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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.

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Presentation on theme: "Restructuring your China Operations in Difficult Economic Times 11 June 2009 French Chamber of Commerce Daniel Chan Partner China Corporate and Tax DLA."— Presentation transcript:

1 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:

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 Closing Down a Rep Office
Case Study 1 Closing Down a Rep Office

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

6 Case Study 1 Closing Down a Rep Office
Procedure and Timing Procedures Timing Remarks 1 Approval on deregistration by the original approval authority 1 to 2 months Only applicable to certain types of special ROs, such as the ROs of foreign insurance institution, financial institution, stock institution, authentication institution and so forth pursuant to the relevant laws and regulations. 2 Deregistration with the tax authority 3 to 4 months An expense and tax clearance audit shall be conducted by a PRC accounting firm before the tax deregistration. 3 Deregistration with the Customs 1 to 2 weeks It may be carried out in parallel with step 2 above. 4 Closing of Bank Account(s) 1 week Remittance of the balance of the bank account(s) to the parent company shall be conducted at the same time. 5 Deregistration with AIC 2 weeks Chops of the RO will be destroyed on site by the AIC in most locations. 6 Other formalities Including: return of the Organization Code Certificate; return of the Statistics Registration Certificate; if applicable, deregistration of the working permit and residence permit the of expatriate representative 6

7 Case Study 1 Closing 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 1 Closing 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 1 Closing 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 1 Closing 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 1 Closing 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 1 Closing 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 1 Closing 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 1 Closing 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 1 Closing 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 1 Closing 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 Closing Down a WFOE Factory and Converting to OEM Model
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 Manufacturing WFOE Main business: manufacturing Auxiliary business: consulting, R&D and other services 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 HKCo HK (iii) Set up contract manufacturing arrangement 100% owned PRC (ii) Transfer assets and relocate employees Manufacturing WFOE Service WFOE (iv) Liquidate Manufacturing WFOE (i) Set up Service WFOE PRC OEMs 20

21 Case Study 2 Proposed 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 effective 1 January 2008. (d) Implementation Regulations of 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 31 Dec 08/ 1 Jan 09 passing of shareholders' resolution to liquidate WFOE (e.g. 1 Mar 09) obtaining approval - liquidation commences (e.g. 1 Apr 09) Liquidation ends (e.g. 1 Dec 09)  What will be the best time to sell the remaining assets of the Liquidating Enterprise? 30 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
(A) Liquidation of Manufacturing WFOE 4. Tax Considerations for Liquidation (a) Liquidating Enterprise Liquidation proceeds* (subject to EIT at 25% (or lower rate). Investing Enterprise (i.e. Shareholder) Dividend – total of statutory reserves and retained earning subject to 10% withholding tax. Capital gain – remaining liquidation proceeds (i.e. Realizable net value of all assets - Net BV assets - Liquidation expenses - Tax expenses – Dividend less EIT paid on liquidation proceeds) subject to 10% withholding tax. *Realizable value of total assets (less actual liabilities paid) – Net BV assets (as of the commencement date of liquidation) – Liquidation expenses – Tax expenses 32 32

33 Case Study 2 Proposed Structure (1) – SERVICE WFOE
Example 1 Balance Sheet as of the Commencement Date of Liquidation Assets Liabilities + Equity Assumptions: ($) Cash 100 Current Assets 200 300 Fixed Assets 700 Total: 1,000 Creditors 400 Statutory Reserves 300 Retained Earning 100 Registered Capital 200 Statutory reserves include (i) enterprise development fund, (ii) reserve, fund, and (iii) employee's bonus and welfare fund. Actual amounts collected from disposing of assets: $1,400 ($100 + $500 + $800) Actual amounts settled for outstanding liabilities: $400 In light of (b) and (c), realizable value of total assets is $1,000 = $1,400 - $400. Liquidation expenses and tax expenses (EIT not included) are $50 and $100 respectively. There is only one Shareholder/Investing Enterprise (i.e. WFOE). 33

34 Case Study 2 Proposed Structure (1) – SERVICE WFOE
Example 1 Balance Sheet as of the Commencement Date of Liquidation Assets Liabilities + Equity Tax Calculation: ($) Cash 100 Current Assets 200 300 Fixed Assets 700 Total: 1,000 Creditors 400 Statutory Reserves 300 Retained Earning 100 Registered Capital 200 Liquidating Enterprise (i) Liquidation proceeds: Realizable value of total assets – Net assets (as of the commencement date of liquidation) – Liquidation expenses – Tax expenses $1,000 - ($1,000 - $400) - $50 - $100 = $250 - $250 subject to 25% EIT - EIT payable on liquidation proceeds: $250 x 25% = $62.50 34

35 Case Study 2 Proposed Structure (1) – SERVICE WFOE
Example 1 Balance Sheet as of the Commencement Date of Liquidation Assets Liabilities + Equity Tax Calculation: ($) Cash 100 Current Assets 200 300 Fixed Assets 700 Total: 1,000 Creditors 400 Statutory Reserves 300 Retained Earning 100 Registered Capital 200 (b) Investing Enterprise (ii) Dividend - Total of statutory reserves and undistributed retained earning of $400 ($300 + $100) shall be distributed as dividend  subject to 10% withholding tax. - Withholding tax payable on dividend: $400 x 10% = $40 35

36 Case Study 2 Proposed Structure (1) – SERVICE WFOE
Example 1 Balance Sheet as of the Commencement Date of Liquidation Assets Liabilities + Equity Tax Calculation: ($) Cash 100 Current Assets 200 300 Fixed Assets 700 Total: 1,000 Creditors 400 Statutory Reserves 300 Retained Earning 100 Registered Capital 200 (b) Investing Enterprise (iii) Capital gain - Remaining liquidation proceeds of $ ($250 x 75%) is treated as capital gain subject to 10% withholding tax. - Withholding tax payable on capital gain: $ x 10% = $18.75 Remaining cash to be remitted to Investing Enterprise: Registered Capital + After-tax Dividend + After-tax Capital Gain = $200 + ($400 x 90%) + ($187.5 x 90%) = $200 + $360 + $168.75 = $728.75 36

37 Case Study 2 Proposed Structure (1) – SERVICE WFOE
Example 2 Balance Sheet as of the Commencement Date of Liquidation Assets Liabilities + Equity Assumptions: ($) Cash 100 Current Assets 200 300 Fixed Assets 700 Total: 1,000 Creditors 400 Statutory Reserves 300 Retained Earning 100 Registered Capital 200 Same assumptions as Example 1, except: Actual amounts collected from disposing of assets: $600 ($100 + $ ) Actual amounts settled for outstanding liabilities: $400 In light of (a) and (b), realizable value of total assets is $200 = $600 - $400 Tax Calculation: (a) Liquidating Enterprise (i) Liquidation proceeds: $200 - ($1,000 - $400) - $50 - $100 = ($550) - No EIT payable for the loss of $150. 37

38 Case Study 2 Proposed Structure (1) – SERVICE WFOE
Example 2 Balance Sheet as of the Commencement Date of Liquidation Assets Liabilities + Equity Tax Calculation: ($) Cash 100 Current Assets 200 300 Fixed Assets 700 Total: 1,000 Creditors 400 Statutory Reserves 300 Retained Earning 100 Registered Capital 200 (b) Investing Enterprise (ii) Dividend - Cash remaining after debt, liquidation and tax expenses: $600 - $400 - $150 = $50 subject to 10% withholding tax - Withholding tax payable on dividend: ($300 + $100) x 10% = $40 Remaining cash to be remitted to Investing Enterprise: After-tax Dividend = $45 ($50 x 90%) 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
Example 1 Assets Liabilities + Equity Facts ($) Cash + Assets 1,000 _____ Total: 1,000 Creditors 1,200 Statutory Reserves 100 Accumulated Loss (500) Registered Capital 200 Manufacturing WFOE does not have enough cash and assets to pay off the creditors' debts, i.e. there is a $200 short of assets to pay off the debts. 46

47 Case Study 2 Proposed Structure (1) – SERVICE WFOE
Example 1 Assets Liabilities + Equity Illustration ($) Cash + Assets 1,000 +200 _____ Total: 1,200 Creditors 1,200 A/P 200 Statutory Reserves 100 Accumulated Loss (500) Registered Capital 200 Manufacturing WFOE borrows FX loan of $200 from its overseas parent. As Manufacturing WFOE has no excess cash to pay off the inter-company loan of $200, WFOE opts to write off such loan. The written off expenses may become ordinary income of Manufacturing WFOE and may be subject to EIT at 25%. (Please see previous slide 31). 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

51 Case Study 2 Proposed Structure (1) – SERVICE WFOE
(A) Liquidation of Manufacturing WFOE 7. What if assets < debts during liquidation? Recovery of Properties (ii) Administrator may petition to the Court to revoke those transactions that occurred within six months of the acceptance of the bankruptcy petition when the debtor (i.e. Liquidating Enterprise) was insolvent but chose to pay certain individual creditors only. (b) Void acts: the concealing or transferring of property to avoid debts; and the fabrication of debts or acknowledgement of debts that are not genuine. 51

52 Case Study 2 Proposed Structure (1) – SERVICE WFOE
(A) Liquidation of Manufacturing WFOE 8. Employment No transfer of employment from one PRC entity to another in China. But, termination of existing employment contracts with Manufacturing WFOE and entering into new employment contracts with Service WFOE for those transferred employee. Liquidation of Manufacturing WFOE is a valid ground for termination of employment contracts, but 30 day's notice is required to be given to the terminated employees. Dismissal of remaining employees (other than those being transferred to new service WFOE) and making severance payment to dismissed employees. Again, any Home Country employment issues? 52

53 Case Study 2 Proposed Structure (1) – SERVICE WFOE
(A) Liquidation of Manufacturing WFOE 9. Other Issues Prior communication with local approval authorities is recommended. Termination of lease and third-party contracts, e.g. utilities contracts. Pending litigation might affect completion of liquidation. liquidation report cannot be finalized. additional fund may need to be reserved for settling the disputes. No commencement of new business, but fulfilment of obligation of on-going projects / contracts is permitted. Books, records and liquidation document would normally be required to be kept inside China. 53

54 Case Study 2 Proposed Structure (1) – SERVICE WFOE
(A) Liquidation of Manufacturing WFOE 10. Tips for preparing for Efficient Liquidation Work out cash flow plan to avoid situations where the Liquidating Enterprise does not have sufficient fund to settle liabilities. Pay out all available retained earnings as dividend before the previous year-end to avoid excessive cash trap (subject to cash flow required for settling outstanding debts and liabilities). Investigate potential past tax issues to prepare for tax audits to minimize delay. 54

55 Case Study 2 Proposed Structure (1) – SERVICE WFOE
(A) Liquidation of Manufacturing WFOE 10. Tips for preparing for Efficient Liquidation (cont'd) Determine the date of ceasing production / business / operation. Settle outstanding labour issues. Identify all creditors and prepare a list of outstanding debts and claims. Review all contracts for termination provisions and identify penalties and liquidated damages associated with early termination. Retain parent company until the completion of liquidation process – e.g. for signing any documents that may required to be submitted to the PRC authorities during liquidation. 55

56 Case Study 2 Proposed Structure (1) – SERVICE WFOE
(B) Set up Service WFOE + Assets / Employees Transfer 1. Capitalization of New Service WFOE Minimum capital requirement applying to city where Service WFOE is to be set up. Working capital requirement for future activities (e.g. R&D, consulting services and technical support) and purchase of assets from existing Manufacturing WFOE – financial and cash flow projection for at least three to five years. Constraints by Thin Capitalization Rules and PRC Foreign Exchange Regulations. 56

57 Case Study 2 Proposed Structure (1) – SERVICE WFOE
(B) Set up Service WFOE + Assets / Employees Transfer 2. Cash Flow and Consideration for Assets Transfer Additional capitalization or funding will be required by Service WFOE for purchase of assets from Manufacturing WFOE. Excess cash may be trapped in Manufacturing WFOE unless Manufacturing needs cash to pay off outstanding debts and liabilities upon liquidation. Careful cash flow planning required for Manufacturing WFOE (for both asset purchase and liquidation). Please see further discussion regarding cash flow planning in the following section. Consideration subject to valuation? 57

58 Case Study 2 Proposed Structure (1) – SERVICE WFOE
(B) Set up Service WFOE + Assets / Employees Transfer 3. Approval and M&A Rules Approval for establishment of an ordinary Service WFOE with consulting or R&D business scope normally takes two months to obtain approval and Business License, and another two to three months for the post-registration formalities. But, establishment of Service WFOE to acquire assets from Manufacturing WFOE may trigger M&A requirements, e.g. submission of asset transfer agreement, preparation of valuation and creditors' notice, etc. – longer time is required to obtain approval. 58

59 Case Study 2 Proposed Structure (1) – SERVICE WFOE
(B) Set up Service WFOE + Assets / Employees Transfer 4. Operation Set Up A closing date required to be fixed to take over the assets and employees from Manufacturing WFOE to Service WFOE – the date on which new Service WFOE is set up and becomes fully operational. Fully operational? – meaning "infrastructure" of the operation is ready, e.g. IT and VAT/finance systems need to be established, supplies or utility contracts with third parties need to be novated, inter-company or third-party service agreements need to be put in place, etc. Other aspects need to be considered for smooth operation. 59

60 Case Study 2 Proposed Structure (1) – SERVICE WFOE
(B) Set up Service WFOE + Assets / Employees Transfer 5. Tax Consideration for Transfer Enterprise income tax – any consideration exceeding NBV of the transferred assets may trigger income tax implication (assuming no carried-forward profits are available for Manufacturing WFOE for offsetting). Indirect taxes – transfer of used fixed assets may be entitled to VAT exemption so long as the transfer price does not exceed their original costs (otherwise, 2% VAT) and other relevant conditions are satisfied. Customs approval required if assets to be transferred involve bonded assets. 60

61 Case Study 2 Proposed Structure (1) – SERVICE WFOE
(B) Set up Service WFOE + Assets / Employees Transfer 6. Employment Severance payment Legally, Manufacturing WFOE should pay severance to all "terminated employees". But, Service WFOE can consider offering "transferred employees" a package which would recognize their past years of services with Manufacturing WFOE -- burden of severance would be borne in the later years by Service WFOE. Any HK (or other home country) employment issues? Proper drafting of termination notice and new employment contract and communication with employees are required. 61

62 Case Study 2 Proposed Structure (1) – SERVICE WFOE
(B) Set up Service WFOE + Assets / Employees Transfer 7. Lease New address for Service WFOE? Apportionment / Splitting of lease? 62

63 Case Study 2 Proposed Structure (1) – SERVICE WFOE
(C) Set Up of Contract Manufacturing Arrangement Identification of PRC OEMs to take over manufacturing function from Manufacturing WFOE. Planning and transition of supply chain (from sourcing to distribution) management function from Manufacturing WFOE to PRC OEMs – Need to be planned carefully before closing down Manufacturing WFOE. Customs approval required for:- bonded processing contract importation of bonded raw materials and equipments, etc. 63

64 Case Study 2 Closing down a WFOE Factory and converting to OEM Model
Proposed Structure (2) – REP OFFICE HKCo HK (iii) Set up contract manufacturing arrangement 100% owned PRC (ii) Transfer assets and relocate employees Manufacturing WFOE Rep Office (i) Set up Rep Office (iv) Liquidate Manufacturing WFOE PRC OEMs 64

65 Case Study 2 Proposed Structure (2) – REP OFFICE
(A) Set up Rep Office 1. Capitalization / Cash Flow No capital requirement as Rep Office is only an extension of the foreign parent company with no legal person status in China. Additional capitalization or funding from the foreign parent company will be required for purchase of assets (generally office equipments) from Manufacturing WFOE, but should not be much. 65

66 Case Study 2 Proposed Structure (2) – REP OFFICE
(A) Set up Rep Office 2. Business Registration Application procedures are straight-forward – normally takes about two to three weeks for Business Registration Certificate and another one and a half to two months to complete the post-registration formalities. 3. Business Scope Limited business scope – liaison type activities only and no direct business. 66

67 Case Study 2 Proposed Structure (2) – REP OFFICE
(A) Set up Rep Office 4. Tax Consideration Taxation base for Rep Office is different from WFOE – cost plus or actual income method for calculating Business Tax and Enterprise Income Tax. Tax exemption is not likely. Unable to issue invoices as Rep Office is not allowed to undertake any direct business activities. 67

68 Case Study 2 Proposed Structure (2) – REP OFFICE
(A) Set up Rep Office 5. Employment No transfer of employment from Manufacturing WFOE to Rep Office. Rep Office cannot hire employees directly. Local employees are hired through local employment agent (i.e. FESCO). Expatriate employees are hired by foreign parent company and then seconded to Rep Office. Termination of existing employment contracts with Manufacturing WFOE and entering into new employment contracts with either FESCO or foreign parent company for those employees who are chosen to "transfer" to Rep Office and agree to the "transfer". 68

69 Case Study 2 Proposed Structure (2) – REP OFFICE
(A) Set up Rep Office 5. Employment (Cont'd) Severance payment – same issue as Proposed Structure (1) Other steps relating to liquidating Manufacturing WFOE and setting up contract manufacturing arrangement will more or less be the same as Proposed Structure (1).  So, whether Proposed Structure (1) and (2) is preferred depends much on the actual business needs of the company, e.g. will the limited business scope of Rep Office be sufficient for the company's non-manufacturing needs or a Service WFOE with wider business scope is required? 69

70 Divesting Part of the Business
Case Study 3 Divesting Part of the Business

71 Case Study 3 Divesting Part of the Business
Existing Business Structure Divesting may be due to: change of business model or strategy spin-off division centralize resources to continue the business area which it does best (Sales or manufacturing) Vendor HK PRC WFOE Sales (S) Manufacturing (M)

72 Case Study 3 Divesting Part of the Business
Common Methods of Divesting Method of Sale will very much be purchaser–driven:- where the Purchaser wishes to avoid hidden or contingent liability of the existing business – Asset Sale where the Purchaser is reasonably satisfied that there is little or manageable risk of hidden or contingent liabilities – Share Sale Vendor HK PRC WFOE Sales (S) Manufacturing (M)

73 Case Study 3 Divesting Part of the Business
Asset Sale - Purchaser WFOE to acquire Manufacturing division Consideration for Purchaser 1. Advantages Avoid unknown or contingent liabilities of vendor WFOE Ability to pick and choose what to acquire Assets booked at purchase consideration (benefit of amortisation/depreciation) 2. Issues to consider Timing – it takes time for the purchaser to establish a WFOE and get it fully operational Acquisition Agreement may need to be submitted to the relevant PRC authorities to support application for vendor WFOE Vendor Purchaser Offshore PRC $ WFOE WFOE S M Sale of Manufacturing Division

74 Case Study 3 Divesting Part of the Business
Asset Sale - Purchaser WFOE to acquire Manufacturing division Continuity Purchaser WFOE must be fully operational to “take over” the existing manufacturing business tax, customs, SAFE issues, etc. IT system bank account Establish business relationships with existing suppliers and service providers so that there is no break in continuity Transfer of employees local employees expatriates Severance payment issues Lease sub-lease or splitting leases? (Business scope issue) Plant & Machinery Permits and Licenses What if the deal falls through after Purchaser WFOE is set up? Vendor Purchaser Offshore PRC WFOE WFOE S M Suppliers/ services providers employees premises plant & machinery

75 Case Study 3 Divesting Part of the Business
Asset Sale - Purchaser WFOE to acquire Manufacturing division Issues for Vendor: Lockup of Sale Proceeds Sales proceed is held at vendor WFOE level Repatriation to HK Holdco by way of dividends (withholding tax issue) and/or repayment of shareholders’ loan only Excess cash will be trapped - to repatriate would require either reduction of capital (to the extent PRC law allows) or liquidation Vendor HK PRC WFOE Only through dividends or repayment of shareholder's loan S $ Sales Proceeds

76 Case Study 3 Divesting Part of the Business
Asset Sale - Purchaser WFOE to acquire Manufacturing division Notification to Creditors Severance payment to outgoing employees relevant tax filings Change of Business Scope Possibility for reducing total investment (and hence share capital) of WFOE Tax concerns:- past tax holiday revoked capital gains on sale Indirect taxes on transfer of fixed assets Withholding tax on dividends to be declared Vendor HK PRC WFOE S

77 Case Study 3 Divesting Part of the Business
Asset Sale (Variation) – The “Seller WFOE” Model The “Seller WFOE” Model With commitment of Purchaser, Vendor establishes a New WFOE New WFOE will acquire the relevant assets, employees, lease, etc, in respect of manufacturing operation Vendor then sells New WFOE to Purchasers Purchaser’s Considerations Advantages Purchaser does not need to expand resources to establish WFOE More streamlined process for Purchaser particularly if SPV is used Vendor Vendor Purchaser HK SPV SPV PRC WFOE New WFOE WFOE New WFOE S M S M

78 Case Study 3 Divesting Part of the Business
Asset Sale (Variation) – The “Seller WFOE” Model Vendor’s Considerations 1. Advantages Vendor in full control of transfer process 2. Issues to consider bear all transfer risk and cost need to outlay purchase consideration to New WFOE to buy assets first before payment is received from Purchaser purchase consideration still trapped in WFOE what happens if deal falls through after New WFOE is fully established? Vendor Vendor Purchaser HK SPV SPV PRC WFOE New WFOE WFOE New WFOE S M S M

79 Case Study 3 Divesting Part of the Business
Asset Sale (Variation) – The “Seller WFOE” Model Tax Considerations Capital Gains vs Trapped Cash Consideration paid onshore vs offshore Vendor Purchaser SPV HK PRC WFOE New WFOE S M Purchase Consideration 1,000 or 2,000 Assets $1,000

80 Case Study 3 Divesting Part of the Business
Share Sale - Acquisition of Vendor’s WFOE Vendor will have to transfer out relevant assets for the retained Sales operation. Purchaser will then acquire the original WFOE with the manufacturing operation intact HK Holdco Purchaser HK PRC WFOE S M

81 Case Study 3 Divesting Part of the Business
Share Sale – Acquisition of Vendor’s WFOE Vendor establishes a New WFOE The relevant assets, employees, lease, etc. of the sales operation are transferred to New WFOE Original WFOE (retaining the manufacturing operation) is then sold to Purchaser Vendor Purchaser Acquisition HK PRC WFOE New WFOE Asset Transfer (Sales Operation) S M

82 Case Study 3 Divesting Part of the Business
Share Sale – Acquisition of Vendor’s WFOE Purchaser’s Considerations: 1. Advantages Saves time in establishing manufacturing operation No tax claw back in respect of past manufacturing tax holidays Original WFOE’s Capital Gains tax likely minimal as limited fixed assets for sales operation 2. Issues to consider Increased Purchase Considerations – Sale proceed (from sale of Sales Operation to new WFOE) may be trapped in the existing WFOE (to the extent not repatriated before sale) Indirect taxes still applicable but again minimized as limited fixed assets being transferred Vendor Purchaser WFOE New WFOE $ M S $

83 Case Study 3 Divesting Part of the Business
Share Sale – Acquisition of Vendor’s WFOE Purchaser’s Considerations (Cont’d) 3. Issues to consider Severance payment on transfer of employees from existing WFOE:- local employees expatriates Lease – sub-lease or split leases? Assumption of past liability WFOE $ New WFOE S M assets Transfer of employees, etc.

84 Case Study 3 Divesting Part of the Business
Share Sale – Acquisition of Vendor’s WFOE Vendor’s Consideration Capitalization of New WFOE must be sufficient to (i) pay for purchase consideration and (ii) operate the New WFOE after closing Business scope of New WFOE – need to ensure business scope covers the activities anticipated by New WFOE (e.g. Wholesaling, Sales Consultancy) Continuity – need to ensure that the customers of existing WFOE are transferred to New WFOE with minimum disruption (change of address, name, bank account details, etc.) Vendor Purchaser WFOE $ New WFOE M S Transfer of assets, employees and lease

85 Case Study 3 Divesting Part of the Business
Share Sale – Acquisition of Vendor’s WFOE Tax Considerations Withholding tax on capital gains on sale of original WFOE Capital gains tax on assets sold Turnover taxes Vendor Purchaser WFOE $ New WFOE M S Transfer of assets, employees and lease

86 Case Study 3 Divesting Part of the Business
Share Sale - Division of WFOE Original WFOE is divided into two WFOEs, one holding Sales Operation and the other holding Manufacturing Operation Purchaser then acquires WFOE with Manufacturing operation Vendor Purchaser HK PRC WFOE S M Division WFOE New WFOE S M

87 Case Study 3 Divesting Part of the Business
Share Sale - Division of WFOE Purchaser consideration: 1. Advantages responsibility of divided WFOE for original WFOE’s liability is clearly set out in division agreement 2. Issues to consider Time consuming (approval) Vendor Purchaser HK PRC WFOE S M Division WFOE New WFOE S M

88 Case Study 3 Divesting Part of the Business
Share Sale - Division of WFOE Vendor’s consideration: 1. Advantages No additional cash outlay to set up new WFOE Sales proceeds not trapped (a) Division can be carried out at cost (b) BUT details of tax consequences of division currently undertaken – new M & A Tax Rules pending 2. Issues to consider Subject to Approval (uncertainty in time and execution) what if the deal falls through after division? Vendor Purchaser HK PRC WFOE S M Division WFOE New WFOE S M

89 Case Study 3 Divesting Part of the Business
Share Sale - Division of WFOE Tax considerations Will existing manufacturing tax holiday continue? Acquisition of divided New WFOE – Capital Gains Tax Transfer taxes? Vendor Purchaser HK PRC WFOE S M Division WFOE New WFOE S M

90 Case Study 4 Crisis Management

91 Case Study 4 Crisis Management
Problems joint venture partner employees creditors documents/chop

92 Case Study 4 Crisis Management
Joint Venture Partner No Agreement special liquidation arbitration clause courts

93 Case Study 4 Crisis Management
Employees Agreement labour department employee committees/representatives local government officials SAFE No Agreement claims production disruption police/public disturbance personal safety of management

94 Case Study 4 Crisis Management
Creditors Agreement SAFE local government officials No Agreement assets seized claims bankruptcy eviction by landlord production disruption unsavory elements personal safety of management

95 Case Study 4 Crisis Management
Documents important/sensitive documents accounting records audited accounts cheque books customs handbooks business license/permits/approval certificates etc sales contracts/employment contracts removal/safe keeping Chops

96 THANK YOU.

97 Do you have any questions?
Q&A SESSION


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