Common mistakes in starting up a business in China : Licence Applications and Tax Issues

Having dealt with the sticky issue of “guanxi“, or people relations in doing business in China and hearing his Introduction to Wholly Foreign Owned Enterprises in China, our resident contributor, Kenneth Wong of SHEN and the Shanghai Singapore Business Association, here shares with us the more legal and (gasp!) boring, yet essential aspects of starting up in China.

In the rush to get into China, many start-up businesses tend to get into trouble because of their naivety in handling their company’s incorporation process and not paying attention to details on tax and legal issues. This article will examine the common mistakes committed by entrepreneurs in their WFOE incorporation and will draw attention to issues that potential investors to China should take note before jumping on board.

Sending Start-up Funds to a third party before WFOE is ready

It takes normally three to four months to complete a WFOE application. However, some foreign investors cannot wait that long and try to send the start-up funds to their local agent or local staff to cover the cost for the initial office fit-out, overhead or even equipment purchases. The problem is that these funds, as paid for the FIE setup can not be recognized as part of an enterprise’s capital injection once the business license is issued, as the capital injection has to be transferred by the foreign investor from their overseas account to the nominated Capital account directly and not via any third party.

An example is a client who had remitted up to USD 100,000 to their local supplier to ask them to pay for rental and purchase equipment prior to the license being issued. Subsequently, it was difficult for them to pursue the balance and to show such purchases as part of their capital injection. It would have been better to arrange this as an internal loan between the parent company and the WFOE and book it as a roll over amount instead of including it as part of the WFOE’s registered capital budget.

Registered Capital Issues

Many ill-advised investments are made in China due to misinterpretation of what the provincial governments term as “minimum registered capital”. Especially for small businesses, this is a much misunderstood area. “Minimum Registered capital” is not supposed to be a ruling on how much an enterprise has to invest, the amount of registered capital needed in the business depends on a number of different factors

Location: Some regions in China apply different levels of capital requirements than others to reflect their lower or higher regional operational costs

Scope: For certain industries or services, the applicable registered capital amount can be quite high. This is sometimes used as a protectionist tool to discourage foreign investment, and is sometimes used to ensure only the right standard of international business can enter the market to ensure the quality of applicant. It would be important to note if an existing business wishes to expand their current scope of business, it may be a requirement to increase the amount of registered capital.

Cash-flow: Registered capital is required to fund the operations of a new business until it is in a position to fund itself. This is usually catered for in the feasibility study report (可行性报告)- which is a business plan type document that is submitted to the authorities as part of the application process. However, in a rush to attract new investments and as a result of a lack of even basic economies, many government agents do not pay much attention to this report.

Often, a foreign investor will naively assume that he has gotten a great deal due to the “minimum amounts” being identified as all that is required. However the business can come to a sudden halt if the registered capital amount is insufficient to support the operations cash flow. Not only would the investor have to wire additional funds to China, it involves the additional procedures as follows:

1. Application to increase the registered capital with the original licensing authority
2. Re-issuing of business license reflecting this- important as the registered capital amount is also the limited liability status of the business
3. Application to the State Administration of Foreign Exchange to transfer funds into China
4. Bank-to-Bank Fund Transfer

The above steps take between six to eight weeks to fulfill. Instead of facing a scenario where one runs out of operational money for his/her business, it would be advisable that one should properly capitalize his/her business in China in accordance not just with government guidelines over ‘minimum registered capital’ but also pure economic and operational realities. Some businesses in China go broke in China because of this issue and certain unscrupulous consultants may not advise on the matter as they may seek to gain more fees from the client in terms of sorting out the problems when they arrive.

Lower Registered Capital Amounts Affecting General VAT Payer Status At Commencement of Business:

VAT refers to Value-Added Tax: It is a type of consumption tax that is placed on a product whenever value is added at a stage of production and at final sale. The amount of VAT that the user pays is the cost of the product less any of the costs of materials used in the product that have already been taxed.

Adhering to the said ‘minimum registered capital’ amount figure may cause additional problems when applying for “General VAT payer” status. The benefits of having a “General VAT payer” status is that it gives the VAT payer the right to issue VAT receipts to their clients, which allows them to deduct the input VAT from purchases when it pays the output VAT for sales.

For the FICE or WFOEs who deal with clients that need VAT receipts such as for industrial related produces, they certainly normally will require VAT General Tax Payer status but if the FICE is only engaged in trading consumable products to individual customers, this is probably not necessary. For larger operations with significant amounts of VAT invoicing likely in their books, in order to qualify from the outset of their operations for VAT General Tax Payer Status, the company has to meet the following additional requirements:

1. Minimum Registered Capital
   外高桥 FTZ = RMB 1,000,000
   浦东/浦西 = RMB 5,000,000
2. The total number of employees shall be over 50 (negotiable in some cities)

If the company cannot meet the above two requirements, then it can only apply for such status once they have reached annual sales in excess of RMB 1.8 million which is the next qualifying level. As all FICE are related to trading, usually a FICE needs to apply for VAT General Tax Payer status for the purpose of deduction of input VAT. Certain trading WFOEs also need to bear this figure in mind. Without bearing this figure in mind, it may cause the company to have cash flow problems. For example if the cost of one’s input/import goods unexpectedly go up, the initial 1.8 million sales threshold means that the deduction of input VAT is not permitted should the FICE or WFOE not meet the registered capital requirement.

Kenneth is currently the President of SHEN, the Shanghai House of Entrepreneurs NUS and the Director of the Youth Chapter in the Shanghai Singapore Business Association. He is doing his internship as a corporate services consultant at Willsonn Partners, a fast growing CPA firm in China. He can be contacted at Kenneth@shentrepreneur.com or Kenneth.wong@willsonn.com or via Shanghai Mobile 86-21-13402065607

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