From contract processing to import processing tax and regulatory concerns

Transcription

1 From contract processing to import processing tax and regulatory concerns Traditionally, contract processing arrangement (CPA) (!) has been a common practice adopted by foreign companies whereby a domestic Chinese manufacturer is engaged to carry out export processing activities. Under a typical CPA, a foreign party will provide the processing factory with raw materials and equipment for the production of finished goods for export. The processing factory then receives a processing fee in return for providing the export processing services to the foreign party. Over the past few years, foreign companies have taken an increasing interest in converting their existing CPA into an import processing arrangement (IPA) (!). Under the IPA, the foreign company will set up a foreigninvested production enterprise (production FIE) to carry out production activities. The production FIE is equipped with the trading right to import raw materials from and export the finished goods to the overseas investor. By converting into an IPA, a foreign company will be able to achieve effective management control over the entire production process and pave the way for entering the domestic market which is otherwise not accessible under a CPA. While it becomes increasingly attractive to adopt an IPA to carry out production activities in China, there are a number of tax and regulatory concerns that may require serious consideration by foreign companies in order to achieve a smooth migration from CPA to IPA. This article intends to draw the attention of foreign companies to specific issues that are worth noting before they proceed to adopt the new production arrangement. Income tax and VAT effect Hong Kong companies in general would be able to qualify for the 50:50 offshore claim under the CPA whereby only 50 per cent of the trading profits derived is subject to profits tax in Hong Kong, i.e., an effective income tax rate of 8.75 per cent. By converting into an IPA, a Hong Kong company may lose the 50:50 offshore claim and 100 per cent of the trading profits would be subject to profits tax. The additional tax cost borne by the Hong Kong company may be alleviated by tax savings as allowed under the 2-plus- 3 income tax holiday, i.e.,two-year full income tax exemption and three-year 50 per cent reduction, granted to the production FIE. However, it should be noted that the income tax effect for individual companies may vary and the management should perform a tax cost evaluation for the purpose of effective tax planning. Due to the reduction in the export VAT refund rate earlier this year, companies also need to consider the VAT effect of such reduction for assessing the cost and benefits of the migration. Transfer pricing concern Under a typical IPA, the foreign investor is usually the major supplier and buyer of the production FIE. Such inter-company sales and purchases would be regarded as related party transactions by the PRC tax authorities to trigger transfer pricing exposure if they are not conducted on an arm s length basis. In an extreme case, the production FIE may be required by the tax authorities to make an adjustment to the transfer price and profit margin of the related buy-sell transactions. As a result of the tax adjustment, the production FIE may be subject to additional income tax. To minimise transfer pricing exposure, transfer pricing policy in respect of the buy-sell transactions between the foreign company and the production FIE should be formulated and properly documented. Usually, this can be done by means of a functional analysis and benchmarking study on the functions and risks undertaken by the production FIE and its related parties. In fact a production FIE may take a more proactive approach by obtaining an advance pricing agreement from the incharge tax authorities regarding the transfer pricing policy. By doing so, the chance of a possible challenge from the tax authorities could be substantially minimised. Transfer of used equipment Normally, a foreign investor may consider transferring the equipment that has been previously used by the processing factory to the production FIE. If the foreign investor of the production FIE happens to be the foreign party of the original CPA, the bonded equipment used by the processing factory can be transferred to the production FIE without undergoing any export and re-importation procedures. However, such kind of equipment transfer is subject to the approval of the PRC Government authorities on completion of a series of statutory compliances. Prior to effecting the transfer, the production FIE should obtain clearance from the relevant Commodity Inspection and Quarantine Bureau (CIQB). It should be noted that the transfer of some of the used equipment may not be allowed by CIQB if they are unable to meet the safety and environmental standards in accordance with the PRC regulations. Another statutory compliance for the equipment transfer is to obtain the relevant import permit from the local Commission of Foreign Economic Relations and Trade (COFERT). In the case of used equipment, the import permit can be obtained from the local Office for the Import and Export of Electric and Mechanical Products (!"#$% ). Apart from the above statutory compliance, another critical step for the equipment transfer is to obtain clearance from the relevant PRC customs. Usually, 54

2 this will be done by performing de-registration of customs supervision with the local customs. Generally speaking, the bonded equipment is subject to a five-year customs supervision period within which the transfer may attract claw-back of customs duty and import VAT based on the depreciated value in accordance with the PRC customs regulations. For equipment transfer that falls outside the five-year supervision period, there will not be any claw-back of customs duty and import VAT. One important rule to observe is that any transfer of bonded equipment should only take place after the equipment has been formally released from customs supervision as endorsed by the PRC customs authorities. The successful transfer of equipment will depend very much on the following two factors: 1. The completeness of the relevant customs records and supporting documents 2. The completion of the deregistration procedures Customs non-compliance may complicate the entire equipment transfer process at a varying degree depending on the nature of the noncompliance concerned. Rectification of the customs non-compliance may be necessary before the transfer can be smoothly implemented. Under the current PRC regulatory framework, tax-free importation of equipment is possible if the production FIE is able to satisfy following criteria: 1. The production FIE is of the Encouraged category in the Foreign Investment Catalogue; 2. The equipment is for self-use only; 3. The value of imported equipment falls within the total investment of the production FIE; and 4. The imported equipment is not on the List of Non Tax-Exempt Commodities for FIEs. Based on the above principles, it is possible for a production FIE to obtain tax exemption for the used equipment transferred from the processing factory as long as they can fully satisfy the aforesaid criteria. For those production FIEs that are engaged in projects under Permitted Category with 100 per cent of their products exported, they would also be eligible for tax-free importation of equipment but customs duty and import VAT will be collected upfront and refunded over a five-year period subject to its actual export performance and verification by the local COFERT and customs authorities. Transfer of inventory The processing factory may transfer the semi-finished goods and finished goods to the production FIE via a factory transfer arrangement. With the endorsement of the in-charge customs of both the processing factory and the production FIE, the processing factory and the FIE may prepare documentation to substantiate the transfer. Unlike semi-finished goods and finished goods, the transfer of bonded raw materials is generally not allowed. The bonded raw materials would have to be shipped to outside of China and reimported by the production FIE. Alternatively, the processing factory may simply complete the existing production contract and utilise all the bonded raw materials to save the otherwise cumbersome procedures of effecting the transfer. Transfer of employees Following the migration from CPA to IPA, many of the production FIEs may prefer retaining the workforce of the processing factory instead of recruiting new staff to kick off the production process. Such will require staff transfer from the processing factory to the production FIE by terminating the employment contracts with the processing factory and concluding new ones with the production FIE. By terminating the employment contract with the processing factory, severance payment to the local staff may be required in accordance with the PRC labour regulations. In order to minimise resistance from the local staff on the change of employer from processing factory to the production FIE, negotiation and thorough discussion with the local staff on the conversion plan may be necessary. The way forward In view of China s blooming economy and the rapid growth of its domestic market, more foreign companies are expected to undergo the migration from CPA to IPA in a bid to capture opportunities in the domestic market. Since the actual impact of the migration may be different for individual companies, it is highly advisable for foreign investors to perform an evaluation by taking into account those issues that are covered in the above paragraphs. The evaluation will enable the foreign company to have a more accurate assessment of the pros and cons of the migration and adopt the right strategy for effecting the change. JOYCE LAW, SENIOR MANAGER, SHIRLEY YU MANAGER, & CARRIE WONG, SENIOR CONSULTANT PRICEWATERHOUSECOOPERS 56

3 HKFRS 2, Share-based Payment Hong Kong Financial Reporting Standard (HKFRS) 2, Share-based Payment, requires an entity to recognise share-based payment transactions, including grants of share options to its employees, in its financial statements. HKFRS 2 applies to financial statements covering a period that begins on or after 1 January 2005 with earlier application encouraged. Measurement principles and specific requirements for three types of sharebased payment transactions are set out in HKFRS 2: Equity-settled share-based payment transactions, in which the entity receives goods or services as consideration for equity instruments of the entity (including shares or share options); Cash-settled share-based payment transactions, in which the entity acquires goods or services by incurring liabilities to the supplier of those goods or services for amounts that are based on the price (or value) of the entity s shares or other equity instruments; and Transactions in which the entity receives or acquires goods or services and the terms of the arrangement provide either the entity or the supplier of those goods or services with a choice of whether the entity settles the transaction in cash (or other assets) or by issuing equity instruments. The requirements are summarised below and in the accompanying road map. Equity-settled share-based payment transactions For equity-settled share-based payment transactions the HKFRS requires an entity to measure the fair value of the goods or services received, and the corresponding increase in equity, directly, at the fair value of the goods or services received, unless that fair value cannot be estimated reliably. If the entity cannot estimate reliably the fair value of the goods or services received, the entity is required to measure the transaction indirectly by reference to the fair value of the equity instruments granted. For transactions with employees and others providing similar services, the entity is required to measure the fair value of the equity instruments granted, because it is typically not possible to estimate reliably the fair value of employee services received. The fair value of the equity instruments granted is measured at grant date. For transactions with parties other than employees and those providing similar services, there is a rebuttable presumption that the fair value of the goods or services received can be estimated reliably. That fair value is measured at the date the entity obtains the goods or the counterparty renders service. In rare cases, if the presumption is rebutted, the transaction is measured by reference to the fair value of the equity instruments granted, measured at the date the entity obtains the goods or the counterparty renders service. For goods or services measured by reference to the fair value of the equity instruments granted, the HKFRS specifies that vesting conditions, other than market conditions, are not taken into account when estimating the fair value of the shares or options at the relevant measurement date. Instead, vesting conditions are taken into account by adjusting the number of equity instruments included in the measurement of the transaction amount so that, ultimately, the amount recognised for goods or services received as consideration for the equity instruments granted is based on the number of equity instruments that eventually vest. Hence, on a cumulative basis, no amount is recognised for goods or services received if the equity instruments granted do not vest because of failure to satisfy a vesting condition (other than a market condition). This approach is shown in the accompanying example. The HKFRS requires the fair value of equity instruments granted to be based on market prices, if available, and to take into account the terms and conditions upon which those equity instruments were granted. In the absence of market prices, fair value is estimated, using a valuation technique to estimate what the price of those equity instruments would have been on the measurement date in an arm s length transaction between knowledgeable, willing parties. The HKFRS also sets out requirements if the terms and conditions of an option or share grant are modified (e.g. an option is repriced) or if a grant is cancelled, repurchased and/or replaced with another grant of equity instruments. Transactions settled in cash or at either party s option For cash-settled share-based payment transactions, the HKFRS requires an entity to measure the goods or services acquired and the liability incurred at the fair value of the liability. Until the liability is settled, the entity is required to remeasure the fair value of the liability at each reporting date and at the date of settlement, with any changes in value recognised in profit or loss for the period. For share-based payment transactions in which the terms of the arrangement provide either the entity or the supplier of goods or services with a choice of whether the entity settles the transaction in cash or by issuing equity instruments, the entity is required to account for that transaction, or the components of that transaction, as a cash-settled share-based payment transaction if, and to the extent that, the entity has incurred a liability to settle in cash (or other assets), or as an equity-settled share-based payment transaction if, and to the extent that, no such liability has been incurred. Disclosure The HKFRS prescribes various disclosure requirements to enable users of financial statements to understand: The nature and extent of share-based payment arrangements that existed during the period; JULY 2004 THE HONG KONG ACCOUNTANT 57

4 How the fair value of the goods or services received, or the fair value of the equity instruments granted, during the period was determined; and The effect of share-based payment transactions on the entity s profit or loss for the period and its financial position. For more information The full text of HKFRS 2, Basis for Conclusions and Implementation Guidance for HKFRS are now available on the HKSA website at org.hk/professionaltechnical/ accounting/standards/ and have been published in the Society s re-launched Members Handbook on 1 June HKFRS 2 Road Map Introduction Summary of requirements Scope Goods/Services obtained in equity-settled or cash-settled share-based payment (SBP) transaction When either the entity or the supplier has the choice of equity-settled or cash-settled SBP transaction Includes SBP transactions between entity s suppliers and entity s parent entity or other shareholders Not include transactions with parties in their capacity as holders of equity instruments of the entity Generally not applicable to transactions under Business Combinations & Financial Instruments Standards Recognition Goods/Services recognised as assets or expenses, as appropriate, when obtained Corresponding increase in equity for equity-settled SBP transaction Corresponding increase in liabilities for cash-settled SBP transaction Equity-Settled SBP Measured fair value (FV) of the goods/services received typically for non-employees or measured Transaction FV (equity instruments) typically for employees Full amount recognised immediately if equity instruments have vested, otherwise over the vesting period Indirect method: FV (equity instruments) measured based on market prices, if available, or estimated using a valuation technique (with no account of vesting conditions) at the date of grant Take vesting conditions into account by adjusting the number of equity instruments included in the measurement Amount recognised in financial statements = Per unit grant date FV x Total instruments vested Modifications of terms: if FV of new instruments > FV of old instruments, incremental amount recognised over the remaining vesting period if FV of old instruments > FV of new instruments, original FV granted expensed as if modification never occurred Cancellation and Settlement: previously unrecognised amount expensed immediately. Associated payments made up to the FV accounted for as repurchase of an equity interest and any excess recognised as an expense Replacement: account for as a modification Cash-Settled SBP Goods/Services obtained, & liability incurred, measured at FV (liability) Transaction Liability remeasured to FV at each balance sheet date & settlement date with value changes recognised in Profit & Loss Supplier s Choice Compound financial instrument = FV (debt) + incremental FV (equity component) Debt component subsequently accounted as a cash-settled SBP transaction Equity component subsequently accounted as an equity-settled SBP transaction On settlement, remeasure liability to fair value if equity-settled, transfer liability to equity if cash-settled, cash applied to extinguish liability, equity component remains in equity Entity s Choice Treatment dependent on whether there is a present obligation to settle in cash. If yes, as cash settled SBP and, if otherwise, as equity-settled SBP If treats SBP as being equity-settled & ultimately settles in cash, payment treatment as if it is a repurchase of equity Additional expense recognised on settlement if elected settlement alternative with higher FV Disclosure Extensive disclosure 58

5 Example Equity settled share-based payment transaction Facts A company grants 10 options to each of 10 employees. The options vest at the end of three years. The fair value of each option at grant date is estimated to be $12, unadjusted for any potential forfeiture. At grant date it is expected that two employees will leave during the vesting period and therefore their rights to the share options will be forfeited. Accounting during the vesting period Scenario 1 If two employees do leave during the vesting period as expected, the amounts charged to the income statement over the three years are as follows: Year 1 = $320 [8 employees x 10 options x $12 x 1/3] Year 2 = $320 [(8 employees x 10 options x $12 x 2/3) - $320] Year 3 = $320 [(8 employees x 10 options x $ 12 x 3/3) - $320 - $320] $960 Scenario 2 During year one, two employees leave. The entity revises its estimate of total employee departures over the three-year period from two to three. During year two, a further one employee leaves. The entity revises its estimate of total employee departures over the threeyear period from three to four. During year three, a further two employees leave. Hence a total of five employees forfeited their rights to the share options during the three-year period, and a total of 50 share options (5 employees x 10 options per employee) vested at the end of year three. Based on the above, the amounts charged to the income statement over the three years are as follows: Year 1 = $280 [7 employees x 10 options x $12 x 1/3] Year 2 = $200 [(6 employees x 10 options x $12 x 2/3) - $280] Year 3 = $120 [(5 employees x 10 options x $ 12 x 3/3) - $280 - $200] $600 Accounting entries for each of the three years would be: Dr Expense (except to the extent that the employee s service can or should be capitalised under another accounting standard) Cr Equity (possibly an account called the Share Option Reserve Account an account that is not subject to statutory restriction and which is therefore capable of being considered as part of the company s distributable reserves) For the amounts indicated above. 60