Choosing the Right Sourcing Model in China

By Cory Lam

Posted: 2nd July 2013 08:25

It can often be difficult for companies (particularly those new to China) to decide on the optimal solutions needed to support their mainland sourcing activities. With so many quality control and trading agents available offering one-stop sourcing services and B2B online platforms that allow direct contact with suppliers, many will argue that it could be just as effective to utilize a subcontracting agreement and intermediate parties to get the job done.
 
Although this can be true and is a perfectly workable option in certain cases, to be more competitive within the global supply chain, many SMEs now require an on-the-ground presence either to gain better control of their supply chain, or to be able to continue servicing their international customers who have also entered the China market.
 
Therefore, to select the most suitable business model, it is important to carefully balance the capability of each option against the primary needs of the sourcing activities. For example, foreign SMEs that consider China an unknown market may prefer the low capital risks associated with a representative office. Alternatively, the wider business scope and operational flexibility that a service company or a foreign-invested commercial enterprise (FICE) offers may also be tempting. However, while an overseas company that has been purchasing directly from China for many years may wish to take full control of the supply chain through a FICE, they may also be deterred by the heavy operational complexity of such an entity – a FICE involved in exporting goods is directly involved with China’s complex VAT system and has to comply with customs requirements.
 
Below, we address some of the common concerns facing foreign buyers that are choosing a formal structure in China, and compare the operational differences between the structures.
 
Balance between registered capital and business scope

Many traditional buyers tend to lean towards the RO structure, purely driven by the preference of not having to inject registered capital into China. For this reason, the RO structure is often recognized as the “safe” and “cheap” model, and the best option for a China office whose primary purpose is to explore market possibilities and help get the overseas head office more value for their purchases.
 
For ROs, expenditures are funded directly by the overseas headquarters at regular intervals, typically on a monthly or quarterly basis. For a service company or FICE model, most of this funding would instead come from the registered capital, which is committed right at the beginning. Registered capital in China is therefore different from the concept of share capital in the West. Instead of an amount that is set aside for statutory purposes, registered capital can actually be used for ongoing operational expenses and is much closer to the definition of working capital.
 
Moreover, the costs of financing the ongoing activities of an RO are very different than a service company or a FICE, since the RO will be taxed on top of expenses while the service company and FICE will deduct costs and pay tax on profits. Consequently, the perceived flexibilities offered by the no-capital RO structure may only apply when the RO’s business scope is sufficient to satisfy the expansion activities of the China office on an ongoing basis, keeping in mind the high cost of financing.
 
With this in mind, companies are advised to consider at least their short to medium term strategy for the China market – the expected expenditure level and desired scope of expansion for the next few years should be fully evaluated. In fact, a large proportion of companies who are ready to undergo formal registration in China may already be familiar with the market and its suppliers, and many would have already established stable relationships with their Chinese suppliers or have been operating on an “informal” basis in the country over the years. If this is the case, the added benefits of a wider business scope provided by a service company or FICE could prove much more valuable and self-sustainable than the traditionally “safe” and “cheap” RO.
 
For these businesses, usually a FICE model is preferred since this structure allows for the widest possible scope for sourcing (including import/export, the ability to make domestic purchases in RMB, wholesale, retail, e-commerce, provision of related services, etc.). In China, many smaller domestic suppliers are also far less willing to transact in foreign currencies, so sourcing through a FICE structure will effectively broaden the selection of local suppliers since the company will be able to buy in China in RMB before consolidating and exporting. Since the business scope is wide, the level of acceptable registered capital required by the Chinese authority will be higher than that for a service company (typical minimums vary depending on location).
 
The service company model also has its own merit, and may be more suitable for companies who want a simpler model going forward. Since the service company cannot trade products directly, the compliance involved is generally quite low and it can also play the part of the intermediate quality control and service agent for the HQ. Although the same effect can be achieved with an RO, this model does have the added capability to receive commission or other service revenues in RMB. For example, it may be a benefit for some hi-tech industries to have the ability to provide technical services to their customers. As such, this model can be more tax efficient than an RO.
 
Supply chain control vs. HR risks

To obtain a comfortable level of control and assurance over the quality and delivery of products, ideally foreign buyers would need to employ reliable staff on the ground to manage quality control, supplier liaison activities, price negotiations, supplier selection and market research. As Chinese markets mature and price competition intensifies, foreign companies not yet in China will need to continually assess whether it is still affordable to function via long-distance relationships with their Chinese suppliers, or whether more substantial operational control is needed to ensure that competitive pricing is achieved. In particular, adequate control of local HR risks is usually one of the main concerns for companies hoping to strengthen their supplier networks in China.
 
Strictly speaking, the Chinese government does not allow foreign companies to operate or to hire locally-based employees without a legal establishment in China. Examples of practical barriers enforced by the Chinese authorities include the fact that expatriate employees are not able to obtain the correct work permits to live and work in the mainland legally unless there is a local entity available to act as sponsor and, for Chinese staff, foreign companies will not be able to formally make mandatory social welfare contributions for its employees, thereby limiting the selection pool of qualified Chinese candidates willing to be employed in this way. There are also some legal and tax risks to both the employer and employees in operating without a local entity – for further details please see the May 2013 issue of China Briefing Magazine, “Understanding Permanent Establishments in China.”
 
The RO, service company and FICE structures can all be used to hire local employees in China, although there are some limitations for ROs. For senior level Chinese staff, there is a general perception that direct employment relationships are more stable and provide additional security. For many companies in the sourcing business, the model may also require staff to be based at multiple locations around the country (e.g. on site at the factory, travelling for quality control purposes, or short term supervision projects). Since the Chinese social insurance system is still managed on a regional basis by the government and since contribution rates and local practices can differ across cities, making cross-province social insurance payments for employees or keeping on top of the changing regulations in each region can become a headache for the employer. These types of practical issues must be fully addressed before committing to the appropriate structure.
 
Complexity, compliance and tax efficiency

The changing globalization trends in procurement processes and the growing competitiveness of other supplying nations means that the FICE model has become much more pertinent, as it allows for two-way traffic in both the inbound and outbound sourcing of products. For example, many SMEs use China as a procurement hub to consolidate regional sourcing activities within Asia, since China’s infrastructure is generally recognized to be more developed and more efficient than countries such as India, Indonesia or Thailand. The FICE model also makes it possible for companies to explore the potential to adapt their products or services for domestic consumption. It is very common for foreign companies that have been sourcing through a FICE for a few years to restructure in order to catch the opportunities offered by the local market. An initial sourcing platform, established as a FICE, might in this case become the perfect starting point to begin wholesale, and maybe retail, activities in China.
 
However, it should be noted that with the added flexibility and complexity of a FICE, the operational and tax compliance requirements are also therefore higher than the other two models. Applying for VAT export rebates, ensuring that VAT fapiaos are all received and verified, managing invoices issued and VAT deductions, warehouse and inventory control, dealing with customs and import duties for all products, keeping track of logistics – these all become the FICE’s responsibility once a direct sourcing model is employed. Competent internal staff, as well as the support of reliable external consultants are key in establishing a successful business.
 
Remaining tax compliant is also important because Chinese authorities tend to keep a closer eye on the activities of foreign companies. Therefore, foreign companies should note the different types of taxes and filings that can apply for the various trading, commission and service activities. From a transfer pricing point of view, statutory filings will need to be completed each year to disclose the sales activities between the company and its headquarters.
 
Conclusion

The optimal choice of structure really comes down to two key factors: local hiring needs and cost-effectiveness. If it is not a requirement to have employees based in the mainland, then dealing from overseas is likely to be the most tax efficient option for SMEs sourcing from China. However, this approach also has the highest risks in terms of quality and price control. If employees are needed on the ground, then (assuming that the total number of employees needed is still relatively low) an RO becomes a very relevant structure due to its simplicity and low compliance requirements.
 
For companies that need more from their China office, the FICE model would generally be the best option for businesses that are focused solely on sourcing activities as it offers the greatest potential to maximize supply chain control and minimize risks. The service company model is not as useful in this regard, however it can still be a good interim solution for companies that are not yet ready to tackle the Chinese VAT system and other operational compliance requirements.
 
Once again, there is no single successful sourcing strategy, and your business can be structured as simply as an RO or as elaborate as a multinational sourcing plan that uses a combination of the abovementioned legal structures. For many SMEs, the latter option will not be possible due to limited resources, so the most appropriate strategy may be a progression between the different models over time. Regardless of the strategy, to ensure that the chosen structure adds sufficient value, HQs will need to regularly monitor the performance of their sourcing offices and continually develop existing and new supplier sources to remain competitive.
 
This article was first published on China Briefing.
 
Dezan Shira & Associates is a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in emerging Asia. Since its establishment in 1992, the firm has grown into one of Asia’s most versatile full-service consultancies with operational offices across China, Hong Kong, India, Singapore and Vietnam as well as liaison offices in Italy and the United States.
 
For further details or to contact the firm, please email info@dezshira.com or visit www.dezshira.com.

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