With China continuing to grow as an economy and in importance to New Zealand, and tax holidays on offer to all those who want to have an active trading company offshore, it's time to re-evaluate how businesses should structure their offshore activities.
Obviously, commercial factors outweigh any tax decisions but that doesn't mean you should ignore a good deal when you see one. And if you qualify for a tax holiday or concession in China then your savings are even better. Bringing dividends back to New Zealand-based companies tax-free further sweetens the deal. However, there are lots of hoops to get through in both countries, which is why up-front planning and analysis is critical.
The New Zealand Government's tax changes exempting offshore trading companies are designed to ensure we are internationally competitive and to maximise our export growth, which is sadly lacking right now. However, as China is our second-largest trading partner, demand for our goods and services will grow along with their economy.
There are also major changes within China exporters need to be aware of. These include more stringent requirements around the use of representative offices traditionally used by many foreign firms as a low-cost initial step into the Chinese market. These offices have no registered capital requirements, a straightforward application process and low operating costs.
Chinese regulators have recently pushed through restrictions on the number of individuals and the activities that can be conducted through representative offices. Many of these no longer qualify for tax exemptions and will be subject to a higher deemed rate of return.
These changes mean it is opportune to consider whether it is cost-effective to establish an incorporated company in China. A wholly foreign-owned enterprise (WOFE) is becoming a popular form of investment into China. Their main advantage is that a domestic Chinese investor is not required, giving foreign investors complete control of the Chinese subsidiary. Another advantage of a WOFE is that it gives a greater level of intellectual property protection in China, where IP infringement is common.
Although complete control and IP protection sound attractive, one should take into account that the lack of a Chinese partner may put a strain on relationships (guanxi) with customers or suppliers. Establishing a WOFE can also be a complex and expensive process, and it may not be an economically viable option for smaller operations with limited resources. If the WOFE proves to be a success, profits derived can be repatriated back to the New Zealand parent company, tax-free if the WOFE qualifies as an active business under New Zealand tax law.
Many investors have used Hong Kong as a springboard for investments into mainland China. With the recently signed New Zealand/Hong Kong Double Tax Agreement, New Zealand investors can have access to further treaty relief in addition to the simplicity of the Hong Kong tax system.
But before getting too excited about the benefits a Hong Kong company can offer, don't be blinded by their tax system.
Investors should be warned that there is increasing scepticism by Chinese tax authorities of the integrity of Hong Kong holding companies.
The Chinese tax authorities are now applying a "substance-over-form" approach regarding the sale of offshore intermediary holding companies owning Chinese resident enterprises.
In June 2010, the Chinese tax authority successfully imposed millions of tax duties on a foreign investor for gains obtained from the disposal of a Hong Kong holding company due to lack of any "business substance".
With this precedent of the Chinese tax authorities applying the anti-avoidance provisions to disregard the holding company, it is now crucial for investors to question whether a Hong Kong holding company is needed.
The new "active business" test in New Zealand would also be biased in favour of a WOFE with active business in China, and bringing the dividends back to the New Zealand parent company will be tax-free, as opposed to with a holding company that does not carry out any physical activities.
A corrective action plan is now critical. Those who adopt a "wait and see" approach may find themselves defaulted to a "wait and pay" approach.
Though every investment structure has its advantages and disadvantages, make sure you have done your homework and talk to your advisers before committing to a business structure. Commercial and tax traps are often costly, but they can be minimised with some careful planning.
- Joanna Doolan is co-ordinating partner and Florence Wong the director of Ernst & Young's NZ China Business Group. Contacts: joanna.doolan@nz.ey.com; florence.wong@nz.ey.com
Do your homework to take advantage of a tricky system
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