Reducing Trapped Cash in China with Outbound Intercompany Loans
Many foreign companies struggle to get profits earned in China out of the country in an efficient way. During the past year, repatriating funds has become much easier with relaxed requirements for intercompany loans to affiliates outside China.
The most straightforward way to bring money home is to have your Chinese subsidiary (Foreign-Invested Entity, FIE) pay out dividend. However, this is not always as easy as it sounds; moreover, it is expensive. FIEs normally pay 25% corporate income tax (CIT) on their gross profit, and when remitting dividend offshore another 5-10% withholding tax is levied (depending on whether a double taxation treaty (DTA) applies).
Dividend may only be paid if all losses for previous years have been made up. Furthermore, an FIE must put 10% of its annual profits into a reserve fund until 50% of its registered capital has been reserved. This inevitably results in cash being trapped in China.
The timing of dividend payments is also restricted. Banks only process dividend payments on the basis of an audit report and tax returns proving the amount of distributable profits and payment of taxes. This makes the payment of interim dividends virtually impossible, and since the audit report and tax returns usually become available only in June or July, most dividend payments must wait until the second half of each calendar year. Sometimes it may take even longer. In a recent case, an FIE waited for six months to obtain all required documents.
Service Fees and Royalties
Due to the costs and limitations of dividend payments, many foreign companies try to minimize their profits in China by charging their Chinese subsidiaries service fees and royalties. This has tax implications (VAT or business tax is levied, and a 10% withholding tax applies, unless the relevant DTA specifies a lower percentage, although service fees are often charged at 10% regardless of any DTA), but the overall tax burden is usually substantially lower than for dividends.
Service fees and royalties are, however, only allowed for genuine arm’s length transactions directly related to the FIE’s business (otherwise the payment is not recognized as an expense and 25% CIT will be levied). This condition puts a natural limit on the amount which can be repatriated by using service fees and royalties.
Outbound Intercompany Loans
One way to send the remaining cash back home is through outbound intercompany loans. This has the added advantage that cash may be sent back to China in due course when the business needs to expand further. Granting such loans has become much easier during the past year.
There are basically two schemes for an FIE to extend loans to an offshore affiliate: loans in foreign currency regulated by the SAFE (State Administration for Foreign Exchange) and RMB loans regulated by the PBOC (People's Bank of China). The key features of each scheme are set out in the table below.
|Onshore corporates (including FIEs, excluding real estate companies)|
|Borrower||Offshore companies having an “equity relationship” with the lender (prior to 2014: limited to FIE’s offshore parent)||Related companies in the same group|
|Quota||Max. 30% of an FIE’s registered capital (the limit of the sum of dividends payable / undistributed profits was abolished in 2014)||No quota – lender to retain sufficient cash for its operations|
|Registration / approval||SAFE registration, local SAFE approval when exceeding quota||Bank approval only (in most cities)|
|Tenor||No limit (2 year maximum tenor abolished in 2014)||No limit|
|Source of funds||Self-owned or borrowed||Self-owned|
|PRC tax implication||25% CIT and 5-10% business tax on interest earned by lender||25% CIT and 5-10% business tax on interest earned by lender|
Coca Cola was reportedly one of the first companies to utilize the PBOC scheme late last year and managed to send out a RMB 250 million loan to an offshore affiliate within 10 working days. Later reports mention that medium-sized companies have also been able to repatriate cash the same way. Compared to dividend distribution, there are two key benefits in providing outbound loans: (a) greater flexibility and (b) deferral of the 10% dividend withholding tax.
As becomes clear from the table above there is no connection with the FIE’s distributable profit (for the SAFE scheme this was previously the case, but it has been abolished earlier this year), meaning that cash which may not (yet) be distributed as dividend can be transferred out as a loan (although under the SAFE scheme there is a cap of 30% of the registered capital). This opens the possibility for de facto interim dividends (since there is no longer any need to provide audited accounts) and to repatriate profits normally stuck in the reserve fund (see above, up to 50% of the FIE’s registered capital ultimately needs to be reserved).
Under the SAFE scheme, loans could be granted for a maximum of two years, but this requirement has been removed this year as well. As long as reasonable business terms are in place, both schemes provide flexibility in terms of repayment and applicable interest rate.
As always in China, practices differ per city (and even per district) and also banks are maintaining their own policies on the conditions for approval. We understand that in practice, lenders may need to satisfy certain basic financial criteria (usually net assets, net profits and net cash flow of the lender all need to be positive, and a no-objection letter from the local tax authorities may also be required). If you intend to use intercompany loans to release trapped cash, make sure to check with your lawyers and bank at an early stage what the exact local requirements are.
Outbound loans have tax implications as well: the FIE needs to pay 25% CIT and business tax on the interest income, though the offshore borrower may offset the CIT paid by the lender if the applicable DTA provides for this. The greater flexibility and deferral of the 10% dividend withholding tax in many cases will outweigh these costs of outbound intercompany loans.
Cash Pooling in the Shanghai FTZ and Cross-border Security
Finally, it is worth briefly mentioning two other recent developments, which are outside the scope of this article, but could also be helpful in reducing cash trapped in China.
Multinational corporations (MNCs) established in the Shanghai Free Trade Zone may now set up a two-way RMB cash pooling system. Several banks already offer such system, which enables MNCs to integrate their onshore RMB cash flow (generated throughout China) with their global cash pool (although certain restrictions apply). Saint-Gobain, Dover Corporation (both with HSBC), Sonepar (with RBS) and Roche (with Citi) are reportedly among the MNCs who already have put such cash pooling systems in place.
Another method for an FIE to utilize trapped cash is to provide it as collateral for loans obtained by its offshore affiliates. This was already possible by providing a guarantee to a PRC bank (which in turn extends the guarantee to the offshore affiliate bank providing the loan), but since June 2014 providing outbound security has been made much easier. An FIE may now directly provide outbound credit support for its offshore affiliates to an offshore lender in both RMB and foreign exchange (arguably, this was already allowed for credit support in RMB). SAFE approval and the quota for credit support in foreign currency have also been abolished.
By Rogier van Bijnen & Maarten Roos