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A Fallacy about the Requirements for Keeping Hi-Tech Status

Background

A multinational group headquartered in Europe (“EU Co”) owns a Foreign-Invested Enterprises in Mainland China, FIE 1, which in turn holds 100% equity interest in FIE 2. FIE 2 mainly purchases raw material from local suppliers, manufactures machines, and sells to FIE 1 who then sells to corporate clients. FIE 2 is certified as a high-tech co based on the data from Year 5 to 7. Accordingly, it enjoys a 75% extra deduction on R&D expenses and a 15% corporate income tax rate till Year 11. EU Co engaged CW to have tax health-checking of both FIE 1 and FIE 2.

Challenge

FIE 1 chose not to pay dividends to FIE 2 before Year 7 because the growth rate of turnover and net asset is one of the scores in the marking scheme for an entity continuing to be qualified as a high-tech co enjoying the preferential tax treatments. EU Co decided to reduce FIE 2’s GP ratio but increase FIE1’s GP ratio so that it could receive dividends from its subsidiaries in Mainland China. This has limited the amount of distribution that EU co could receive. More importantly, the pricing adjustments might have exposed the group to unnecessary Transfer Pricing (“TP”) challenges by the tax authorities in Mainland China.

Solution

According to CW’s analysis, FIE 2 could still pay dividends to FIE 1 but some sensitivity analysis would need to be made, bearing in mind that turnover and net asset growth ratio is only about 10% contributing factors to be considered for its being continued to be qualified as a High-Tech status. Also, keeping the GP% of FIE 2 at a level that can be benchmarked to its competitors would mitigate the risk of being challenged on the transfer pricing issue.

Irrespective of the fact that FIE 2 as a High Tech co is eligible for preferential rate for High-tech companies at 15%, it could in fact enjoy an even lower CIT rate at 5% that given that it is eligible to claim itself as a low-profit enterprise.

Conclusion

Whilst overseas investors might have reliable local staff in their subsidiaries in Mainland China, the staff might not have the professional knowledge and experience to analyze some financial dilemmas on a holistic view, to assess the gives and takes of striking a balance of looking after the group’s benefit whilst ensuring compliance with local rules and regulations. This is especially so when the rules and regulations and preferential policies in Mainland China change frequently. Investors are therefore recommended to have tax and financial health checking by experienced international professional advisors on a regular basis.

For more information, feel free to contact Louis Tan (email: louis.tan@cwhkcpa.com) or Therese Feng (email: therese.feng@cwhkcpa.com ).

 

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This case study is for illustrative purposes and meant to provide an example of the Firm’s process and methodology. An individual case may vary based on the specific circumstances encountered. There can be no assurance that similar results can be achieved in comparable situations.

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