xxxxx Doing Business in China #AsiaQ
Asia Intelligence Unlocking Opportunity The Power of Together #AsiaQ xxDoing Business xxin China 1 Doing Business in China / kwm.com Asia Intelligence Unlocking Opportunity A key differentiator for King & Wood Mallesons is our unique insight and expertise in one of the world’s fastest growing economies. To succeed in the Asian Century and the new global marketplace, you first have to understand Asia. AQ, or Asia Intelligence, is our approach to unlocking opportunities for clients looking to connect with Asia, and connecting Asia with the rest of the world. It sits at the core of the way we approach our clients and their business - every day. Having AQ is vital if you are looking to deliver tangible, long-term business growth. Your success will be directly proportionate to the investment you make in accessing genuine insights into the way Asia does business. Fact. The dividend comes with how you build and share this knowledge. In a rapidly changing and constantly moving world, doing business has become more complex. Having an international perspective with deep local understanding is crucial. Cultural fluency has never been more relevant than it is today. With local, on-the-ground relationships and more than 2,700 lawyers working in key financial centres and the growth capitals of Asia, we truly understand how to do business in China. Since our emergence as a global law firm in March 2012, we have learned a great deal - both in partnership with our clients and by pushing the frontiers of what can be achieved in this new region of opportunity. Our mission is to connect you to future success - shaping a new world for your business, and for your people. Stuart Fuller Global Managing Partner © 2014 King & Wood Mallesons. AQ® (Asia Intelligence) is a registered trademark of King & Wood Mallesons. For more information visit kwm.com “China continues to welcome foreign investment...and the door… will open even wider…” “我们对中外企业向 来一视同仁…中国 的大门将继续敞开 并不断扩大…” Introductionssss I f the first 12 months under the leadership of President Xi Jinping and Premier Li Keqiang will be remembered by their improvement of standards of governance, the second year promises to be all about reform and regulatory change. This will present challenges but also significant opportunities for investors in China. NPC Premier Li Keqiang, Opening ceremony of the Annual Meeting of the New Champions 2014 (Summer Davos Forum), on 10 September 2014. In this publication we answer the key questions being asked by clients looking to unlock investment opportunities in China. Those questions include: What are the business models available for investing in China? What are the current issues that I should be aware of? How do I protect and ultimately exit my investment? Against a backdrop of regulatory reform, economic transition and heightened regulatory enforcement, we explore and position the investment trends in China, the relevance of the new Shanghai Pilot Free Trade Zone, the role Hong Kong might play in China’s future plans, and the relevant opportunities that these two destinations represent. Building on our unrivalled depth of capability and on-the-ground experience of over 1,000 lawyers in China, we discuss the key opportunities, the key concerns and issues facing foreign companies investing, operating and/or sourcing from China, and how this is changing over time. Throughout this publication we offer our insights and opinion on a range of topics that are currently top of mind for investors looking to do business in China, and the Asian region. China presents some of the world’s most exciting opportunities, and also a unique set of cultural, legal and political challenges. Through this publication we hope that we can add value to your business opportunities in China and we would be delighted to discuss them with you further. Wang Junfeng Global Chairman Stuart Fuller Global Managing Partner Doing Business in China / kwm.com Pudong District, Shanghai 3 We say… The Third Plenum pinpoints economic reform as key. The Government has now elevated the role of the market from a basic role to a decisive one, signalling that vital changes lie ahead. This is welcome news for foreign investors. xxChina’s xxInvestment xxEnvironment R ecent actions of China’s legislators and regulators mean that China’s investment environment can be characterised as one of significant medium to longer-term opportunity balanced by some short-term risk. As outlined in China’s current Five Year Plan (2011-2015), and the National People’s Congress, China is seeking to re-balance its economy to achieve qualitative sustainable growth led by consumer consumption as opposed to fixed asset investment and export driven growth of the past. The Plan encourages foreign capital, broadening of investment opportunities and markets, improvement in investment quality and environment, and protection of the interests of foreign investors. The Plan particularly encourages innovation, foreign investment in finance and logistics, outsourcing of services, and gradually opening the door to foreign investment in education, medical treatment and sports. The Plan will likely lead to a re-allocation of capital away from provincial and central State-Owned Enterprises (SOEs), and the gradual opening of market and industry opportunities to private companies that were previously reserved for SOEs. We are already seeing the introduction of structural reforms to give effect to the goals in the Plan, in particular those outlined in the Resolution passed by the Third Plenary Session of the 18th Central Committee of the Communist Party of China (Third Plenum). 4 Xu Ping Corporate M&A Partner (Beijing) The diagram below illustrates some of the key changes: What’s in store for 2014/2015 Third Plenum Resolution (9-12 November 2013) To increase: o perational transparency c ertainty in administration & judicial procedures Encourage investment, innovation and competition from private domestic companies Build China under the rule of law Build a new open economic system Expedite establishment of FTZ R elax investment access Enhance vitality and deepen reform of state-owned sector Expedite transformation of government functions Establish law-based and service-oriented government Company Law No minium registered capital N o capital verification reports Doing Business in China / kwm.com F acilitating proper relationship of the government and market A llow market to play decisive role in resource allocation Expedite movements in modern market system Increase restriction & supervision of use of authority Target corruption through punishment and prevention methods Improve mechanisms to integrate urban & rural development Changes to hukou household registration system, which will support further investment in housing, schools, hospitals and transport systems What are the Opportunities for Investing in China? With the push to move away from being the world’s factory, China is steering investments away from low value add, labour-intensive businesses – particularly those involving conventional technology and highly polluting and resource intensive technologies - in favour of high value added and technically advanced manufacturing and strategic technologies in goods and services. China’s Catalogue for Guidance for Foreign Investment (Catalogue), a kind of 'bible' for foreign investors, reflects this priority. Foreign investors into China generally fall into four main groups: More recently, these firms are seeking to bypass agents, establish their own sourcing offices (particulary with a focus on ethical sourcing) and procure higher value and more complex goods and services Much of this is being driven by consumers who are increasingly demanding more from their leaders, which is leading to a range of supply opportunities, such as the licensing of environmental technology for Beijing’s new war on pollution 1 Firms interested in engaging in sourcing and procurement Firms meeting demands of governments in the supply of goods and services across China 3 2 Firms focussed on selling to, and also within, China Financial investors, including private equity funds 4 Doing Business in China / kwm.com Pursuing opportunities arising from an emerging consumer boom, particularly in the retail and online sectors Seeking to benefit from what we anticipate will be a new wave of industry consolidation, privatisation of SOEs and the opening up of new sectors to competition 5 xxChina’s xxInvestment xxEnvironment Business Models Available and Considerations Where foreign investment is restricted, parties may consider contractual options instead or a variable interest entity. Often the level of complexity of the business operation, and the depth of integration of the business in China, will dictate the type of investment vehicle and strategy. Foreign investment in China typically occurs through establishment of a new entity on a stand-alone basis, formation of a joint venture, or through merger or acquisition of an existing business. over existing Take assets and business Asset deal, share deal investment in Private public equity (PIPE) Which option? Venture Joint vs WFOE Land acquisition Construction License and permits production, R&D, distribution, logistics Level of complexity High Distribution Product registration Joint R&D, licensing Contract manufacturing OEM agreements Cooperation Mergers & Acquisitions Greenfield Projects Contractual Arrangements Product Sales deals into A-share listed companies Strategic relationship Full due diligence Post-deal integration 4 3 2 1 Low 6 Level of commitment to target market Doing Business in China / kwm.com High A. Greenfield Projects The main forms of foreign invested enterprises (FIE) for investing in greenfield projects in China are set out below: # Type of vehicle Introduction 1. Equity Joint Venture (EJV) Joint PRC and foreign ownership. Shareholders have joint management of the company. Profit and loss are distributed in proportion with each party’s capital contribution. In certain industries, there may be restrictions on foreign ownership in EJVs. An EJV is incorporated as a legal person limited liability company. 2. Contractual Joint Venture (CJV) Provides more flexibility in terms of what a party may contribute as registered capital, cooperative conditions, distribution of profits and liability, and return of investment, which may be agreed in the joint venture document. A CJV can be incorporated either as a legal person limited liability company or a nonlegal person entity. Typically, the preferred investment vehicle for joint construction and management of hotels, commercial complexes, infrastructure and mining projects. 3. Wholly Foreign Owned Enterprise (WFOE) A limited liability company with 100% foreign ownership. Investment vehicle of choice for most foreign investors in industries where there are no restrictions on foreign investment. 4. Representative Office (RO) Provides basic market entry without formal legal establishment. Restrictions on direct business activities. Recent regulatory changes make ROs very unattractive as an entry vehicle. 5. Foreign Invested Partnership (FIP) Established by two or more foreign entities or individuals with or without a Chinese partner. Profits and losses are distributed according to partnership agreement. Income tax is assessable on each partner, and not on the partnership. 6. Special FIEs Certain industries warrant special FIEs. For example, wholesale and retail entities use foreign invested commercial enterprises (FICE), companies wishing to invest in real estate projects use foreign invested real estate companies (FIREC), and foreign invested venture capital enterprises (FIVCE) are used as private equity funding vehicles. 7. China Holding Company A foreign investor with substantial operations in China will be eligible to set up a CHC to hold its equity in investments in China. (CHC) Doing Business in China / kwm.com 7 B. FIE Establishment Process A typical regulatory approval process when establishing a WFOE is illustrated below. This is also generally applicable to other FIEs, although timing may differ: 1 3 Name preregistration with SAIC MOC Approval 5 4 (30-45 days) Public Security Bureau SAIC Registration (2-3 days) (5-10 days) Name Approval MOC Approval Letter & Certificate Business License May require: 2 Lease Lease matters (Timing will depend on negotiations with landlord) Lease Registration Certificate SASAC approval if state-owned assets Industry regulator approval i.e. CBRC, CIRC, CSRC Taxation Bureau (5 days) b State Administration of Foreign Exchange c (3 days) Open bank accounts with relevant bank (10 days) Statistics Bureau Key (5 days) Days Working days MOCMinistry of Commerce, authority that approves foreign investment into China Finance Bureau SAICState Administration for Industry and Commerce or its local counterpart SASACState-owned Assets Supervision and Administration Commission Quality Supervision Inspection & Quarantine Bureau Additional regulatory approvals will be required in sensitive/restricted sectors or involving SOEs. If SOE assets are involved, a formal valuation by a licensed appraiser of the relevant assets and approvals from the State-Owned Assets Supervision and Administration Commission (SASAC) will need to be obtained. However, the general trend is towards a reduction in red tape. For example, National Development and Reform Commission (NDRC) project approval is generally no longer required for the establishment of manufacturing FIEs in 8 Post Registration Matters (1-5 days) non-restricted industries. Further, recent changes to the PRC Company Law have relaxed capitalisation requirements and various reforms applicable to FIEs have also commenced. The most challenging and time-consuming aspects of establishing a FIE are (i) negotiating and entering into suitable leased premises, (ii) crafting relevant business scope, and (iii) aligning organisational interests in a manner that enables the client to obtain the various approvals. As such, appointing an individual with strong project management Doing Business in China / kwm.com a d (10 days) (5 days) skills will be critical to the success of a project and help shave valuable time off the establishment process (e.g. a company is up and running in 2 to 3 rather than 3 to 4 months). In our experience, advance planning and coordination can help minimise disruptions throughout the process. We say… With the liberalisation of foreign investment,WFOEs now dominate the investment landscape and are typically the most suitable for initial PRC market entry. One must have compelling reasons to adopt a JV over a WFOE; too many businesses have come undone because of relationship impasses with their Chinese partners. Where those reasons exist, appropriately structuring the arrangements and investing in the relationship can help mitigate the risks. Martyn Huckerby, Corporate and Regulatory Partner (Shanghai) C. JV or WFOE? In sensitive industries and markets, restrictions on foreign investment mean that foreign investors are limited to joint venture structures (JV) with a Chinese partner. Many of the early JVs have not met investor needs and have been restructured because of insufficient due diligence, misaligned interests or management conflicts. Reasons that require the choice of a JV structure include: (a)legal restrictions (i.e. in restricted industries); (b)equity investment into an existing company whose shareholder does not wish to fully exit; (c)reliance on a Chinese partner is deemed as critical; or (d)private equity (in China, private equity investments are often minority positions). D. M&A Foreign investors may also operate businesses in China as a result of mergers or acquisitions (asset, equity, or both), which will result in an FIE. Foreign investors cannot circumvent restrictions on foreign investment through M&A transactions. Sectors that are closed to foreigners will remain off-limits. These are typically investments that are either culturally significant (e.g. traditional Chinese medicine), strategically important (e.g. rare earth), pose serious pollution or health concerns (e.g. radioactive mineral processing) or politically sensitive (e.g. media). If an M&A transaction meets certain global and domestic revenue thresholds, it will trigger anti-monopoly merger review notification to the Ministry of Commerce (MOC). The thresholds are low and surprisingly easy to trigger. This will have a significant impact on the timing of the proposed deal, as MOC approval can take up to 20 weeks. If an acquisition in China is part of a larger international arrangement, a global strategy will be required given increasing coordination between regulators. Procedural rules that are expected to follow the recent clarifications on the substantive criteria for “simple cases” may clarify whether time periods for review will be shortened or filing requirements simplified. Separately, China’s national security review requirements and other regulatory foreign investment approvals must also be considered. In light of increased enforcement actions by Chinese regulators, investors should prioritise due diligence on targets to cover off any compliance risks associated with competition, anti-bribery and corruption breaches. Investors should also carry out due diligence with regards to home jurisdiction regulatory requirements, including personal data privacy protection constraints. E. Share Market After a 13-month ban and the issuance of more market-driven rules in December 2013, A-share initial public offerings (IPOs) resumed in early 2014. Since then, 79 companies successfully listed in the first eight months of 2014 although the China Securities Regulatory Commission (CSRC) had yet to review a backlog of more than 620 prospective issuer applications at the time of publication. Even so, the CSRC generally encourages listings in the H-Share market. As evidenced by the increasing number of quotas for qualified foreign institutional investors (QFII) in the past few years, the Government is encouraging foreign direct participation in the A-share market. Alternatively, foreign parties can act as strategic investors upon MOC approval, though pre-IPO JV investors are subject to 36-month lock-up periods. To accelerate Renminbi (RMB) internationalisation, since 2011, RMB qualified foreign institutional investors can also use overseas RMB funds (RQFII) to invest in the A-Share market subject to annual quotas. In addition to participating in onshore markets, there are increasing opportunities to acquire equity interests in Chinese companies who list overseas. Alibaba’s recent initial public offering on the New York Stock Exchange that raised USD21.8 billion was the third largest in history and is likely to result in other Chinese internet businesses following suit. We say… Completing a merger or acquisition transaction in China within estimated time periods and without undue regulatory hindrance is only half the battle. Foreign parties often underestimate the volume of work that lies ahead on integration issues particularly if corporate headquarters genuinely intends to close the culture gap. The merging of technical infrastructure, systems and people present real growing pains for newly merged entities and must be given due consideration upfront. Zhang Yi, M&A Partner (Hong Kong/Shanghai) Doing Business in China / kwm.com 9 F. Contractual options If a foreign party is looking to distribute and sell its products in China, or source input material for manufacturing or assembly overseas without having to establish a permanent presence onshore, it may elect to enter into contractual arrangements with local parties to act, respectively, as agents and distributors, trading or sourcing agents. Franchising is an option for businesses seeking to launch and expand the market for its branded goods or services. Many defer to contractual distribution models instead given the regulatory roadblocks that accompany a franchise model in China. G. VIE Structure One type of contractual structure that has exploded in popularity, and controversy, is the variable interest entity structure (VIE). Where a proposed investment is subject to foreign investment restrictions (e.g. value–added internet services), parties commonly use a VIE to otherwise obtain access. A VIE refers to a structure where a wholly or partially foreign owned entity enters into contracts with a PRC operating company that has the approved business scope and holds the necessary licences to operate in a foreign investment restricted or prohibited sector (Local Licence Company). The first well-known VIE structure was adopted by the Chinese online media company, Sina Corp. in its 2000 listing on the NASDAQ. Other high-profile companies that have adopted a VIE structure include China’s largest internet companies Alibaba, Baidu and Tudou, interactive digital media advertising company Focus Media and education services company New Oriental. that VIEs were used to circumvent industry investment regulations and restrictions. For example, in 2011, Delaware-based Buddha Steel had to withdraw its registration statement for its US public offering as the Chinese authorities had disallowed its suite of VIE agreements citing that they contravened foreigninvestment policies and were against public policy. In some cases a foreign investor may feel it has no choice but to proceed with a VIE, but needs to take steps to mitigate risks associated with seeking to circumvent foreign investment restrictions in China as well as difficulties in enforcement. For example, a foreign investor should invest in additional on-the-ground representation and support to ensure that business operations continue to evolve in a way that both the foreign investor and local partner are comfortable. As a priority, companies should consider whether the newly-established China (Shanghai) Pilot Free Trade Zone (FTZ) could be of benefit. Provided that the relevant industry is not delineated on the 2014 Negative List (Negative List), companies can benefit from simplified filing procedures, reduced foreign investment restrictions and greater ease of operations. Parties only need to file their establishment applications with the State Administration of Industry and Commerce (SAIC) who will coordinate approvals with other government departments, thereby shrinking establishment timeframes to one week. In terms of money flows, resident FTZ companies will, now or in the near future, have access to: (a)Simplified foreign exchange registration - open capital accounts without prolonged foreign exchange registration approvals; (b) F ree trade accounts - open free trade accounts (FTA) and transfer funds freely between FTAs, other offshore accounts, and onshore nonresident accounts; To obtain control over the operation and management of the Local Licence Company, various contractual arrangements are put in place among the WFOE, the Local Licence Company and its domestic shareholders. (c) O ffshore RMB loans - borrow offshore RMB funds subject to certain requirements (e.g. limits on use of such offshore RMB loans and loan term); The controversy surrounding VIEs stems from significant legal risks inherent in its structure. In particular, no PRC regulatory body has officially approved a VIE structure and controls have tightened over VIE structured candidates wishing to list on the Hong Kong Stock Exchange. In recent years there have been several challenges by regulators based upon the allegation 10 H. Free Trade Zone in Shanghai (d) RMB convertibility - enjoy full convertibility of the RMB under capital accounts along with any future benefits foreign exchange reforms may present (e.g. FIEs can convert Doing Business in China / kwm.com I. Considerations for Investing in China via Hong Kong We say…. The FTZ is a laboratory for China’s next round of economic reform following the Third Plenum, including heavily reducing government red tape and further opening-up of the financial service sector such as pushing for RMB internationalisation. Lessons learned from the FTZ are expected to be applied to other parts of China in the future. The FTZ will be a breeding ground for pioneers and innovation will be the order of the day. Structuring China-related investments through a Hong Kong holding company can provide the following benefits (including easing the exit strategy as discussed later in this publication): (a) Economic benefits Stanley Zhou, Banking & Finance Partner (Shanghai) (e) (f) foreign exchange into RMB from day one and enjoy RMB hedging, whereas outside the FTZ an FIE must wait until there is a commercial contract requiring hard currency payment); A number of key sectors have already benefited from the reforms in the FTZ, these include the banking sector (HSBC and Citibank), mobile gaming (Microsoft and Sony), logistics (Steinweg-Handelsveem BV) and healthcare (Artemed Group). Deposit rate liberalisation - enjoy higher interest rates for foreign exchange and RMB deposits with banks due to the loosening of the statutory interest rate limits; and If the FTZ is a viable option after preliminary examination, parties should: Others - significant changes will benefit parties wishing to operate banking and finance, transportation, commerce and trade, culture, public and other professional services. For example, foreign investors can now invest in certain categories of valueadded telecommunication services. The 8-page Negative List, which includes 18 industries affecting 56 categories of investment areas, is a dynamic document that will be regularly reviewed and updated. The current version of the Negative List was updated on 30 June 2014, less than a year since its first reiteration issued on 29 September 2013. Compared to the 2013 version, the Negative List has 51 less restricted business items and is organised by sectors, which now varies from how the Catalogue is organised. The next version is anticipated to be shorter and further relax existing restrictions. Most central and Shanghai government level regulators have issued detailed implementation rules to supplement the largely macro level rules issued to date. (a) Consult the FTZ Management Commission Closely monitor FTZ legislative developments in the relevant industry and consult with the FTZ Management Commission on potential investment; (b) Consider an investment plan Obtain clarification with FTZ authorities that an established entity will benefit from FTZ policies as some branches and subsidiaries will not (e.g., a FTZ resident sub-branch would not be able to borrow foreign debt like other resident FIEs as a sub-branch is not subject to any paid-in capital, a pre-requisite to determining the amount of foreign debt allowed); and (c) Application process Carefully complete an online application and maintain access to a laptop to enable last-minute adjustments prior to on-site submission. Dividends received by a Hong Kong holding company from a Mainland subsidiary are unlikely to be taxable in Hong Kong, no dividend tax is levied on the Hong Kong holding company when distributing dividends to investors, and a lower income tax is levied on the Hong Kong company compared to its Mainland counterparts; (b) Flexibility Greater ability to tailor multiple investors’ rights and obligations and governance provisions in a Hong Kong holding company due to less restrictive corporate legislation; (c) Funds access Quick access to both domestic and international funds, under a stable regulatory framework; and (d) CEPA Qualified Hong Kong companies can take advantage of preferential treatment under the Mainland and Hong Kong Closer Economic Partnership Arrangement (CEPA) to invest in certain industry sectors in Mainland China that are partly or fully restricted to investors from other countries or regions. We say…. Establishing a special purpose vehicle in Hong Kong is a strategic move that can generate economic benefits through a tax efficient jurisdiction, greater protection through established Hong Kong laws governing shareholders, unrestricted access to funding and a ready exit strategy. This can translate into an environment that is responsive to business needs, an incredible asset when doing business in China. Raymond Wong and Huang Xuhua Corporate M&A Partners (Hong Kong) Doing Business in China / kwm.com 11 Financial Market Opportunities A. Banking Reform The restructuring and opening up of China’s financial markets has been at the heart of China’s economic reform agenda for the past two decades but progress in recent years has been limited. Xi Jinping has emerged as a powerful leader, with a clear and ambitious agenda for reforming the markets. Changes announced at the Third Plenum and endorsed by the National People’s Congress (NPC) in March 2014 provide a clearer and more predictable framework for assessing potential investment opportunities. Those changes have the stated aim of enhancing the stability, resilience, competitiveness and openness of the financial system and institutions. Importantly they also address many of the areas that have been problematic to foreign investors: there will be further liberalisation of the interest rate market, including the introduction of a new bank deposit insurance scheme; and there will be other reforms to strengthen social safety and spur the call to spend more and save less. Although regulatory impact and compliance continue to be major concerns for foreign banks and financial institutions, recent changes have nevertheless expanded the permitted scope for qualified foreign banks to conduct business in China. For example, locally incorporated foreign banks are now permitted to take part in asset-backed securitisations and opportunities now exist for foreigners to participate in niche areas such as automobile financing and equipment financing. China’s capital account will be opened further, allowing easier investment abroad by China’s wealthy, and expanded portfolio and direct investments by foreign companies into China; A stated end-goal of China’s reform process is to make the RMB an international currency and one that is freely convertible. China is already actively promoting the use of RMB to settle international trade contracts and to realise China’s ambition for convertibility policy makers are progressing initiatives to support the development of deep and liquid domestic RMB markets, as well as developing deeper bond markets and derivative markets to hedge currency and other risks. The growth of the offshore RMB market has been spectacular in recent years. Chinese banks see this as a strategic opportunity to follow their clients abroad and develop their international payments clearing business. Foreign banks see this as an emerging growth opportunity to support their clients who increasingly will need to buy, pay and invest in RMB. The full implications of RMB internationalisation are only just emerging, but if your organisation is active in the global trading and investment markets, now is the time to review the opportunities that will arise from the rapid take up of this new international currency. These include: the entry barrier to foreign companies will be lowered, allowing more foreign capital into the Mainland and increasing competition within the financial sector; (a) Cross-border borrowing Chinese companies may be more inclined to borrow from foreign banks on a crossborder basis to take advantage of the cheaper funding costs for offshore RMB compared to those for onshore RMB; the domestic financial markets will be fostered by the development of the equity, bond and derivatives markets with accelerating changes to liberalise the terms and access to credit for private companies; 12 B. RMB Internationalisation Doing Business in China / kwm.com We say…. The latest reforms of China’s financial markets are particularly beneficial to foreign financial institutions and corporations operating in China. Foreign financial institutions will have increased capability to launch new products to the markets, which in turn will provide companies more access to financial support for business development. Wang Ling, Managing Partner China (Beijing) (b) Cash-pooling Treasurers of multinational corporations or their Asian headquarters may wish to make use of cross-border RMB cash pooling products to assist in centralising and mobilising onshore RMB cash; (c) Cross-border funding Dramatically enlarged cross-border fund channels will make it more flexible to structure cross-border financing and raise funds due to the availability of RMBdenominated cross-border guarantees and outbound RMB lending by Chinese subsidiaries to their offshore affiliates; and (d) Asset management and custodian business The market for cross-border RMBdenominated investments (e.g., RFQII, RMB Qualified Domestic Institutional Investors, RMB bonds and asset-backed securities) will act as a catalyst for more asset management and custodian business. C. Financial innovation driving reform Deposit and lending rates are heavily regulated in China and banks are able to earn a fixed and lucrative return from the country’s vast pool of money. With few alternative investment options, Chinese depositors have either had to accept low returns from banks or seek higher returns in the largely unregulated (and riskier) "shadow banking" market. The emergence of internet finance in China is providing new options and hastening the pace of financial reform. Now, financial products like Yu’E Bao from e-commerce giant Alibaba are acting as a catalyst and putting pressure on banks to change. Yu’E Bao and other products are essentially undermining Chinese banks’ biggest comparative advantage - their low cost of capital. While the deposits held by internet and e-commerce companies are still very small proportionately, and likely to become subject to more stringent regulatory oversight, they provide a critical insight as to the potential direction and growth of the financial markets. Many traditional banks are launching new financial products and building online digital channels. This will have the effect of gradually changing China’s banking landscape from bricks-and-mortar to digital based. Entrepreneurial enterprises from within China and abroad have reason to be encouraged by these developments. Doing Business in China / kwm.com The emergence of internet finance in China is providing new options and hastening the pace of financial reform. 13 xxCurrent Concerns for xxForeign Companies xxInvesting in China Based on our clients and recent experience, issues having the most significant potential impact on foreign investors at present are as follows: (a) Anti-bribery and Corruption The Government has been aggressively targeting bribery and corruption breaches. Significant investigations in 2013 included the investigation of GlaxoSmithKline Plc in relation to incentive schemes to doctors and hospitals, and allegations of corruption by Chinese companies and their executives. In September 2014, a Chinese court imposed record fines close to AUD560 million (RMB3 billion) on the company and suspended prison sentences of up to 4 years on its executives. The results highlight the impact of unethical behaviour on international businesses in China, which subsequently launched investigations in various other jurisdictions that remain ongoing; (b) Competition Enforcement Throughout 2014 there has been a heightened level of enforcement activity by the Chinese antitrust authorities. Both the NDRC (responsible for price oversight) and the SAIC (responsible for non-price conduct) have launched extensive industrywide investigations and imposed large fines on foreign and domestic firms for anticompetitive conduct including resale price maintenance (RPM), price fixing and abuse of dominance. Investigations have involved various sectors including optical lenses, auto-makers, software, building materials, telecoms, insurance, second-hand cars, tourism, special equipment, water supply, gas and packaging materials and have generally been triggered by complaints from competitors, customers and trading partners. 14 This period of heightened enforcement creates short term business risk as firms operating in China may need to adjust their practices to comply with rules that may not have been enforced previously. In the long run however, these developments may result in a levelling of the playing field, the entrenched position of SOEs opened up to competition and a more open and transparent business environment, which should assist foreign companies in making China investment decisions; (c) National Security Review The Third Plenum’s newly minted National Security Commission is likely to have oversight over the national security review of foreign investment and M&A transactions in China. Foreign investment or acquisitions in key areas such as agriculture, energy and resources, infrastructure, transportation, key technologies and equipment manufacturing (and areas otherwise critical to China’s economic security) are likely to be subject to more stringent reviews and enforcement by the Government; (d) T axation on Real Estate and Transfers Parties holding or transferring real property in China may be subject to more governmental taxes in the future. The Government is reinforcing collection of land value-added tax on property transfers and proposing a national network to record property owner identities with the intention of instituting an appropriate framework to overlay real property tax; (e) Employment Structuring and preparing employment contracts for executives and staff, including localising internal employment policies or handbooks, must be dealt Doing Business in China / kwm.com with prior to market entry to underpin the foreign company’s values and policies in order to institutionalise its corporate culture in its onshore operations. This will also align with employee hiring criteria, rights to dismiss, and long-term retention policies; (f) Criminal Liability of Executives High profile cases are emerging of PRC company executives being detained and/ or arrested in China, and even a few foreign executives such as Rio Tinto’s Stern Hu. Foreign companies, therefore, have real concerns on how to ease the minds of incoming executives tasked with running onshore operations. This issue is particularly acute given the Government’s ramped up efforts to crack down on compliance in a legal environment that is not always clear-cut; (g) Managing JV Relationships Although WFOEs are increasingly common, the JV structure, both EJV and CJV, continue to be widely used. However, many JV relationships that are not invested with the appropriate levels of resources, skills, and personnel end in embittered legal disputes and lengthy negotiations over divergent interests and expectations that aggregate over time; and (h) VIE Structures Investors that have relied on a VIE structure to address foreign investment restrictions are increasingly finding there are limitations to enforcing the various contracts required to structure the VIE and/or to carry out its operations. Also disconcerting are the increasing challenges by government authorities as to whether the VIE’s shareholding and operating companies are engaged in restricted industries or operating outside their business scope. Doing business in China: key concerns table Key Increased concern Diminished concern The following chart is illustrative of the evolution of key concerns facing foreign investors in China. While corruption and intellectual property rights infringement have remained key issues, rising costs and human resource constraints have become major issues over recent years. Though China has seen multinational corporations’ regional headquarters relocate elsewhere lately (i.e. ADM and GM), this trend reflects more a desire to take advantage of further opportunities in the South East Asian region rather than a reaction to business challenges in China. 1 2 3 4 5 6 Inconsistent regulatory interpretation / unclear laws Management-level human resource constraints Obtaining required licenses Bureaucracy National protectionism Corruption 2010 No change from previous year New/emerging concern Bureaucracy Management-level human resource constraints Labor costs Rising costs Management-level human resource constraints Inconsistent regulatory interpretation / unclear laws Inconsistent regulatory interpretation / unclear laws Human resource constraints Inconsistent regulatory interpretation / unclear laws Non-management level human resources onstraints Shortages of qualified employees Domestic competition IPR infringement Obtaining required licenses Corruption Lack of market maturity Corruption Corruption Shortages of qualified management Corruption / fraud Obtaining required licenses Bureaucracy Obtaining required licenses IPR infringement 2011 2012 2013 2014 Source: American Chamber of Commerce 2014 China Climate Business Survey We say…. In our experience, none of these issues are insurmountable or prevent foreign investors from having success in China. However, it is imperative that companies consider these issues in preparing their market entry plans well in advance and have a clear strategy to address them prior to committing capital. Wang Rongkang, Corporate Partner (Shenzhen) Doing Business in China / kwm.com 15 xxHow do I Protect xxmy Investment? The following section contains the recommendations that will address or at least minimise the potential impact of the risks for most investors. 1 A continually improving legal system A cornerstone of the Third Plenum is to enhance rule of law by ensuring independence and fairness in prosecuting bodies and courts. The recent curbing of the Communist Party’s Political and Legal Committee’s powers, a body tasked with overseeing security services, and public pronouncements by China’s top judge on how improvements must be made to exercise judicial power independently, suggest an intention to move in a positive direction. 2 Overall, we expect there will be a greater reliance on complex contracts with the growing sophistication of Chinese counterparties. Foreign firms will benefit from Chinese parties who frequently deal with Western counterparts evolving as their corporate thinking matures and becomes more refined. Measures and supervision To maintain oversight of investments from the point of market entry to sustaining operations, firms should undertake the following: (a) Due diligence Regardless of the structure of investment, conduct thorough due diligence through fieldwork rather than relying solely on data rooms (nothing beats a random physical site inspection); (b) Risk assessments Assess risks from both a legal and practical perspective to clarify and prioritise actual versus theoretical dangers; (c) Unique transaction (d) Involve Headquarters Keep headquarters continually involved and apprised of developments and ensure good corporate governance to maintain communication lines; (e) Understand Cultural Differences Take time to understand local customs and practices, both between China and the West, and between provinces within China; and (f) Post Transaction Audits Conduct regular internal audits post-transaction to manage compliance issues proactively. Treat each transaction as being unique and avoid wholly relying on foreign or Chinese standards; 3 Strong compliance culture PRC Criminal Law criminalises official bribery and commercial bribery with sanctions ranging from criminal detention to life imprisonment. China’s anti-bribery legislation applies to all PRC citizens wherever located and foreign investors and legal entities in China. While Chinese law does not require businesses to institute anti-bribery systems and controls, many businesses in China have done so in order to comply with the anti-bribery laws of foreign jurisdictions that have extra-territorial reach, such as the U.S. and UK. 16 The Chinese competition authorities are now actively enforcing the AML and have been imposing significant fines of up to 10% of turnover. Foreign companies should review their existing practices to ensure their China businesses are compliant with Chinese competition laws and that senior executives and other front line staff are trained to respond effectively to the unique investigation procedures of the Chinese anti-trust authorities. Doing Business in China / kwm.com We say…. Foreign firms that utilise third party intermediaries, interact with government officials or deal with SOEs have heightened compliance risks. It is imperative that foreign firms rigorously evaluate the adequacy and robustness of their existing compliance regime. Particular attention should be given to guidelines covering business development expenditure, due diligence processes into third party intermediaries, “dawn raid” guidelines in case of government inspection and processes of handling “whistle-blowers”. Internal audits alone will not be sufficient. Firms should continuously monitor compliance risks through their enterprise risk management processes and conduct regular training programs to ensure that employees are aware of their obligations to foster a culture of compliance. David Tiang, Regulatory and Compliance Partner (Shanghai) 4 Managing JV relationships Due diligence on your JV partner is imperative; mechanisms. It can be difficult to enforce deadlock events in China due to regulatory requirements i.e. corporate actions taken by a JV must be approved by the relevant authority who in turn seeks unanimous JV partner consent prior to providing approval, which results in inability to progress matters; (b) Effective management costs (d) Corporate governance Identify and engage committed, capable hands-on management who are able to act diplomatically at all times, but assertively when needed; Ensure JV documentation expressly provides for detailed corporate governance provisions that facilitate operations; For those who adopt a JV structure in China, particularly those engaged in a 5050 split, we recommend the following to manage inherent conflicts: (a) Know your partner (c) Deadlock mechanisms Ensure JV documentation specifies detailed dispute resolution and deadlock 5 (f) Compliance Establish a compliance committee or engage personnel to oversee compliance of domestic laws; and (g) Risk control Establish a committed and professional risk control team to manage and address prevailing issues, especially as monetary damages are often insufficient and injunctive relief is rarely available. (e) Repatriation of profits Clarify in JV documentation the timing and requirement to repatriate profits, how to deal with trapped cash and withholding tax issues; Officers and Directors Liability Protection Directors, senior management and/or legal representatives in an FIE are subject to statutory obligations of fidelity and diligence, and contractual duties and liabilities set out in relevant employment agreements or articles of association. Personal liability can be limited to individual actions adjudicated to be against the interests of the relevant FIE, i.e., misappropriating funds, conversion of business opportunities, and seeking improper personal benefits for him/herself. To effectively mitigate the risk of potential liabilities, a company may: Purchase liability insurance; Clearly allocate duties and responsibilities in the articles of association; Establish proper internal controls and supervision to monitor business activities; and Educate directors or individuals in other positions of authority to expressly raise objections to any resolutions that may violate laws and record the same in relevant minutes. Doing Business in China / kwm.com 17 6 I mproving intellectual property protection There will be an increasing emphasis on measures to protect intellectual property, as China transitions from a low-cost manufacturing centre to a research and technology leader and innovator, and as R&D investment continues to grow in the double digits. This has become more evident in recent reforms to the Trademark Law, including the introduction of the new invalidation proceedings, more stringent approach to combat trademark squatting, clarifications of the protection of wellknown trademarks and an increase of statutory damages. However, for now, intellectual property enforcement remains inconsistent. Accordingly, an FIE should take appropriate steps to protect itself by: (a) Register IP Registering trademarks and patents by respectively submitting and designating China in its international trade mark application pursuant to the Madrid Protocol and using the Patent Cooperation Treaty application process to harness the 30-month priority period; (b) IP Policy Implementing corporate policies that emphasise confidentiality obligations and other intellectual property protection measures including specifying ownership invention and inventor remuneration; (c) IP Ownership Structure Considering whether it is eligible to reduce enterprise income tax under the national High and New Technology Enterprise program before centralising intellectual property ownership offshore; and 7 Labour and workforce End to Labour Dispatch Arrangements? Many companies hire staff through a labour dispatch arrangement to circumvent issues that typically arise in direct engagement relationships. From 1 March 2014, enterprises (other than representative offices) must have no more than 10% of its workforce engaged through a labour dispatch arrangement. Any labour dispatch positions must only be for temporary (less than 6 months), auxiliary (not part of main business) or substitution purposes (covering employees who are on a period of leave). Managing Employment Disputes We anticipate that companies will continue to experience an increase in the number of labour disputes due to employee friendly labour legislation and staff becoming increasingly cognisant of their statutory entitlements. Disputes often involve employee claims of wrongful termination or insufficient severance payments. Employers can minimise labour disputes by ensuring that they have a robust human resource strategy that fully aligns with local employment laws, strictly follow and document/record the processes on which employees have been consulted (i.e. underperformance management process), and retain clear written records, including robust employment contracts (e.g. taking into account the enforceability of noncompetition clauses). (d) Actively Voice Concerns Communicating any intellectual property concerns through MOC’s Mechanism of Regular Communication with FIEs. 18 Doing Business in China / kwm.com 8 Taxation 2013 witnessed significant tax development in China, in terms of legislative reform and unprecedented efforts to crack down on tax fraud and tax avoidance schemes. Key recent developments include: (a) Expansion of VAT Reform In an effort to eliminate double taxation, the conversion of business tax to a consumption-oriented VAT has been expanded to a greater range of industries and service sectors, with the aim of phasing out business tax by 2015; and (b) Transfer pricing Increased anti-avoidance investigations on transfer pricing conducted by more sophisticated panels, which will drive companies to better devise and assess cost/expense sharing structures supported by reasonable commercial substance and effective payment mechanisms. Shenzhen, Guangdong province We say…. The Chinese government has been ramping up efforts to combat tax planning schemes that exploit gaps and loopholes of the current tax system to artificially shift profits out of China, especially in the areas of transfer pricing of cross-border trade or service/IP transactions, indirect shares transfer of offshore intermediary holding vehicles, as well as treaty shopping. Multinational companies should proactively review their onshore business dealings and pricing models and take remedial actions where necessary to ensure a sustainable tax-efficient structure. Tony Dong, Tax Partner (Beijing) Doing Business in China / kwm.com 19 xxHow do I exit xxmy investment? Preparing ahead Given the need to factor in PRC approval requirements upon the sale of a business, the best way to prepare for a successful exit from an investment is to ensure it is structured with that potential in mind at the outset. Common exit strategies include an asset sale, equity sale or a combination of the two. If clients are looking for short-term investments with a clear exit strategy, a special purpose vehicle in Hong Kong could be the ideal choice due to: (a) Ease of transfer The ability to transfer shares in the Hong Kong holding company without the need for onshore regulatory approval under most circumstances. Such trade sales have increased in popularity given the inactive domestic IPO market; and (b) IPO Favourable and efficient pre-IPO investment environment. Structuring considerations We usually find that sellers generally prefer an equity sale as it attracts less tax and is more straightforward. In some circumstances, a merger may be considered given it might be eligible for tax-deferrals. With Chinese tax authorities paying greater attention to whether related party transactions use arm’s-length pricing, parties need to ensure that a deal’s negotiated transaction price is defensible. In 2013, we also saw clearer guidance on, but more stringent enforcement of, Circular 698, a requisite item on deal checklists. Circular 698 requires transferors to report indirect equity transfers in certain offshore transactions to Chinese tax authorities who are empowered to levy tax despite equity transfers occurring offshore and having no onshore shareholding changes. Further, a sale of property will be subject to various taxes including income tax, value-added tax, business tax, land valueadded tax, deed tax and stamp duty tax, although exemptions may apply to certain asset transfers. As such, parties must consider any tax costs and tax exposures upfront during the deal negotiation phase. In preparing for a transaction, foreign parties should factor in longer negotiation times with any Chinese counterparties who may often wish to re-open issues. Executing detailed minutes of each meeting will assist in recording parties’ intentions and provide a clear discussion roadmap. Companies should also settle in advance plans for employees as the sale of assets or a merger is a material change in circumstances under PRC employment laws; staff will have the right to claim for termination compensation upon the transaction taking effect even if they stay on as employees. This is often dealt with by the seller paying all severance pay prior to transfer. 20 Doing Business in China / kwm.com Repatriating profits and unwinding an investment Parties can repatriate dividends to their shareholders in any financial year provided that the company has met statutory financial obligations to settle previous years’ losses, pay requisite taxes, and allocate sufficient monies to its reserve fund and employee bonus and welfare fund. In practice, dividend repatriation is made no more than once a year, as documentary requirements to convert funds into foreign currency for transfer are determined on an annual basis (i.e. tax payable, audit reports). Parties should negotiate suitable conditions and incorporate clear and detailed profit distribution terms into relevant documentation (i.e. JV contract and articles of association). If funds are not repatriated, parties may reinvest or redploy undistributed profits inside and/or outside China. Liquidating an FIE in China will typically take between 6 to 18 months. The tax deregistration process is the most complex and time-consuming aspect as authorities seek to verify that an entity has fully complied with its tax obligations for at least three years prior to the dissolution process. Due to the nature of the liquidation process, we recommend that clients avoid establishing temporary stepping stone structures, such as representative offices, if the intention is ultimately to graduate to a more permanent FIE in the near future. Clients would be better served focusing efforts in structuring an FIE that can be scaled up for long-term plans. When disputes arise Increasing use of arbitration Disputes involving foreign investment have increased considerably. We are seeing larger disputes having a significant cross-border element requiring coordination in various jurisdictions and companion cases for off-shore litigation filed in China. Generally the disputes have become more complicated and may require expertise in various jurisdictions. According to the World Bank’s ‘Doing Business Project (2014)’, China was ranked 19th out of 189 countries for “ease of enforcing commercial contracts.” Chinese courts continue to gain more experience in resolving foreign-related disputes and legal code changes now offer better protections. Yet concerns remain about the influence of external parties and local protectionism on the People’s Courts. While this influence is diminishing, it explains why many foreign investors prefer commercial arbitration for foreign-related disputes. Unlike court judgments, arbitration awards rendered in China are enforceable in more than 140 countries pursuant to the New York Convention. Conversely, China will also enforce arbitration awards rendered in other convention countries. (SAIC); and There are more than 200 arbitral institutions inside Mainland China. The choice of institution can be complicated and clear dispute resolution clauses are critical. When drafting a dispute resolution clause, keep in mind the following: (a) Treatment for Specific Industries Disputes involving particular industries, such as natural resources, must be arbitrated in venues inside Mainland China; (b) Absence of Interim Measures While the disputes arbitrated in regional venues outside Mainland China may provide an additional assurance of impartiality, interim measures of relief to preserve a party’s property located in China would not be available; (c) Institutional Arbitration Choose institutional as opposed to adhoc arbitration to ensure enforcement of an arbitral award in China. Common venues include the China International Economic and Trade Arbitration Commission (CIETAC), Shanghai International Arbitration Centre (SHIAC), Hong Kong International Arbitration Centre (HKIAC) and Singapore International Arbitration Centre Doing Business in China / kwm.com (d) Choice of Law Be aware that some business relationships, such as Sino-foreign JV contracts, equity or asset transfer agreements, must be governed by PRC law. China has an increasingly sophisticated network of international investment treaties. While investor-state arbitration against China is rare, foreign investors should keep this option in mind if an investment is damaged or destroyed by government action. This year some trends will continue, for example continued focus on IP litigation, investor, and JV disputes. Domestically, listed company litigation may be on the rise due to more active regulation and increasing demands for transparency and accountability by shareholders. We may also begin to see more disputes involving trust arrangements, as so– called “shadow banking” arrangements become legitimised. 21 Asia Intelligence Unlocking Opportunity Opportunity x Meet x the team Key Contacts Stuart Fuller Global Managing Partner Hong Kong Martyn Huckerby Partner Shanghai T: +86 21 2412 6018 Sharon Wong Of Counsel Shanghai T: +86 21 2412 6108 Hong Kong Europe Australia China Rupert Li Partner Hong Kong T: +852 3443 8313 Rob Day Managing Partner London T: +44 20 7111 2988 Tim Bednall Managing Partner Sydney T: +61 2 9296 2922 Wang Ling Managing Partner Beijing T: +86 10 5878 5016 Richard Mazzochi Partner Hong Kong T: +852 3443 1046 Stephen Kon Senior Partner London T: +44 20 7111 2237 Berkeley Cox Managing Partner Brisbane T: +61 7 3244 8149 Jack Wang Partner, Banking Shanghai T: +86 21 2412 6000 Wang Junfeng Global Chairman Beijing Guangzhou, Guangdong province 22 Regional Contacts Scott Gardiner Managing Partner Sydney T: +61 2 9296 2158 Doing Business in China / kwm.com Your team to unlock China and Asia opportunities The Power of Together Contributing Partners Tony Dong Partner, Tax Beijing T: +86 10 5878 5588 Harry Du Partner, Real Estate Beijing T: +86 10 5878 5021 Xuhua Huang Partner, Corporate Hong Kong T: +852 3443 8310 Handel Lee Partner, Corporate Beijing T: +86 10 5878 5588 Cecilia Lou Partner, IP Shanghai T: +86 21 2412 6000 Zhang Mingyuan Partner, Securities Shanghai T: +86 21 2412 6000 Susan Ning Partner, Competition Beijing T: +86 10 5878 5010 Xu Ping Partner, Corporate Beijing T: +86 10 5878 5588 Wang Rongkang Partner, Corporate Shenzhen T: +86 755 2216 3300 Mark Schaub Partner, Corporate Shanghai T: +86 21 2412 6003 David Tiang Partner, Compliance Shanghai T: +86 21 2412 6022 Meg Utterback Partner, Litigation Shanghai T: +86 21 2412 6086 Sophia Wang Partner, Corporate Hong Kong T: +852 3443 8319 Raymond Wong Partner, Corporate Hong Kong T: +852 3443 8300 Zhang Yi Partner, Corporate Hong Kong/Shanghai T: +852 3443 8328 T: +86 21 2412 6002 James Zeng Partner, Corporate Guangzhou T: +86 20 3819 1003 George Zhao Partner, Corporate Beijing T: +86 10 5878 5186 Stanley Zhou Partner, Banking Shanghai T: +86 2412 6056 Nongfan Zhu Partner, IP Beijing T: +86 10 5878 5080 Doing Business in China / kwm.com 23 Together, we’re helping businesses across the globe make smart choices to shape their future world. 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