STRATEGY
Operating a Regional Headquarters in Shanghai
April 25, 2006
Shannon Cheung, Head of Payments and Cash Management China, Business Development, HSBC Global Payments and Cash Management

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Given China's strict limitations on business scope and stringent licensing requirements, setting up the proper legal structure for your business is particularly important. This article takes a look at current regulations governing a regional headquarters in Shangahi.

• Managing disparate businesses and their revenue streams present problems for multinational corporations in China.
• New state regulations have permitted holding companies to upgrade to regional headquarters subject to stringent requirements. Expanded business scope is then granted.
• Shanghai is an increasingly popular destination for the headquarters of multinational entities, and is offering supplementary municipal regulations enabling foreign companies to set up there and benefit from doing so.

China has continued to attract the world's leading multinational corporations (MNCs) to invest, as evidenced by the record pace of foreign investment, with cash pouring into the country. In the first half of 2004, actual foreign direct investment (FDI) grew to USD34bn, and is projected to rise to a record USD60bn for the full year.

Over the past few years, as MNCs continue to establish more investments by setting up new joint ventures or wholly owned subsidiaries in China, the issue of being able to effectively consolidate management among the various subsidiaries has been a pressing one. For many MNCs with sizable operations in China, the need to form separate joint ventures with different partners at different locations has forced them to create a complicated corporate structure. In certain cases, some corporate groups are managing over 50 separate legal entities; some in the form of majority- or minority-owned joint ventures, others as wholly foreign-owned enterprises. In addition, while some entities are held directly under a China holding company, others may be directly held by offshore special purpose vehicles.

The quest of finding the ideal legal structure has long been the holy grail for many MNCs operating in China. A fragmented structure presents a massive challenge to management, with multiple local partners to manage, numerous board meetings to attend and inconsistencies in terms of practices and policies. From a cost perspective, the duplication of most core business functions, such as marketing, finance, IT, procurement and administration is also costly and inefficient.

Nevertheless, given China's strict limitations on business scope and stringent licensing requirements, setting up the proper legal structure for a headquarters in China is particularly important. For example, some foreign companies with multiple ventures have decided to put their China management team at one of their manufacturing ventures, while others have set up separate representative offices to house their China CEOs and CFOs. However, it should be noted that placing China management teams at an operating venture or a representative office may not be a viable option, as this would involve the provision of management services to other companies and a company involved in this manner can be deemed to be operating outside of its business scope. As such, a more appropriate set-up would be to establish a holding company or a management company to house the management team.

China Focus Holding Company Regulations
In 1995, to permit corporate groups to have an onshore investment and centralised management vehicle, China issued regulations governing the establishment of investment companies (more commonly known as holding companies) by foreign investors. These refer to enterprises set up with limited liability status, which can engage in direct investment activities all over China. The requirements for eligibility in establishing holding companies are high. In addition to a number of conditions regarding financial strength and investment capital already contributed, foreign investors are also required to commit USD30m in fresh capital, to be paid up within two years of the issuance of its business licence.

Despite the high set-up requirements, over 260 holding companies have already been set up in China, the vast majority of which are in Shanghai and Beijing. Quite a number of MNCs consider the main advantage of having a holding company to be the enhanced corporate image a holding company brings when dealing with regulators in China. Other benefits include:

First, having a holding company enables the foreign company to have a China management office and provides an eligible vehicle to house this team. Some MNCs have even taken this concept further, by establishing shared services centres and payment factories, thereby eliminating the need to have duplicate finance teams across multiple entities. However, holding companies can only provide services to investee companies if such a project is unanimously approved by the board of directors, and if the holding company has at least a 10% shareholding in the investee company.

Second, for corporate groups that plan to have their dividends reinvested into China, having a holding company will also make the process more tax-efficient as the dividends can be reinvested in China without being subject to offshore taxes.

Third, the holding company can also conduct domestic and international trading by selling the products manufactured by its investees in domestic and foreign markets and providing after-sales services. By acting as a principal in selling investees' products, holding companies can now centralise sales and invoicing of group products and present a "single face" to customers. Some MNCs have taken advantage of the right to export products (for goods which are not subject to export quota and licences) by establishing export procurement centres under their holding companies.

Finally, on the financial services side, the holding company can conduct intra-group lending and balance foreign currency among investee companies. However, in reality, such intra-group lending and balancing transactions are often not easy to execute.

In addition, establishing a holding company also has drawbacks. Aside from the high set-up costs and the requirement for fresh capital, establishing a holding company adds another layer to the corporate structure. This would then insert an additional layer in the dividend process and lead to a duplication of the reserve requirement, which in turn leads to an additional cash trap. Additionally, trades and services between the holding company and investees are also treated as sales between separate entities and would be subject to value-added tax or business tax.

Shanghai Regional Headquarters Regulations
Over the past several years, we have seen an increasing number of MNCs establishing local or even regional (Greater China or Asia-Pacific) headquarters in China, in particular Shanghai. This relocation trend is due to the support from the Shanghai government in offering additional benefits and incentives to attract MNCs. In fact, in July 2002, the Shanghai government issued a specific set of regulations, "The Interim Regulations to Encourage the Establishment of Regional Headquarters by Foreign Multinational Companies in Shanghai", offering a number of incentives to support MNCs in setting-up regional headquarters (RHQs) in the city.

In a nutshell, MNCs with their holding companies registered in Shanghai can easily designate their holding companies as their RHQ. For those that do not have a holding company, they can also set up a management company (with USD2m paid-up capital) and designate this as their RHQ. Compared to the holding company RHQs, the incentives available to management company RHQs are more limited, although the set-up costs are less stringent. At the time of writing this article, 79 MNCs, including General Electric, China Focus General Motors, Honeywell, Kodak, Alcatel, ExxonMobil, Suntory and others from the US, Europe, Japan, Indonesia, the Hong Kong Special Administrative Region, Taiwan, have applied for, and received, this official RHQ status.

Ministry of Commerce Regional Headquarter Regulations
In February 2004, the Ministry of Commerce (MOC) further updated its administrative rules governing holding companies. The key part of this regulation is that, provided certain prerequisites are met, the MOC now also recognises certain holding companies as RHQs (unlike the Shanghai RHQ regulations, the MOC RHQs do not necessarily have to be registered in Shanghai). Requirements for being recognised as an RHQ include having registered capital of at least USD100m (or USD50m in paid-up capital, provided certain investment and profit criteria are satisfied), and the establishment of two research and development (R&D) units.

If a holding company is acknowledged by the MOC as an RHQ, it would then be entitled to a few additional expansions in its permitted business scope. This includes the ability to import and sell group company products and the spare parts necessary for maintenance services; the capacity to provide services outsourced by domestic or overseas group companies; the right to establish a domestic finance company to serve the holding company and its investee companies, and other services that are permitted by the MOC and other relevant authorities. At the time of writing, eight companies, including Alcatel (based in Shanghai) and Seiko Epson (based in Beijing), were among those who have received RHQ status for their holding companies under the MOC rules.

Q&A with Simon F. Huang, Deputy Director, Shanghai Municipal People's Government Foreign Economic Relations and Trade Commission, Shanghai Foreign Investment Commission, China

Q: Can you give an introduction about your commission in Shanghai? What are the main functions and objectives?

A: The Shanghai Foreign Investment Commission is a division of the Shanghai Municipal People's Government. The main responsibility of the commission is to attract foreign investment into Shanghai. We provide investment information, examine and approve foreign investment projects and coordinate crossdepartment issues for foreign investors. Since its establishment, it has approved more than 33,000 foreigninvested projects and helped Shanghai attract more than USD80bn in foreign capital. I believe today one of the challenges for the Chinese and Shanghai governments in attracting foreign investment is to identify our investors' demands and to respond to them quickly. Our investors are changing fast, so are their business models, their strategies and their internal corporate governance. They want the government to be interactive and to accommodate these changes. Hence, the commission has been set up to cater to their needs.

Q: What are the advantages of investing in Shanghai? What are the plans for its future development?

A: Underlying Shanghai's success story are its unique advantages. I can summarise them into three categories: location and infrastructure, human resources and the advantage of Shanghai being a pilot site for many of China's reforms.

First of all, Shanghai is located at the mid-point of China's coastal line. It leads the Yangtze Delta, where there are 15 cities with a population of 130 million. In recent years, this area has grown rapidly to become an extremely robust and dynamic area, both as a supply base for the world market and as one of the largest regional consumer markets in China. Historically, Shanghai is the country's window to the outside world. Shanghai has developed business relations with 275 harbours in 96 countries and regions. The container dealing capacity has reached 11.3 million TEUs (Twenty feet Equivalent Unit), and it now ranks the third-busiest container terminal in the world, after Hong Kong and Singapore. Currently, Shanghai is also the only city in China that has two international airports.

A new deep-water harbour on Yangshan Island is under construction. The whole project is projected to be finished by the end of 2020. Eventually the new port will have 50 berths with annual capacity of 22 China Focus million TEUs. The first phase of the project, which is scheduled to be completed by the end of 2005, includes five berths for fifth- and sixth-generation container ships with an annual capacity of 2.2 million TEUs. The new harbour will be connected to the continent by a 32km cross-sea bridge. Meanwhile, Shanghai is trying to make its new Pudong International Airport into the hub for the region. The second runway will also be finished around 2005, which will increase the airport's passenger volume to 40 million per year.

Second, in terms of human resources, Shanghai has a strong talent pool. There are 50 universities and colleges with over 40,000 graduates, 5,000 post graduates and 1,000 doctorates each year. Shanghai also attracts talents from other areas as well as from overseas, and has become the first choice in China for overseas students to start their careers.

Finally, Shanghai also permits foreign investors to have a first-mover advantage by being the location where many trial activities for the country are conducted, especially in certain sensitive sectors such as finance. It was one of the first cities where foreign financial institutions were able to establish operations and foreign banks permitted to offer renminbi (RMB) services. Right now, Shanghai is home to 89 foreign banks and other financial institutions. Their total assets have reached USD27.4bn, accounting for half of all foreign financial assets in China.

In other sectors, world-class firms also have their footprint in Shanghai; for example, the "Big Four" accounting firms (PriceWaterhouseCoopers, KPMG, Deloitte & Touche, Ernst & Young), 71 foreign law firms and almost all leading consulting firms have a presence in the city. Shanghai has also attracted more than 100 international logistics companies such as Fedex, APL, and UPS. In the manufacturing sector, Volkswagen came to Shanghai as early as 1985, followed by General Motors in 1997. In 2004, the two companies were ranked first and second in terms of automobile sales in China. Of the Fortune 500 companies, 166 of them have investment in Shanghai, with a total capitalisation of USD10.8bn.

For Shanghai, the capacity to undertake trial initiatives from the Chinese government is also a process of building competence and offers a competitive advantage for investors, which I believe will enable Shanghai to enter into a virtuous cycle in its progress.

Q: What are the key priorities for Shanghai in terms of attracting foreign investment and developing its economy?

A: Shanghai's aim is to be an international centre for finance, trade and shipping and modern services. More foreign financial institutions, retailing and trading companies, logistics companies and professional service companies are being introduced into Shanghai, especially under the Closer Economic Partnership Arrangement (CEPA) between Hong Kong and Shanghai. According to China's World Trade Organization commitment, Shanghai will be one of the first cities to open its financial sector. Foreign banks, insurance companies, security companies and even fund management firms are greatly encouraged to locate in Shanghai. We are also making efforts to introduce a number of international logistics companies, which will leverage the function of Shanghai's ports, but at the top of government's agenda is the development of Shanghai as the city of choice for MNCs to locate their RHQs.

Q: Why is the attraction of RHQs such a key priority to Shanghai?

A: Shanghai's aim to become a hub for MNC RHQs dates back to as early as 1990 when the central government decided to open up and develop the Pudong area of the city. However, not until 2002 did this plan turn into reality. During these 12 years, a huge amount of foreign capital was invested in China and Shanghai. This has led to the need to set up a centralised management vehicle for companies that have committed large investments across multiple entities in China.

I believe one reason behind this initiative is that the Shanghai government realised that it should differentiate itself from neighbouring areas in attracting FDI. Moving up the value chain to re-position itself as a destination for MNC RHQs and operation centres seems to be the right option for a city whose aim is to be a world-class metropolis, and a city facing fierce competition in attracting foreign investment China Focus from neighbouring areas. The government promulgated "The Interim Regulation on Encouraging Multinational Companies Setting Up Regional Headquarters in Shanghai" and its implementing rules in July 2002 and March 2003 respectively. Basically, the regulation and its implementing rules cover four categories of issues relevant to RHQs, namely: tax incentives; cash management of both RMB and foreign exchange; trading rights for companies using a holding company as a vehicle for RHQs; and extended residential and work permits for senior foreign managers.

Q: Can you give us an update on Shanghai RHQ developments?

A: By the end of August 2004, Shanghai had granted RHQ status to 79 MNCs, of which five actually moved from Beijing to Shanghai. Most of the 79 MNCs are Fortune 500 companies such as General Motors, General Electric and ExxonMobil. Sixty-three of them use their holding companies as a vehicle for their RHQs while another 16 have set up management companies. Within Shanghai, 41 RHQs are registered in the Pudong area.

Q: What are the benefits of having your RHQ located in Shanghai?

A: This can be explained by looking at tax incentives, cash management, trading rights, and residential and work permits.

The first benefit is that RHQs registered in Pudong will enjoy a 15% tax rate for corporate income tax. RHQs with research and development (R&D) functions can also enjoy the same rate anywhere in Shanghai. The revenues from providing training to invested companies will be exempt from business tax. Regarding the individual income tax of senior foreign managers, some allowances such as housing allowance and relocation allowance are deductible and non-taxable.

Second is cash management. This is an essential function of the RHQ. Right now, there are two ways to conduct cash pooling. One is to set up an independent finance company under the holding company, such as Siemens Financial Services. The other option for RHQs in Shanghai is to use entrusted loans to centralise their cash. In addition, RHQs can now use cross-border entrusted loans to lend their excess RMB or foreign currency cash to entities outside of China.

Third, with regards to trading rights, holding companies with RHQ status can import products from parent companies for test-marketing sales and import components for systems integration. They also have the rights to purchase goods for export on which they can enjoy a tax refund.

Finally, the duration of residential and work permits for senior managers such as the CEO and CFO of RHQs can be extended by up to five years. Other managers' residential and work permits can be extended by up to three years. The spouse and children of these categories of people will receive the same treatment.

Q: What is the relationship between the Shanghai and MOC RHQ regulations?

A: Quite a few companies have already asked me why the MOC has separately issued a state regulation on RHQs under the new holding company rules. As the criteria for being granted RHQ status is different in the state versus the Shanghai regulations, it is easy for companies to be confused. Here I would like to clarify that the Shanghai RHQ regulation was passed by the Shanghai government in July 2002, but carried the consent of the central government at the time.

The Shanghai regulation on RHQs and its implementation is a trial for the state policy on RHQs. Hence, there are no conflicts between the two regulations and they will continue to co-exist for the foreseeable future. In this case, if a holding company based in Shanghai meets the criteria required by the state regulation, (these are USD100m paid-up capital or USD50m paid-up capital provided the group has total assets of more RMB3bn in China), it can apply to the MOC via the Shanghai Foreign Investment Commission for RHQ status and receive expanded business scope and trading rights. Shanghai will also automatically recognise it and allow it to enjoy preferential policies as a municipal RHQ.

China Focus Companies in Shanghai who cannot meet the criteria of the state regulation but wish to set up an RHQ in Shanghai would still be permitted to do so according to the municipal policy, so there will be no clash between the state and municipal regulations.

Q: What are the future directions from a regulatory standpoint on the RHQ regulations in Shanghai?

A: We have just finished a survey of RHQs in Shanghai, and the following areas seem to be of great concern to RHQs.

First, cash management - although the People's Bank of China will lower the capital requirement from RMB300m to RMB100m for establishing a finance company, the cost of maintaining an independent legal entity is still high and thus not a viable solution for some RHQs. Some RHQs have also complained that bank charges on entrusted loans are considerable when the volume is high. Direct cash transfer has been proposed but this is not compatible with the current legal framework.

Second, foreign exchange controls - for RHQs, efficient and timely cross-border transfer of foreign exchange is essential. One solution is to allow RHQs to have an offshore foreign exchange account in China. As far as I am aware, this is being considered, though discussions on this are preliminary.

Third, the lack of tax consolidation for holding company RHQs is also a concern. Basically, there are two reasons for the existence of this issue. The first reason is that the RHQs may have many investee companies around the country, and different companies may also be enjoying different phases of preferential tax policies, which makes it quite difficult to produce a consolidated return. The second reason is that tax consolidation will result in transfers of tax revenue between different provinces and cities. So we do not expect there will be much improvement in this area in the near future.

We are also aware that the individual income tax rate is too high for expatriates, which will cause extra costs for RHQs and thus offset other incentives the RHQs enjoy.

Finally, I have already received feedback from HSBC and other MNCs that suggest the Shanghai RHQ regulations are too "one-size-fits-all", without adequate consideration of specific requests from MNCs in different industries. For example, in the IT industry, MNCs wishing to apply for RHQs may wish to have additional incentives when setting up R&D centres. In the manufacturing and trading industries, MNCs may wish to have expanded trading and distribution rights. The Shanghai Foreign Investment Commission is now working on these issues, so that in the future, each MNC can "find the shoe that fits its foot" when considering setting up regional operations in Shanghai.

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