Meaning
Corporate governance rules in China require all joint-equity and foreign-invested companies to dedicate a portion of their annual after-tax profits to a non-distributable internal reserve before issuing any dividends to shareholders. The process of statutory reserve fund allocation is designed to build a capital cushion that protects corporate creditors and ensures the long-term financial stability of the enterprise. This mandatory mechanism prevents the rapid extraction of earnings by foreign parents, ensuring that companies retain a portion of their local profits for risk mitigation.
Corporate Allotment
Companies must allocate ten percent of their annual after-tax profit to this statutory reserve at the end of each fiscal year. This step of statutory reserve fund allocation must be completed before any net profits are distributed to equity holders. The calculation is based on the audited financial statements prepared according to domestic accounting standards.
Funding Ceiling
The requirement to allocate these funds remains active until the accumulated reserve reaches fifty percent of the registered capital of the company. Once this threshold is achieved, the statutory reserve fund allocation becomes optional, allowing the company to retain more distributable cash for its shareholders. However, if the registered capital of the firm is subsequently increased, the reserve must be built up further to meet the fifty percent benchmark.
Usage Restriction
The funds accumulated in the reserve are strictly protected and can only be used for approved corporate purposes. For instance, they can be deployed to offset accumulated operational losses or converted into registered capital to expand the business operations. This prevents the unauthorized return of these reserves to foreign shareholders via hidden pathways.
