Legal-Ease

Outsourcing Manufacturing Operations to China

By CHRIS DEVONSHIRE-ELLIS

Processing and Assembling Factories in China

During the early years of China’s economic reform, processing and assembly factories (LLJG factories) were very popular in the coastal regions, especially in the Pearl River Delta, where the first LLJG investment was recorded as early as 1978. This form of investment has been widely used by early-day Hong Kong and Taiwan investors as it did not require setting up an entity on its own rights, and it was good enough to entrust a local factory to manufacture products for export with supplied raw materials. Up to the present day, should your clients not be located in China and should you not want to set up a fully-fledged foreign-invested enterprise (FIE) in China and still take advantage of China’s low labor cost, then the LLJG factory may still be a possible choice of investment.

What Is an LLJG Factory?

LLJG means processing and assembling of imported/supplied materials or parts. An LLJG factory does not have a legal person status; instead, it is a contractual arrangement between a Chinese partner (“party A”) and the foreign investor (“party B”). Usually, but not necessarily, party B provides equipment free of charge to party A to be used in the manufacturing process. Equipment that enters duty- and VAT-free and are subject to a customs supervision period of five years. When the supervision period expires, the equipment/machineries shall be released from customs supervision.

During the period of customs supervision, the equipment shall not be sold or transferred by party B. After being released, the equipment/office facilities can either be returned to party B or kept within the LLJG factory. All raw materials/parts supplied by party B are considered “bonded” when imported into the China factory and thus do not incur VAT and customs duties. The end-products must be exported 100 percent within the term of the production contract. No domestic sales are allowed for LLJG factories.

Equipment and raw materials/parts provided by party B are imported under the name of party B, which retains ultimate ownership. After the processing agreement is finished, party B has the right to dispose of them. If the processing agreement has to be terminated ahead of schedule, equipment and raw materials provided by party B shall be exported back out of China. The Chinese partner, or party A, normally provides existing premises and labor. The person in charge (legal person) of the LLJG factory shall be from party A. However, in practice, even though party A appoints someone as the person in charge (whose name is printed on the LLJG business license), party A would not normally interfere in the operations of the factory. Further processing between different LLJG factories is allowed. Goods can be transferred to another LLJG factory by means of “factory transfer” as long as the final products are exported 100 percent.

Processing Fee

Party B, the foreign party, will not charge the LLJG factory for the raw materials/parts provided. It would pay instead a processing fee to the Chinese factory. Relevant government departments will take around 20-25 percent of the processing fee, while the remaining 75 to 80 percent will go to the LLJG factory account.

Advantages and Disadvantages of LLJG Operations

Advantages

No registered capital is required;

There is no need to invest into new buildings and facilities;

Only payment of processing fee is required with no VAT and import duty applicable;

There are no VAT-related additional costs under the light of new 2004 VAT regulations (reduction of refund rate) or increased cost of sales for exporting enterprises;

There is possibility of multiple productions of different products allocated to different factories, while, with a WFOE, the investor must strictly adhere to the business scope indications and must invest in different production lines for different products;

The equipment imported into China under this arrangement can always enjoy exemption of customs duty and VAT, while, for WFOEs, it depends on the different type of projects and industry;

Further processing/assembling is allowed; and

Lean and short-term production contract that enables to shift operations elsewhere in case of quota restrictions.

Disadvantages

No domestic sales is allowed;

Enterprise income tax is assessed by the tax administration on the processing fee amount and this may give rise to potential foreign exchange creative arrangements and additional paperwork to offset local official tax liabilities;

Bonded goods and operations are closely monitored by authorities;

It needs to rely on good relationship with the Chinese party;

For domestic purchases, no VAT rebates are applicable; and Rigid structure is unavoidable.

NOTE: This is the second part of a four part series on outsourcing. Part three follows in Issue 7.