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An insider’s look at costs, tax benefits, transfer pricing, arm’s length pricing and off shoring when using a HK company to buy from China.

The following is the exclusive transcript of highlights from an interview I did on the subject of “transfer pricing/ HK offshoring” with the “global from Asia” podcast.

An insiders look at costs tax benefits transfer pricing arms length pricing and off shoring when using an HK company to buy from China.

Visit https://www.globalfromasia.com/transfer-pricing/ for the full podcast.

Q: So today’s topic transfer pricing, this is something I learned about when first in China – can you explain a quick definition?

Mike Bellamy (MB): First off-  I’m not an accountant or lawyer, so today, I’m just sharing what I have learned setting up my own supply chains and managing them on behalf of our clients.  Having said that, simply put, transfer pricing works like this:

Example: you buy a widget in China at 1 USD and you sell it in your home market for 10.  Your profit was 9, you are taxed on that profit.

Let’s say you set up a HK company (or you hire one), and that HK entity buys for 1 USD and sells to your HQ back home for 9, and then HQ sells to the end user for 10.  In this case 8 bucks of markup stays with the HK entity and only 1 USD profit is on the books with the HQ.

The magic happens when you realize that if you set up a HK company or outsource it, in the right way, profits are not taxed. HK called this an “offshore transaction” and its profit is not taxed by HK if you set your HK company up right and following some simple rules set by the HK government.  Of course, when you repatriate the funds back home, you get hit with tax, but until that time…this pile of money builds up in HK and can be recycled to buy the next order “tax free” if you will.

That’s an over simplification, but you get the picture.

Q: Many business owners listening today are doing trade around the globe, buying from china, via a HK company a lot of times, selling to their company in USA – what are some normal cases for transfer pricing?

MB: While the HK tax code is very business friendly, things get complex in your home country depending on how that HK company is viewed. Now we are talking about “Arm’s length” issues.

Also, the PRC tax man is also wise to the game, especially if you own the PRC company and sell to your HK arm.  It’s a big red flag is you are selling it at a loss in China to avoid PRC profits taxes.

Q: So they should setup multiple companies? Or just buy direct from the factory from your USA company? How to value the product, at each stage in the distribution chain? There’s manufacturing, importing, wholesaling, retailing – are there standard margins people can or should use?

MB: There are actually a couple of important sub questions on there. I’m assuming you asking the question with regards to transfer pricing and keeping an arm’s length.

For example…if you own a WFOE in China, you need to be asking the question: what’s the lowest price I can sell from my WFOE to my HK company without breaking any laws in the PRC. That required some benchmarking. Kepe in mind you are going to pay taxes, I’m not suggesting breaking any laws, I am suggesting your simply optimize your global tax plan to reduce and defer taxes in full compliance with the laws in all the juristictions where you operate.

In the worst case, depending on how seriously you home country takes this “arm’s length issue”, there may be no advantage for having a HK holding company. If your government views that HK as under your “control”, then you may get taxed anyway.

Another big mistake is to count on things being “profit tax free” in HK, only to realize too late that you broke the rules about how to enjoy the  “offshore” classification. For example, if you sign deals in HK, have contracts with HK based customers, or keep a formal office with real staff based in HK…then you will need to pay HK profits tax because it’s not “off shore” business.  Granted, the tax rates are a lot better than back home in US or Europe, so paying tax in HK isn’t that bad!

Q: All governments want the max in tax income, does each country have different rules and policies?

MB: Yes, here are the questions to ask your domestic income and business tax advisor:

  1. From my government’s perspective, how do they define “control” and “arm’s length” issues regarding overseas companies that I may be associated with?
  2. If I set up a HK company, can I used it, in a fully legal way, to reduce my taxes back home?
  3. Do I even need to have a company back home? What if I moved my business to HK, how would that impact my personal income tax?

 

Q:  Mike, you are American, have a HK holding company and source from China. You talk about “doing it right”,  any tips for my listeners with regards when is the right time to setting thing up right in HK?”

MB: Don’t try to be sneaky, realize you are going to need to pay tax somewhere. So just be smart about it and find the option that is fully legal, yet reduced your global tax exposure.

If you are spending less than a few million USD in China, then setting up a HK company may be over kill. If you are spending more than a few million USD in China and you haven’t explored your options in HK, then you are doing yourself a big disservice and missing a major opportunity.

Q: What stages of a business, say an Amazon seller, should start to think about this? Is there an easy way to get started, then get more complex?

MB: At risk of sounding like a salesman, a first step can often be to work with a company, like mine (www.PSSChina.com), that has operations in China, HK and clients globally. We have a system in place already that can be leveraged for small/medium client, and when the project gets large, the client can think about setting up their own operations.

Q: Some may have their heads spinning now, what is #1 thing a listener can take away today to get started improving their business with transfer pricing/ HK off shoreing?

MB: Look at the corporate tax rate in HK vs your country. Multiply it against your annual business volume. If the difference is tens of 10…not worth the effort. If 100’s of thousands of USD, then you need to look into things a lot closer.

Related Resources:

http://www.psschina.com/passagemaker-resources

China sourcing: Good Price and Quality but Limited Engineering/ R&D?

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What to do when the supplier has good price and quality, but limited engineering/ R&D?

Common dilemma: a small factory in China is excited about your order size, but they may not have the engineering chops of the big factories. The big factories have a full R&D department, but they are not interested in your small order.

A client recently asked:

I like my manufacturer but they are small, which is ok for now as I like the attention that comes with being a large client of a small but professional factory. But in other ways it’s bad, because they aren’t the fastest at developing new ideas or even getting all the kinks out of what they designed and made in the past. I am currently in talks with a couple other manufacturers, mainly for OEM products with our branding, but soon I will want to dive further into our ODM and need designers and such that I can trust. I trust that small factory a lot, but worry they can’t handle my need for R&D.

In general, these small companies are great at making a given widget at a good price when you give them your design with details of exactly how to make it. But they drop the ball when asked to create new designs.

Small factories are usually great at production but not R&D. The solution may be to let them focus on production and outsource design, to be specific, outsource the DFM (design for manufacture).

Here are my thoughts in detail:

Unfortunately, if you are doing anything new or customized, leaving the engineering to the typical small Chinese manufacturer is not the best option for the following reasons:

a) Intellectual Property Concerns.

Non-Disclosure/ Non-Compete Agreements are very hard to monitor and enforce with Chinese companies. Even if the supplier is paid for their engineering, they will feel a sense of ownership. That is very dangerous if you decide to change suppliers or stop production unilaterally. Some manufacturers will even leverage the engineering work done for your project to land other clients who may be your competitors.

b) Biased Designs.

The manufacturer will engineer the product as they see fit. That means engineering to Chinese standards rather than international standards. The engineering will also be tailored to the production methods of that particular factory, which may or may not be the design which leverages the best production efficiencies and technologies available in China at a national level. Furthermore, the engineering may be tailored for the Minimum Order Quantity (MOQ) that the factory desires, rather than the expected order size of the customer.

What are the global options for hiring an engineering firm to do the DFM?

If you find yourself in a situation where DFM work is needed but you are hesitant to allow the manufacturer or a Chinese based entity to arrange the DFM engineering files for the reasons stated above, don’t worry, there are still plenty of options.

To cut to the chase, my preference is to use China-based Western-owned Engineering firms. That means a pricing point for China-savvy engineering that is slightly more than a local Chinese firm but well below the hour rate back home. Plus they may even be willing to cap their engineering fees and ideally they have a policy to refuse to accept any compensation from suppliers. Because the last thing you want is an engineering firm that is secretly steering you towards a pre-agreed production method or location where they get a kick back. Let’s explore the other options for your reference.

> In India you will get slightly lower CAD/Engineering rates than in China, but if the production is going to be in China, they may not be capable of a DFM package fit for China in terms of using the right materials and production method. Savings gained from a good China-oriented DFM will easily out-weigh the upfront savings of Indian based engineering labor.

> Not only is N. American/EU/Australian engineering exponentially more expensive than Chinese, but also there are some common flaws:

a) A western production set up is highly automated due to costs of labor while in China there is more flexibility thanks to lower labor rates. A Western based engineering firm may not have a grasp on the realities of Chinese production. The result might be overspending on tool & dies and designs that aren’t efficient on a China production line.

b) Western engineering firms tend to operate like law firms in that they bill by the hour, sometimes without even a cap on hours in place. Also, they use junior staff behind the scenes to do as much engineering as possible in order to maximize their revenue.

c) Worst of all, engineers in the West tend to see their job as complete when the design is done, as opposed to China-based engineering that is more integrated into the trial runs and even production troubleshooting.

d) Because engineering is so expensive in the West, many engineering firms in places like the US and EU will quote engineering at/ below internal cost in exchange for a future margin or royalty when production starts. This is extremely dangerous because if the engineering firm is aligned with the supplier, they are designing for their benefit not the customers. Plus it is a common tactic to under quote the upfront engineering rates only to later raise the pricing on production once the client is locked in with the engineering/supplier partners.

One down side of using a China-based, Western Engineering firm is the time zone and ability to communicate face to face. Should you decide to have your engineering in China, make sure they have a good track record of keeping client’s happy as you’ll need to find a good communicator if you outsource your DFM to the other side of the world.

More tips for finding a partner for DFM and general engineering needs

Ask your account manager at PassageMaker for an introduction or visit the endorsed service providers list online (here) to meet reputable China-based engineering firms as we are happy to introduce the DFM firms we have used in past.

The next step is to contact the firms and learn if they will be a good fit for you. I like DFM providers that have at least 5 years of experience engineering in China for China.

Are they a legitimate company with proper business licensing?

Do they have a clear track record of performance? If they can’t give you some client references, run away. That is a very big red flag.

Are they focused on a certain set of services or do they try to do everything for everybody? Stay away from the sourcing-slash-engineering firms.

Once you narrow it down to a hand full of options based on initial talks and references, ask for an estimate on the DFM. What separates the great companies from the good ones will be the format and timing of their quote. If they take more than a few days to get back to you, it probably means that they don’t have well developed system in place. Try to avoid having your project serve as some engineering firm’s first attempt at doing DFM for China.

I like to have my payments staggered to the engineering firms so that they get paid for performance and only once pre-agreed project gates are reached.

Don’t be afraid to ask questions!Better to ask in advance before getting hit with surprise charges later.

Related Content:

Subscribe to the advanced buyer YouTube channel presented by PassageMaker

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YouTube’s Advanced Buyer Video Blog hosted by PassageMaker’s Mike Bellamy

Wishing you successful China sourcing!

Protecting intellectual property in China: Don’t be a guinea pig!

Protecting intellectual property in China Dont be a guinea pig

In the West we say “don’t burn your bridges”

In China they probably say “let the bridges you burn light the way”.

In a recent China Daily article, Heavy Equipment Manufacturer LiuGong (think of a Chinese knock off of Caterpillar) proudly explains how their company, over a 50 year period, leveraged naive international buyers and partners to grow their business. Here are some excerpts, be warned, you will see no sense of remorse.

An Australian customer bought a loader from LiuGong. Because the loader was equipped with an imported automatic gearbox, the mismatch between it and the supporting system caused many malfunctions. The angry customer set the loader on fire.

LiuGong discovered one of its Italian clients had repainted its products once the machines arrived in Italy because the customer said, “the ugly design cannot be changed, and the rusty look is intolerable”.

In other words, the strategy was “get the order, ship some junk, learn where the customer is not happy, and try to improve on the next order”.

I’m not sure if this strategy is part of Sun Tzu’s art of war, but it certainly is commonly used by Chinese suppliers large and small, even today. And there is absolutely no sense of embarrassment regarding the abuse of clients for unilateral gain.

Pretty smart. They found a way for early clients to finance the R&D, yet early clients don’t get any return on that investment.

The article goes on to explain that

“Mergers and acquisitions became a shortcut for Chinese enterprises to acquire technology and marketing channels, especially after the financial crisis in 2008.”

But you don’t have to have a formal JV in place for your technology to be hijacked. Plenty of technology is transferred because naive buyers share the “secret sauce” without taking protective measures like registering IP or setting a 3rd party black box for sensitive assembly. (Click here for an example.)

Related Videos:

Video 1: Finding Suppliers
Video 2: Evaluating Suppliers
Video 3: Negotiations
Video 4: Project Management and Quality Control
Video 5: Protecting Your Intellectual Property
Video 9: Returning Defective Products
Video 10: Resolving a Dispute

Buyers are often seduced by the siren’s song of low cost. But after the sweet and temporary taste of low price fades, the bitter taste of poor quality remains for a long long time.

As the article in the China Daily proudly explains, many China factories simply do not believe the expression “you have one chance to make a first impression” because there are so many international buyers (who take unnecessary risks) that if the factory screws up the order, they simply drop that project and go out and find another buyer. Repeat process until they manage to improve their product and production process.

Conclusion:

Make sure you or your representative make sure the so called factory is reputable and has experience making exactly what you want at the level of quality you expect.

Know the difference between “factory can make this” and “factory has made this”.

Protecting intellectual property in China is paramount. Don’t be a guinea pig for a Chinese factory’s R&D department.