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Policy Interpretation

Dec 31, 2019

Profit Distribution and Capital Withdrawal

There are a lot of similarities between profit distribution and capital withdrawal. Both of them are about giving assets of the legal person to its investors (shareholders). However, the two of them are distinctly different. While profit distribution is the normal practice of a business, it is punishable to withdraw capitals without appropriate procedures.

In plain language, capital withdrawal refers to the transfer/distribution of the non-distributable profit and/or assets of the legal person (the Chinese laws do not define what capital withdrawal is).

As it does with capital withdrawal, the Company Law of the People’s Republic of China does not define profit either. Instead, it dwells on the orders how profit is to be allocated before distribution (please refer to the article 177 of Company Law of People’s Republic of China for further information).

In addition, the Accounting Principles of China (article 37 of the General Principle of Accounting Standard) defines profit as “business performance gained in a certain span of time”.

It further holds that profit is composed of the margin of revenues less cost and expenses and less the margin of gains and losses. In short, profit is composed of commercial margin (revenue less cost less expenses) and the non-commercial margin (gains less losses).

To be more precise, the non-commercial margin (gains less losses) is not necessarily recognized as profit. Some of them is considered as capital reserve and owner’s/shareholder’s interest, which is not distributable (this is not very commonly used in normal operations of the company. We do not talk about it here in order not to cause confusion).

Capital will not make proceeds if it is not circulated (used). The proceeds produced in the circulation of the capital is profit. Only this portion of proceeds are distributable to its investors (shareholders) if some conditions are met. The capital that is not put into circulation cannot be distributed. Otherwise, it is a conduct of withdrawal of capital.

Then what profit is distributable, and what conditions need to be met before it is distributable?

To answer this question, we need to have some basic knowledge about company.

Chinese laws defines a company a profit organization, and holds that its purpose is to make a profit. The net profit (gross profit less corporate income tax) is only distributable after it goes through a process of allocation.

According the Company Law and the Accounting Principles of China, net profit will first be used to make up the losses of the previous year(s), and then 10% of the balance will be withheld as surplus reserve (shareholders can choose not to withhold surplus reserve if it has amounted to 50% of the registered capital; there is also an at-will surplus reserve that has not limit to its total amount, but it is subject to the shareholders’ consent).

It is the at-will surplus reserve that empowers a company not to distribute even one cent of profit although a company makes huge profits.

The balance of the net profit after making up previous years’ losses and withholding surplus reserves is called distributable profit (dividend). Only this portion of money is legally allowed to be distributed to the shareholders (investors).

Therefore, any distribution of the assets of a company but the distribution in the preceding paragraph is illegal under the Chinese laws, and if not done properly may sustain legal liabilities.
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