Rein in pre-incorporation expenses

By Maria Kotova

Incorporation of a wholly foreign-owned enterprise (WFOE) in China is a time-consuming endeavor. As overseas parent companies rush preparation work, additional pre-incorporation expenses can be incurred. Foreign investors often underestimate the pre-incorporation expenses required to set up a WFOE. In this article, we discuss some key points to consider when setting up a company in China and provide suggestions for tax and financial planning during the pre-incorporation process.

How to rein in pre-incorporation expenses

Generally, investors are required to disclose capital to China’s Administration for Industry and Commerce (AIC) and Ministry of Commerce (MOFCOM), which will appear on the company’s business license after incorporation. Although the minimum registered capital requirement was abolished in 2014, in practice, authorities still check whether the company’s subscribed capital can cover operational costs for the first business year.

However, companies can expect a legally existing business license to take a few months; without one  the company cannot open bank accounts for capital injection or pre-incorporation expenses. The most common expenses include office rent (a WFOE has to provide a lease contract with at least one year’s term to start the incorporation process), decoration, furniture, equipment,and service fees for consulting and marketing firms. These expenses, paid by the parent company on behalf of the WFOE, can be difficult to transfer back because of China’s strict foreign exchange controls. It is important to note that, in this instance, there is still subscribed capital to be paid in.

What is a temporary capital account?

A WFOE can open a temporary capital bank account under the parent company’s name during pre-incorporation and then merge it with its capital account after formal establishment. A temporary bank account must be approved by the State Administration of Foreign Exchange (SAFE) after the company name approval is granted.

An investor can wire foreign currency into this account and spend these funds on pre-operation expenses. Purchases of office equipment are subject to bank review to determine the legitimacy of payment and ownership. However, the temporary bank account cannot be used to pay salaries or to purchase materials for manufacturing.

The maximum amount allowed in a temporary capital account is typically $300,000. Investors must obtain special approval from SAFE to exceed the limit. In practice, this amount should not exceed 20 to 30 percent of the total registered capital and will be examined by the SAFE depending on the WFOE’s type, size, and business activities. The temporary bank account is valid for six months, but can be extended with SAFE approval.

Foreign exchange settlement is required for each transaction, which can be time consuming, particularly when the investor is abroad. Investors are advised to open a temporary bank account with the same bank as their overseas parent company because most banks require the investor’s signature and a shared bank can simplify the process.

No temporary capital account, but want to withdraw expenses?

Companies that have paid all their expenses (including subscribed capital) through their overseas account will face problems when trying to charge those expenses back.

Whether or not the expenses can be withdrawn is determined jointly by the bank and SAFE. A bank might be reluctant to approve the withdrawal, as certain risks go hand-in-hand with such transactions.

There are several issues that need to be taken into When determining if expenses. These include qualify, authorities consider the time of payment, contractual parties, supporting documents such as  invoices, the nature of the transactions, and location of the WFOE’s vendors.

In particular, the time when the payment occurs might be one of the key factors in the bank’s review. A WFOE is considered a legal entity once it obtains its business license. The expenses incurred prior to that are therefore likely to be deemed as the parent company’s expense.

In a case where the expenses occur after a WFOE has obtained its business license, the consistence of contractual flow, invoice flow and payment flow is important. This means that all the agreements signed during this period should be either between a WFOE and its supplier, or a three-party agreement which also involves the parent company. The invoice flow can be challenging – investors need to ensure they are issued in the name of the WFOE rather than its parent company. The final decision largely depends on the bank’s judgment, with additional supporting documents occasionally required according to the internal policies of the bank.

Even if both the bank and SAFE have approved the charge back, there is an additional consideration – China’s tax bureau. Most of these transactions (e.g., construction, marketing or consulting expenses) are subject to a withholding tax, which covers taxes such as value-added tax (VAT), corporate income tax (CIT) and local surtax, ranging from 14 percent to 20 percent depending on the description of the services in the agreement. Certain transactions, such as business travel expenses and accommodation, are tax free.

Please note that these requirements, the tax payable, and the time required can vary widely across different areas of the country depending on the specific situation of the company, local banks and tax bureaus.

What are the other thresholds to consider after the WFOE is successfully established?

Obtaining general value-added taxpayer status can potentially help the WFOE save a large amount of taxes, as the status allows WFOEs to offset output VAT against input VAT. This status needs to be applied for and WFOEs must meet certain requirements.

A WFOE could also have paid for some expenses before they acquire general taxpayer status and may want to use the invoices they received to credit against output tax. This can be challenging in cases where the company’s vendors issue special VAT invoices prior to the effective date of the general VAT taxpayer status. Overlooking the invoice issuance date could result in a huge additional tax burden (the VAT rate for services is six percent and 17 percent for goods).

Recently, the SAT released Announcement 59 to clarify how to deal with input VAT incurred during the waiting period before the WFOE obtains general VAT taxpayer certification. More details regarding the status application procedure and tax deduction method can be found in our previous article, here. In practice, the new regulation is gradually implemented in China and challenges may still exist for taxpayers to get their input VAT recognized by the local tax officer. Therefore, companies are recommended to defer transactions with their vendors and delay the issuance of the special VAT invoices in order to reduce the input tax occurred during the waiting-for-status period.

Specialist law firms and accounting firms working separately often overlook some of these key challenges, as they tend to focus on only one side of the issue – mostly, the legal aspects of incorporation. Investors are therefore strongly recommended to have these specialists work side by side to ensure compliance while preparing for potential challenges and risks during the pre-incorporation process.

About the Author:This article was first published on China Briefing. Since its establishment in 1992, Dezan Shira & Associates has been guiding foreign clients through Asia’s complex regulatory environment and assisting them with all aspects of legal, accounting, tax, internal control, HR, payroll and audit matters. As a full-service consultancy with operational offices across China, Hong Kong, India and emerging ASEAN, we are your reliable partner for business expansion in this region and beyond. For inquiries, please email us at [email protected]. Further information about our firm can be found at: www.dezshira.com