This question should be very familiar to all companies currently running operations in more than one country as well as to those who intend to do so in the future. When the firm grows to be international, the downturns of running suboptimal profit allocation strategies, among its entities, are significant. If it intends to reap the real benefit of an international presence, the firm should accurately, and a timely manner, plan where to turn a profit.
Hong Kong (HK), in respect to Mainland China, is a well know case. Enterprise income tax in the HK Special Administrative Region (SAR) stands at 17.5%, a much more attractive rate if compared to those on the Mainland and still a competitive one when compared to PRC’s Special Economic Zones, such as Shenzhen, where the rate runs at 15%. This latter, though, stands out as an exception rather than a rule, and a transitory one also, since the policy of unification of tax rates among areas and among foreign and local enterprises is in the implementation stage and we estimate a 2-3 year timeframe before changes to a unified rate of about 24% will affect the bottom line of foreign investors.
Let’s have a look then at how to setup a sound offshore structure. We will refer to the diagram on the next page, demonstrating how this works for an export oriented manufacturing company. We will assume a 24% enterprise income tax rate for the Mainland and a 17.5% for the HK SAR. The Chinese entity will be the one running the operations, while the HK entity will allow for optimization of the company’s offshore corporate structure. Please note that the figures are purely indicative and are not intended to be recommendations on how to implement such arrangements.
Once the goods are produced in the Mainland, they can be sold to the HK parent company, which will act as the primary client of the Chinese entity. The pricing for the transaction, as usual, will have to account for both the full industrial cost and a margin. This latter must be configured in order for the Chinese entity to reach a sound financial and fiscal performance, but still providing wide enough space, to the HK entity, to build its margins. In practice, the margin can vary considerably and must be carefully chosen according to industry sector and the actual financial performance, among other factors. For a manufacturing company, the figure could be 10%. The HK company will then realize its turnover by selling to its clients, according to its marketing strengths. The margin involved in this latter transaction will then build the bulk of the profits. Professional advice on offshore corporate structure can save approximately $ 0.07 for every one dollar worth of goods. A considerable difference.