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Restructuring your China Operations in Difficult Economic Times 11 June 2009 French Chamber of Commerce. Daniel Chan Partner China Corporate and Tax DLA Piper Hong Kong T: +852 2103 0821 Email: daniel.chan@dlapiper.com. Content. Introduction Case Study 1 – Closing down a Rep Office

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  1. Restructuring your China Operations in Difficult Economic Times11 June 2009French Chamber of Commerce Daniel ChanPartner China Corporate and TaxDLA Piper Hong Kong T: +852 2103 0821 Email: daniel.chan@dlapiper.com

  2. Content • Introduction • Case Study 1 – Closing down a Rep Office • Case Study 2 – Closing down a WFOE Factory and converting to OEM Model • Case Study 3 – Divesting Part of Business • Case Study 4 – Crisis Management

  3. Introduction Situations which necessitate closing your PRC operation: • Entity Elimination / Reduction • Change in Economic Circumstances • Tax Restructuring / Operational Efficiency • Change of Business Model • JV Partner Dispute • Expirations of Operational Term • Many others … 3

  4. Case Study 1 Closing Down a Rep Office

  5. Case Study 1Closing down a Rep Office (“RO”) • Procedures and Timing • Employment Issues • Practical Issues • Replacement Model HK Co PRC Rep Office 5

  6. Case Study 1Closing Down a Rep Office Procedure and Timing 6

  7. Case Study 1Closing Down a Rep Office Employment 1. Local Employees: Termination of Secondment with FESCO 1) Timing • prior to the commencement of the deregistration; 2) Method • termination through consultation and three-party agreement; 3) Severance • 1 month’s salary for every 1 full year of service with the RO • 1 month’s salary = average monthly salary for the 12 months prior to the termination • 6 months ≦period < 1 year: counted as one year • period < 6 months: one-half of the monthly salary • Cap the severance calculation base: 3 times the local average monthly salary (only applicable to the severance corresponding to the years of services after 01/01/2008) 7

  8. Case Study 1Closing Down a Rep Office Employment (cont’d) 2. Expatriates • Expatriates to a RO need to be registered as the (chief) rep of the RO. • Deregistration of the rep (s) (excluding the chief rep) may be conducted prior to the commencement of the deregistration of the RO • The chief rep, whose signature will be required on most of the application documents for deregistration, need to be kept (at least on paperwork) until completion of the deregistration with the AIC. • The chief rep may be required to attend the deregistration with the Customs in person in some locations. • The termination of the employment contract for the expatriate may not be triggered by the closing down of the RO since the employment contract for the expatriate to the RO is between the expatriate and the parent company of the RO. 8

  9. Case Study 1Closing Down a Rep Office Practical Issues • Validity of the Certificates of the RO • Lease • Disposal of Assets • IIT Filing and Payment for Expatriates • Clearance Audit Report • Time for Closing the Bank Account(s) 9

  10. Case Study 1Closing Down a Rep Office Practical Issues 1. Validity of the Certificates of the RO • In some locations, the Tax Registration Certificate and the Registration Certificate of the RO shall be kept valid until the completion of deregistration. 10

  11. Case Study 1Closing Down a Rep Office Practical Issues (cont’d) 2. Lease • In some locations where a valid Registration Certificate and Tax Registration Certificate are required for the deregistration, a valid lease contract will be required in order to renew these two certificates. • It is advisable to retain a valid lease till the completion of the tax deregistration. • Where the certificates are still valid, some local tax authorities may accept the absence of a valid lease after the RO’s business closing date specified by the parent company • Highly subject to the local requirements 11

  12. Case Study 1Closing Down a Rep Office Practical Issues (cont’d) 3. Disposal of Assets • Assets of the RO mainly include the office appliances, computers and furniture • VAT will be exempt if the transfer of used assets at a price equal to or lower than the original purchase price • The RO apply to the tax authority to issue the VAT invoice for sales of the used assets but in some locations, may not be able to obtain such VAT invoice • Assets imported in the name of the RO (mainly automobile) – to be disposed of or transfer subject to the consent of the Customs 12

  13. Case Study 1Closing Down a Rep Office Practical Issues (cont’d) 4. IIT Filing and Payment for Expatriates During the Tax Deregistration Period • Subject to the discretion of the tax official in charge • Some may require the IIT filing and payment for the expatriates, who have not yet been deregistered as the representative, until completion of the tax deregistration • Some may accept the IIT filing and payment for the expatriates until the RO’s business closing date specified by the parent company • Better not to send the rep who has not yet been deregistered into China for IIT purpose 13

  14. Case Study 1Closing Down a Rep Office Practical Issues (cont’d) 5. Clearance Audit Report • A clearance audit report on the expenses of the RO shall be prepared prior to the tax deregistration • In some locations, the tax authorities consider the clearance audit report valid for 3 months from the issue date. If the tax deregistration cannot be completed within this period, the tax authority will require a new clearance audit report. 14

  15. Case Study 1Closing Down a Rep Office Practical Issues (cont’d) 6. Time for Closing the Bank Account(s) • It is advisable to have the bank account(s) of the RO to be closed after all the taxes and customs duties (if applicable) have been cleared (i.e. upon completion of the tax and customs deregistration) 15

  16. Case Study 1Closing Down a Rep Office Replacement Model • Complete withdrawal • Establishment of a Foreign-Invested Enterprise (“FIE”) instead • Establishment of a branch of an existing FIE instead • To maintain some kind of presence without registration, such as • Independent contractor • Exceptions (i.e. registration is required under the following circumstances): • Oil and other mines exploration; • Construction Contract; • Operation of a Foreign-invested Enterprise by entrustment; • A branch of a foreign bank; and • Other manufacturing or operation activities approved by the government. 16

  17. Case Study 2 Closing Down a WFOE Factory and Converting to OEM Model

  18. Case Study 2 Closing down a WFOE Factory and converting to OEM Model Current Structure HKCo HK 100% owned PRC • Main business: manufacturing • Auxiliary business: consulting, R&D and other services Manufacturing WFOE 18

  19. Case Study 2 Closing down a WFOE Factory and converting to OEM Model Objectives for Restructuring • To outsource manufacturing function to third-party vendors in China ("PRC OEMs"). • To focus on and retain R&D and non-manufacturing functions in China only.  to replace Manufacturing WFOE by (i) Service WFOE, and/or (ii) Rep Office. 19

  20. Case Study 2 Closing down a WFOE Factory and converting to OEM Model Proposed Structure (1) – SERVICE WFOE HK HKCo (iii) Set up contract manufacturing arrangement 100% owned PRC (ii) Transfer assets and relocate employees Service WFOE Manufacturing WFOE (i) Set up Service WFOE (iv) Liquidate Manufacturing WFOE PRC OEMs 20

  21. Case Study 2Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 1. Major Legislations for Liquidation (a) PRC Company Law passed by the Standing Committee of National People's Congress on 27 October 2005 – effective 1 January 2006. (b) Guidance Regarding Dissolution and Liquidation of Foreign Investment Enterprises promulgated by the Ministry of Commerce on 5 May 2008 (Shang Fai Zi [2008] No. 31) – effective on the same date. (c) PRC Income Tax Law passed by the National People's Congress on 16 March 2007- effective 1 January 2008. (d) Implementation Regulationsof the PRC Income Tax Law passed by the State Council on 6 December 2007 – effective 1 January 2008. 21

  22. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 2. Reasons for Liquidation • *Expiry of term of operation or emergence of matters triggering liquidation as provided in AOA. • Shareholders' resolution to dissolve the company. • Cancellation of business license or cessation of business according to law. • Decision of People's Court. • Pleading by at least 10% of the shareholders to People's Court for dissolution because of the company's serious operation difficulties and huge loss. 22

  23. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 3. Application for Liquidation:- - Procedures (a) Shareholders to pass resolutions for liquidation / board resolutions may be required according to AOA or local practices in some cases. (b) Shareholders to establish liquidation committee. • Number – not specified in PRC Company Law; but normally at least 3 liquidation committee members are required; • Composition – any person(s) designated by shareholder(s); 23

  24. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 3. Application for Liquidation:- (b) Shareholders to establish liquidation committee (cont'd) • Function and power • to examine the property of the company and prepare a balance sheet and property list; • to notify creditors by notice or announcement; • to dispose of and liquidate relevant unfinished business of the company; • to pay all outstanding taxes and taxes incurred in the course of liquidation; • to clear up claims and debts; • to dispose of the property remaining after full payment of the company's debts; • to participate in civil litigation activities on behalf of the company. 24

  25. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 3. Application for Liquidation:- (b) Shareholders to establish liquidation committee (cont'd) • Liabilities of liquidation committee members: • Civil Liability – liable to compensate the company or the creditor's loss caused by the members of liquidation committee's wilful act or through gross negligence • Liability imposed on liquidation committee members (normally fine and confiscation of illegal income) by Administration Authority for:- • failure to notify creditors; • concealing property, making false record or distributing company property before repayment of debts; • a company engaging in any business operation irrelevant to the liquidation; 25

  26. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 3. Application for Liquidation:- (b) Shareholders to establish liquidation committee (cont'd) • Liability imposed by Administration Authority for:- • failure to submit liquidation report to AIC or submitting liquidation report concealing major facts or having major commission; • taking advantage of his/her power to practice favoritism, seeking illegal proceeds or embezzling on any company asset. • Criminal Liability – authorizing the transfer or disposal of the company's properties which causes serious injury to the interests of the creditors or any other person. • Indemnity to liquidation committee members by shareholder? 26

  27. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 3. Application for Liquidation (cont'd):- • Liquidating Enterprise to file details of Liquidation Committee with AIC within 10 days after the establishment of Liquidation Committee. • Approval authorities to issue Approval regarding early termination. • Liquidation Committee to notify creditors and make public announcement. • Liquidation Committee to prepare the property list, evaluate the value of the assets (collect debt, formulate a liquidation plan for approval of shareholders or court (as applicable). 27

  28. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 3. Application for Liquidation (cont'd):- • Sale / Disposal of remaining assets according to liquidation plan. • CPA firm to issue liquidation report (shareholder or court approval, as applicable, is required). • Completion of first round of de-registration processes including tax de-registration and customs deregistration. • De-registration with AIC. • Remittance of liquidation proceeds. • De-registration with Statistics Bureau, Organization Code Certificate, SAFE, Closing of bank accounts, etc. 28

  29. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 3. Application for Liquidation (cont'd):- • De-registration of liquidation committee. * Inquiry must be made with local authorities regarding the exact liquidation procedures and document requirements. - Timing • Whole liquidation process normally takes at least six to nine months to complete assuming that everything goes smoothly. 29

  30. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 4. Tax Considerations for Liquidation (a) audit report for the period from 1 Jan to 31 Mar 09 (b) liquidation report for the period from 1 Apr to 31 Dec 09 1 Jan 09 Liquidation ends (e.g. 1 Dec 09) passing of shareholders' resolution to liquidate WFOE (e.g. 1 Mar 09) obtaining approval - liquidation commences (e.g. 1 Apr 09) 31 Dec 08/ 1 Jan 09 What will be the best time to sell the remaining assets of the Liquidating Enterprise? 30

  31. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE • Tax Considerations for Liquidation - Tax clearance audit by local tax bureaus – may result in additional tax payment. - Claw back of tax holiday – repayment of past taxes exempt or reduced by virtue of tax holiday if Liquidating Enterprise fails some of the conditions required for entitlement of the tax holiday (e.g. Manufacturing WFOE should operate for at least 10 years). 31

  32. Case Study 2 Proposed Structure (1) – SERVICE WFOE 32

  33. Case Study 2 Proposed Structure (1) – SERVICE WFOE 33

  34. Case Study 2 Proposed Structure (1) – SERVICE WFOE 34

  35. Case Study 2 Proposed Structure (1) – SERVICE WFOE 35

  36. Case Study 2 Proposed Structure (1) – SERVICE WFOE 36

  37. Case Study 2 Proposed Structure (1) – SERVICE WFOE 37

  38. Case Study 2 Proposed Structure (1) – SERVICE WFOE 38

  39. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 5. Sale of Assets (Raw Materials, WIPs and Finished Goods) • When to sell assets (before or during liquidation)? • Sell as much assets as possible before liquidation so that retained earnings can be distributed to overseas as dividend before the previous year-end (i.e. 1 January 2008) to avoid:- • cash trapped inside China until the completion of liquidation (since retained earnings cannot be distributed as dividend once liquidation process commences and approval for distribution and payment of interim dividend during the year is difficult to be obtained). • But, need to retain assets which are still required for production / operation. 39

  40. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 5. Sale of Assets (Raw Materials, WIPs and Finished Goods) (cont'd) • Who can approve sale of assets during liquidation? • Liquidation committee. • Decision to sell assets by majority vote. • Valuation of the assets? • General principle: assets transferred at fair market value (especially for related parties transactions), if not, best realizable value. 40

  41. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 5. Sale of Assets (Raw Materials, WIPs and Finished Goods) (cont'd) • Return of bonded raw materials and assets • Can the customs books be matched and verified? • Additional customs duty and import VAT? • Customs approval is required. • Can the bonded raw materials and assets be directly "dropped shipped" from Manufacturing WFOE to the third-party domestic seller without physical shipping out of China and then re-imported back to China? • Any FX payment issue? 41

  42. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 5. Sale of Assets (Raw Materials, WIPs and Finished Goods) (cont'd) • Restriction on disposal of self-use assets or inventory to overseas entity. • Customs approval is required for export of self-use assets or inventory to overseas entity – can be obtained in most cases. • Accordingly, liquidating entity (i.e. Manufacturing WFOE) can collect FX purchase price from overseas. 42

  43. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 5. Sale of Assets (Raw Materials, WIPs and Finished Goods) (cont'd) • Any PRC tax implications on sale of assets? • Sale of raw materials, WIPs and finished goods – 17% VAT (borne by seller). • Sale of used fixed assets – VAT exemption or 2% VAT. • Disposal of obselete assets – any implications? 43

  44. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 6. Cash Flow Planning • Sufficient cash (after selling some of the assets to Service WFOE for its R&D and service businesses) for paying off the outstanding debts and liabilities for liquidation? (Please see Section 7 for bankruptcy implications). • If not, other ways of generating cash flow for Manufacturing WFOE? • Injecting additional capital into Manufacturing WFOE before commencing liquidation? • approval required and take time. 44

  45. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 6. Cash Flow Planning (cont'd) • Loan by Parent to Manufacturing WFOE, subject to:- • Thin capitalization rules / FX borrowing quota. • FX loan registration. • 10% withholding tax (or lower rate pursuant to applicable tax treaty) on interest income received by Parent. • All outstanding loan must be cleared before the completion of liquidation unless the loan due to the Parent is written off. But, written off of outstanding loan might have EIT implication. 45

  46. Case Study 2 Proposed Structure (1) – SERVICE WFOE 46

  47. Case Study 2 Proposed Structure (1) – SERVICE WFOE 47

  48. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 6. Cash Flow Planning (cont'd) • Increase selling price of disposal of assets • Settlement of outstanding debts outside China – FX issue? 48

  49. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 7. What if assets < debts during liquidation? • If assets of Liquidating Enterprise is not sufficient to pay off the outstanding debts (i.e. insolvency) during liquidation, then, (a) Liquidation Committee • should file the case with the Court for bankruptcy; and • should hand over the case to the Court. (b) Creditor • can sue for the debt under normal civil procedure; and • can file a petition for bankruptcy with a competent court which will decide whether to accept the bankruptcy petition. 49

  50. Case Study 2 Proposed Structure (1) – SERVICE WFOE (A) Liquidation of Manufacturing WFOE 7. What if assets < debts during liquidation? • Recovery of Properties (a) Upon bankruptcy, Administrators may recover property obtained as a result of the following voidable transactions (i) Administrators upon petitioning to the People's Court have the power to undo the following transactions involving properties of the debtor (i.e. Liquidating Enterprise) taken within one year before the Court accepts the bankruptcy petition. • gifts; • transfers at an undervalue; • security given for unsecured debts; • early repayment of debts that have not fallen due; and • abandonment of rights to repayment. 50

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