A Representative Office (RO) can represent the interests of a foreign investor by acting as a liaison office for the parent company but has decreased in popularity due to its many restrictions. ROs are permitted to conduct market research and to develop partnerships and business channels, but all business transactions, including the issuance of invoices, must be managed by the parent company. An RO is taxed on its expenses and cannot generate revenues.
• The parent company must have existed for at least two years in order to be eligible to set up an RO in China;
• ROs may not hire local employees directly and must rely on a government-authorised employment agency;
• An RO is limited to four foreign employees;
• There is no investment requirement because ROs are not classed as a legal entity in China;
• The registration process takes around four months to complete, depending on location.
An RO may be suitable for businesses looking to establish a short-term presence in China with no need to generate revenue, or for very limited sourcing ventures. However an RO should not be regarded simply as a way for new entrants to China to minimise their exposure in the event of failure because, in most cases, ROs do not provide the optimum platform for success and have the following disadvantages:
• Liability – An RO is not an independent entity. It is an extension of its parent company. As such, the parent company and the RO’s Chief Representative take responsibility and liability for its operations. A WFOE provides greater protection because it is a form of Limited Liability Company (LLC). However it does not offer the same level of protection as in other jurisdictions, so an offshore holding company is often inserted between the Chinese entity and its ultimate beneficiary.
• Capitalisation – An RO has no registered capital requirement and instead generally pays taxes on its expenses (effective tax rate approximately 11%) because its purpose is not altruistic and it contributes indirectly to the revenue potential of its parent. If the Chinese tax authorities decide that an RO is generating revenues from outside its intended activities, they can levy a tax on its deemed revenues and income. A WFOE, on the other hand, is required to make an initial capitalisation, which is tax free, but is expected to pay taxes on both its revenues and profit. If a Chinese entity’s expenditures exceed a certain threshold, a WFOE is, in fact, more tax efficient than the RO.
• Scope of activities – ROs are limited to providing business development, market research and support activities (such as quality control for sourcing from China), while a WFOE is permitted to generate revenues from the commercial activities prescribed in its business licence. If a business operating through an RO decides to begin selling products or services in the future, it will be required to re-establish as a new company. With a WFOE, however, it is generally possible to expand the scope of business to accommodate this.
• Human resources – ROs are not permitted to hire Chinese citizens directly but must use a licensed ‘labour dispatch’ service provider. However, many of these providers are refusing to dispatch local employees to new RO’s due to recent changes in the labour laws. Furthermore, an RO is limited to no more than four foreign employees as Representatives, which includes the Chief Representative. A WFOE, however, can hire as many PRC citizens as it wishes, while its ability to employ foreign nationals is generally based on the size of its registered capital. Some local employees dislike being hired via a dispatch service provider and prefer direct-hire relationships.
• Ongoing costs – Generally speaking, the RO has fewer ongoing compliance costs than a WFOE, particularly in respect of accounting and tax compliance. However, depending upon the length of operations and the size of annual expenditure, a WFOE may be significantly less expensive to operate as a whole due to the lower effective tax rates and a five-year carry forward of losses.
• Marketability – A WFOE is perceived as a more substantial market presence and suggests to prospective clients or partners that a business has made a long-term commitment to the Chinese market. New market entrants often overlook this, but such a perception can be a significant barrier to business development.
• Office location – ROs are limited to leasing office space in locations that are specifically licensed to host ROs. Typically this means paying Grade-A office rents. A WFOE, however, can lease any office space that is zoned for its intended business. Neither an RO or a WFOE should use a “virtual office” – this is unlawful and will create problems at both the registration and operational phases.
• Flexibility – It is generally possible to set up branch offices of a WFOE in other cities and expand the scope of a business to include additional lines of business, but this is not possible with an RO. ROs also cannot be converted into a WFOE. If you want to restructure, you will have to set up a new WFOE and consider if you need to close the RO.
• Parent company – The parent company of an RO must be at least two-years-old before it is permitted to establish in China. The Chinese government is discouraging the use of ROs and different locations may place additional restrictions upon the parent company before an RO is permitted to establish.
Taxation of a Representative Office in China
ROs (except for those engaged in legal or accounting services) are not permitted to generate revenue, so their tax base for CIT and VAT is presumed on the basis of their expenses. In Shanghai and Beijing, a minimum presumed profit rate of 15% is used for the CIT calculation but this could be determined elsewhere on a case-by-case basis. For VAT the tax is based solely on the amount of expenses incurred.
This method of calculating tax liability for ROs is applicable in Shanghai and Beijing. It is possible that the minimum presumed profit rate could be determined on a case-by-case basis.