Business Basics in China: Currency Regulations, Intellectual Property Threats Add to Challenges

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With U.S.-China trade at record highs and China as the world's second largest economy, the JofA asked Timothy J. Hilligoss, CPA, MST, partner in charge of Asia for Southfield, Mich.-based firm Clayton & McKervey PC. to share some basics on what U.S. companies face when investing in Chinese ventures.

LEGAL/REGULATORS

JofA: What are the available forms of organization for doing business in China (simplest to more complex)?

Hilligoss: There are three common methods for a U.S. investor to do business in China. Those being a representative office (RO), a wholly owned foreign enterprise (WOFE of WFOE) of an equity joint venture (EJV) in which the direct foreign investment is less than 100%. Both the WOFE and EJV are limited liability companies.

JofA: What are the advantages and disadvantages of each?

Hilligoss: The pros and cons:

RO: A RO is not a legal entity and is not allowed to directly participate in revenue generating business activities (for example, conclusion of contracts, buy and sell directly, issuance of invoice, etc.). ROs cannot directly employ local nationals, are allowed a limited number of representatives, and require annual license renewal. There are no minimum capitalization requirements. Currency controls are less restrictive. However, the establishing U.S. entity must have been in existence for two years. A RO is required to use the actual or deeming method to determine taxable income and pay China corporate income tax. (A RO may have income taxes without actual income.)

WOFE: A WOFE is a legal entity subject to China's minimum capitalization rules. WOFEs are subject to restrictive currency controls, but they allow 100% foreign ownership and control, which may be beneficial for IP (intellectual property) protection. WOFEs require 10% of after-tax profits to be held in company reserve (until the cumulative reserve reaches 50% of the registered capital).

EJV: An EJV is a legal entity that requires a Chinese partner. WOFE rules apply to EJVs. The structure may expose IP to a Chinese partner, but the partner may share in liabilities and costs as well as provide easier entry to the Chinese market.

JofA: What statutory financial reporting is required, and what accounting principles need to be followed?

Hilligoss: Chinese tax authorities require entities with foreign ownership to submit an audited financial statement with their annual corporate income tax returns. The audit is required under Chinese or "PRC" GAAP. Audited financial statements ate also required during the annual inspection of an RO, WOFE of EJV with foreign ownership.

JofA: What do companies need to understand about protecting intellectual capital in China?

Hilligoss: While we are not attorneys, we certainly see this question come up a lot in our client base. Everything we have seen tells us you cannot stop someone from stealing your know-how. What you can do is limit or piecemeal what any vendor or supplier may be privy to and look to protect how you put all the pieces together. China, since joining the WTO (World Trade Organization), has implemented legislative changes setting general standards for IP protection and enforcement.

JofA: What are important aspects of labor?

Hilligoss: Focusing on the tax and economic factors, China is seeing double-digit growth in wages. Certainly, you expect some areas like Beijing and Shanghai to lead the way. However, because of heavy foreign investment, there is significant wage growth in Nanjing, Chongqing, Tianjin and Changchun. This fast growth can make it difficult to keep and find employees. From the cost/tax perspective, China has social taxes just like the U.S. They also have holiday and overtime pay, as well as severance pay requirements, which typically equate to one month pay for each year or portion thereof worked. Total costs of social security, health and unemployment taxes equate to about 40% of basic payroll costs. …