Corporate Strategy: Choosing the Right Sourcing Model in China

China allows foreign entities to operate representative offices. Because these types of offices cannot undertake any commercial or industrial activities, receive payment in local currency, or manage export/import activities, they are considered an ‘indirect’ method of managing a sourcing operation.

The cost of financing the on-going activities of a representative office is very different from a service company or a foreign invested commercial enterprise. The representative office will be taxed on top of expenses while the service company or FICE will deduct costs and pay tax on profits

“Direct’ sourcing requires that a foreign firm establish an office from which they will be able to directly manage procurement. This entails that the company’s office be in control of various levels of the sourcing operation and be able to receive payment in the country’s local currency.

Although this option inevitably necessitates a greater financial and legal burden for the investing company, it is an effective means of ensuring higher performance levels from an Asia-based sourcing operation.

Here, we discuss how these types of ‘indirect’ and ‘direct’ sourcing platforms function in China.

Representative Office

Many traditional buyers in China tend to lean towards the representative office structure, purely driven by the preference of not having to inject registered capital. For this reason, the representative office is often recognized as a “safe” and “cheap” model, and the best option for a China office whose primary purpose is to explore market possibilities.

For representative offices, expenditure is funded directly by the overseas headquarters at regular intervals, typically on a monthly or quarterly basis. Conversely, for a direct sourcing entity such as a service company or foreign-invested commercial enterprise (FICE), most of this funding comes instead from the registered capital, which is committed right at the beginning.

Moreover, the cost of financing the on-going activities of a representative office is very different from a service company or a FICE, since the representative office will be taxed on top of expenses while the service company or FICE will deduct costs and pay tax on profits.

Consequently, the perceived flexibility offered by the no-capital representative office structure may only apply when the representative office’s business scope is sufficient to satisfy the needs in China of the overseas parent company.

Foreign-Invested Commercial Enterprise

A large proportion of companies that are ready to undergo formal registration in China may already be familiar with the market and its suppliers, and many will already have established relationships with their Chinese suppliers. In this case, the added benefits of a wider business scope provided by a FICE could prove much more valuable and self-sustainable than the traditionally “safe” and “cheap” representative office.

For these businesses, a FICE model is usually preferred because it allows for the widest possible scope for sourcing (including import/export and the ability to make domestic purchases in RMB).

In China, many smaller domestic suppliers are far less willing to transact in foreign currencies, so sourcing through a FICE structure will effectively broaden the selection of local suppliers because the company will be able to buy in China in RMB before consolidating and exporting.

Since its business scope is wide, a FICE’s minimum registered capital requirements will be higher than those of a service company (varying between different locations).

Service Company

The service company model also has its own merits. Since a service company cannot trade products directly, the compliance involved is generally quite low and it can also play the part of an intermediate quality control and service agent for headquarters. 

Although the same effect can be achieved with a representative office, this model does have the added capability of receiving commission or other service revenues in RMB. As such, this model can be more tax-efficient than a representative office.

As Chinese markets mature and price competition intensifies, foreign companies not yet in China will need to continually assess whether it is still affordable to function via long-distance with their Chinese suppliers, or whether more substantial operational control is needed

It is also a good interim solution for companies that are not yet ready to tackle the Chinese VAT system and other operational compliance requirements.

Supply Chain Control vs. HR Risks

To obtain a comfortable level of control and assurance over the production and delivery of products, foreign buyers should employ reliable staff on the ground to manage quality control, supplier selection and liaison activities, price negotiations and market research.

As Chinese markets mature and price competition intensifies, foreign companies not yet in China will need to continually assess whether it is still affordable to function via long-distance with their Chinese suppliers, or whether more substantial operational control is needed.

The representative office, service company and FICE structures can all be used to hire local employees in China, although there are some limitations for representative offices.

For senior level Chinese staff, there is a general perception that direct employment relationships are more stable and provide additional security. For many companies in the sourcing business, staff may be required to be based at multiple locations around the country (such as on-site at the factory, travelling for quality control purposes, or short term supervision projects).

Since the Chinese social insurance system is still managed on a regional basis, and since contribution rates and local practices can differ across cities, cross province social insurance payments for employees can become a headache for the employer.

Complexity, Compliance and Tax Efficiency

The changing trends in global procurement and the growing competitiveness of other supplying nations mean that the FICE model has become much more pertinent, as it allows for two-way traffic in both the inbound and outbound sourcing of products.

For example, many SMEs use China as a procurement hub to consolidate regional sourcing activities within Asia, since China’s infrastructure is generally recognized to be more developed and more efficient than countries such as India, Indonesia or Thailand.

The FICE model also makes it possible for companies to explore the potential of adapting their products or services for domestic consumption. An initial sourcing platform, established as an FICE, might in this case become the perfect starting point to begin wholesale, and maybe retail, activities in China.

However, it should be noted that with the added flexibility and complexity of a FICE, the operational and tax compliance requirements are also higher than the two other models. 

Applying for VAT export rebates, ensuring that VAT receipts are all verified, controlling inventory, dealing with customs and import duties – these all become the FICE’s responsibility once a direct sourcing model is employed. Competent internal staff, as well as the support of reliable external consultants, are key in establishing a successful business.

Remaining tax compliant is also important because the Chinese authorities tend to keep a closer eye on the activities of foreign companies. Therefore, foreign companies should note the different types of taxes and filings that can apply to their various trading, commission and service activities. From a transfer pricing point of view, statutory filings will need to be completed each year to disclose the sales activities between the company and its headquarters.

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 was first published in China Briefing and was reedited for clarity and conciseness. For further details or to contact the firm, please visit www.dezshira.com.

Photo credit: Shutterstock

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