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Business in China: Modes of Entry. Dr. Stephane J. Grand. BACK TO THE BASICS. WHAT WE HAVE SEEN SO FAR Importance of personal relations in China and local preference Problems with contracts Relative importance of power vs. authority Appearances vs. fact-based reality
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Business in China: Modes of Entry Dr. Stephane J. Grand
BACK TO THE BASICS • WHAT WE HAVE SEEN SO FAR • Importance of personal relations in China and local preference • Problems with contracts • Relative importance of power vs. authority • Appearances vs. fact-based reality • Do not take anything for granted, remember that Chinese culture is different and just as real as western cultures S.J. GRAND
THE PROJECT • DEFINE WELL THE GOALS • Importing into China • Sourcing from China • Taking advantage of production costs in China for foreign markets • Producing in China for the Chinese market S.J. GRAND
THE SPECIFICITIES OF THE PRC FDI REGS • THE HURDLES • Convertibility of the RMB, both for repatriation of dividends and payments into China • High import duties and taxes • High capital investment • THE REGULATORY FRAMEWORK • The Foreign Investment Catalog S.J. GRAND
1. COMPANY SETUP S.J. GRAND
ENCOURAGED INDUSTRIES “The most favored category” CHINA’S FOREIGN INVESTMENT CATALOGUE • Examples of “Encouraged” industries: • Water conservation technology; • Intellectual property services; • Mining; • Manufacturing; • Transportation; • Warehousing; • Sanitation, fitness, and social welfare industries • Education, culture, art, radio, film, and television industries; • Foreign funded projects that directly export all of their products; • Vocational education and training. • Subject to less strict administrative requirements • Eligible for favorable tax treatment and other benefits • Investment only requires its registration with the PRC government • Encouraged investments generally relates to: • New and/ or advanced technology to China • Projects increasing exports • Projects improving manpower efficiency • Projects conserving the resources • Projects protecting the environment CONFIDENTIAL
PERMITTED INDUSTRIES “The standard category” CHINA’S FOREIGN INVESTMENT CATALOGUE • Examples of “Permitted” activities: • Production of carbonated soft drinks; • Construction and operation of oil refineries- (Annual output of eight million tonnes or less); • Franchise business, Commission business; • Automobile wholesale, retail and logistics; • Medical institutions – (Investment here is limited to equity joint ventures and contractual joint ventures); • Financial leasing companies; • Distribution and importation of books, newspapers and journals; • Importation of audiovisual products and e-journals; • Internet music services. • Investment approval is generally assumed to be granted without a hitch • No particular restrictions • No favorable tax treatments and other benefits • Investment requires its registration with the PRC government • Reasons for allowing investments under permitted category and not under encouraged one: • Potential overcapacity • Concerns over “blind investments” in Chinese market CONFIDENTIAL
RESTRICTED INDUSTRIES “The category subject to high scrutiny” • Examples of “Restricted” activities: • Certain agricultural, forestry, animal husbandry and fisheries • Mining of precious metal and certain ores • Certain manufacturing (tobacco, certain textiles) • Electricity (adoption of low capacity generator) • Certain telecommunications • Certain wholesale and retail trade • Electricity, gas, and water production • Banking and insurance industries • Real estate in high end property • Golf courses • Production and distribution of radio and TV programming CHINA’S FOREIGN INVESTMENT CATALOGUE • Subject to higher levels of scrutiny and stricter administrative requirements • Automatic approval of the investment cannot be assumed • Reasons for investments being subject to restrictions: • Technology has already been imported into China • Industry is not conducive for healthy environment • Industry is prone to high energy consumption • Industries is highly regulated by the State or fall under State central planning CONFIDENTIAL
PROHIBITED INDUSTRIES “The disbarred category” CHINA’S FOREIGN INVESTMENT CATALOGUE • Foreign investment is not permitted • Investment may be denied at the discretion of approval authorities • Reasons for investments being prohibited: • Endanger state security • Pollute the environment • Against public well-being • Occupy a large amount of farmland • Endanger the use of military resources • Use manufacturing techniques that are unique to China • Examples of “Prohibited” activities: • Mining of radioactive materials • Arms and ammunition manufacturing • Air traffic control • Postal Services • Futures trading • Social research • Gambling • Pornography • Publication of books, magazines, and newspaper • Construction and operation of villas. • Breeding and growing of precious, high quality breeds of animals CONFIDENTIAL
LIMITATIONS TO LIMITATIONS • BEING SMART ABOUT THINGS • It is always possible to structure businesses differently when needed, and have licenses held by third parties; • Some industries are only forbidden to foreign businesses on paper: • The Variable Interest Enterprise • Law firms and their tax regimes S.J. GRAND
COMPANY REGISTRATION IN CHINA • INITIAL PHASE IS CRITICAL • Your business scope, structure and location will affect registration procedures and required documentation, minimum registered capital, tax and insurance obligations, environmental and hygiene regulations; • Early mistakes can be costly to correct. S.J. GRAND
PREPARATION CHECK-LIST S.J. GRAND
MOST COMMON FIE STRUCTURES 1. Representative Office ("RO")2. Wholly Foreign-owned Enterprise ("WFOE")3. Equity Joint Venture ("EJV")4. Contractual Joint Venture ("CJV") CONFIDENTIAL
DECIDING ON STRUCTURE REPRESENTATIVE OFFICELeast dynamic of available entities. Legal status: No capacity under Chinese law; head office liable for its RO activities in China. Sources of fund: Exclusively from RO’s head office. Employment: Can NOT directly employ Chinese employees; must be employed via a registered human resources agency. • STRUCTURAL LIMITATIONS • Research and market surveys relating to the products/ services of the head office • Head office product/service displays and promotional activities • Liaison activities in connection with product sales, the provision of services, domestic investment by head office • Cannot issue invoices (Fa Piao) • Cannot engage in profit making activities • Cannot receive payment • Cannot sign contracts S.J. GRAND
DECIDING ON STRUCTURE WFOEMost popular option Legal status: Limited Liability Company Sources of fund: Minimum registered foreign capital requirements set according to business scope and location. Employment: Can hire directly; staff must be provided with contracts that are duly prescribed under Chinese law concerning matters of employment, remuneration, dismissal, welfare benefits etc. • STRUCTURAL LIMITATIONS • Research and market surveys relating to the products/ services of the head office • Head office product/service displays and promotional activities • Liaison activities in connection with product sales, the provision of services, domestic investment by head office • Cannot issue invoices (Fa Piao) • Cannot engage in profit making activities • Cannot receive payment • Cannot sign contracts. • ADVANTAGES • Independence; no domestic partner required • Autonomous legal entity • Able to take advantage of industry- and location-based tax exemptions and subsidies • Greater level of IP protection • Can issue invoices and receive revenue in RMB • DISADVANTAGES • Lengthy registration and licensing process • Lack of established connections of joint venture partner S.J. GRAND
DECIDING ON STRUCTURE • STRATEGIC ADVANTAGES • JOINT VENTURESA joint venture is an entity formed by a foreign investor or a foreign individual with a Chinese company, in which the foreign party owns more than 25% of shares • Equity Joint Venture (EJV) • Limited liability company; profits and losses are distributed between parties according to the capital in proportion to their respective equity • Requires board of directors and contractually appointed management team • 2. Contractual Joint Venture (CJV) • Can operate as limited liability company or as non-legal person; profits and losses distributed according to provisions of CJV contract S.J. GRAND
TYPICAL WFOE REGISTRATION PROCESS Submit your name for pre-registration Open a temporary account (optional) Approval by relevant ministries for restricted activities (education, law, medical and other fields) Submit Articles of Association for approval Approval by the Ministry of Commerce Organization Code Corporate Certificate of Approval by the Ministry of Commerce Issuance of the Business License by SAIC Capital injection Capital verification report issued by CPA firms Registration with Public Security Bureau Production of company, finance and legal representative seals Organization code certificate Open basic RMB bank account Tax Bureau Registration Open Foreign Currency Capital Account Foreign Exchange Registration Tax Machine Setup Statistics Registration Certificate Finance Registration Certificate Customs Registration Certificate (import/export companies) Registration with social insurance institution. TIME: 12 weeks – 5 months (longer for some industries) S.J. GRAND
WFOE FINANCING – REGISTERED CAPITAL • Funds should be transferred specifically to denominated Capital Account. • Payer's name must match exactly the investor on the Certificate of Approval • The capital injection(s) must follow the amount and periodicity indicated in the Articles of Association. Based on Chinese regulations the amount should either be equal to the full amount of the capital or at least 20% of total registered capital and be injected within 90 days from the issuance date of the business license. • Bank fees should not be deducted from transferred capital but instead paid at the remitter's level in China including the bank fees charged by the remitting and intermediary bank(s); • Have sufficient funds available (to cover at least 2 months of operations) to avoid the need for time consuming capital increases or unapproved shareholder loans. • The Capital Account can only be used for capital injection. • Actual injection amount and registered capital amount must match 100% • Capital transfer must be in the same currency as indicated in the Articles of Association and the Certificate of Approval • Capital Denominated in RMB becoming possible S.J. GRAND
SPECIFIC ACTIVITIES: IMPORT AND EXPORT The largest businesses (foreign and Chinese) are certainly importation of foreign goods into China and export of Chinese production. Purchasing from China has been made easy, but: • Payment terms are rarely convenient when buying from a Chinese factory, • Quality control is a critical issue, • Ethical issues subsist (child or prisoner labor, source of some raw materials).
EXPORTING TO CHINA An opaque regulatory environment, weak rule-of-law, and intellectual property rights violations continue to challenge export business. Without proper knowledge and thorough research, entering the China market may turn out to be a fairly complex, risky and challenging process.
For an exporter looking to enter China market, it can be intimidating to know exactly where to begin. EXPORTING TO CHINA THINGS TO DO BEFORE EXPORTING TO CHINA
2. SPECIAL CASE: ACQUISITIONS S.J. GRAND
ACQUIRING A CHINESE COMPANY IS THIS REALLY WISE? • Stepping into a Chinese company is a sure way to feel a real culture shock; • What are you really buying? Production capacity? Distribution network? Personal relations?; • Why it might make sense to do an asset deal rather than a share deal; • Always seek counsel; • Always do legal, financial, operational and environmental due diligence work. S.J. GRAND
DUE DILIGENCE ACCOUNTANCY • Analyze fixed assets: are they reflecting the reality of the company’s operations? Assets may be overestimated or have inaccurate depreciation. Ensure that the company is the true contractual owner of the fixed assets; • Accounts receivables: confirmation with clients is essential in order to double check the target company’s explanations of total billing. This process should also apply extra scrutiny to a company’s aged receivables balance. Where applicable, suppliers should also be verified; • Cash position should be confirmed through a letter from the banks, and in some cases sending it to the regional headquarters may be preferred; • Check other payable and liabilities: analysis should be done on salaries, social insurance payments or liabilities such as pension payments for former employees; In some cases, higher salaries are negotiated in exchange for underpaying social insurance obligations; • Business expenses: check the authenticity of invoices. S.J. GRAND
DUE DILIGENCE TAX • How does the PRC GAAP differ from the accounting standards normally used by the investor? Do these issues have the potential to create confusion about the overall financial position of the target investment? • Do transfer pricing issues or exposure to transfer pricing apply to the company in question? • What are the applicable preferential tax rates based on the company’s industry or operational scope, and what is the extent and time length of these preferential rates? • Is the company in compliance will all foreign exchange regulations? • Is the company fulfilling its withholding tax responsibilities? • If applicable, are all customs regulations being followed? S.J. GRAND
DUE DILIGENCE OPERATIONAL • Experienced foreign investors and companies have been duped because they did not conduct investigative operational due diligence. • Reviewing financial statements and other company documents is unlikely to provide all vital information for a potential investor, and is inadequate to provide a complete picture of a company’s operations • Unofficial site visits must be conducted to confirm “on paper“ activities. • Independently verify volumes of sales or purchases from suppliers. • Can you secure interviews with lower level staff or security guards at factories or facilities? Sometimes interviewing lower level personnel who have not been coached on what to say to investors can help in getting a truer picture of the target in question. S.J. GRAND
DUE DILIGENCE LEGAL • Have you confirmed your target has rights to its technology, trademarks and patents? • Does it have all necessary licenses and permits? • Investigate ownership structure carefully. Are there any hidden owners or partial shareholders? • Investigate human resource management; confirm activities of all major employees. Family members often “employed” to minimize tax. • Confirm that the company in question owns the land use rights itself and that these rights are not owned by third parties or parent/affiliate companies of your target. • Common problems include unenforceable informal arrangements between companies and local officials, land improperly zoned for current use, or mortgaged land and buildings detracting from the target company’s overall value. S.J. GRAND
DUE DILIGENCE ENVIRONMENTAL • Company’s holding of all appropriate environmental permits; • Examining any potential outstanding liabilities or costs due to environmental contamination or degradation; • Ensuring land included as part of any deal is not contaminated (soil sampling can determine this); • Clarifying what environmental management systems a company has in place; • In the case of land containing factories, examining wastewater management and waste disposal capabilities and procedures; • Investigating any existing arrangements with a locality’s governing environmental body.
POST-MERGER INTEGRATION • The most difficult thing after an acquisition is to convince people that the company has changed hands: • Establish internal control procedures, • Effect strong cultural changes with Chinese characteristics, • Communicate well with suppliers and customers, • Remove the former owners from management.
3. FINACING BUSINESSES IN CHINA S.J. GRAND
THE PROBLEM WITH THE RMB WE ARE STILL IN A COMMUNIST COUNTRY • The currency is not freely convertible, which means that funds brought into the country are more difficult to take out (procedure); • Funding a company with loans: • Cash pooling is exceedingly difficult because of business scope limitations • Local loans are exceedingly difficult to get; • Thin capitalization rules impact intercompany loans in foreign exchange.
THE PROBLEM WITH THE RMB WE ARE STILL IN A COMMUNIST COUNTRY • What is a thin capitalization rule: • A rule that limits the amount of loans a company can get in proportion to the paid-in capital. • TCR in the PRC; • Total investment equals registered capital plus borrowing gap: • You contribute 100 worth of registered capital • The formula gives you a total investment of 140 • The borrowing gap is 40 • TCR table:
THE PROBLEM WITH THE RMB WE ARE STILL IN A COMMUNIST COUNTRY • The registered capital is fixed, and has to be legally increased in order to bring in more capital. • Each increase in registered capital can take from 30 days to forever. • The increase in registered capital does not always mean a direct increase in total investment. • Some local authorities use a cumulative investment calculation method • Some others use a one-shot investment method • What does this mean? • Business planning is key: a clear evaluation of the financing needs upfront is critical
“What Carrefour is doing right (in addition to grabbing and building as many retail outlets as it can in the big cities) is simple: They're selling in a Chinese way to Chinese consumers” - Paul K. Ward, CRM Consultant, in 2005
China’s Consumers The shopping experience in China has evolved dramatically over the past decades. Chinese consumers continue to place great importance on the freshness and quality of ingredients. On one hand, the primary retail establishments for fresh food items in China are OPEN MARKETS (« wet markets ») which represent a wide variety of products and a social experience. On the other, FOREIGN RETAIL CHAINS such as Walmart (U.S), Carrefour (France) have open hypermarkets in major Chinese cities. They provide low prices and one stop shopping for food and general merchandise.
Carrefour vs Walmart “ Global expansion will be a key avenue for retailers in developed markets to generate new sources of revenue to offset slower sales growth at home....They [American firms] will be late to the game, especially compared with large European retailers..” -Retail Forward 2006
Carrefour Success Story 25 Stores openings by year €86,6 billion Total annual sales in Asia and €55,83 billion total annual sales in China. 77% Represents sales in China among total Asia sales.
Key dates Carrefour Success Story 1989 First settlement of Carrefour in Taiwan, helping to get into Chinese market. 1995 Settlement of Carrefour in China. First group which set up hypermarkets in the country. 2006 Carrefour was already operating 83 hypermarkets in 34 cities
?Why such a success • Carrefour settled in China with the SUPPORT OF THE GOVERNMENT and made agreements with local authorities. • Carrefour purchased high goods volume from China which permits to WIN FAVOUR POLICIES from local government. • The group first introduced the CONCEPT OF HYPERMARKETS in the country • Carrefour has a RETAILER ADVANTAGEand based its strategy on selling also through small suppliers • The group ADAPTED ITS RANGE OF PRODUCTS to Chinese local tastes and consumer habits
Business in China: Modes of Entry Q & A Dr. Stephane J. Grand