One of the most challenging elements for foreign investors to manage their Chinese operations is to ensure sufficient and appropriate funding of your business in China. Improper strategies to financing your business can result in missed business opportunities and improper financial planning can further create an inability to ensure liquidity and proper cashflow of your Chinese subsidiary.
The Chinese government implements strict rules and regulations to financing a company, especially with regards to cross-border financing of a Chinese subsidiary. However, this does not mean it is impossible for foreign businesses to fulfill their financing needs in China. In this article we will set out the 4 main ways foreign investors can use to finance their business in China.
As different companies will have different financial needs, depending on the specific phase of operations the company is in, solid financial planning is of vital importance. The importance is especially evident during the start-up phase, to ensure the appropriate amount of funding is available. As such, we highly recommend foreign companies to carefully assess the available methods to finance their China operations during the pre-establishment- or early life cycle phases.
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Through Registered Capital in China
When registering a company in China, foreign investors must define and register the subsidiary’s total investment and registered capital. Here the total investment refers to the total amount of funds which the investor requires to realize the company’s productions or operations, and includes both the registered capital and the so-called ‘financing gap’.
On the other hand, the registered capital refers to the total amount of equity or capital contributions which the shareholders intend to contribute to the Chinese subsidiary. For a further overview on the difference between registered capital and total investment, please refer to our article.
In terms of funding a company in China, the registered capital offers investors an opportunity to finance their Chinese operations, particularly in the start-up and initial phase of their existence. The registered capital can be used to fund a Chinese subsidiary during this initial phase and can be used to pay for rent, salaries, materials and other items until the company is able to generate sufficient cash reserves to finance its operations independently.
Using registered capital to finance your China business has several advantages and disadvantages, namely:
+ Registered capital is virtually a tax-free financing contribution, with only stamp duty tax being applicable.
+ Apart from China’s capital conversion regulations, registered capital is administratively not as complex as loans to execute.
– Usage of registered capital is regulated by China’s foreign exchange regulations. As a result, capital must first be registered and cleared, after which it usually needs to be converted to RMB in order to finance a Chinese subsidiary, increasing administrative compliance costs.
– There are limitations to the type of payments for which registered capital can be used and SAFE regulations require banks to take stock of these type of payments, meaning the company must provide proof for which it has used capital funding or has to provide such proof in advance.
– One of the few methods by which investors can recuperate the benefits of their investment of registered capital is via future profit distributions (e.g. dividends).
It is common for registered capital to not cover a company’s financing needs in the long-term and once the registered capital is fully used up a company must turn to other methods to fund their China operations (e.g., through loans, revenues or via banking solutions). Investors can also resort to a capital increase, enabling the investors to brink in more funds into China by way of registered capital, but the process involves several applications with government authorities and may take up to 1-1.5 months to complete in the worst case scenario.
Different Types of Loans in China
Another method to finance your China business operations is by acquiring an intercompany loan or by borrowing from Chinese or international institutions. However, the amounts which can be obtained via a loan in China are highly regulated depending on the chosen method.
Intercompany Loans
The first option is for a company within the company’s group, generally speaking the shareholder, to grant a loan to the China subsidiary for funding of its operations. In China, there are two methods used for investors to finance their China operations via a loan:
- The ‘Financing Gap Method’, where the financing gap is the difference between the registered total investment and the company’s registered capital.
- The ‘Net Asset Method’, which is a macro prudential method by which a Chinese subsidiary can borrow a maximum of two times the value of its audited net assets.
For both methods there are several requirements that must be fulfilled before a loan for a Chinese subsidiary can be granted, such as the signing of a loan agreement (with interest rate in line with the PBOC policy and specified duration/repayment terms), filing of an application with the relevant authorities and the opening of a special loan bank account. In our full article on the topic of intercompany loans in China you can read more about these requirements.
Bank Loans
Another option for a Chinese subsidiary to attain a loan is from a banking or other financial institution. Whereas several Chinese banks offer the opportunity to borrow money to foreign-invested firms in China, it is generally difficult for foreign companies to acquire the required funding from Chinese banks due to the limited knowledge from the bank of the company in question and the collateral available.
Instead, most foreign invested companies generally turn to their home country or international banking partner to fund their China operations via bank loans. The options for foreign investors to borrow funds via a loan from a bank or financial institution include:
- Entrustment loan.
- Loan under guarantee.
As can be observed above, loans offer an alternative option to financing a Chinese company but are still characterized by several advantages and disadvantages, including:
+ A loan is only a temporary financing method and funds must be returned to the headquarter or borrower and thus the headquarter does not have to commit funds that will remain in China indefinitely.
+ The headquarter could earn interest on the provision of a loan, which can be considered a method of profit repatriation.
– The application procedures to file for a loan with the Chinese authorities and opening of bank accounts make a loan administratively complex.
– Interest charges from a headquarter to its Chinese subsidiary are taxable under Chinese law.
Intercompany Revenue Structures: Cost Plus, Commissioning & Prepayments of Goods
An often-overlooked method in the initial phase for foreign investors to finance their Chinese operations is through intercompany financing in the form of charging service fees or related charges. Such charges often occur in the form of a cost-plus agreement or commissioning scheme, whereby the Chinese subsidiary invoices the headquarter for services it provided such as sales support, business development or representation of the group.
Additionally, for these intercompany service fee structures it is important to note that the company must have in place the relevant documents and materials, and follow the proper administrative procedures, in order to receive such funds. For example, a company will need to have in place the relevant contract and invoicing scheme to support their claim of the provision of the relevant services and release funds from their bank accounts.
A temporary financing solution for companies engaged in the sourcing and exporting of goods and materials is the prepayment of these goods. Whereas normally companies are required to provide proof of the export of goods/materials in order to receive payment for exported goods, in case of a prepayment the company would need to provide at the moment of receipt of funds additional materials explaining the prepayment and must still at a later stage after exporting of products provide relevant customs declaration forms.
A further complication for the use of prepayments is that the Chinese State Administration of Foreign Exchange maintains a record of the total flow of funds and goods (value) internationally and will match both on an annual basis, where in case of large discrepancies between both figures due the usage of prepayment the company may face further enquiries from the in-charge authorities.
Banking Solutions
Lastly, in addition to the provision of loans, both local and international banks offer various other financing solutions such as trade financing, the issuance of letters of credit and more. For more information on this matter, you can review the options with your banking partner to compare the available solutions.
Our Thoughts
Proper allocation of finances for your Chinese subsidiary is vital for successfully starting and sustaining a business in China. In this regard it is essential that investors not only consider the current financial needs of their Chinese business but also consider its long-term group strategic plans and role of the Chinese subsidiary therein.
For a proper assessment of the available methods to fund a Chinese business, foreign investors should familiarize themselves with Chinese business practices and take into consideration the relevant expenses that could occur in various stages of their operational lifecycle, such as rent, salaries, social insurance contributions, customs duties, direct and indirect taxes, logistics and marketing costs among others.
At MSA we have advised our clients for over a decade on the proper methods to finance their Chinese operations and have support with the relevant application procedures and formalities to ensure compliance with Chinese legislation.
