Trading Haven Finally Within Reach?

MOFCOM has reportedly received, to date, over 70 applications from existing FIEs to expand their business scopes to include distribution. Approval of such applications from MOFCOM has, however, been slow in coming, partly because of lack of guidelines for addressing numerous issues accompanying the inclusion of distribution in the business scopes of existing FIEs, as discussed below.

Circular Concerning Expansion Into Distribution

On April 2 2005, MOFCOM issued a Circular on Certain Issues Concerning the Inclusion of Distribution in the Business Scope of Foreign-invested Non-commercial Enterprises (Circular).

The Circular requires a relevant FIE to amend its articles of association and/or joint venture contract in connection with the expansion of its business scope, and to follow the same approval procedures as those for the establishment of a new distribution FIE set forth in the Procedures. The existing FIE thus needs to submit its application for the expansion of its business scope, along with its amended charter documents and other required documents, to the provincial arms of MOFCOM. The latter will examine the application documents and decide whether to grant a preliminary approval before submitting the documents to MOFCOM for its final approval. Under the Circular, the FIE is required to warrant that it has completed its capital contribution, passed annual inspections, and otherwise complied with relevant laws and regulations. The Circular indicates that foreign invested holding companies/regional headquarters are also permitted to incorporate distribution into their business scopes.

Tax Implications

One major concern associated with the expansion of a manufacturing FIE's business into distribution is the resulting tax implications. Informal comments by MOFCOM officials seem to indicate that the value of sales derived from manufacturing would need to reach a minimum percentage threshold for the FIE to continue to enjoy tax benefits intended for manufacturing FIEs.

The Circular indirectly confirms this point. While the Circular does not directly address the tax issue anywhere, a form attached to the Circular for use by an FIE in applying for incorporation of distribution in its business scope, and a footnote to the application form in particular, make it clear that generally only if the value derived from distribution activities of the FIE remains at 30% or lower of the FIE's total sales revenue, can the FIE continue to be classified as a manufacturing FIE. The unstated inference appears to be that if the value derived from the distribution activities exceeds 30% of the FIE's total sales revenue, the FIE will as a rule lose any tax benefits it may otherwise enjoy as a manufacturing FIE.

A MOFCOM official has reportedly suggested that the coordination needed between MOFCOM and the tax authorities for addressing tax issues raised in the expansion of an FIE's business into distribution might delay the associated application process.

It remains to be seen whether and/or how MOFCOM will coordinate with the State Administration of Taxation (SAT) to reconcile the Circular with a 1994 circular issued by SAT that permits an FIE (engaged in both manufacturing and non-manufacturing activities) to apply for any relevant tax exemption or reduction so long as the operational revenue from the FIE's manufacturing activities is at least 50% of the total revenue of the FIE.

Restriction on Products Distributed?

Another question raised by the incorporation of distribution into an existing manufacturing FIE's business scope is whether any restriction applies to the range of products that the FIE may distribute. MOFCOM officials have indicated informally that an FIE can only trade in products that relate to, or belong in the "same category" as those manufactured by the FIE itself, without further specifying how to define such a "category".

The Circular is silent on the issue of any restriction applicable to the products distributed, merely requiring that an FIE specify the intended mode of distribution (i.e. wholesale, retail or commission based sale), and provide a list of the products intended for distribution activities. Assuming that certain restrictions will be applied here, it is unclear whether MOFCOM intends to rely on informally stated fuzzy (or internal) guidelines or offer further guidance on this point in the future.

Conclusion

Foreign investors with existing FIEs in China are well advised to take into consideration the relevant tax implications, approval procedures, and hitherto lack of clarity as to potential restrictions on the types of products a pre-existing FIE can distribute before choosing between establishing an independent distribution FIE and adding distribution to the business scope of an existing FIE.