ERIC: Good afternoon. I’m from Asia. Thank you for joining this session on China Tax System and Economic Growth Webinar. My name is Eric Chai and I’m the Executive Director based in Singapore for the Private Wealth Association and very much focused on high net worth and family offices.
We’ve got a nice panel of experts and I’m just going to ask them to do a short introduction of themselves and maybe their areas of expertise. Maybe could we start with Kristina?
KRISTINA: Sure. My name is Kristina Koehler-Coluccia. I’m a director at Koehler Group. I’ve been working in the firm now since 13 years. I’ve been working in the Shanghai office for 13 years and we’ve been helping companies with their market entry into China assisting with pre‑investment advisory, tax optimization structures, and then the actual implementation of those structures in China.
ERIC: Thank you, Kristina. Steve, perhaps an introduction from you.
STEVE: Yeah, my name is Steve Dickinson. I’m an attorney with the Seattle law firm of Harris Moure. I’m actually based in Qingdao, China and I’ve been working in China since 1976. I’ve been working as a lawyer since 1981. I’m one of the authors of China Law Blog and our focus is on helping small and medium enterprises do whatever they want to do in China; sometimes investment, sometimes only in manufacturing, sometimes sale of goods, sometimes technology transfer. But our clients are almost exclusively from North America and Europe coming into China.
ERIC: Thank you, Steve. And Grace, maybe a word from you.
GRACE: Hi everybody, I’m Grace Shi. I’m the founding partner of ECOVIS Beijing. My background is CPA and a CTA. I have 15 years experience of international accounting, tax, and audit matters. Our focus is on the advisory for the foreign investment in China happening to doing a well business in China from the financial and the tax compliance perspective. And nowadays we’re also helping the domestic company to their outbound business overseas.
ERIC: Thank you, Grace. And perhaps we could jump into the panel discussion with a few questions. I’ll start off with the first question and we’ll see from different perspective and your experience in this job. So what are the main or most important features of international taxation from a Chinese or China perspective?
STEVE: I can start with that from my experience. The issue that we face with small and medium businesses is that in the old days, prior to 2008, China did not tax foreign investors in China and China did not impose an income tax on any of its citizens. So many people who have spent a lot of time in China have the impression that either China does not have a tax system of any kind that applies to foreigners, in other words foreigners can ignore the tax system, or they mistakenly believe that the tax system is very low and that tax will be a trivial factor in their businesses in China.
Now all of this is not true. China is actually now a very, very high tax jurisdiction and China imposes many kinds of tax on business transactions beyond just the normal income tax. And I find that in my inbound people who are doing investment, it’s virtually never the case that the companies have done a sound tax analysis before they consider operating in China. They look at many other factors but they don’t look at tax, and this leads to many, many, many problems down the road.
So the first hurdle that we have to confront with our small and medium clients is in convincing them that tax even matters in China. Those of us who live here find that kind of an odd point of view. But when I bring foreigners in that’s the consistent position that people take and it can cause lots of trouble.
ERIC: Thank you, Steve.
KRISTINA: Yeah, maybe I could just add on to that a little bit as a next stage. I think also a lot of—well, obviously a lot of foreign investors that come into the market, they’re not aware of how the tax administration works, what is decided upon in Beijing, how it then filters down into the various cities, and how then you might have various interpretations of the tax law and the tax regime. And in some cases you may even have different rates.
I think that all is then combined together with the fact that when you Google ‘what is tax in China’ or you search for different tax definitions or different tax rates, you find such a variety of information from what was historic and what is actual rates today.
And people in general, even if you are a CFO or a finance manager, you’ll just get such differing points of view and different information on your plate that you don’t even know how to digest it or interpret it. So it is also a situation in China where you really do need to have an expert on the ground to guide you and to help you create that tax analysis. But just as a funny point to add on to Steve, most of my small, medium-sized clients, let alone doing a tax analysis, creating a budget just in itself for the investment into China is sometimes pulling teeth as well.
STEVE: I agree with that for sure.
ERIC: Thank you, Kristina.
GRACE: Yeah. Yeah, also the fact that actually China from the tax perspective, from the legislation and the administrative regulation point of view, China is really in developing. But on the very positive side, yeah, we can also see China has been more actively participating on the cross-nation efforts to the new order of the international tax system. For example, for China, also during the BEPS since 2013 and now already achieved some good results in tracking tax evading.
And also China has also been trying to establish a tax system which is more sophisticated and also in the high end and international standard. So we can see for the corporate tax reforming, we can see China is also doing something and being very active to improve the situation and the regulations and make it more international. And having said that, actually I think China wants to reinforce in the taxing rise to get more fair share from the international taxation bond. This is my view.
ERIC: Thank you. And it does brings me back to my memory when I was living in Shanghai and having the big Chinese income tax, which is almost as high as Brussels and as complicated as well. So thank you for sharing that. It is much more important to understand and navigate the landscape. May we move in to the next question? Is there any blacklist of jurisdiction applicable with respect to taxation in China?
KRISTINA: Maybe I’ll take that first and then the others can also comment on it. I can only vouch from the experience that I’ve had with my clients. And I’ve had clients invest in China through Seychelles companies, Cayman Islands, BVI. From my experience, it’s not necessarily the tax field that is questioning. It’s more the administration of industry and commerce during the application process that would be suspicious and would wonder why you are utilizing those types of entities to make the investment into China. And I see this more and more today, or at least in the last 12 months, than I ever have before.
In terms of taxes, obviously when you’re repatriating funds from China, the biggest key issue, especially if there is a double taxation agreement is, is there commercial and economic substance in the holding company. And again, if you have an offshore entity that you’re using as the investor, that’s then where difficulties lie. But other than that, I have not in my experience seen in any real issues in terms of utilizing other jurisdictions for investing into China.
GRACE: I agree with Kristina’s point. Actually from our knowledge there’s no blacklist for such conduct issue, but in China nowadays it’s a trigger more about passing through rules. If a company is just using the offshore company as a tax evading purpose and then China may challenge for the tax preference or treatments. And then this can be invalid. So while utilizing the offshore companies in these regions like the Seychelles or Cayman and so on, the investor needs to be careful.
STEVE: In my experience, I tend to form companies outside of the big areas, not in Shanghai and not in Beijing. And there’s no blacklist but there’s a great suspicion in these other cities about any kind of entity that is doing the company formation that has obviously been created purely for tax purposes and it isn’t the primary operating company. And there’s a lot of pressure outside of Shanghai and Beijing to force companies to abandon these intermediate structures and to have the real operating company be the actual investor.
The way they do it in the second-tier cities is they don’t have a blacklist. They just simply don’t process the transaction. They just sit. And eventually they’ll make it clear why they’re sitting. And the way they do it is they make it impossible to prove the existence of a company. Proving the existence of a Seychelles company or Brunei company or a Naru company or a Guernsey company now is really, really difficult in the second-tier cities in China. And they’re really pushing hard to have direct investment from the actual operating company and to abandon this whole concept of intermediary BVI-type, Cayman-type holding companies.
But this is only my experience in what we call the second-tier cities. I don’t have too much experience lately of problems in Shanghai and Beijing. They just run it through in those cities.
KRISTINA: Steve, I mean I think maybe another question that would be quite relevant and has become relevant for us, and I’d be curious to know your experiences in the second-tier cities on that, we are even getting—again, this is more associated with repatriation of funds—a lot of issues with Hong Kong and Singapore entities that are purely used intermediaries, as holding structures, as pass through entities.
We don’t have issues with those structures obviously in terms of incorporating, but I’d be curious to hear what your experiences are with that in terms of having Hong Kong and Singapore where you know it’s just a holding, you know it’s just been recently set up. Or even Grace, what have your experiences been with that.
STEVE: That’s an excellent question. In second-tier cities, like, for example, just the city of Qingdao, we’ve been openly told, “This is obviously a pass-through and we won’t approve it. If you want to repatriate funds, plan repatriating them to the operating company. We won’t accept the whole concept of using an intermediary.” And there’s clearly no legal basis for that position, but they have the power and they can say whatever they want. And so I would say five years ago almost every company we formed in China used a Hong Kong or a BVI intermediary. Now, almost zero use it for the reason that we can’t get it through anywhere.
GRACE: Yeah, I agree with Steve’s comments. Actually in Beijing and also Shanghai, there’s no law space for such kind of handlings, but the tax officials do have the right to see when a shareholder is from the BVI, from some other offshore companies, they have the right to challenge you, to ask you to provide the documentations when you are doing the business in China. So this is, I think, the same.
KRISTINA: We’ve had a lot of issues with Hong Kong holdings lately, in the last 12, 18 months, in terms of repatriating funds and things like that, yeah. The tax officers are really cracking down on wanting additional documentation to prove the substance and to see payroll lists and operational activity, et cetera, yeah.
STEVE: What they’ll tell us is they’ll—even in the formation stage, totally without any legal basis—they’ll require that the holding company be in existence for three years, for example. And there’s no legal basis for that, but I’ve had that requirement imposed a number of times recently which causes us to just abandon the concept for most of our clients. Most of our clients aren’t investing for tax purposes. They’re just normal everyday investors and they just want to make stuff and so they’re fine, actually, most of our people with abandoning Hong Kong and taking out that layer of complexity.
ERIC: All right. And first moving on to OECD stuff. Has China made much progress in accordance to the tax BEPS projects and its new international standard? Maybe Grace?
GRACE: Yeah. Actually, as you know, at the beginning of October 2015, OECD just released the final report of all the 15 actions for BEPS action plan so only five days later Chinese tax office just hold a conference in Beijing. And then they present a stance on the BEPS package and also let show their future action plans to localize their recommendations on the BEPS. So I think that China will also do much more about their transfer pricing and also for the DTTs as well, based on the BEPS action plan.
ERIC: Okay. Maybe just your view on the current trends for Renminbi and what do you foresee for that currency.
STEVE: I’d like to say one thing before you get there. I have a question just to the other panelists. About five years ago transfer pricing was a very big deal, and my clients had a lot of issues related to transfer pricing. And we had to do a lot of extra contract drafting work to deal with transfer pricing problems. But in the past year, none of our clients have raised any issues with transfer pricing. And I don’t know whether that’s because they just did what we said and the problems are over or whether it’s not as big an issue in the Chinese tax world. I just wonder what the experience of the other panelists is on that.
KRISTINA: I can talk about it. Our clients coming into—I think one thing to clarify is the clients that we have, when they arrive in China, for me, I define them as startups. They’re small companies in China. They’re not going to start off from day one with a hundred people. They’re going to be building their businesses step by step. Unless of course you’re going into a manufacturing sector and you need blue collar workers.
So for my sets of clients, they’ve never been asked or they don’t have the revenue thresholds to need to submit transfer pricing documentation. And as a result of that, they’ve never been impacted by transfer pricing. What I think for me is really interesting to see in terms of my clients that are really doing their research and are really prepared for doing their investments now in China compared to five years ago is that transfer pricing is now on their discussion lists.
If I look five years ago when transfer pricing was such a big topic in China, transfer pricing was really at the bottom of their discussion points. The topic never even came up. Whereas today it’s really in the top five discussion points. And like you said, there’s a lot of contract work that needs to be involved for the cross border transactions, et cetera, and I see the clients being more prepared to take that topic on compared to previously.
STEVE: That’s interesting.
KRISTINA: But it’s always nice to see clients that are prepared.
GRACE: Yeah, actually I think really our focus is more for SMEs. They are now the target right now for the tax officials in China, so they may focus more on the multinational clients. Our client is also getting more focusing on the transfer pricing as well. So in our view, our client is also just doing some preparations and just be ready when they are challenged by the tax officials. This is also a good sign, I think.
STEVE: You know what it’s a sign of? It’s a sign of that they’re making some money that they need to repatriate, which is an excellent sign.
ERIC: All right. Good stuff. And then let us moving on to the currency and trends that you are seeing for Renminbi or Chinese yen.
STEVE: I just spent a whole day on a currency project for a big manufacturer so I’ve been doing a lot of research over the past months to work with this client. Currencies are a wonderful thing because if we understood what was happening, we’d all be like George Soros and we’d be very wealthy and we wouldn’t be worrying about seminars and things. But the experts, and I’m not one of them, have divided into two camps in my experience. And everyone has their own experience.
Both camps agree that there will be a gradual decline in the value of the Renminbi over the next five years. One camp holds that that decline will be very, very gradual, that the central government, the BOC, will hold the line and keep that reduction in value to be very, very, very moderate but steady over the next five years. The idea is that now that they’re in the IMF basket, they don’t want a sudden change to sort of sully the image of the Renminbi.
There’s another school who is a big group that believe that in the next two years the Renminbi will decline in value by a substantial amount, maybe 30%. And I don’t know, except that both groups agree that it will decline in value over the next five years.
KRISTINA: Yeah, from my side, I feel there’s just a lot of speculation on the market right now in regards to that. I think what is probably more interesting from my side is what do my clients think about it. And I think when the Renminbi currency dropped, there was no impact. I mean my clients were absolutely—they were not panicking, they were not horrified. But again, my clients in China are small companies. They are not the size of the multinationals, meaning that they don’t have ten branches and they’re not cash pooling, they’re not worrying about all of these issues. So for them it hasn’t impacted them tremendously yet.
STEVE: Well, from a client, different issue, that if you work in contracts in China, if you do that kind of business in China, Chinese contracts are very, very strange because they don’t worry—Chinese companies don’t worry about things that companies in other parts of the world worry about. And one of the things that’s very odd about China over the past 10 years is Chinese companies don’t build into their contracts an exchange rate adjustment mechanism.
But this change in August really did shake up the Chinese exporters and importers from America. And the reason why I spent the entire day today is that people are now starting to add exchange rate adjustment mechanisms into their sales contracts. And that was never done in the past and that’s a big change. And people are starting to notice that there is no—like I said, if we knew what was going to happen we would get rich. We don’t know what’s going to happen. And so what people now are trying to do is what rational people all over the world do, is they try to set up a mechanism where neither side takes exchange rate risk.
In the old days, one side or the other was taking all the risk. But now we’re seeing people that are doing a more rational approach and either hedging the risk with forward contracts or just writing their contracts so that no side takes any risk at all. So it’s not that they’re panicked, but they’re seeing that the old days where everything is just sort of fixed in stone is no longer the case anymore.
GRACE: Yeah, because the changes for the Renminbi and then we also advise our clients no matter for the companies or for the individuals. For example, like the individual, when they sign a contract with their employer, we also suggest that it should have some flexibility terms in the payment. For example, partially in Renminbi, partially in foreign currency. This makes them more safe when the exchange rate fluctuates.
STEVE: I was in Japan when the exchange rate went from 360 to 1 Renminbi in a very short period of time and nobody prepared for that in Japan and it was a big disaster. And I think that event has really focused people on the need generally around the world to deal with exchange rate. And now, as Grace says, people are starting to see, I guess in all contracts, even employment contracts, it’s better to think about it rather than to load the risk onto one side when you don’t even know where the risk is. It’s completely unknown where the risk is.
ERIC: And I think it’s also interesting because this is unexplored territory where the yen, there’s not much more volatility and even weakness. So I suppose that’s something that we have to learn to deal with in the new normal. But in my own conversation it’s also interesting that from various conversations in Beijing, they are actually very mindful of what happened in the Japan economy as well as the Thai economy when the exchange rate was so volatile and it totally disrupted the China economy. So I’m sure that at the same time they’re internationalizing the Renminbi, but at the same time, they are trying to maintain their control. So it’s a really interesting development. So I suppose it’s just keeping watch of what’s to come.
STEVE: That’s true. Everybody writes about Japan and Thailand and I don’t think anyone’s paid any attention at all. Those are very strong cautionary tales from the ‘90s. But my experience goes way back to the ‘80s and it was a disaster then too.
ERIC: All right. As you guys are working very closely with the business and also the SMEs, what’s your sense of the root reason that there’s this slowdown in the economy and what do you think needs to happen to jumpstart it.
STEVE: You like to ask really simple questions, don’t you?
ERIC: It’s more of economist question, but I think because you guys are working so much with the business people, what’s your sense of what’s happening in the economy slow down?
KRISTINA: I think I can only associate it with my industry, so go ahead, Steve.
STEVE: Our own people. With the people that I work with, the economy is slowing down and it’s going to continue to slow down. There’s no question about that. And it’s a dream to think it won’t. And I’ve lectured on that subject for the past 10 years and now what I’m saying is coming true. And, of course, now that’s coming true everybody says, “Well, we thought that all along,” when they told me I was crazy 10 years ago. But what we’re saying is people are rational, our clients are rational. They’re responding to this shift very rapidly in two ways, my people.
One is for outbound OEM-type manufacturing, the slowdown in the economy is good because it means their customers are much—their factories in China are much more flexible and much more willing to work with them. The rapid increases in wages and rents and other things that were pushing the price of OEM-type products being exported from China are abating so it’s a very good development for them.
And then for people that are coming in to the China, people are shifting away from wanting to sell into the retail market; consumer goods and luxury goods. And what we’re seeing now is people are more focusing on old-fashioned technology transfer where the Chinese factories and manufacturers are attempting to upgrade their system so that they’re more efficient in the face of this general economic slowdown.
And so we have actually an increase in business oddly enough during this downturn, but it’s clear that the clients had very clearly identified where things are going and they are focusing on the areas that have a fit with the current economic environment.
KRISTINA: From our perspective, what we’ve seen—and again it’s nice to hear that as well—I mean we ourselves don’t have a slowdown. We still see a lot of inbound investment into China. I think there’s a tremendous shift now where it’s a lot of service-oriented businesses that are going into the market in order to service people versus, like Steve said, versus selling goods, going into the retail market, et cetera.
What I’ve also seen is as the luxury brands are cutting back, meaning they are not opening as many shops as they used to, or they are cutting down in the quantity that they have now and are focusing more on e-commerce, it’s given a room and a space for the midmarket brands to come in and take some of that market. And as there is a slow downturn, I’ve seen also consumers focus more or focus less on the luxury brands and more on this midmarket sector. So that’s the shift that I’ve seen recently.
And to jumpstart it, I think that is a—how to jumpstart the economy again, I think having an economy still at 6% or at 7% is fantastic when you look at it on a global scale and you see all other jurisdictions in the world and where they are today. So I don’t know if we have to necessarily jumpstart it. I think China is doing pretty good as it is. But again, you know, my perspective.
GRACE: Yeah. I think right now China is in a transition period purposely more focusing for the manufacturing now, for the investment, for infrastructures, for the road, for some real estate. But now also the government also realizes that it’s not okay because we are doing something that is not great for the whole country and we need to change. For example, for the service industry, we need to encourage for the consumptions and so on. So for this slowdown I think it is only a short period problem. After the whole transforming is finished, I think this will go to the more stabilized economic growth.
ERIC: And I totally agree with Kristina. You know, 6%, 7% growth is a very good growth by any standard. Since we were touching on e-commerce and e-commerce with the likes of Alibaba and all the e-malls is really taking off in China. What’s your view on this sector and obviously what are the government’s moves to tax this growing industry?
GRACE: Now, for the e-commerce, it’s really booming in China in the recent years. But from the tax perspective they really have lack of controls and the lack of investigations because there’s no real rule for that. But I think in this year, maybe middle of this year, the tax officials also want to step by step to investigate what happens. And they want to take some samples to check what’s the background, how is the portion of the e-commerce business, and what the potential tax burdens might be. And I think the Chinese government and also the China tax office will just step by step to trigger more on the e-commerce business because there is really a big tax part there.
KRISTINA: I haven’t really seen any changes or anything like that in terms of tax. Obviously the shift with the creation of the Shanghai Pilot Free Trade Zone and other now pilot free trade zones, the customs bureaus have done a lot in order to make the e-commerce process more efficient. But from a tax perspective I haven’t seen any changes. It’s just like a standard trade transaction.
STEVE: There’s two issues related to e-commerce. The ground of it is that China is moving to become dominated by e-commerce far more than any country in North America or Europe. And there’s lots of reasons for that that I won’t go into.
And there’s two issues. The first issue we talked about here. I have lots of friends in China and I have lots of friends who sell on Taobao. Not one of them has ever paid a penny of tax to the Chinese government. I mean it’s never happened. That’s why they sell on Taobao because they don’t want to pay tax. And it’s not that they reduce their tax. They don’t pay a penny of tax.
Now what the Chinese government has said—I mean they did some policy papers recently—they’ve said that they want to go to the owners of the websites, in other words JD and Alibaba and Amazon, and force the owner of the website add the tax from the people who are on the site. Now what that means for Taobao and Tmall is that if they do that, the site will empty out and no one will be there anymore because people are there specifically to avoid paying tax. And that’s a big problem in China and no one has a solution for that.
The other problem, from my perspective, and maybe Kristina’s perspective in e-commerce, is that Alibaba is not a Chinese company and Ten Cent is not a Chinese company. Sina is not a Chinese company. Weibo is not a Chinese company. Even Amazon China is not a Chinese company. They’re all virtual variable interest entities. They’re foreign companies. And the fact is China excludes foreign companies from participating in e-commerce in China. And that is a big issue because that’s what all my clients want to do. They want to do e-commerce in China and they’re excluded.
There’s two points of view in China on what to do about that. In recent reports from the government, from the central government, from the state council, they’ve talked about splitting the Internet into two pieces. One piece would be information; news and movies and things like that, but basically news, and have that remain under Chinese control. But that they would take e-commerce and make that a unique type of Internet activity and allow foreign participation into e-commerce. And the people who run the Shanghai Free Trade Zone have talked about doing this. But every time they start to do it, they stop. And I think the reason they stop is they get a phone call from Alibaba that says, “We’re in but we don’t want anybody else in so why don’t you just leave it closed.” And so there’s been no progress on that issue.
And then the third issue, which Kristina mentioned, is there has been progress on trying to extract tax from imported products that come in to Tmall and do the e-commerce structure. And Alibaba has actually participated in a very large pilot program that’s based in Hangzhou where Alibaba is located, and they claim that they’re working to solve the problem. But I haven’t personally seen any claims on resolving that, because once again that’s the whole reason people use e-commerce in those sectors is to avoid tax. And once the tax is imposed, then the great burgeoning development of Chinese e-commerce may follow a different path. I don’t know what that would be but it would be different.
ERIC: All right. Since it’s always very interesting developments and nothing is as clear as crystal in China. So moving on to this topic, which is fairly interesting, is also that individuals and companies are going to China because of the opportunities. But when you are profitable, when you do make some money, how do you remit funds oversees? And what the tax implication is. As far as we’re concerned, I think the currency is totally controlled with restriction, but what are your experiences on remitting funds and tax implications?
GRACE: Now this is the really day-to-day service we are helping the client to do. Every day as a company, I want to remit my service, I want to remit the royalties, I want to remit the service fees. How can I do that? So this is really a hot topic. And actually in China there are several kinds of tax you need to pay before you remit the money out. So simply saying, for example, for the salaries and so on, you have to pay the individual income tax before you remit the money out. And for some services you need to pay some VATs and withholding tax before you pay the money out.
And also for some special things, like the dividends and some royalties for the withholding tax is also need to consider. So in China before you pay the money out, you need to pay the tax first and then you need to apply kind of tax certificates showing to the bank and then the money can be paid out. Otherwise it’s quite difficult for you to repatriate the money out of China.
KRISTINA: I think just to add on to what Grace said, lately from my own experience, as Grace mentioned, you have to pay the taxes first. And the issue at that point is what documents do you need to show the tax bureau in order to be able to repatriate. And that’s where a lot of issues have arisen in terms of showing proper contracts, making sure the contracts are in Chinese, having the right terminology in the contracts, having reasonable rates and calculations for licensing fees, royalty fees, marketing fees, management fees. And it’s always the belief of many foreign investors that, “Oh, this is such an obstacle. This sounds like so much work that needs to be involved in terms of paperwork, et cetera.”
Be assured it’s the tax advisors themselves who are doing the work and with their experience they have ways of negotiating with the tax officers to repatriate funds. But I will say this, whereas in 2003 really the tax officers were not looking at contracts and they were just putting their stamp of approval to make the repatriations, times have certainly changed whereas today they really do look at the documentation. They may ask for additional documentation than they ever did before.
They will answer back to you with more questions, particularly with dividend repatriation. They’re going to look at the commercial and economic substance of the holding company, et cetera. Just one final point to mention there. Always look at your double taxation agreement. Look at the rates that are applicable and what you can achieve when you want to repatriate funds.
STEVE: And it’s important to understand the background of the situation. There’s a two-step process. We tell our clients you can repatriate your profits as a dividend. And China has been very good. Unlike many other developing countries, China has not pulled the rug out from under people and changed the rules in midstream. They’ve been very consistent with the rule that you can repatriate your profits as a dividend. However, you can only repatriate your profits as a dividend, which means you have to have reported the profits to the government and paid the tax on the profits, which means you have to wait till your tax return is done before you can repatriate.
And I have had clients over time—this is very common—where they don’t want to wait till the end of the year and after their profits have been reported. They want to send money out now. And so what they do is they set up consulting contracts between the Chinese entity, the WFOE, and the parent in the United States. And they pay money to the parent as a service fee. This is where transfer pricing comes in but it also comes in to what’s becomes the big issue in China.
We represent—I’m sure a lot of you do—we represent a lot of service companies. We have service contracts in China and it’s an American company or European company providing service in China. It used to be they would just do the services and the Chinese company would pay the bill, end of story. Now, it’s just what Kristina and Grace described. It’s a long, complicated, very detailed, highly documented process that many people aren’t used to and rebel against. But when they rebel against it, it means they don’t get their money. Why?
A report just came out today. Over the past 10 years, US$ 1.7 trillion has been illegally sent from China overseas; $1.7 trillion. And the primary mechanism for doing that is fake contracts where a Chinese parent company has a subsidiary in Indonesia and they say, “Okay, Indonesian subsidiary explore the Indonesian waters for oil and we’ll pay you $100 million for that service.” And then they send $100 million to Indonesia. Well, where does that money go? It goes to Switzerland. Same in the United States, same everywhere.
So fake contracts, our clients aren’t involved in fake contracts. Our clients are just normal people doing work. But they get caught up in the concern with these fake contracts and so they get inspected with a fine-tooth comb. That’s issue number one.
Issue number two is five years ago the Chinese authorities—I don’t know, Grace and Kristina, what your experience is—but five years ago the Chinese authorities did not impose VAT or business tax when foreign companies provided services in China. But now they consistently impose a kind of tax.
You never know. Sometimes it’s withholding, sometimes it’s VAT, sometimes it’s business tax; every jurisdiction is different. But they impose some kind of tax. And this is a big shock because people that were making $100 now are making $70 because 30% is getting chinked out for tax. And this is a huge issue and people that just get irritated and complain never get a resolution because this is just the way it is now.
And for us, for example, all our contracts have to be in Chinese now. And our invoices have to be in Chinese. And they have to be signed for a service contract. They have to be signed and chopped in Chinese. And you say, “Well, we never did that before,” “Fine. That means you don’t get your money.” So it’s been a big huge—this has been the biggest change maybe in my own personal practice is this area in services with the new taxes that have been imposed on. And they’re all completely justified. There’s nothing unjustified about the imposition of tax. They just didn’t used to do it. But now they do.
GRACE: Yeah, right. Actually, also because the Chinese tax office also pays more attention to the profit shifting because they realized the companies in China, they want to shift profit to overseas countries. That’s why they pay more attention, ask for more documentation, and so on. So I think it’s also what in the future I can foresee is we’ll be more and more strict managed by the tax bureaus.
KRISTINA: I also agree with Steve. We’ve seen a shift in our own practice in terms of European or US or even Australian clients coming to us and saying, “We don’t actually have an entity in China. We’re providing a service there, but could you do a review on a contract we’re about to sign and give us a tax analysis.” That’s becoming an increasing part of our business in regards to helping them. And it’s nice to see that companies are thinking ahead of time before actually signing or negotiating these contracts.
ERIC: All right. It does sound like a bit of a minefield and it seems like a lot of foreign investors who may not understand Chinese or how the Chinese tax system works. What would you recommend to first time investors that’s coming in to China, besides of course calling on your services?
KRISTINA: I mean I think the first thing is, well, obviously I guess everyone would assume this is common sense, but for many companies, it’s not. Physically go to China, see it for yourself. If you are the CFO and you are responsible for creating a budget yourself, you should go to China and see what the costs are like. Usually you have the sales managers, purchase managers go. I always try and push the CFOs themselves to go and see what it looks like and look at what costs are like.
I think one of the key difficulties I’ve been having lately in terms of explaining things to clients, especially the small, medium-sized ones is the fact that China is not as cheap as people think it is. Rents are up. Salaries are up. Tax systems are becoming more unified and are becoming more aligned. Like Steve said, five years ago taxes just were not imposed. And now things are changing in that area. So things are not as—you know, buying equipment. Things are not as cheap as they used to be. And that’s the first thing I try to put into my client’s minds. Create a budget that is an appropriate budget according to 2015 rates.
And in terms of China being a minefield, I guess after 13 years I don’t consider it a minefield anymore based on the experiences that I have. I think it’s just a matter of talking. I think the beauty of China is that everybody is willing to share their own story and people are willing to talk about their experiences. And as a foreign investor you should take that opportunity. Go to networking events. Try and meet as many people so that you can hear the variety of mistakes that companies have made and, trust me, everyone has made a mistake in China.
So I think it’s a matter of talking to people, networking with people, and just physically being on the ground and seeing for it yourself. A key point that I tend to try again to push my team with, even though they outsource the tax work to us, I usually want the CFO or the finance manager from abroad to go to a tax bureau in China and see how it looks like. What it looks like, how your tax officer looks like. So that when obstacles do arise, you have that picture in your mind of how old-fashioned the system really is. And you have more clarity of the difficulties and obstacles that do arise.
GRACE: Yeah, the other recommendation I would give to my client, for example, they want to invest in China and Beijing or other source city, and then I will give them a reference checklist. They can contact my current client for a call or for a meeting. They can understand better what’s going on in China, especially if they are in the same field. It’s going to be more helpful for them to understand because they’re already a startup company. They have already experienced a lot of Chinese stories here, so this is going to give them a briefing what’s going to happen if they invest in China.
STEVE: The issue that I have, I mean you may think, Kristina, which earlier she was being very frank and she said her big problem is getting her clients to even do a budget at all. And that sounds crazy but it’s actually true that we get people who come in and they say to me, “Steve, what’s the registered capital for this project?” I said, “I refuse to tell you.” “Tell me how much money you need to do the project.” “I don’t want to tell you what’s the registered capital numbers is. Tell me how much money you need.” And they’re dumbfounded. “Why do I have to tell you that? It’s irrelevant.” “Well, no it’s not irrelevant.”
And with respect to tax, here’s the issue I find, and Grace and Kristina can comment. What I find is that, Kristina and Grace, when I get the CFO involved, they almost adamantly refuse to consider the Chinese tax system. They look at their budget and then they make their decision on how much tax they’re going to pay based on the system in their home country. And they make two big mistakes. The first mistake they make is they assume the rate is low, and it’s not. It’s high.
The second mistake they make is they think they can do tax planning. They think they can work out a loophole and avoid paying tax. And my experience in China is China doesn’t do loopholes. There is the code and there’s how much you have to pay. The code is short compared to the US code, it’s short, and you get to pay that tax. And as soon as you talk to one of these local tax bureaus about tax planning and doing special techniques to reduce the tax burden, you just end up in trouble. Not in a good area, in a bad area. You have to expect to pay the tax and that means income tax, VAT tax, business tax, and exorbitant taxes on your employee.
VAT is 17%. I don’t have a single American client that understands what a 17% VAT tax means on their bottom line when they’re doing trading. And yet they say, “Oh, I don’t have to pay the 17%. Some guy that I met in the airport told me I can get out of that. I don’t have to pay it.” And that’s the problem, Kristina and Grace, with people talking to old China hands and telling stories. The story they get is the wrong story. “Oh, don’t worry, you won’t really have to pay that tax. We never pay it out in the countryside in Dongguan or in the suburbs of Qingdao or the suburbs of Jinan. We never actually pay that tax.” Well, the locals don’t pay it but the foreigners do. And if they don’t, they end up in a lot of trouble.
And then the final thing I want to mention that’s a shock to people is that the tax officer is in your face every month in China. There’s none of this do it and then at the end of the year submit some forms on a piece of paper. Individual human beings from the tax office are in your office or you’re in their office every single month and they only have one goal, not to help you out but to extract more money from you. And they’re the powerful people in the local…
Once your company is approved, the people that have power over you and that exercise power over you on a day-to-day basis is the tax office. And they do. And so this notion that we can just forget them and not worry about it is the biggest misconception that the people I bring into China have. And they’ve suffered mightily from having that misconception because their business goes from highly profitable to zero profit really fast once all the taxes. Perfectly legitimate authorized tax, no funny stuff. Perfectly standard taxation hits them from being highly profitable to negative very, very quickly.
And five years ago the locals, the country people, were just glad that you were there. That time is over. The locals are in there collecting tax. They’re not just happy to see you. They’re happy to see you to collect the tax. And you better be prepared to pay or forget it. Don’t come. It’s too much risk.
ERIC: Thank you, Steve. All very good common sense. I think the law is there to be respected and you have to play by the system of whichever country that you’re in. Just my thought, the time and perhaps we cannot cover China without the biggest parts of the industry, the property market and the real estate market. What’s the taxation system like for real estate investment in China and how does investor take that into account when they are actually investing into China?
STEVE: I’ll let these guys talk first. My experiences aren’t so good.
KRISTINA: Well, I mean I was planning on investing personally in property in China. I didn’t in the end of the day for a number of variety of reasons. I think at that time my biggest fear was if I do eventually sell, how will I get my money out of the country and what taxes would be then imposed on the capital gains. In terms of real estate developers investing in property, that’s not my client field so I don’t have experience in that area.
STEVE: Well, before I came to China, my major area was real estate investing. I created the largest real estate—no, I worked in creating the largest real estate company in the history of Japan, $5 billion in real estate, and I did a lot of real estate work in the United States with Korean and Japanese investors coming into the United States.
When I came to China, I expected that’s what I would be doing in China. That’s what I thought. And the situation in China, and Grace can reflect on this if you worked in it, China’s tax system is set up. The tax system is set up to prevent people from flipping property. The tax system is set up to push a long-term hold. So people who buy property, develop property and flip it quickly are subject to extremely high tax burden.
And when I worked with people in the—there was a period briefly in China where foreigners could invest in real estate and I worked with a number of those investors. And when they bought and hold in a two-year period, bought and sold in two years, their effective tax rate was 60%, which of course made their investments worthless.
And therefore much of the real estate investment in China is designed quite frankly to evade income tax. And it makes a foreign investor in the real estate market in China, it makes it very, very difficult to evaluate, because if you say, “Well, what about this rule and what about that rule?” the developers will frankly look you right in the face and say, “Well, we’re not going to pay that, we’re going to do something else.” And then when they tell you what else they’re going to do, it takes two-and-a-half days and there’s so many boxes and arrows on the whiteboard that you can’t figure it out anymore and it makes it very, very, very tough.
This is the reason, by the way, why there is so much pressure in China to invest in foreign real estate because foreign real estate is very straightforward and very clear. And China is just a nightmare for outsiders primarily because of the tax system.
GRACE: Yeah, that’s true. Actually for the tax relevant to the real estate business, it’s quite complicated. It’s including the property tax, land use tax, land use fee, land value-added tax, a lot of things. So because of that, even the tax officials have no idea, so it’s also difficult. For example, one of our clients they are just doing the developer business. And then if they want to pay the tax to the tax bureau by the end of the year because annually they will have the annual closing for the land VAT, the tax bureau says, “No, no, no. Next year we can talk about this because their tax has been fully collected.” So because lack of knowledge of the tax bureaus and because the tax has been fully collected, they just don’t want you to pay the tax.
So also that’s why a lot of companies face a lot of troubles when paying the tax, because they need to explain to the tax bureaus how is tax collected, what we should pay and so on. So this is also a big headache for the company who hold the assets and the properties in China.
STEVE: My experience too. I had this problem even in the Jinan district of Shanghai, which if any area is the most sophisticated in China, Jinan is the most sophisticated, and we had the same problem. We went in and they looked at us with terror because I’d done a lot of research so I knew all the questions to ask and they didn’t have any answers. They didn’t know and they didn’t want to reveal that they didn’t know because it was a loss of face. So they just didn’t want to hear about any discussions, just as your experience is.
And you can imagine in the smaller towns what it’s like. If Jinan can’t figure it out, Chaoyang in Beijing and Jinan in Shanghai can’t figure it out, nobody can. But it’s very—you know, to get on a soapbox, it’s not a good thing because it pushes people who really would be fine with paying tax into a tax evasion mode because there is no other way to operate. It’s not good.
ERIC: It’s definitely an interesting round of discussion. I think for the audience that there was a lot of experiences and perspectives that they need from you working on the ground in China. Perhaps just some final words from you and I’ll issue a challenge and if you could use a few words to describe your experience on what the China tax system is. And it’s just perhaps try and to concise it for the audience.
GRACE: Yeah, I would like to say in the past that China is quite a friendly environment for the foreign investment company. So from the tax point of view they say, “Okay for this, okay for that.” But nowadays they are more strict on the foreign investment companies. So being more compliant to being more updated for the tax regulations is very crucial for the foreign companies in China. So we highly suggest them to hire the right person, right tax person, and hire the right tax advisor is also very important to them. This is my final comment. Thank you.
STEVE: Well, my comment is people all the time—this excludes real estate by the way. Let’s put real estate aside—but people come to us all the time and say, “The Chinese tax system is too complicated. We can’t figure it out. There’s no way we can figure out what to do.” That’s never true. The Chinese system is pretty straightforward. As Grace said, it’s based on—they don’t do the Russian approach anymore—they do pretty much an international approach, and it’s not that hard to figure out.
What’s hard for my clients is to figure out that they have to pay. That’s their problem. It’s not figuring out the system. It’s figuring out, “Hey, you’ve got to pay it.” And so my final word is if you’re going to come to China, figure out in advance whether you can handle the tax system because if you can’t, you shouldn’t come to China. There’s other ways to do business in China that doesn’t involve direct investment. And you can let the Chinese side figure it out. You can do a contract or something. But don’t come in and listen to people that say, “Oh, don’t worry about it. We don’t pay tax.” Those kind of advisors are no good. Talk to advisors who tell you the number and tell you how to do it. That’s the way to go.
KRISTINA: I’m going to add on to what everybody has just said. I think from my perspective again, the tax system is not complicated once you start utilizing it and you start knowing how it works. And I think more importantly when you know how the tax bureau thinks and works and how you’re able to negotiate with them.
The issues that I’ve seen is more in relation to my sets of clients who are not clear in their heads in terms of the business models that they want to create in China. And because of that, they cannot figure out and do a tax analysis.
You know, one day they’ll come and decide, “We want to do it direct from Europe.” The next day they’ll say, “No, we need a Chinese entity and we’ll do it from here.” “No, we want to do just commission-based work.” “No, we want to do physical trade ourselves.” “No, we want to do service and invoice it directly from China.” “No, we want to do service and invoice it directly from Europe.” They have no clue what they want to do and they don’t sit down and analyze each scenario to see what, first of all, operationally can they manage, and two, what are the tax implications for each of those scenarios.
So again, not only don’t they do budgets, they also don’t analyze business models and scenarios, which I guess are the two things. I think the key is being prepared when you’re coming into China and really doing a research study and understanding what models exist and what are the tax implications and what operationally you’re able to achieve from doing those models.
STEVE: Right. That’s exactly right. I guess my little comment on that is that unlike many countries, the Chinese government officials look at investment proposals every single day. So if you say something to them that’s just ridiculous, they will laugh because they’ve seen it before. And they’ll just laugh and walk away. So you have to be prepared because you’re not dealing with boobs and bumpkins. You’re dealing with people who their entire business, their entire career is evaluating foreign investment proposals. Be prepared for it because they’ll just laugh at you if you fool around.
MATEO: Okay. I think we had a great discussion today. I want to thank each one of you for participating; Kristina, Steve, Grace and Eric. Just to get some admin issues out of the way, we will have the recording probably sometime next week. We will upload that onto Taxlinked and I’ll it share with the panelists. We’ll also have a transcript. That’ll take us a bit more time to get done, but the transcript we should have in about two weeks approximately and we will blog about it and we’ll share that full transcript with all of you.
So with that said, on behalf of Taxlinked, thank you very much for participating. Peter unfortunately couldn’t be with us today. He had some urgent matters that popped up at the last minute so hopefully I’ll send him the link and he will enjoy it on his own time. So once again, thank you very much and we’ll be in touch.