Hong Kong, 21 November 2016
When planning to expand in Asia, the top management of a corporate group (“Group”) may be facing a tough decision on where to locate the trading business that can often result in a choice between Hong Kong and People’s Republic of China (“China”). This is especially true if together with the trading business the Group plans to establish also a manufacturing company based in China that is wholly owned by a holding company based in Hong Kong.
This Newsletter aims to point out some of the main issues to consider when facing such decision.
The analysis will consider tax, financial and legal advantages for a trading business in Hong Kong compared to China, in relation to the products manufactured in China and sold everywhere in Asia, besides China[1].
1. Hong Kong as a financial hub
Hong Kong is one of the most dynamic and largest financial centre in the world[2], representing the gateway to China for inbound and outbound investments.
As at 2014, almost 58% of all China’s outward Foreign Direct Investments (“FDI”)[3] had as destination Hong Kong.
On the other side, Hong Kong is the largest source of overseas direct investment in the Chinese mainland. By the end of 2015, among all the overseas-funded projects approved in the Chinese Mainland, 44.7% were tied to Hong Kong interests.
Furthermore, according to China’s Customs statistics, Hong Kong is the second largest trading partner of the Chinese mainland after the US, accounting for 8.7% of its total trade in 2015.
1.1. Movement of capital: comparing Hong Kong and China
Here below we have highlighted some of the main advantages from a financial point of view to establish a trading business in Hong Kong in comparison with China:
- Possibility to receive payments in other currencies besides RMB. In Hong Kong, banks allow and provide a wider currency selections (i.e. including USD, EUR, GBP, CHF, CAD, AUD, NZD, CNY, HKD, JPY, SGD) for companies to tailor their business operation needs when compare to China. With the current instability of RMB, companies in Hong Kong has an advantage to make and receive payments freely in their ideal currencies in order to better control their currency risk exposures.
- No specific limitation with the movement of capital: make payments abroad and receive payment from abroad.
- China is known to be a country with restricted currency controls and regulated by the State Administration of Foreign Exchange (SAFE). Chinese companies are still required to seek for specific approvals from the SAFE for any business capital accounts’ overseas inward and outward transactions. Prior to the pre-approval, no capital funds are allowed to pull out of China. On the contrary, Hong Kong companies has no limitation on any remittances and no pre-approval needed, which allowing Hong Kong companies to operate timely.
- No limitation on currency exchanges. Until today, the Chinese government still maintains strict exchange controls. Firstly, there are certain limitations on the amount of foreign exchange can be held in Chinese companies’ accounts. Secondly, Chinese companies are required to prepare and to show relevant documentation on foreign business transactions. On the contrary, business account holders in Hong Kong have neither deposit nor foreign transactions/exchange limitations, allowing company owners to easily cope with their business operations.
- Better access to different financial products.
- Better Lending rates in Hong Kong.
1.2. Funding: equity or loan
Before setting up a business or even later on when business operations already started, it is quite important to determine whether the funding is done by equity or loan.
In Hong Kong it does not matter whether the funding is done through an injection of share capital or a loan. Both procedures are straightforward and the related funds are available to the company as soon as the bank transfer is completed.
On the other hand, in China things are quite different from this prospective with specific rules that govern the portion of share capital and shareholding loan that may be used to fund the foreign invested company. The general principle in China is that the invested share capital shall be appropriate and adequate to render the Chinese company able to engage all the activities listed in its business scope. This means that in order to get the relevant initial approval from the Chinese government the amount of the initial share capital of a company shall be consistent with the wideness of its business scope. The actual amount of share capital to be contributed can be defined only after consultation with the relevant authorities once the draft of the business scope has been submitted to their attention. Furthermore, the funding of a foreign invested company through the loan from its overseas shareholder is under the SAFE controls and subject to specific restrictions. Specifically, it will be a cap to the maximum amount of shareholding loan at disposal of the foreign invested company that shall be equal to the difference between the “total investment” and the “registered capital”. For example, it means that for companies with total investment less than or equal to 3 Mil USD, the maximum amount of shareholding loan shall be 30% of the total investment (and, consequently, the minimum registered capital equal to 70% of the total investment). Any loans beyond this threshold will be rejected by SAFE.
2. Comparing Hong Kong and China tax systems
There are a number of tax issues to consider at the time of establishing a trading business in Hong Kong, in comparison with China:
- Hong Kong corporate tax rate (Profits Tax) is 16,5% compared to 25% (Enterprise Income Tax) in China.
- Hong Kong does not tax dividends. Instead China tax dividends paid abroad 10% if no tax treaty is applicable. In case the Hong Kong holding company directly owns 100% of the capital of a Chinese subsidiary[4], the Hong Kong holding company may benefit from the withholding rate of 5% as stated under the tax treaty between China and Hong Kong, provided that the Hong Kong holding company is the beneficial owner of the dividend.[5]
- There are no VAT regulations in Hong Kong and therefore making it much easier to import/export products by having virtual no administrative burdens for trading businesses. China, on the other hand, levies VAT on the sale of goods, but the exports of goods generally attract a zero rate of VAT, i.e. zero output VAT on export, and along with a refund of input VAT, ranging from 0% to 17%, incurred on materials purchased domestically for the export of goods.
- Hong Kong does not tax capital gains. However, capital gains derived from a Hong Kong holding company from the alienation of shares in a Chinese subsidiary will generally be subject to China withholding tax at 10%[6]. On the other hand, any capital gains derived from the future disposal the Hong Kong holding company should not be subject to profits tax in Hong Kong; however, the indirect disposal of the Chinese subsidiary via the Hong Kong holding company, the intermediate company, may be subject to the reporting requirements in China, and if the transaction is re-characterized under the “looking-through” approach, the income from indirect transfer shall be subject to China withholding tax at 10% . This topic shall be considered in respect of a future exit strategy from the investment.
Moreover, from a general perspective, the trading business in Hong Kong will grant to a Hong Kong parent company more substance which is an important requirement from an international tax point of view and therefore reducing the risk of possible future tax audits.
3. Commercial law in China and Hong Kong
The formation of a business presence in Hong Kong is easy, clear, efficient and has a low cost without complicated procedures in any kinds. On the opposite, formation of a business presence in China could be complicated and bureaucratic as both of the state authorities’ laws and regulations together with the specific city authorities’ local regulations must be considered at the same time.
In Hong Kong, both foreign individuals and/or foreign companies may easily incorporate a limited company by shares normally within 4 working days after submission of the incorporation documents to Hong Kong Companies Registry. Hong Kong Companies Registry will then issue Certificate of Incorporation and Business Registration Certificate to the Hong Kong company. According to Hong Kong Companies Ordinance (Cap. 622), a company must have a company secretary. The company secretary of a Hong Kong limited company must ordinarily reside in Hong Kong (for individual) or the registered office or place of business must be in Hong Kong (for body corporate).
On the other hand, if a foreign company chooses to establish a business presence in China, it may choose among the most common types such as WFOE (Wholly Foreign Owned Enterprise), JV (Joint Venture), FIPE (Foreign Invested Partnership Enterprise) and Rep Office (Representative Office) according to its actual needs.
In general, the most usual type of entity is the WFOE which is a limited liability company formed in China entirely with foreign capital and under full control and 100% ownership of the foreign company. It usually takes 4 to 6 months to set up for normal easy WFOE cases. The registered capital requirement may vary across different industries and cities in China.
The governance of a company from a corporate law perspective is simpler and more time and cost effective in Hong Kong than China. All corporate changes (e.g. change of company name, appointment/removal of directors, alteration of articles of association etc.) can be implemented quickly in Hong Kong while in China there is still a lot of bureaucracy which creates a complex and slow system. Moreover, in Hong Kong a shareholder who holds at least 75% of the issued share capital of a company has complete control over it whilst under Chinese laws there are certain important corporate decisions which require the unanimous consent of all shareholders, and therefore also a shareholder who holds a minority stake can easily create situations of deadlock.
Generally, Hong Kong has a very efficient and fair legal system with many legal instruments which allow a great degree of flexibility while Chinese laws are more restrictive. Also from an employment perspective, hiring and dismissing employees in Hong Kong is relatively simple and straight forward while Chinese laws are heavily employees friendly.
Given all the above, when it comes to regulate the relationships between shareholders it is always preferable from a legal standpoint to do it at the Hong Kong level and to choose the Hong Kong courts (or arbitration centers) as venue to settle possible disputes.
For more information, please contact:
Marzio Morgante
Dottore Commercialista, LL.M.
Managing Partner
Rooms 501-2, Wilson House,
19-27 Wyndham Street,
Central, Hong Kong
Email: marzio@atatax.hk
Tel: (852) 3102 1995
Fax: (852) 3102 0991
[1] Products manufactured in China and sold to the Chinese market shall be sold domestically directly, since a Hong Kong company cannot purchase the products from a Chinese manufacturer in China and sell them directly to the Chinese market, without having the products exit and enter China and therefore applying customs duties and VAT at the time of import.
[2] According to the UNCTAD World Investment Report 2016, global FDI inflows to Hong Kong amounted to US$175 billion in 2015, behind only the US (US$380 billion). In terms of outflows, Hong Kong ranked third with US$55 billion in Asia, after Japan (US$129 billion) and the Chinese mainland (US$128 billion).
[3] According to the 2014 “Statistical Bulletin of China’s Outward Foreign Direct Investment” published by the Ministry of Commerce of the People’s Republic of China, Chinese outbound investment amounted to US$123.1 billion in 2014, of which 58% had as destination Hong Kong.
[4] The reduced rate of 5% dividend withholding tax applies only when the beneficial owner is a company directly owning at least 25% of the capital of the company which pays the dividends.
[5] As to whether a Hong Kong holding company qualifies as the “beneficial owner” of the dividends so that the preferential DTA withholding tax rate would apply, reference should be made to Circular of the State Administration of Taxation on the Interpretation and the Determination of the “Beneficial Owners” in the Tax Treaties [Guo Shui Han [2009] No. 601] (“Circular 601”).
According to Circular 601, the term “beneficial owner” refers to a person who has the right of ownership and control over the item of income, or the right or property from which that item of income is derived. It further notes that a beneficial owner, generally, must be engaged in substantive business activities and that an agent or “conduit company” will not be regarded as a beneficial. The presence of the following would be considered factors that could negatively affect an applicant’s status as the beneficial owner:
- The applicant is obliged to distribute most of its income (e.g. more than 60%) to a resident of third country within a prescribed time period (e.g. within 12 months from the date of receipt);
- The applicant has no or minimal business activities;
- Where the applicant is an entity such as a corporation, its assets, scale of operations and personnel deployment are not commensurate with its income;
- The applicant has no or minimal control and decision-making rights and does not bear any risk; and
- The income of the applicant is non-taxable or, if subject to tax, is subject to a low effective tax rate.
When a taxpayer applies for treaty benefits, it will need to provide documentation to the local tax authority to support its claim as being the beneficial owner of the relevant income and that it does not fall within the scope of any of the above.
[6] Under the tax treaty between China and Hong Kong, capital gains from the alienation of shares in a Chinese company will be subject to China withholding tax at 10% if 1) the Chinese company has property that consists directly or indirectly principally immovable property in China, or 2) if at any time within the 12 months before the alienation, the recipient of the gains had a participation, directly or indirectly, of not less than 25% of the capital of the company.
