The money a WFOE earns in China has to be remitted to the foreign parent company through a formal process. The remittance is subject to Chinese withholding tax, the foreign parent company’s home country tax, and foreign exchange controls that require the WFOE to demonstrate that the remittance is a legitimate distribution of after-tax profits. A foreign company that structures the dividend flow incorrectly loses 10% or more of the profit to unnecessary tax.
Here’s how dividend repatriation works, what the taxes are, and how to structure it efficiently.
The Dividend Process
A Chinese company can distribute dividends to its shareholders from its after-tax profits. The distribution requires the company to have audited financial statements that show distributable profits — the retained earnings on the balance sheet — and a board resolution or a shareholder resolution that authorizes the dividend. The resolution specifies the amount of the dividend, the shareholders entitled to receive it, and the payment date.
The dividend payment is made from the WFOE’s RMB bank account to the foreign parent company’s bank account outside China. The payment requires the WFOE to convert the RMB dividend amount into the foreign currency — typically USD or EUR — through the bank’s foreign exchange service. The bank processes the foreign exchange conversion and the international wire transfer, and the foreign parent company receives the foreign currency in its bank account.
The bank requires documentation to process the dividend payment. The documentation includes the board resolution or the shareholder resolution authorizing the dividend, the audited financial statements showing the distributable profits, the tax payment certificates showing that the WFOE has paid its corporate income tax, and the withholding tax return showing that the WFOE has withheld and paid the dividend withholding tax. The bank reviews the documentation to confirm that the dividend is a legitimate distribution of after-tax profits and that the withholding tax has been paid.
The bank may also require the WFOE to provide documentation that the foreign parent company is the legitimate shareholder — the articles of association showing the foreign parent company’s equity interest, the capital verification report showing that the registered capital has been contributed, and the foreign parent company’s certificate of incorporation.
The Withholding Tax
The dividend withholding tax is a tax on the dividend payment that’s levied by China on the foreign shareholder. The standard rate is 10% of the gross dividend amount. A dividend of 1 million RMB attracts a withholding tax of 100,000 RMB, and the foreign parent company receives 900,000 RMB.
The withholding tax is paid by the WFOE on behalf of the foreign shareholder. The WFOE withholds the tax from the dividend payment and pays it to the tax bureau, and the foreign parent company receives the net dividend — the gross dividend minus the withholding tax. The withholding tax is a Chinese tax, not a foreign tax, and it’s a cost of doing business in China.
The tax treaty rate may reduce the withholding tax. A foreign parent company that’s a resident of a country that has a tax treaty with China — and that meets the treaty conditions — may qualify for a reduced rate. The most common reduced rate is 5% for a foreign parent company that holds at least 25% of the Chinese company’s capital. A UK parent company, a German parent company, or a Singapore parent company holding at least 25% of the WFOE’s capital qualifies for the 5% rate. A US parent company qualifies for a 5% rate if it holds at least 10% of the voting stock.
The treaty rate is not automatic. The WFOE must apply for the treaty benefit by filing a treaty benefit application with the tax bureau, together with the foreign parent company’s certificate of tax residence from its home country’s tax authority. The tax bureau reviews the application and determines whether the foreign parent company qualifies for the treaty rate. A foreign parent company that doesn’t have a certificate of tax residence, or whose certificate has expired, pays the standard 10% rate.
The anti-treaty-shopping rules may deny the treaty benefit. A foreign parent company that’s established in a treaty jurisdiction — Hong Kong, Singapore, the UK — for the primary purpose of accessing the reduced treaty rate, and that doesn’t have commercial substance in the treaty jurisdiction, may not qualify for the treaty rate. The Chinese tax authorities look at the substance of the foreign parent company — its office, its employees, its business activities, its management — and deny the treaty benefit if the substance is insufficient.
The Home Country Tax
The dividend received by the foreign parent company from its Chinese WFOE is taxable in the foreign parent company’s home country under the home country’s tax rules. The foreign parent company includes the gross dividend — the dividend plus the Chinese withholding tax — in its taxable income and pays the home country tax on the dividend.
The Chinese withholding tax can be credited against the home country tax, subject to the foreign tax credit rules in the home country. The credit reduces the home country tax on the dividend by the amount of the Chinese withholding tax, so that the same income is not taxed twice — once by China through the withholding tax and once by the home country through the corporate income tax.
The foreign tax credit is limited to the home country tax on the dividend. If the Chinese withholding tax is 10% and the home country tax rate is 30%, the foreign tax credit of 10% reduces the net home country tax to 20%, and the total tax on the dividend is 30% — 10% Chinese withholding tax plus 20% home country tax. If the Chinese withholding tax is 10% and the home country tax rate is 5%, the foreign tax credit is limited to 5% — the home country tax — and the excess 5% Chinese withholding tax is not creditable. The total tax on the dividend is 15% — 10% Chinese withholding tax plus 5% home country tax, minus the 5% credit.
The foreign tax credit rules vary by country. Some countries allow the credit for the full amount of the Chinese withholding tax, subject to the limitation. Other countries allow the credit only if the Chinese withholding tax is not reduced by a tax treaty — a credit for the treaty rate of 5% but not for the standard rate of 10% to the extent that the 10% exceeds the treaty rate. The foreign parent company should obtain tax advice in its home country on the foreign tax credit rules before structuring the dividend flow.
The Holding Company Structure
A foreign company that operates multiple WFOEs in China, or that operates in multiple countries, may use a holding company structure to manage the dividend flow. The holding company — a company established in a jurisdiction with favorable tax rules for dividend income — holds the shares of the Chinese WFOEs and receives the dividends from them. The holding company accumulates the dividends and reinvests them or distributes them to the ultimate parent company.
The holding company jurisdiction is chosen for its tax treaty with China — a jurisdiction that has a treaty with a low dividend withholding tax rate — and for its domestic tax rules — a jurisdiction that exempts foreign dividend income from tax or that taxes it at a low rate. Hong Kong and Singapore are common holding company jurisdictions for Chinese investments because their treaties with China provide for a 5% dividend withholding tax rate for substantial shareholders, and their domestic tax rules exempt foreign dividend income from tax or tax it at a low effective rate.
But the holding company must have commercial substance to qualify for the treaty rate. A holding company that’s a shell — a registered office and a nominee director, with no employees, no business activities, and no management in the jurisdiction — may not qualify for the 5% treaty rate because the Chinese tax authorities apply the anti-treaty-shopping rules. A holding company that has a physical office, employees, management, and business activities in the jurisdiction — that’s more than a post office box — is more likely to qualify.
The holding company structure also affects the home country tax on the ultimate parent company. The dividends are remitted from China to the holding company — paying the Chinese withholding tax at the treaty rate — and then from the holding company to the ultimate parent company. The home country may tax the dividends when they’re remitted from the holding company to the ultimate parent company, or it may apply controlled foreign corporation rules that tax the dividends as they’re earned by the holding company, regardless of whether they’re remitted.
The Reinvestment Alternative
A WFOE that doesn’t need to remit dividends to the foreign parent company — because the foreign parent company doesn’t need the cash, or because the cash is better reinvested in the China business — can avoid the dividend withholding tax by reinvesting the profits in the WFOE. The profits are retained in the WFOE, used to fund the WFOE’s expansion, and not subject to the dividend withholding tax because no dividend is declared.
The reinvestment alternative is tax-deferred, not tax-exempt. The dividend withholding tax is deferred until the profits are eventually remitted to the foreign parent company, but the deferral period can be indefinite — the WFOE may operate in China for decades without remitting dividends. The deferred tax is a liability on the WFOE’s balance sheet — the amount of the withholding tax that would be payable if the accumulated profits were distributed — and the liability grows as the profits accumulate.
A WFOE that has accumulated significant retained earnings and that’s eventually sold — a share sale — may avoid the dividend withholding tax entirely if the sale is structured as a sale of the WFOE’s shares rather than a distribution of the WFOE’s profits. The seller pays Chinese tax on the capital gain from the share sale — at 10% if the seller is a non-resident without a Chinese permanent establishment — but the accumulated profits are not subject to the dividend withholding tax because they’re not distributed. The indirect transfer rules may affect the analysis — a sale of the holding company that holds the WFOE may be treated as a deemed sale of the WFOE — and the tax advice on the sale should address the treatment of the accumulated profits.
