The liberalisation of China’s wholesale and retail sectors at the end of 2004 was greeted by foreign investors with great flourish.

The trend since has been to establish foreign-invested commercial enterprises (FICEs), which seem like the perfect solution for distributing goods in China.

FICEs can import and export goods, purchase China-sourced products and sell to customers on the mainland. They can also engage in cross-border foreign currency sales as well as local renminbi sales.

Nevertheless, while FICEs provide an avenue for foreign participation in the highly lucrative distribution industry, they are not a panacea for operating in China hassle-free.

China’s tax, customs and regulatory environment still contains many surprises, which can appear counter-intuitive and bizarre, especially for the uninitiated.

For example, FICEs are not always able to purchase goods directly from factories in China. Many goods in China are produced under processing trade arrangements that are fairly prevalent throughout the country.

These arrangements allow raw materials to be imported duty-free on condition that the finished goods are subsequently exported. If finished goods are sold directly to the FICE, the factories must retroactively pay customs duties, import value-added tax and interest payments on the imported raw materials.

Hence, in most cases, either the finished goods must be exported and re-imported before they can be sold to the FICE – to avoid additional customs duties and VAT – or the FICE must find another supplier that manufactures for the domestic market, which would limit its choice of suppliers.

Second, the FICE may have to pay VAT even if there is no sale. China has “deemed sales” rules that impose VAT on the movement of goods within a company.

In a retail operation, inventory is typically moved from a central location to individual retail stores. If the stock in one of the stores needs replenishment, goods may be moved from one retail location to another. Each time these goods are moved across different municipalities, VAT is levied on the cost of goods in addition to a mark-up.

Apart from the administrative nightmare associated with keeping track of the movement of goods and ensuring that the appropriate amount of VAT is paid, this results in additional cash flow being tied up in tax payments.

These are some examples of the issues that FICEs have to grapple with.

Given China’s huge market, it is unlikely that these problems will discourage foreign investors from establishing FICEs. However, sophisticated investors will need to plan in advance to anticipate nasty surprises and nip them in the bud.

The writer is a registered foreign lawyer with Baker & McKenzie in Hong Kong

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