engage in liaison and quality control - activities that are perfectly suitable for a consultancy WFOE (wholly foreign-owned enterprise). Those businesses that are trying to expand on the Chinese market could benefit from replacing their rep. office structure with a trading WFOE.

Representative Office vs. WFOE: Legal considerations

The main benefits of the rep. office have always been that they are easy to establish and especially, that they are convenient to finance: an investor does not need to commit a fixed amount of capital, but can remit funds regularly based on the need to cover salaries and expenses in China.

On the other hand, the establishment of the WFOE has also become much more straightforward, and is now only slight more complicated than setting up a rep. office. Moreover, while an investment (in the form of registered capital) must still be made, the requirements on this amount capital have gradually diminished over the years. By law, the minimum registered capital of a single-shareholder is now CNY 100,000; industry regulations, local rules or practices may still require a higher amount, but this is generally negotiable and will depend on the scale of the expected business. In practice, the amount and timing of the investment rarely form a major obstacle to foreign investors.

At the same time, the legal benefits of the WFOE are considerable. Perhaps most important is that the WFOE is a limited liability company, which means that the investor's liability is limited to the amount of registered capital to be contributed. This

contrasts to the rep. office, where the investor remains fully responsible for the office's debts, a liability which could even impact the freedom of movement in China of the investor's authorized representatives. Other notable benefits of the WFOE are:

  • Chinese employees can be hired directly (Rep. office: Chinese employees must be hired through an employment agent;
  • There is no quota on the hiring of foreigners (Rep. office: maximum number of foreigners is four);
  • WFOE's foreign legal representative does not have to file for taxes in China (Rep. office: the foreign chief representative must always file taxes); and
  • Annual audit includes only the WFOE's accounts (Rep. office: annual audit includes proof that the investor continues to exist, through notarized / legalized documentation).

Representative Office vs. WFOE: Fiscal (tax) considerations

The rep. office does not have any operational income - it is directly financed by its investor. However the value created by the rep. office is still subject to taxes in China. With tax exemptions now rare, most rep. offices are taxed on total amount of expenses.

The most important taxes are business tax at 5% (depending on the location), and corporate income tax at 25% (to keep things simple, we do not include additional minor taxes in our calculations below). Since the rep. office has no income, business tax is levied on total cost and corporate income tax is calculated based on a deemed income over that cost, which since 2011 is at least 15%.

With no deductions of expenses, a quick calculation shows that if deemed income is 15% (which is the minimum), then average due taxes are approximately 11-12% of total expenses:

Case Example 1:
Representative Office with budget of USD 1 million

Deemed income =
Expense / (1- deemed profit rate 15% - business tax rate 5%)
Income tax =
Deemed income x deemed profit rate x income tax rate 25%
Business tax = Deemed income x business tax rate

If the expense of the office is USD 1 million, the calculation will be
Deemed income = USD 1,000,000 / (1-15%-5%) = USD 1,250,000
Income tax = USD 1,250,000 x 15% x 25% = USD 46,875
Business tax = USD 1,250,000 x 5% = USD 68,750

Total main taxes = USD 46,875 + USD 68,750 = USD 115,625
Average tax rate on total expenses: USD 115,625 / USD 1,000,000
= 11.56%

A straight tax comparison for the rep. office and the WFOE that shows the tax savings if the former is liquidated and the latter takes over the business, is not easy to make. The WFOE's tax situation is more complex, and due taxes depend on a number of factors including:

  • Activities (e.g. trading or consultancy);
  • Location (Shanghai charges value-added tax (VAT) instead of business tax);
  • Scale (if VAT applies, whether the company is a small-scale tax payer or a general tax payer);
  • Expenses in China that bring input VAT.

Another major factor is the budget of the WFOE compared to its income; in contrast to rep. offices, the WFOE's corporate income tax is levied on actual profit rather than deemed profit. Consider for example that many consultancy WFOE's provide marketing, liaison and quality control services directly to their investor or affiliate, and issue the corresponding service invoice at a cost-plus basis. Chinese law does not determine a minimum of this "plus", and so the lower the margin, the lower the tax burden. result in a lengthy restriction on exiting the country. A way to mitigate this restriction is to seek permission of the courts to appoint an agent (usually a law firm) to represent the (foreign) legal representative in the process.

In any case, the tax burden of a WFOE is very likely to be lower than that of a rep. office. The following example is illustrative (and for reference only):

Case Example 2: WFOE with budget of USD 500,000

1) WFOE is small-scale taxpayer (i.e. VAT is 3%)
2) profit rate is 5%

Profit = 5% x USD 500,000 = USD 25,000
Income tax = USD 25,000 x 25% = USD 6,250
VAT = (USD 500,000 + USD 25,000) x 3% = USD 15,750

Total main taxes = USD 6,250 + USD 15,750 = USD 22,000
Average tax rate on total expenses: USD 22,000 / USD 500,000
= 4.4%

Case Example 3: WFOE with budget of USD 1 million

1) WFOE is a general VAT taxpayer
2) profit rate is 5%
3) WFOE has USD 100,000 input VAT

Profit = 5% x USD 1,000,000 = USD 50,000
Income tax = USD 50,000 x 25% = USD 12,500
VAT = (USD 1,000,000 + USD 50,000 - 100,000) x 6% = USD

Total main taxes = USD 12,500 + USD 57,000 = USD 69,500
Average tax rate on total expenses: USD 69,500 / USD
1,000,000 = 6.95%

The exact calculation will differ according to the actual circumstances. If the WFOE is general taxpayer, for example, it may have more input VAT (e.g. services or goods purchased in China; VAT already paid can be deducted from due VAT), or it could be VAT exempt.

Conclusion The End of Representative Offices nearing?

Some foreign investors continue to prefer the rep. office structure for convenience, and because they are used to it. They may also not want to make the one-time cost of establishing a new WFOE, transferring employees and assets, and then liquidating the rep. office. It looks however as if it is just a matter of time before wrap up. The Chinese government has clearly set the trend, and most foreign investors are expected to follow.

Many companies find the opportunity to introduce limited liabilities, install better corporate governance systems and at the same time save taxes, sufficiently attractive to invest now in establishing a consultancy WFOE, and then liquidate the representative office. Those businesses that are also interested in the domestic market have an additional incentive to change their structure without delay.

Besides a one-time cost, one challenge of the restructuring remains that investors need to determine in advance the investment they will need in China, and when their business can become profitable. In this dynamic but complex business environment, planning ahead may not be such a bad thing.

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.

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