China’s online game market in 2008 created a 20.8 billion yuan revenue, representing an increase of 52.2 percent over the previous year. More than 80% of the income were from the participation of large-scale multi-player online games, the rest of the games were from the web page games and mobile games. In the next five years, the entire gaming market is expected to be at an average annual growth rate of 20 percent. iResearch estimated that by 2012 China’s online game market scale will be more than 68 billion yuan, accounting for nearly half of global market share.

iResearch report showed that, at present, the United States, China and South Korea are the world’s top three online games market, occupying 29%, 27% and 21% market share respectively. China has a huge group of online game players, the number is still growing, which will further promote China’s online game industry. According to the latest data released by China Internet Network Information Center, China currently has 55.5 million online game players.

Your decision here will depend upon instructions from your parent company overseas, however there are a number of tax-related factors to bear in mind. This article first introduces the procedure that must be followed when declaring dividends and the extra steps necessary if funds are to be reinvested. It also covers the incentives available to investors either re-investing funds into their existing Chinese entity or another operation in the country.

Repatriation of profits from China is of course preferable if your organisation requires the funds for re-investment abroad, or to return to the shareholders.

The process for declaring dividends and repatriating funds

1. First of all the amount of funds available must be confirmed. The fourth quarter?s Foreign Enterprise Income Tax filing for 2006 will need to be made in the first two weeks of January 2007 (China having a calendar fiscal year), and after this an annual audit must be carried out. (explained elsewhere in this month?s China Briefing). The annual clearance process reflects the results of the audit on the accounts, and this is submitted to SAT for approval.
2. Assuming there are no problems with the submitted documents, SAT will issue a tax receipt confirming the final amount of FEIT payable.
3. With this figure defined, the profits tax payment for 2006 can be completed and the net profit figure derived.
4. Not all profit can be repatriated or reinvested. A portion of the profit (which must be at least 10% for WFOEs) must be placed in a fund reserve account. This is treated as part of owner?s equity on the balance sheet. This account is capped when the amount of reserves equals 50% of the registered capital of the company. In addition the investor may choose to allocate some of the remainder to a staff bonus/welfare fund or a development fund, although these are not mandatory for Wholly Foreign Owned Enterprises.
5. The remaining balance is available for redistribution. Firstly, a resolution of the Board of Directors to authorise such redistribution must be signed by each director, and translated into Chinese.
6. Then an application form supported by the following documents (all in Chinese) must be submitted to SAT :

   • annual audit
   • capital verification report
   • annual clearance report
   • quarterly FEIT filings
   • tax receipts proving FEIT payments have been made in full
   • bank and general details of the Chinese entity and entities receiving funds

7. SAT will review all these documents to check that everything is legitimate and issue an Evidence of FEIT Payment certificate.
8. This certificate authorises the bank to disperse funds as detailed on the certificate.

Some of these documents need to be provided by your licensed CPA firm in China (such as the capital verification report) and as the documentation can be awkward to manage for businesses overseas it is usually part of the role of the company’s accountants to assist with the repatriation process and ensure transparency at all stages in the transaction. There have been cases of company employees arranging to have profits distributed elsewhere and then disappearing.

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Luckily, the authorities do try to make it is easy as possible for you ? you can either submit your details via the internet, or by going to an office where officials from a total of seven different agencies come together temporarily for this process.

These seven agencies are (almost) the same as the ones to which you have to submit your audited accounts :

• the Bureau of Foreign Trade and Economic Co-operation (BOFTEC)
• the Administration of Industry and Commerce (AIC)
• the Economic Committee
• the Financial Bureau
• the State Administration of Taxation (SAT)
• the State Administration of Foreign Exchange (SAFE).
• China Customs

The procedure for the annual co-operative examination for FIEs is as described below

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The information below is limited to RO who are expenses-based taxpayers (the major category for ROs).

• cash ? are your bank statement and bank reconciliation correct ?
• foreign currency issues – is the transaction rate entered correctly ?
• fixed assets purchasing ? has it been recorded into expenses ? If not, has it been approved by the tax authority ?
• fixed asset disposal gain/loss ? is it recorded into expenses ?
• funds from the parent company – are these consistent with the parent company?s records ?
• interest income/expenses – have they been identified in the expenses report correctly ?
• expatriate Individual Income Tax ¨C for high level management, such as the Chief Representative, has the IIT calculation and pertinent rate been correctly assessed ?
• audit fees – have the audit fees been accrued and separately entered ? Are they listed in the expenses report ?
• rental expenses – have the rental expenses been accrued and separately entered ? Are they listed in the expenses report ?
• employer contributions to overseas social security plans – If employees are involved in overseas social security plans, has this payment has been included into the expenses report ?
• expenses paid on behalf of the head office – the local tax bureau may require such expenses to be recorded into the expenses report.
• BT and FEIT payments – these tax payments should be excluded from expenses report.
• stamp duty – is the RO subject to stamp duty ?
• unofficial Invoices (fapiao) – has the RO received unofficial invoices (non VAT) as part of its expenses ? If so this can be subject to tax penalties.
• business licenses and related administrative matters – the annual renewal of all of your licenses such as registration certificate, tax licenses and so on (see also separate article in this issue)
• local employees registered with FESCO and valid work permits for expatriate staff – has all this been completed in accordance with the pertinent regulations ?

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Adjustments for foreign related payment income
If the foreign company has paid any overseas insurance for their expat employees, it should be noted that this is not tax deductible unless it is recorded as a salary payment and with IIT paid. Foreign sourced income should be provided for by providing evidence of foreign taxes paid with the relevant foreign documentation. Otherwise, foreign taxes may be accrued by the FIE.

Related party transactions
If your FIE had any transactions with related parties, you must make sure that these were at arm?s length and with adequate documentation to substantiate the charges/income, so that the results were not materially affected by related party transactions that were not in the ordinary course of business. Pay particular attention to transfer pricing issues. Tax officials reserve the right to adjust transfer prices, interest charged by related parties based on market prices or even based on prescribed profit margin.

Withholding obligations
If the FIE made or accrued in its costs or expenses any payments, such as rental (including office and expat housing), royalty charges, interest, services or management fees for services performed in China by foreigners (individuals or organisations), pursuant to related contracts and agreement, the relevant withholding obligation should be provided for on an accrual basis. This means 10% withholding enterprise income tax and 5% business tax apply (the tax rate might be different according to each individual case). All the charges shall be accompanied by substantial evidence, otherwise they are not deductible. All the above debts in foreign currency also need to be registered with the SAFE prior to approval for remittance.

China uses a calendar fiscal year to impose statutory audits, so those for 2006 are nearly due and must be filed by April 2007 at the latest. So you have about three months to get everything prepared, organized, audited and presented to the government – the clock is ticking !

These statements will be used for calculating the FIE?s taxable and distributable profit. Thus, an annual audit by a firm of Certified Public Accountants registered in the PRC is required under Chinese law.

FOREIGN INVESTED ENTERPRISE ANNUAL AUDIT REQUIREMENTS 2007

AUDIT REQUIREMENTS FOR WHOLLY FOREIGN OWNED ENTERPRISES, FOREIGN INVESTED COMMERCIAL ENTERPRISES AND JOINT VENTURES IN CHINA

[ By Edward Ma, Manager, Dezan Shira & Associates Beijing office ]

Broadly, the audit system for foreign businesses in China operates as described below, apart from some minor regional differences in audit practice for WFOEs and Joint Ventures that we will identify.

National Audit Principles
In China, the following audit requirements exist :

• submission of the Audited Financial Report
• the Foreign Exchange Audit Report
• the Annual Report

These need to be prepared and submitted to seven different government departments, namely the Bureau of Foreign Trade and Economic Co-operation (BOFTEC), the Financial Bureau, Customs & Excise, the State Administration of Taxation, the local tax bureau, the Administration of Industry and Commerce (AIC), and the State Administration of Foreign Exchange (SAFE).

FIEs may also need to submit to both the national tax bureau and local tax bureau the Annual Taxation Consolidation Reporting Package, authorised by a CPA firm by the end of April 2007. In this reporting package, a CPA firm shall verify all the taxes including VAT, Business Tax, Consumption Tax, Foreign Enterprise Income Tax (FEIT), and other taxes on the basis of the audit result.

The FEIT is obviously the most important issue to be disclosed in this report. The related taxable elements, and in particular items involved in FEIT such as income, cost and expenses, are specified in detail, while the auditing firm shall make the FEIT reconciliation between financial profit and taxable profit in accordance with PRC FEIT regulations.

If the audited taxes are different from the taxes paid by the FIE, the FIE shall discuss the variation with the tax bureau. For example, should the audited tax figure be lower than the figure paid, the FIE will need to apply for a tax rebate or tax reduction for the fiscal year in question. Accordingly; should the audited tax figure be higher than the paid FEIT, once the FIE submits the report, it would have to pay the balance due to the tax bureau. Your auditors should be competent to handle such rebate issues.

Additionally, there are some regional reporting variations.

FIEs in Shenzhen
Shenzhen FIEs are exempted from the requirement of providing an additional Annual Tax Final Declaration Report authorised by a local CPA firm to tax bureaus, although authorities in other Pearl River Delta cities do require it.

And similar to the situation in Shanghai, FIEs in Shenzhen need to complete the annual audit and obtain two auditor reports, a general one and one addressing foreign currency issues. Only after the local CPA firm has performed the audit for your FIE can you submit the documents to the seven government authorities. All submissions should be completed before the end of May 2007.

Furthermore, as part of year end closing formalities, FIEs also need to complete the final EIT declaration and final VAT ?exemption, reduction, refund? declaration in order to satisfy the tax bureau?s requirements.

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Thus far, there are no regionally specific investment incentives available to foreign investors in Central China that are not already generally available on a national basis. Although it may be possible to negotiate preferential treatments for larger investments, Central China as yet does not offer any specific tax breaks for investors to assist with the absorption of the higher costs of transportation in the region. The authorities are however considering what additional incentives might be offered in the future.

BASIC ANALYSIS

Obviously there is a lot of difference between types of international investor, and this piece is non-specific. For retail operations such as Wal-Mart and so on, the region, with its massive population, is going to be (and already is) a fertile playing ground. International commodities manufacturers such as Mittal Steel, ensuring its dominance over global steel supply, have made a strategic investment in the region of one of China’s largest steel manufacturers. In time, businesses supplying such industries may begin to enter the central China market. Yet for export-based businesses, central China, with its burden of increased transportation costs, still seems like a bridge too far until competition, a breaking of existing monopolies, and an increase in transportation infrastructure can start to bring those costs down. This would appear to be a longer goal target. Of the cities and regions to note, two strike us as being worth further investigation :

Hefei (Anhui Province), and its proximity to the regional powerhouse of Shanghai may be worth looking into as a manufacturing area if those logistics costs can be brought under control, and Wuhan, with its river infrastructure. But for now, with no discernable benefits available for investing in the region, China’s desire to move investors out of the coastal cities and inland will have to wait a little while longer and move beyond a pure marketing campaign into something more financially viable.
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The remaining 30% is often somewhat industry-specific and we leave this portion open for your specific analysis. Operational overheads such as utilities also vary, however not to a huge extent between first and second tier cities, accordingly we have disregarded them from this survey. However, concentrating on the two most significant manufacturing overheads ? albeit as a mean average, does allow us to fix at least a line in the sand to try and weigh up the pros and cons of investing in Central China. Averages are just that ? and it must be pointed out that in reality you can expect about a 30% swing in costs either way depending upon location, specific investment circumstances and the power of negotiation.

To get at what this could mean for an investor, we?ve assumed an average small scale foreign invested enterprise as an example, and for the sake of calculating a reasonable export amount, suggested an auto component manufacturer as this industry is relatively commonplace and is China wide. We have assumed a factory unit size of 2,500 sq meters and 100 staff to base our cost analysis on. A factory like that with such a product could typically export about 10 containers a week. Taking the figures we have thus far, and converting them to USD for ease, (rate of 8 RMB to 1 USD) we can reach the following assumptions :

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Foreign investors should also be keeping an eye on such developments. As the coastal regions and cities get more expensive, pure economics encourages savvy international investors to look inland in order to both reduce costs and develop new domestic markets. Many are already there ? and prospering. But what are the demographics of central China ? Where are the places to look out for ? What risks are there ? And what incentives exist ?

The Go Inland Campaign
As an official initiative, for central China, this project includes the six provinces of Anhui, Henan, Hubei, Hunan, Jiangxi and Shanxi. This area comprises a population of some 361 million people over an area of 1.028 million sq km. If it were a country in its own right, it would be the third largest in the world after China and India, while the population is the same as Indonesia and Japan combined. It includes 30 airports, 12 inland ports capable of handling up to 10,000 tonnage berths, 460,000 km of highway (about double that of Germany), and approximately 15,000 km of railway (about the same as the UK). Collectively, the region imported some USD21.6 billion worth of goods in 2005, and exported some USD27.8 billion worth of products.

Why Go Inland ?
There are two essential drivers : economics, and opportunity. Let’s look at these separately and consider the balancing factors.

ECONOMICS ? LOWER OPERATIONAL COSTS INLAND ?
The argument, simply put, goes that China’s main commercial centres on the coast, such as Beijing / Tianjin, Shanghai and the Yangtze River Delta and to a smaller extent the Dalian / Qingdao corridor, are getting more expensive. The cost of land and labor is increasing, and this trend shows no sign of changing. However, it is also true that for export-biased businesses, proximity to a port is a major advantage that going inland is going to start to eat into in terms of increased transportation costs. The main debate here then is a pure trade-off between the costs of land and labor, the predicted trend for these, and the comparisons between China’s coastal cities and those further inland. Balanced against this must be the additional logistics cost of getting product out of central China and to a port.

Taking the first-tier cities of Beijing, Shanghai and Guangzhou as benchmarks, we can compare the current legally permissible minimum salaries payable in these cities, and the capital cities of each of the six inland provinces and start to draw some conclusions. These statistics are courtesy of Dezan Shira & Associates National Investment Intelligence Unit.

To know more, the whole issue is available (after a free subscription) on China Briefing website with others archives
For more information on China’s legal and tax issues or to ask for professional advices in related matters, please write to info@dezshira.com