Essay: Review on Optimal Plans for Additional Investment of Korean Companies in the Chinese Market: Focused on the case of M Company

Since South Korea and China established diplomatic relations in 1992, investment in China made by South Korea rapidly grew. According to statistics by the Export-Import Bank of Korea in 2013, the number of new corporations that made investment in China is around 23,000, and the amount of investment USD 59,975,470,000, China has been the largest investee to Korea. Particularly, major South Korean corporations including Samsung, LG, SK, and Lotte have established a local corporation in China in an attempt to expand their presence in the Chinese market, while many small and medium businesses are also making various efforts to target the largest consumer market in the world.
Today, after 23 years since South Korea began to invest in China, investment in China is now mainly made as an additional investment based on Korean corporations already established in the Chinese market. Therefore, this study aims to find the optimal form of investment for ‘optimal investment recovery,’ when corporations that have already entered the Chinese market decide to make additional investment. To bring out an effective result, the study was based on the case of M Company, which is already established in China.
The study was conducted as follows:
In Chapter 2, ‘decision tree’ was used to examine possible forms of investment and advantages and disadvantages of each option. Especially, the advantages and disadvantages of the case in which a holding company is established in Hong Kong and a subsidiary or branch in China were reviewed, and, for some service businesses for which direct investment in China is limited, CEPA(explain what is this) provisions were used to explore possibilities.
In Chapter 3, the optimal form of investment for investment recovery was proposed, and, based on the case of M Company, a service provider, the cash flow was predicted. In the prediction, all applicable taxes for different options were reviewed based on China and Korea. The result suggests that making additional investment through a branch of an existing corporation is most advantageous in terms of cash flow. Also, the optimal plan for investment recovery was reviewed based on dividend, charges, research fee, and royalty income, and ‘dividend’ was decided to be most advantageous considering the ‘applicable taxes.’
In the last chapter, operation plan of ‘branch,’ which is the most optimal option, tax issues relating to the branch in China, and establishment procedure were reviewed.
The author wishes this study will be a useful guide for planning additional investment in China.
I. Overview
1. Purpose
Today, after 23 years since South Korea began to invest in China, investment in China is now mainly made as an additional investment based on Korean corporations already established in the Chinese market. Therefore, this study aims to find the optimal form of investment for ‘optimal investment recovery,’ when corporations that have already entered the Chinese market decide to make additional investment.
2. Case Description
In 17th, March, 2014, the headquarters of the company M has founded the company M by holding 100% of the stocks and it is now in operation. The registered capital of the M company is 5M RMB, approved operational deadline is 30 years. The permitted business scope of the M company is available in china.
The headquarters is planning to enter into several markets in china by using a same business scope of the M company. This report presuppose that it reviews the company which perform a same business scope in the Chinese market.
3. Scope
To bring out the optimal plan as of the date of research, the following were analyzed and examined:
‘ Review on alternatives for selection of investment areas and ownership structure (including Hong Kong)
‘ Optimal option based on operational characteristics for different options
‘ Selecting the optimal option through review on investment recovery according to the options
‘ Proposal of plan for investment recovery based on the optimal plan
‘ Proposal of plan for future operation based on the optimal option decided
4. Research Procedure
The following is the overall procedure applied to the research.
Description Main procedure
Reviews on options for selection of investment areas and ownership structure ‘ Number of cases if establishing in China
‘ Feasible options based on review of the current law
Optimal option based on operational characteristics for different options ‘ Characteristics and advantages/disadvantages for different options
‘ Optimal option decided based on an algorithm
Selecting the optimal option through review on investment recovery according to the options ‘ Examination of assumptions to calculate investment recovery according to the options
‘ Calculation of investment recovery according to the options
Proposal of plan for future operation based on the optimal option decided ‘ Review of characteristics of the optimal option
‘ Proposal of the future operation plan
5. literature review
The advanced research of entering into the Chinese market is classified as ‘Entering strategies of specific industries’, ‘Marketing strategies of the Chinese market’, ‘Entering strategies analyzing the environmental base and corporation policies in china’. Directly related advanced research is ‘Entering strategies analyzing the environmental base and corporation policies in china’ and details are as blow.
Based on ‘ Go,Tae-Gon,2007, China consistently insists that the country is required to change into the market economy as establishing the law of reality, and emphasizes the continuous monitoring for recessive benefits of the foreign company as a uniformed corporation income tax, regal and environmental changes.
According to Chun,Yoon-Jeong,2008, China has the special local colors and their policies are heavily fluctuating, it is strongly recommended to monitor policy changes consistently.
This research is also progressed based on current policies in China, It means that if the political changes occurred, the result of this research will be changed. Therefore, it will be required to monitor continuous policy changes/
However, could not find out the advanced research reviewing the form of corporation when the parental company considers additional expansion. Therefore, hope that this report to be a qualitative guideline for the companies running a business in china already.
II. Review on Investment options
1. Review on All options
The following are variables that influence the plan to set up a Korean corporation in multiple regions in China like those already established in China:
‘ Existence of a corporation in Hong Kong
‘ Existence of a holding company in China
‘ Legal format of the Chinese site (branch or subsidiary)
The following is analysis of possible options regarding the variables above by using a decision tree.
As presented in the decision tree above, total 12 options are available and the following were reviewed to see which options are possible:
‘ Possibility of setting up a corporation (holding company) in Hong Kong
‘ Possibility of setting up a holding company in China
‘ Possibility of setting up a branch of an established corporation
‘ Possibility of setting up a subsidiary of an established corporation
‘ Exclusion of unprofitable options
2. Review on Possible Options
The following are possible options reviewed:
Classification Result
Possibility of setting up a corporation (holding company)
in Hong Kong Possible
Possibility of setting up a holding company in China Not possible (Option #1 excluded)
Possibility of setting up a branch of an established
corporation Possible
Possibility of setting up a subsidiary of
an existing corporation Possible (However, on condition)
Exclusion of unprofitable options Not possible (Option #2 excluded)
2.1 Possibility of setting up a corporation (holding company) in Hong Kong
Setting up a corporation (including holding company) in Hong Kong does not require special qualifications. Therefore, it is possible to establish a corporation in Hong Kong.
2.2 Possibility of setting up a holding company in China
According to the Article 22.3 of 2004 Ministry of Commerce Ordinance , the following requirements must be satisfied:
(1) Requirements for the parent company (‘ or ‘)
‘ The parent company is in a good financial state and the total assets of the parent company one year prior to application for establishing a holding company must be no less than USD 400 million. And the registered capital that was actually paid by the foreign-invested company in China must be no less than USD 10 million.
‘ The parent company is in a good financial state and has established 10 or more foreign-invested companies in China. And the registered capital that was actually paid by the foreign-invested company in China must be no less than USD 30 million.
‘ In case of establishing a holding company by joint investment, the Chinese investor has good credit funds and financial capacity to establish a holding company, and the same investor must have had total assets of no less than RMB 100 million one year prior to the application.
(2) Requirement relating to the holding company to be established
‘ The holding company must register capital of no less than USD 30 million.
The total assets of the existing Korean head office(Ex. M Company) is amount to USD 12 million, and our total assets do not satisfy the ‘financial requirement of the parent company.’ Therefore, the Korean head office cannot set up a holding company and #1 was excluded from the options.
2.3 Possibility of setting up a branch of an established corporation
According to State Council Ordinance Article 156, , Companies in China can set up a branch. Branches neither have a legal personality nor require registered capital, Therefore, there is no limitation in establishment.
Therefore, it is possible to establish a branch of an existing corporation.
2.4 Possibility of setting up a subsidiary of an existing corporation
According to current regulations relating to foreign investment in China, there are no requirements or restrictions for establishing a subsidiary. Therefore, it is possible that the existing corporation establishes a subsidiary. However, if the capital of a foreign investment company is transferred in a ‘foreign currency,’ a ‘sales-related tax bill’ is required to withdraw the capital. For that reason, it is not possible to set up a subsidiary with registered capital. (It is possible to establish a subsidiary with funds collected from sales.)
Therefore, it is possible for the existing corporation to establish a subsidiary.
2.5 Exclusion of unprofitable options (#2)
#2 is an option in which a holding company is established in Hong Kong and the site operated in China is established as a branch or subsidiary of an unlimited company. This option means that the subsidiary managed by the holding company is an existing corporation, which is meaningless. Therefore, it was excluded from possible options.
3. Examination of Possible Options
In conclusion, the following options were found:
Classification Description
Option 1 After establishing a corporation in Hong Kong, all the sites in China are established as subsidiaries of the Hong Kong corporation
Option 2 Without establishing a corporation in Hong Kong, all the sites in China are established as subsidiaries of the Korean head office
Option 3 Without establishing a corporation in Hong Kong, the sites in China are established as subsidiaries of an existing corporation
Option 4 Without establishing a corporation in Hong Kong, the sites in China are established as a branch of an existing corporation
The following is different ownership structures for each option.
In the report, the following have been reviewed to bring out the optimal option:
– Optimal option based on Operational Characteristics
– Selection of the optimal option for investment recovery
III. Optimal Option Based on Operational Characteristics
The review was conducted in the following steps in order to select the optimal option among the four options above:
After reviewing operational characteristics of these options, the following results were found:
1. Step1: Establishing a Corporation in Hong Kong
Hong Kong does not have tariff and foreign exchange management act, or restrictions on investment. For that reason, the country is used as a strategic hub for global or Asian markets of many multinational corporations. However, some Korean companies have set up a corporation in Hong Kong without thoroughly analyzing operational advantages and disadvantages, thus, wasting operational costs every year. Therefore, the following offers a review on operational characteristics and analysis on advantages and disadvantages relating to setting up a corporation in Hong Kong.
1.1 Characteristics relating to setting up a corporation in Hong Kong
The following presents advantages and disadvantages relating to setting up a corporation in Hong Kong.
Classification Classification Main points Application to company
Advantages For entering the Chinese market ‘ Facilitates entering the Chinese market by using CEPA provisions ‘ Not applicable to the company
‘ Relatively easy to enter the market because of geographical advantages ‘ Not applicable to the company
For management ‘ Responsible management enabled by setting up a separate corporation- improved efficiency for management ‘ All options enable ‘responsible management’
‘ Location as a logistics and financial hub of Asia
‘ Good infrastructure of transportation, communication, facilities, etc. ‘ A simple holding company cannot take advantages of the logistic and financial hub
For funding ‘ It is relatively easier to be listed on the Hong Kong stock market than the Chinese one ‘ Not applicable to the company
‘ Holding companies have generally higher credit ratings than individual subsidiaries, therefore, lower funding costs. ‘ From the same perspective, the funding cost is lowest for the head office (Korea)
For taxes ‘ Low corporate tax- 16.5%
‘ No VAT for transaction ‘ The benefit of low corporate tax cannot be enjoyed if the investment is sent to Korea
Establishment and liquidation process Simple procedure for establishment and liquidation ‘ Simple procedure for establishment and liquidation
Disadvantage For management Increased operation costs ‘ Additional operation costs
The details are as follows:
1.1.1 For entering the Chinese market
(1) Entering the Chinese market by using CEPA provisions
CEPA(Closer Economic Partnership Agreement) is a free trade agreement introduced in June 2003 to reinforce economic partnership between China and Hong Kong. If a corporation that was legally founded in Hong Kong satisfies provisions stipulated in CEPA, it can enjoy ‘tariff exemption’, ‘no restrictions in the service industry’, ‘simplified clearance.’
‘ Agreement on Commodity Trade
According to CEPA, products made in Hong Kong are not subject to tariffs (Only customs duties are exempted, and other taxes including VAT are not applicable). For a manufacturer in Hong Kong to be exempted from tariffs: 1) it must obtain Certificate of Hong Kong Origin ‘ CEPA [CO(CEPA)], which is a certificate of CEPA origin defined by CEPA; and 2) prove its capacity to produce export products in the factory survey of Trade and Industry Department (TID), before factory registration.
This provision is applicable only to manufacturing businesses.
‘ Agreement on the Service Sector
The CEPA agreement on the service sector mainly gives more right to Hong Kong companies than companies from other countries the rights to enter a market earlier and more diverse industries, by allowing single-person corporations, limiting equity, and easing regulations on paid-in capital, minimum sales, selection of location, and sphere of business. Beneficiaries of the CEPA agreement on the service sector are Hong Kong service suppliers (HKSS), and, for HKSS certification via TID, they must have been operating in Hong Kong for more than three years or more and engaging in ‘practical’ business activities. (Other requirements must be fulfilled as well. For instance, 50% or more employees must be Chinese or Hatemongers.)
For a corporation that has been already established in China, it proves that the relevant business can be operated in China by foreign investment. Therefore, there is no benefit from applying the above provision. Also, this provision is not applicable unless the business has been operating for three years or more in Hong Kong in the same business sphere.
Therefore, the benefits of CEPA are not applicable to companies examined in this study.
(1) Entering the market because of geographical advantages
The area of China is 9,596,960Km2, about 44 times of that of South Korea, and Hong Kong is located in the southwest of China.
Geographical advantages of Hong Kong are only relevant in case of targeting regions close to Hong Kong (e.g. Guangdong) and do not apply to other northeast or northwest regions.
Therefore, it is not applicable to companies that aim to enter various regions in China.
1.1.2 For management
(1) Responsible management enabled by setting up a separate corporation- improved efficiency for management
If a separate corporation is established as a holding company, it can make strategic decisions for the mid to long term, rather than for day-to-day management, evaluate the subsidiaries based on objective indexes like ROE, and distribute managerial resources according to the evaluation, improving efficiency of both individual subsidiaries and the entire group
However, all of the options (1, 2, 3, 4) operate as a ‘separate corporation,’ and, therefore, enable ‘responsible management.’ Therefore, it cannot be an advantage of setting up a Hong Kong corporation.
(2) Infrastructure of Hong Kong
Hong Kong is a logistic and financial hub of Asia, with excellent infrastructure in transportation and communication. Therefore, corporations in Hong Kong can enjoy this advantage.
However, if the corporation only acts as a holding company instead of engaging in sales activities, the infrastructure has no use to the company.
1.1.3 For funding
‘ Listing on the Hong Kong stock market
To be listed on the Hong Kong stock market requires a net profit of HKD 30 million or more, and sales HKD 500 million or more. (Other requirements include mandatory ratio of public offering and requirements for directors.)
The head office of the existing corporation in the example did not reach the required net profit and sales in 2013. Considering that the head office also failed to satisfy requirements to be listed on the Hong Kong stock market, it is not realistic to expect the holding company in Hong Kong to satisfy the requirements and be listed on the Hong Kong stock market. Therefore, this option cannot be an advantage of setting up a holding company in Hong Kong.
‘ Lower funding costs
In general, holding companies require less funding costs than individual subsidiaries. The consolidated financial statement of subsidiaries ‘consolidate’ income, assets, and liabilities of individual subsidiaries to create the financial statement. Therefore, generally, it leads to lower funding costs because of increased mortgage ability and credits.
In that perspective, generally, the Korean head office has higher mortgage ability and credits, thus, lower funding costs, than the Hong Kong holding company. Therefore, lower funding costs cannot be an advantage of setting up a Hong Kong corporation.
1.1.4 Hong Kong tax law
Taxes imposed in Hong Kong can be divided, according to taxable subjects, into income tax (individual income tax, profit tax), property tax (including real estate), consumption tax (liquor tax, tobacco tax, oil tax). Particularly, Hong Kong does not have VAT and the only transfer tax is the consumption tax.
(1) Profit tax (as enterprise income tax)
In general, taxpayers in Hong Kong including corporations are imposed of the corporate tax only if the source of income is within Hong Kong and the following conditions are met:
‘ In trade, sales, or specialized fields,
‘ the person engages in trade, sales, or specialized fields,
‘ and the profit from trade, sales, or specialized fields is derived or made from Hong Kong.
The rate of the profit tax for corporations is 16.5%, the standard tax rate, and, for individuals, 15%.
However, even if the conditions above are met, the following cases are exempted from the tax:
‘ Income from interests: Interests from deposit in an authorized institution or certificate of deposit issued by an authorized institution are exempted from the profit tax.
‘ Dividend income: Dividends paid by corporations are not taxable.
‘ Capital gain: Profit made by selling capital (stocks) is exempted from the profit tax, which is only applicable to profits made by sales or current transactions.
(3) Consumption tax
Hong Kong does impose neither tariffs on imported goods nor VAT. However, liquors, tobacco, and oil products are subject to the consumption tax.
(4) Tax Summary
As explained above, The corporate tax rate in Hong Kong is 16.5%, which is lower than in China (25%) and South Korea (20%). The low corporate tax rate can be taken advantage of only if the profits made by the Hong Kong corporation or its subsidiaries are not transferred to South Korea. If dividends are transferred to South Korea, the Korean head office will be imposed of the relevant tax at 20%. Therefore, to maximize investment recovery, for the corporation in this study, the low corporate tax rate cannot be an advantage. (However, it is beneficial if the company does not transfer the investment to the head office but, instead, re-invests dividends, etc. from subsidiaries to China or Hong Kong.)
1.1.5 Increased operation costs
Setting up a separate corporation in Hong Kong will incur corporation costs, additional operation costs (rent, accounting costs, etc.) and, when necessary, liquidation costs. The amount of operation costs will be decided by the operation plan for the Hong Kong corporation (number of employees, etc.).
1.2 Decision based on the operational characteristics
As examined above, from the company’s perspective, there is no advantage in setting up a Hong Kong corporation, except that ‘the incorporation and liquidation process is simple.’
Therefore, companies applicable for this study are advised not to establish a corporation in Hong Kong as it will only increase operation costs.
2. Step2: Deciding a Legal Format of the Chinese Site (Choosing between Branch and Subsidiary)
2.1 Comparison of characteristics between a subsidiary (option 2, 3) and branch (option 4)
According to and relevant regulations, subsidiaries and branches have the following characteristics:
Classification Subsidiary Branch
Types Limited company, corporation, limited liability company Managerial branch, Contact Branch
Definition A company that has an independent legal personality and engages in its own business activities A sales or management base engaged in actual management under the head office
Legal status A company established in China according to the Chinese laws. It has an independent legal personality No legal personality
Civil liabilities Civil liabilities are imposed as an independent legal personality No independent civil liabilities as it has no legal personality
Company organization Requires decision-making and business execution body including articles of incorporation and board of directors Does not require decision-making and business execution body including articles of incorporation and board of directors
Business scope Can conduct its own business activities including production, sales, and consulting Can conduct business activities within the business scope of the head office
Equity capital Must satisfy the minimum capital required by different laws No need for equity capital as there is no independent legal personality
Transaction contract Possible Possible
Registration at Trade and Industry Bureau Required Required
Tax registration Required Required
Tax bill Tax bills for VAT and business tax can be issued Tax bills for VAT and business tax can be issued
business tax, VAT report Required Required
Enterprise income tax Self-settlement according to the tax law Advance payment in the location, total payment by the head office when confirmed and reported
This means that, if a subsidiary is established (option 2,3), capital must be paid and execution body set up to operate the company. However, in case of establishing a branch (option 4), there is no need to pay the capital and it is possible to conduct business.
Also, the following are advantages and disadvantages of setting up subsidiary and branch.
Classification Subsidiary Branch
Advantages – Profits and loss of individual subsidiaries are settled independently. Therefore, if a company makes loss, the ‘dividend’ transferable to the head office is larger, in comparison to setting up a branch.
– Apart from the business scope of the parent company, business can be conducted within its own scope – Does not require capital to set up the branch. Maximum 3 months is required to establish a branch.
– Simple liquidation process
– Profits are combined for tax payment. Therefore, if a company makes loss, less corporate tax is imposed than for a subsidiary
Disadvantages – Capital must be paid at the time of establishment, and minimum 3 to 8 months are required until incorporation.
– Each subsidiary settles the profits and pays taxes. Therefore, if a company makes loss, more corporate tax is imposed than for a branch
– The liquidation process is complicated and time-consuming – Profits and loss of individual subsidiaries are settled independently. Therefore, if a company makes loss, the ‘dividend’ transferable to the parent company is smaller in comparison to setting up a subsidiary
– Business can be conducted within the parent company’s business scope
2.2 Result of comparison between subsidiary (option 2, 3) and branch (option 4)
The company has a plan to build exhibition halls in many regions in China. Therefore, from the managerial perspective, it is advantageous if the administrative process for building the exhibition halls is simple and requires a relatively short time and lower costs.
For branches, capital is not required and building exhibition halls takes maximum three months. And, for liquidation, subsidiaries take between one year and two years, whereas branches can be liquidated within three months to one year. Also, among many sites in China, if one or more sites make loss, because the branch settles the enterprise income tax by combining profits of all sites, the enterprise income tax becomes lower.
Therefore, from the managerial perspective, the option 4, meaning setting up the Chinese site as a branch, is most advantageous.
3. Step3: The Parent Company Being a Korean or Established Corporation
As examined in Step 2, it is most advantageous to set up the Chinese site as a branch (option 4). Therefore, it is not necessary to consider Step 3. However, it was explained as a reference in this study.
3.1 Comparison between subsidiary (option 2) and second-tier subsidiary (option 3)
For both a subsidiary (option 2) and second-tier subsidiary (option 3), the legal entity is ‘corporation.’ Therefore, there is no difference in legal entity.
Also, if a second-tier subsidiary (option 3) is established, it is considered as a ‘foreign capital firm’ and, therefore, subject to ‘the law for establishment.’ Therefore, there is no difference between option 2 and option 3 at the time of establishment.
However, in some regions, foreign capital firms that are set up as a subsidiary (option 2) have ‘tax benefits (local tax).’ Therefore, technically, it is more advantageous to set it up as a subsidiary.
IV. Optimal option for Recovering Investment
1. General Assumption for Simulation
1.1 Estimated period and applicable tax law
The estimated period for optimal option for investment recovery was based on 2015, after the business was launched, and the tax law applied for estimating cash flow was the current tax law as of the date of report. However, as the Taxation Convention between South Korea is to come into effect from April 2015, the Taxation Convention was exceptionally taken into account in this report.
1.2 Estimated profits of each site in China
Three Chinese sites were used for the estimation, and net income of the existing corporation and Chinese sites was estimated as below. To improve accuracy of estimation, it was assumed that some corporation makes loss and another profit.
(currency: KRW)
Classification Existing corporation Site A Site B Site C
Estimated operating profit before tax 10,000,000 20,000,000 30,000,000 (-)25,000,000
2. Applicable Tax Review
The following table presents applicable taxes for each option and ‘foreign tax payment credit’ if the Korean head office receives dividends.
Classification Tax paid in China and Hong Kong Foreign tax payment credit in Korea
Description Tax rate
option 1 China: Enterprise income tax of each company for the business year 25% Not possible to deduct indirect foreign taxes
China: Enterprise income tax withheld upon transferring dividends 10% Possible to deduct direct foreign taxes
Hong Kong: Enterprise income tax of each company for the business year 16.5% Possible to deduct indirect foreign taxes
Hong Kong: Enterprise income tax withheld upon transferring dividends 10% Possible to deduct direct foreign taxes
option 2 China: enterprise income tax of each company for the business year 25% Possible to deduct indirect foreign taxes
China: Enterprise income tax withheld upon transferring dividends 5% Possible to deduct direct foreign taxes
option 3 China: Enterprise income tax of each second-tier subsidiary for the business year 25% Not possible to deduct indirect foreign taxes
Second-tier subsidiary in China: Enterprise income tax withheld upon transferring dividends – –
Subsidiary in China: Enterprise income tax of each company for the business year 25% indirect foreign taxes deductible
Subsidiary in China: Enterprise income tax withheld upon transferring dividends 5% Possible to deduct direct foreign taxes
option 4 China: enterprise income tax of each company for the business year 25% indirect foreign taxes deductible
China: Enterprise income tax withheld upon transferring dividends 5% Possible to deduct direct foreign taxes
The following is detailed analysis of the applicable taxes for each option.
2.1 Applicable tax for option 1
If a Chinese corporation allocates dividends to a Hong Kong corporation, and the Hong Kong corporation allocates the dividends to the Korean head office, the payable taxes (withheld enterprise income tax) are as follows:
Classification China ‘ Hong Kong Hong Kong ‘ Korea
Classification Requirements satisfied Requirements unsatisfied Requirements satisfied Requirements unsatisfied
Tax rate 5% 10% 10% 15%
Application to company 10% Tax rate because the requirements were not satisfied 10% tax rate because the requirements were satisfied
After the Korean head office receives the dividends, according to the Korean , withheld ‘foreign tax payment credit’ is settled as follows:
Classification ‘Enterprise income tax for each business year’ of the local corporation ‘Enterprise income tax’ withheld upon transferring dividends
China Hong Kong China Hong Kong
Direct foreign taxes – – deductible deductible
Deemed foreign taxes – – – –
indirect foreign taxes nondeductible deductible – –
2.1.1 Taxes paid in China
(1) Tax rate for enterprise income tax withholding
(Hereafter’ China-Hong Kong Taxation Convention’) and (National Tax Guide [2009]81) states that, if some requirements are satisfied, a limited tax rate of 5% is applied in China, and, if the requirements are not met, according to the Article 91 of , the tax rate for non-resident corporations of 10% is applied. The following are requirements according to the Taxation Convention and National Tax Guide Notice.
1 The recipient company of the dividends must be the ‘beneficial owner’
2 For 12 consecutive months before receiving the dividend profit, the company has owned 25% or more share
3 The company applied for tax exemption to the tax office and received ratification
The following is description of a ‘beneficial owner’:
(5) Beneficial owner
(National Tax Guide [2009] 601) states as follows, with respect to definition and determination of beneficial owners:
1 Definition
In general, a beneficial owner refers to an individual, company, or organization engaged in practical management activities, and representatives and special purpose companies are not beneficial owners. Special purpose companies mean companies that are not involved with practical management activities such as manufacturing, sales, and management.
2 Criteria
The following are general criteria used by the taxation bureau for determining beneficial owners. In the following cases, the subject may not be determined as a beneficial owner:
‘ The owner of the earnings is obliged to give or allocate the whole or part of the earnings within a defined time (e.g., in 12 months since acquisition of the profit) to a resident in a third party country (region)
‘ The owner of the earnings does not own an asset from or right to the earnings, and is not involved with other management activities.
‘ The owner of the earnings is an entity such as a company and the size of assets and number of employees is too small to be proportionate to the earnings
‘ Earnings from another nation was not taxed or exempted from taxation, or taxed, but at a lower tax rate
‘ A deposit or loan agreement exists between an owner of earnings from other sources than interest or loans related to payment and a third party, and the agreement is similar in the amount, interest rate, time of agreement, etc.
‘ A transfer agreement relating to publication right, patent, or rights to own or use a technology exists between an owner of earnings and a third party, apart from the agreement to transfer the right to use patent, publication right, technology, etc., relating to reception and payment of patent royalty
2.1.2 Taxes paid in Hong Kong
(1) Dividends received in Hong Kong(China ‘ Hong Kong)
According to Hong Kong , dividends received from a corporation are not included in taxable profits.. Therefore, dividends received from a Chinese corporation is not taxed. Because it is not taxed in Hong Kong, there is no problem of double payment of corporate tax that was paid in China.
(6) Dividends paid to Korea (Hong Kong ‘ Korea)
When a Hong Kong corporation transfers dividends to the Korean head office, no tax is imposed in Hong Kong as of the date of this report. However, July 8, 2014, KC Chan, the secretary for Financial Service and Treasury of Hong Kong, and Youngcheon Cho, the consul general in Hong Kong, officially signed ‘Korea’Hong Kong Taxation Convention,’ which was initialed in September 2013, and, the Taxation Convention is to come into effect from April 1, 2015 after ratification in both countries. Considering the time when the company will launch its business, the Taxation Convention will be applied to it, and, therefore, the following report was based on the Taxation Convention.
According to the (Hereafter’ China-Hong Kong Taxation Convention’), which is soon to come into effect, when some requirements are satisfied, a limited tax rate of 10% is applied in Hong Kong. The requirements according to Taxation Convention are as follows:
1 The recipient company of the dividends must be the ‘beneficial owner’
2 For 12 consecutive months before receiving the dividend profit, the company has owned 25% or more share
3 The company applied for tax exemption to the tax office and received ratification
2.1.3 Taxes paid in Korea
The company pays the taxes described above in China and Hong Kong, and, also, is taxed for domestic source income in Korea. In other words, the total amount before tax payment in Hong Kong is taxed in Korea as well. As a result, for the same taxation period, the same income is taxed in Korea, China, and Hong Kong, which means international double taxation. To solve this problem, South Korea uses the general foreign tax payment credit and inclusion in deductible expenses to deduct taxes on foreign source income, and taxpayers can choose either of the systems.
2.1.4 Foreign tax deduction
As stated above, a company may choose either foreign tax payment credit or inclusion in deductible expenses for taxes paid in a foreign country. For corporations with long-term deficit, inclusion in deductible expenses is more advantageous, and, for general corporations, tax credits. Since the company is not a corporation with deficit, it is more advisable to adjust double taxation by using ‘tax credits.’ Foreign tax payment credit is composed as follows:
Classification Applicability to the company Legal ground
Direct foreign tax payment credit Applicable Corporate Tax Law ??57 ‘
Deemed foreign tax payment credit Not applicable Corporate Tax Law ??57 ‘
Indirect foreign tax payment credit Applicable (However,
‘corporate tax for the business year’ paid in China is not applicable) Corporate Tax Law ??57 ‘
(1) Direct foreign tax credit
If the tax base amount of a domestic corporation in Korea includes foreign source income, this system allows the foreign corporate tax that was actually paid or is payable to a foreign government (including local governments) for the relevant income.
Enterprise income tax withheld when a Hong Kong subsidiary or Chinese second-tier subsidiary pays dividends is included in direct foreign taxes.
VAT, consumption tax, business tax, sales tax, etc., which are not subject to clauses A, B, and C of Article 57.1 of are not taxes on income, and, therefore, not subject to foreign tax payment credit.
Therefore, ‘direct foreign taxes’ include only ‘enterprise income tax on dividends paid.’
(7) Deemed foreign tax payment credit
According to Article 57.3 of , this system allows a domestic corporation in Korea that has foreign source income to be deducted of the amount of the deducted corporate tax on the foreign source income of the business year within the limit set by Taxation Convention. Although Article 23 of Korea’China Taxation Convention stipulates deemed foreign tax payment credit, currently, in China and Hong Kong, tax reduction based on special law does not exist. Therefore, there is no applicable deemed foreign tax payment from the taxes paid in China and Hong Kong. (International Tax Base Management-437, 2010.10.19)
(8) Indirect foreign tax payment credit
According to Article 57.4 of , if the income of a domestic corporation in Korea of the relevant business year includes dividends or surplus from a foreign subsidiary, this system allows the amount of dividend income of the year to be deducted from the foreign corporate tax imposed on the income of the foreign subsidiary. If dividends are received from a China and Hong Kong subsidiary, this provision is applied for indirect foreign tax payment credit. However, the ‘enterprise income tax of the business year’ paid by a China subsidiary is counted as tax-free income when settling profit tax in Hong Kong, and, therefore, not included in indirect foreign taxes. (Reply to the relevant query: Ministry of Strategy and Finance, Office of International Taxation System ‘ 109, 22.03.2011) Therefore, only the profit tax paid in Hong Kong is included in indirect foreign taxes.
2.2 Applicable tax for dividends in option 2, 3, 4
The enterprise income taxes are withheld as follows, depending on if dividends are paid to a corporation in China or a Chinese corporation pays dividends to a Korean shareholder:
Classification Dividends to a corporation in China Dividend from China to Korea
Classification No classification Requirements satisfied Requirements unsatisfied
Tax rate No tax imposed 5% 10%
Application to company – 5% tax rate because requirements are satisfied
The following shows the foreign tax payment credit when settling taxes according to Korean after the Korean head office receives dividend:
Classification ‘Enterprise income tax for the business year’ of the local corporation ‘Divined withholding tax’ paid upon transfer of dividends
Chinese second-tier subsidiary Chinese subsidiary Chinese second-tier subsidiary Chinese subsidiary
Direct foreign taxes – – deductible deductible
Deemed foreign tax payment – – – –
indirect foreign taxes Nondeductible deductible – –
2.2.1 When a Chinese corporation pays dividends to a corporation in China
The company can give dividend after paying the ‘enterprise tax for the business year, ‘ and, therefore, if the corporate tax is imposed again at the time of receiving dividends, it causes the problem of ‘double taxation in China.’ Therefore, does not impose tax on dividend income received by a corporation in China from another corporation in China.
2.2.2 When a Chinese corporation pays dividends to a Korean corporation
and (National Tax Guide [2009]81) states that, if some requirements are satisfied, a limited tax rate of 5% is applied in China, and, if the requirements are not met, according to the Article 91 of , the tax rate for non-resident corporations of 10% is applied. The following are requirements according to the Taxation Convention and National Tax Guide Notice:
1 The recipient company of the dividends must be the ‘beneficial owner’
2 For 12 consecutive months before receiving the dividend profit, the company has owned 25% or more share
3 The company applied for tax exemption to the tax office and received ratification
The Korean head office satisfies the requirements above, and, therefore, the limited tax rate of 5% is applied.
2.2.3 Taxes paid in South Korea
The company is taxed for both the taxes mentioned above in China and domestic source income in Korea. Therefore, the enterprise income tax that was already paid in China can be included in the ‘foreign tax payment credit’.
Classification Applicability to company Legal ground
Direct foreign tax payment credit Applicable Corporate Tax Law ??57 ‘
Deemed foreign tax payment credit Not applicable Corporate Tax Law ??57 ‘
Indirect foreign tax payment credit Applicable (However, the ‘corporate tax for the business year’ paid in China is not applicable) Corporate Tax Law ??57 ‘
For details relating to foreign tax payment credit, please see Option 1.
3. Simulation result by option
The cash flow for different options in terms of profit sharing is as follows.
(Currency: KRW, ‘000)
Classification option1: Hong Kong holding company option2:
subsidiary option3: second-tier subsidiary option 4: branch
Net income (presumed) 1,435,000 1,435,000 1,435,000 1,435,000
Investment recovery 32,805 38,475 35,269 22,444
Total tax 283,257 277,768 280,625 270,371
Net Cash Flow 1,151,743 1,157,232 1,154,375 1,164,629
Deductible carry-over 157 5,468 – 3,196
Consider Deductible carry-over CF 1,151,900 1,162,700 1,154,375 1,167,825
3.1 Comparison between Hong Kong corporation (option 1) and options 2, 3,4
Irrespective of deductible carry-over, if a corporation is established in Hong Kong and dividends are received, it leads to the highest corporate tax and, thereby, least cash flow. It is because the corporate tax paid by an individual corporation in China is not deducted from the indirect foreign taxes in Korea. (See below)
Therefore, in terms of investment recovery, it is advantageous not to establish a corporation in Hong Kong.
3.2 Comparison of subsidiary incorporation (option 2, 3)
For cash flow, it is more advantageous to establish a subsidiary (option 2) than a second-tier subsidiary (option 3). It is because, if the ‘corporate tax for the business year’ of the second-tier subsidiary is imposed on the subsidiary, since it was included in the tax-free income, it will not be deducted from the ‘indirect foreign taxes’ paid by the Korean head office. Therefore, the head office pays more corporate tax.
Therefore, for cash flow, it is more advantageous to establish a subsidiary than a second-tier subsidiary in China.
3.3 Comparison between branch (option 4) and subsidiary (option2)
In case of establishing a branch, profits of all of the sites are combined when the existing corporation pays the ‘corporate tax for the business year.’ Therefore, if a site makes loss as in this hypothetical situation, it leads to the least corporate tax paid in China, thus, maximizing cash flow.
Therefore, for investment recovery, ‘establishing a branch (option 4)’ was found to be optimal. See below for details.
4. Details of Simulation
4.1 Simulation result for option 1
The following is simulation result relating to net income after tax and ‘actual dividends remittance’:
(currency: KRW)
(1) When a corporation in China transfers to the holding company in Hong Kong
For a corporation in China to give dividends, it must have after-tax profit and can allocate the dividends only after 10% of the after-tax profit reaches 50% of the capital. Therefore, in this simulation, Site C which is presumed to have a negative profit cannot pay dividends, and the existing corporation, Site A, and Site B are presumed to give dividends of the amount after excluding 10% of the after-tax profit.
Also, according to China-Hong Kong Taxation Convention, when dividends are paid from China to Hong Kong, if the requirements are met, 5% of the withholding tax rate is applied, and, when they are not satisfied, 10%. Because the Hong Kong corporation in this simulation does not satisfy requirements to be a beneficial owner because it is only a holding company. Therefore, it was presumed that 10% of tax rate is applied.
(2) When a Hong Kong corporation sends the dividends
As explained above, the dividends received by the Hong Kong corporation is included in tax-free income, and, therefore, not imposed of the corporate tax. Also, if the Hong Kong corporation transfers dividends, according to Korea-Hong Kong Taxation Convention, which is to come into effect, 10% of dividend tax rate (requirements for a beneficial owner satisfied) was applied.
(3) Foreign tax payment credit of the Korean head office
‘ Direct foreign taxes
The profit tax and enterprise income tax paid by the Hong Kong and Chinese corporations when transferring dividends are included in direct foreign tax payment credits. Therefore, it can be deducted from the tax.
‘ Indirect foreign taxes
The ‘enterprise income tax for the business year’ paid by the Chinese subsidiary was included in the tax-free income when settling the profit tax in Hong Kong. Therefore, it is not included in the indirect foreign taxes. (Reply to the relevant query: Ministry of Strategy and Finance, Office of International Taxation System ‘ 109, 22.03.2011) Therefore, only the profit tax paid in Hong Kong is included in the indirect foreign taxes, and, for option 1, because there is no profit tax paid in Hong Kong, there is no tax deduction.
4.2 Simulation result for option 2
The following is simulation result relating to net income after tax and actual dividends remittance'(currency: KRW)
(1) When a corporation in China transfers to the Korean head office
For a corporation in China to give dividends, it must have after-tax profit and can allocate the dividends only after 10% of the after-tax profit reaches 50% of the capital. Therefore, in this simulation, Site C, which is presumed to have a negative profit, cannot pay dividends, and the existing corporation, Site A, and Site B are presumed to give dividends of the amount after excluding 10% of the after-tax profit.
Also, according to , 5% of dividend tax rate (requirements for a beneficial owner satisfied) was applied.
(2) Foreign tax payment credit of the Korean head office
‘ Direct foreign taxes
The enterprise income tax paid by a Chinese corporation when transferring dividends is included in the direct foreign tax payment credit. Therefore, tax deduction was applied in this simulation.
‘ Indirect foreign taxes
The ‘enterprise income tax for the business year’ paid by each site in China is included in the indirect foreign tax payment credit, and the corresponding amount was deducted according to the .
4.3 Simulation result for option 3
The following is simulation result relating to net income after tax and ‘actual dividends remittance’
(currency: KRW,)
(1) When a corporation in China transfers money to the company
For a corporation in China to give dividends, it must have after-tax profit and can allocate the dividends only after 10% of the after-tax profit reaches 50% of the capital. Therefore, in this simulation, Site C, which is presumed to have a negative profit, cannot pay dividends, and the existing corporation, Site A, and Site B are presumed to give dividends of the amount after excluding 10% of the after-tax profit.
Also, according to Article 26 of , dividends paid between resident corporations are considered as tax-free income, and, therefore, the dividend income was included in ‘tax-free income’ when calculating the corporate tax.
(2) When the company transfers dividends
As explained above, the dividends received by the company are included in tax-free income, and, therefore, not imposed of the corporate tax. Also, it was assumed that, if the company transfers dividends, according to Korea-China Taxation Convention, 5% of tax rate (requirements for a beneficial owner satisfied) is applied.
(3) Foreign tax payment credit of the Korean head office
‘ Direct foreign taxes
The enterprise income tax paid by a Chinese corporation when transferring dividends is included in the direct foreign tax payment credit. Therefore, tax deduction was applied in this simulation.
‘ Indirect foreign taxes
The ‘enterprise income tax for the business year’ paid by the Chinese subsidiary was included in the tax-free income when settling the profit tax in Hong Kong. Therefore, it is not included in the indirect foreign taxes. (Reply to the relevant query: Ministry of Strategy and Finance, Office of International Taxation System ‘ 109, 22.03.2011) Therefore, only the enterprise income tax paid by the existing corporation is included in the indirect foreign taxes, and, for option 3, the corresponding amount was deducted.
4.4 Simulation result for option 4
The following is simulation result relating to net income after tax and ‘actual dividends remittance’.
(currency: KRW,’000)
(1) When a corporation in China transfers to the Korean head office
For a corporation in China to give dividends, it must have after-tax profit and can allocate the dividends only after 10% of the after-tax profit reaches 50% of the capital. In option 4, the site in China is a branch, and, therefore, it is combined into the financial statements of the existing corporation when settling the corporate tax, etc.
Also, according to , 5% of dividend tax rate (requirements for a beneficial owner satisfied) was applied.
(2) Foreign tax payment credit of the Korean head office
‘ Direct foreign taxes
The enterprise income tax paid by a Chinese corporation when transferring dividends is included in the direct foreign tax payment credit. Therefore, tax deduction was applied in this simulation.
‘ Indirect foreign taxes
The ‘enterprise income tax for the business year’ paid by each site in China is included in the indirect foreign tax payment credit, and the corresponding amount was deducted according to the .
V. Proposal of Operation Method According to Optimal Investment Plan
As reviewed above, the most optimal option is the option 4, that is, operating the sites in China as a branch of the existing corporation without establishing a corporation in Hong Kong. The details are as follows:
1. Legal Nature of a Branch
According to the , a corporation in China can set up a branch, which will not have an independent legal personality and its legal liabilities are borne by the head office. In other words, branches can only conduct management activities within the business of the parent company and the parent company is liable to such management activities.
2. Types and Characteristics of Branches
Branches are classified as contact branches and managerial branches according to the business scope, and the following are details relating to tax report:
Classification Managerial branch Contact branch
Tax registration Required Required
Individual income tax report Self-report by the 15th of the following month Self-report by the 15th of the following month
Distribution tax report
(VAT, business tax, consumption tax) Self-report by the 15th of the following month Self-report by the 15th of the following month
Advance payment of enterprise income tax Required Not required (report not required)
Independent financial statement Required Not required
2.1 Contact branch
This branch is set up for market research and contact with the head office and is not authorized by Trade and Industry Bureau for other activities than contact. Therefore, as it does not perform any independent management activity, it is not obliged to pay transfer tax. (However, it is obliged to report). Also, it cannot issue tax bills.
In addition, if salary is paid to employees of a Contact branch, although the company does not conduct independent management activities, it is still a ‘withholding agent’ according to and, therefore, obliged to report for the individual income tax.
2.2 Managerial branch
This branch is established to conduct management activities within the business scope of the head office, and authorized by Trade and Industry Bureau for such activities.
A managerial branch can issue tax bills and, when it does, it is obliged to pay VAT or business tax. Also, since the branch performs independent management and production activities, according to , ‘State Administration of Taxation Announcement No. 57, 2013,’ it is also obliged for advance payment of the enterprise income tax, for which it must create and report independent financial statement for each quarter.
3. Operation Plan
Since the company plans to conduct independent management and production activities from the branch, it must manage independent financial statements and other tax reports as explained above. Therefore, to perform tax obligations stipulated by the laws, it must close accounts on its own.
Although a branch is not an independent corporation, it is required by the law to close accounts on its own and, to maximize operational benefits, each branch must perform ‘responsible management’ as an ‘independent corporation.’ If each corporation performs responsible management, it will be possible to evaluate subsidiaries based on objective index and allocate managerial resources accordingly, improving efficiency of individual branches and the entire group.
VI. Conclusion
The format of foreign capital firms entering the Chinese market determines not only the operational format but also success and failure of the business. Therefore, it is critical to decide the format when entering the market, and, for that reason, this report reviewed different options and found the most optimal option according to prospective investment recovery. The following four options were reviewed in this report:
Classification Description
option 1 After establishing a corporation in Hong Kong, all the sites in China are established as subsidiaries of the Hong Kong corporation
option 2 Without establishing a corporation in Hong Kong, all the sites in China are established as subsidiaries of the Korean head office
option 3 Without establishing a corporation in Hong Kong, the sites in China are established as subsidiaries of an existing corporation
option 4 Without establishing a corporation in Hong Kong, the sites in China are established as a branch of an existing corporation
After reviewing operational characteristics, it was decided that ‘establishing a branch (option 4)’ is an optimal option as it also maximizes cash flow for investment recovery. This option has the following operational benefits:
‘ It does not require capital for establishment, requires a short time for establishment (maximum 3 months), and involves a simple procedure.
‘ The liquidation procedure is simple and takes a short time.
‘ Because the enterprise income tax is imposed on combined profits, if a company makes loss, less corporate tax is imposed than for a subsidiary
‘ Responsible management can be performed as an individual corporation
For those reasons, and for investment recovery, establishing the sites in China as a branch of the existing corporation is optimal.