Forecasting the financial performance of a proposed business and accurately assessing the investment required to launch operations is always a complex affair. In China, where foreign currency restrictions significantly complicate cross-border transactions, the strategic planning of funding foreign-invested entities (FIEs) is of particular importance.
This is illustrated in the case study explored in this article, a scenario that Dezan Shira & Associates commonly encounters while advising clients that have an entity in China or are in the process of setting one up.
The case study will not only aim to illustrate the common pitfalls associated with funding a Chinese business, but will also be used to introduce five different strategies available to investors contemplating the funding of a wholly foreign owned enterprise (WFOE).
What options does an investor have to inject capital into a WFOE once injected registered capital runs out? What options are available to efficiently plan the WFOE’s financing in the first place?
A Not Uncommon Scenario
Just six months after incorporation, a foreign-invested company involved in commodities trading runs out of registered capital. The business was established on the premise that revenue would be generated quickly, as a major client had pledged to place a large order and settle the invoice within 90 days.
However, the payment on the order was delayed and the trading company could not meet its cash flow target. Meanwhile, it was incurring significant expenses, having to pay its suppliers for raw materials, its landlord for the large warehouse rented, and its newly-hired employees.
Upon being notified of the situation, the parent company immediately re-initiated registered capital injection installments. But it took several weeks for the process to be completed and for the capital to arrive in the company’s bank account.
As a result of this delay, the company was not able to pay its Chinese employees at the end of the month and make social insurance contributions on time.
This situation is not uncommon in China. Many investors decide to inject only a limited amount of registered capital into their Chinese company at the start, optimistically forecasting rapid income generation and/or underestimating upcoming expenses.
In addition, there is the inherent risk of dedicating resources to a new and foreign market, and it is perfectly sensible for investors to seek to keep investments to a minimum until the guarantee of returns becomes apparent.
The scenario raises two critical questions:
- What options does an investor have to inject capital into a WFOE once injected registered capital runs out?
- What options are available to efficiently plan the WFOE’s financing in the first place?
Option 1: Injecting registered capital gradually
A cautious investor could decide to commit significant registered capital to its FIE in China, but will gradually inject the funds in increments according to the company’s cash flow needs. Capital is not injected fully in one initial transaction to avoid the risk of getting considerable funds entrapped within the Chinese company.
The problem is that each injection of capital triggers approval and verification procedures with the State Administration of Foreign Exchanges (SAFE), the body in charge of monitoring foreign currency transactions in China. The whole process generally takes between one to two weeks from the point of remittance to the time at which capital becomes readily available to settle expenses.
On top of the costs and inconvenience associated with undertaking these procedures, such a strategy requires the careful anticipation of upcoming obligations well ahead of time so as not to miss payment deadlines. It becomes vital to carefully plan the capital injections so that the WFOE’s funds do not run out between two capital injection milestones.
Option 2: Increasing the registered capital ceiling committed
If a WFOE runs out of registered capital after reaching the maximum amount that is allowed to be injected, there is always the option of increasing the ceiling of registered capital committed at the start.
However, this is not a simple process. Prior authorization from the Administration of Industry and Commerce (AIC) would need to be obtained, and amendments would subsequently need to be made to the entity’s business license and other official records.
In effect, many of the steps completed during the incorporation stage of the company would need to be repeated. The whole process can take between eight to 12 weeks, and the time lags involved could jeopardize any business that is running out of funds.
Service fees do not constitute a capital-account transaction, and as such can be organized more rapidly without obtaining prior approval from SAFE. But the WFOE’s bank, acting on behalf of SAFE as an enforcement body, will check the supporting documentation
Option 3: Implementing inter-company service agreements
The investor may also inject funds into its China WFOE in the form of a service fee, with the WFOE entering into service agreements with the parent company overseas. For example, it is common practice for the China entity to provide ‘consulting services’ to headquarters, with the resulting transaction acting as a funding mechanism.
The service fee would be subject to a 6% value-added tax (VAT) rate and related surcharges, although a VAT rebate may apply as the service recipient is located overseas. Additionally, the resulting WFOE revenue remaining as profit is subject to a Corporate Income Tax (CIT) of 25% in most instances.
Unlike the injection of registered capital, service fees do not constitute a capital account transaction, and as such can be organized more rapidly without obtaining prior approval from SAFE directly.
Nevertheless, the WFOE’s bank, acting on behalf of SAFE as an enforcement body, will check the supporting documentation and verify the consistency of the transaction with the communicated business purpose. The funds transit via an escrow account, and may end up being held up by the bank in the event that its expectations or requirements are not fully satisfied.
It should be noted that in the event of a tax audit further down the timeline, the audited entity may be asked to provide supporting documents proving that the service fees received were based on genuine transactions, such as the service contract. It is therefore important to plan ahead and prepare sound service agreements that limit the risk of raising future undesired scrutiny.
Also important to note is that inter-company service agreements may trigger transfer pricing (TP) ramifications if they lead to significant shifting of profits between the two parties.
According to the “Public Notice Regarding Refining the Reporting of Related Party Transactions and Administration of Transfer Pricing Documentation” (SAT Public Notice  No. 42), released by the State Administration of Taxation (SAT) on June 29, 2016, the transaction thresholds triggering the need for the preparation of TP documentation are as follows:
- RMB 200 million for tangible assets transfers
- RMB 100 million for financial assets transfers
- RMB 100 million for intangible assets transfers
- RMB 40 million for other related party transactions in total
It is critical for taxpayers to be familiar with SAT Public Notice No. 42, and assess their related party transactions according to the new thresholds.
These three reactive funding options are certainly appealing for a WFOE that has run out of registered capital. But is there a safer way to commit sufficient capital at the start to avoid the need to later on organize cumbersome capital account transactions or taxable service transactions?
Option 4: Injecting substantial registered capital from the start
Injecting considerable registered capital from the beginning ensures that the company’s expenses are covered in the long term, without having to go through multiple capital injection rounds. And since the amount of registered capital committed to a company is publicly available information, a large registered capital commitment can increase the credibility of the investor in the eyes of potential business partners.
However, a rational investor may feel reluctant to over-commit, as excess capital would sit idle in a bank account that brings no returns. The funds could likely be put to a more lucrative use if invested through alternative means, earning a return as a bank deposit or otherwise employed. Thus, there is an opportunity cost of over-injecting registered capital into a China company.
It can take four weeks to register the foreign loan agreement with SAFE and open a specific foreign loan account with the bank – two to three times shorter than the time it takes to increase the registered capital ceiling
Additionally, there is always the risk that the value of the money held in the capital account becomes subject to exchange rate fluctuations, with very limited options available to the investor to quickly respond to such a risk.
Furthermore, when the time comes that the WFOE is cash-flow positive and the investor wants to repatriate profits, in most cases registered capital will have to have been fully injected into the WFOE before dividends can be issued. As such, a large registered capital commitment could delay the much anticipated process of profit repatriation.
Option 5: Committing to registered capital alongside a foreign loan
Within the gap between the total investment into a WFOE and the amount of registered capital committed, authorities allow for a capped loan amount to be arranged between an overseas creditor and the WFOE.
Together with registered capital, company loans constitute the total investment injected into the WFOE. Different from the injection of registered capital, a foreign loan can be returned to the shareholder (or related party) in accordance with the terms indicated in the loan agreement.
There is considerable flexibility in this regard, as the loan agreement can be amended pending the approval of the relevant authorities. As such, resorting to company loans can help the investor inject money into its WFOE at a relatively low level of risk.
Moreover, the application procedures are comparatively simpler than that for increasing registered capital. It can take four weeks to register the foreign loan agreement with SAFE and open a specific foreign loan account with the bank. This is two to three times shorter than the time it takes to increase the registered capital ceiling.
The case study presented demonstrates the complications intrinsic to funding the operations of FIEs in China, and how important it is to carefully assess the different funding options introduced above.
Because of the difficulty of correctly anticipating a WFOE’s cash flow needs and the optimal amount of registered capital to inject at the start, it is likely that an investor will have to inject funds during the life of the company, sometimes abruptly in response to a financial constraint.
However, each strategy comes with a number of advantages and drawbacks, and as such it is essential to understand the various funding processes and anticipate their consequences. Discussing WFOE funding strategies with a competent advisor is of the utmost importance in order to map out a financing plan that best serves business objectives and mitigates risks.
About the Author
Dezan Shira & Associates is a specialist foreign direct investment practice that provides advisory services to multinationals investing in emerging Asia. This article first appeared in China Briefing, and was re-edited for clarity and conciseness. For further details or to contact the firm, please visit www.dezshira.com.