Rocky road for foreign-invested holding companies

Implications of the Circular

In the past, it was not necessary to increase a Holdco's own registered capital in order to reinvest its legitimate income earned in China.

The new requirement of the Circular makes the reinvestment procedures more time-consuming, because now increasing a Holdco's own registered capital becomes a precondition for reinvestment of its legitimate income earned in China.

In addition, the new requirement also increases the tax burden of the Holdco's shareholder(s). Under PRC tax law, when a Holdco's after-tax profits are transformed into its registered capital, its shareholder(s) are deemed to receive “dividends” from the Holdco and then reinvest such dividends in the Holdco. As such, the Holdco's foreign shareholder(s) have to pay 10% Chinese withholding tax for such “dividends” (unless a lower tax rate is available under the applicable double taxation treaty).

Before the issuance of the Circular, a Chinese Holdco structure was viewed as tax efficient for dividend reinvestment. Under thePRC Enterprise Income Tax Law (中华人民共和国企业所得税法) (EIT Law), qualified dividends distributed by one tax resident enterprise (TRE) to another TRE are exempted from enterprise income tax. This also applies to the dividends received by a Holdco from its Chinese subsidiaries. In contrast, if there is no Holdco structure in China, foreign investors (as non-TREs) shall pay 10% (or a lower tax treaty rate where applicable) withholding tax for the dividends received from their direct Chinese subsidiaries before such dividends are reinvested in China. The new Circular has eliminated such tax advantage of having a Chinese Holdco. Since a Chinese Holdco shall now first transform its undistributed profits into its registered capital, its foreign shareholders can no longer avoid the Chinese withholding tax for dividends.

Reaction from the commerce authorities

The Circular claims that the new requirement is based on Decree [2006] No. 3 issued by the PRC Ministry of Commerce (Mofcom). However, this earlier Mofcom decree only covers the situation where foreign investors use their legitimate income earned in China to invest in a Holdco as capital contribution to the latter. The Mofcom decree does not cover the situation where a Holdco reinvests its legitimate income earned in China. There is hardly any logical link between the Circular and the Mofcom decree.

Not surprisingly, the commerce authorities take a cautious approach on how to cooperate with Safe on this issue. Like every other foreign-invested enterprise, a Holdco shall also obtain an approval from the competent commerce authority before it can increase its registered capital. According to information received from the Shanghai Authority of Commerce, they have been instructed by Mofcom to temporarily suspend granting approvals to Holdcos regarding capital increase applications for reinvestment purposes as requested by Safe. Without such approval from the competent commerce authority, a Holdco will not be able to increase its registered capital and, consequently, will not be able to go through the relevant procedures with Safe for the reinvestment of its legitimate income earned in China.

For the time being, due to the seemingly different opinions of Safe and Mofcom, Holdcos are currently not able to make reinvestment in China. The two authorities are reported to be in the process of coordinating with each other to work out a joint guidance in this respect.

Final thoughts

Before Safe and Mofcom have successfully coordinated with each other, Holdcos may have to wait for reinvestment of their income earned in China. For investment projects where time is essential, Holdcos may need to consider other financing alternatives such as using their registered capital or taking out shareholder or bank loans.

For investors considering establishing a Holdco structure in China, it is important to follow up with the future development of this issue in order to make a sound business decision.

Ulrike Glück, Partner and Charlie Sun, CMS China, Shanghai