Investing in mainland China

by Michael To

With mainland China now the fourth largest economy in the world and growth set to continue, it is no surprise that foreign investors and investment houses are looking towards investing in mainland China

Acquisition of privately owned mainland Chinese domestic enterprises
Direct investment in mainland China is the most preferred option for foreign investors to invest in China. However, foreign investors may find it difficult to invest in a new market like mainland China, given the business and cultural differences.

Purchasing an existing business in mainland China is an alternate strategy that many foreign investors consider. The perceived benefit is that it is easier to acquire an existing operation that has been running for some time and it can provide the purchasers with a track record. It is also perceived that this will save investors the trouble of locating premises, hiring and training employees, installing production facilities etc. In many cases, there are real benefits to such a strategy and with appropriate due diligence and planning, this strategy may achieve the benefits anticipated.

The most common ways to acquire the businesses of privately owned mainland Chinese domestic enterprises are through (i) direct acquisition; or (ii) asset acquisition. Both methods have their advantages and disadvantages and these are discussed below.

Direct acquisition
Direct acquisition refers to the purchase of the whole or part of the equity interest in a Chinese domestic enterprise by foreign investors. It should be noted that most domestic enterprises are not formed by shares; they have registered capital that has been approved by the Chinese authorities. Foreign investors do not therefore purchase shares in mainland Chinese enterprises but an equity interest.

Scope and approval
Direct acquisition will involve obtaining approval from the Chinese authorities. The procedures are more or less similar to the set up of a new entity by foreign investors.

Enterprises set up in mainland China are designated a specific business scope and they can only carry out business activities within this business scope. Foreign investors should refer to the Provisions on Guiding Foreign Investment Direction and the Catalogue for the Guidance of Foreign Investment Industries when they submit their application, to consider whether or not the proposed business activities are restricted or prohibited in mainland China. Approval for direct acquisition is obtained by the Ministry of Commerce (MOFCOM). If approval is granted, the domestic enterprise will have to perform various registrations with various authorities including the Ministry of Industry and Commerce, Tax Authorities, Customs Authorities etc to ratify their records. New certificates will then be issued.　 

Foreign invested enterprise
If over 25% of the equity interest of the target mainland China enterprise is acquired by foreign investors, the domestic enterprise may apply to change its status to a foreign invested enterprise (FIE). FIE is a collective term to include wholly foreign-owned enterprises, equity joint ventures and co-operative joint ventures.

Currently China has two sets of enterprise income tax law: one is applicable to FIEs and the other is applicable to domestic enterprises. If a target mainland Chinese domestic enterprise changes its status to an FIE, the Foreign Enterprise Income Tax law will apply. As such, the FIE would be able to apply for a two year tax holiday plus a subsequent three years' half tax reduction period or other preferential tax treatments available to FIEs engaged in recognised business activities.

Advantages and disadvantages of direct investment
In comparison to asset acquisition, direct acquisition is less cumbersome as investors do not have to go through the "pick and choose" exercise to select the preferred assets from the domestic enterprise's long asset list. In theory, the day after the completion of the deal, the new investor can carry out business activities immediately.

Unfortunately, it is not a perfect world. The buy-sell agreement will need to be submitted to the approval authorities and will be subject to scrutiny. This may cause delays during the acquisition process and the terms of the deal will be unavoidably disclosed to non-related parties. The biggest disadvantage is of course due diligence, which is discussed in detail below.

Due diligence
It is advisable for foreign investors to arrange for legal and financial due diligence before they decide to invest in a Chinese domestic enterprise. Due diligence will not offer full protection to the purchaser, but it will identify issues so that investors can make an informed assessment of any potential risks that may be involved.

Based on experience, there are many common problems with the process, including debtor recoverability, record keeping, tax reporting, unclear title to land and buildings, unclear connected party transactions etc. This list is by no means exhaustive.

Asset acquisition
Given the potential due diligence problems, many foreign investors opt for asset acquisition in order to limit their exposure to the past.

It is common for foreign investors to set up an FIE for such a purpose. Using this route, a capital contribution would be made to the new FIE. The capital monies received can then be used to acquire the selected assets from the target mainland Chinese domestic company. The new FIE would also be entitled to the tax holiday and preferential tax treatments available if it is engaged in a recognised business activity.

Asset acquisition can be a concern to the vendors, who may not want to sell assets leaving the enterprises with liabilities. In addition, the vendors would have certain tax exposures and there could be legal considerations associated with creditor protection.

Taxation
The following taxes would be applicable to an asset sale:

By contrast, for a direct acquisition, the vendors will only be subject to stamp tax and enterprise income tax/ individual income tax from the disposal of the equity interest to foreign investors.

Transfer pricing developments in China
In the last decade, China's transfer pricing regime has undergone rapid development. Before 1998, the Chinese approach to transfer pricing was relatively primitive and was incorporated into "The Income Tax Law of the People's Republic of China on Enterprises with Foreign Investment and Foreign Enterprises". 

Since its admission to the World Trade Organisation, China has been under pressure to bring its tax system into line with international standards. China has now developed a solid foundation for transfer pricing regulations.

Current legislation
The most up-to-date legislation with regard to transfer pricing is Guoshuifa [2004] No.143. The new legislation has standardised transfer pricing administration procedures and clarified certain unclear areas contained in an earlier piece of legislation: Guoshuifa [1998] No. 59.

The salient issues in Guoshuifa [2004] No.143 are summarised below:
Taxpayers effectively have 90 days to provide information requested by the tax authorities if written consent from the relevant tax authorities is given. Penalties can be imposed for late submission of information or submission of false information.

If the taxpayer is unable to provide the required information, provides false information or is unwilling to provide information, the tax authorities can adjust the revenue or profits of the taxpayer based on one of the following methods:

Tax authorities can make transfer pricing adjustments retrospectively for a period of 3 to 10 years. The 10-year adjustment may apply under the following circumstances:

Overpayment to related parties after transfer pricing adjustments could be deemed as dividend payment and be subject to withholding income tax (with no exemptions). Where there is a transfer pricing adjustment to disallow part of the interest or royalty payments, withholding tax already paid is not refundable.

Future changes
It is understood that the State Administration of Taxation is currently drafting documentational requirements in relation to Transfer Pricing. It is anticipated that these requirements will specify that certain transfer pricing documentation will need to be submitted with the annual filing of the tax return.

To date the documentation requirements in relation to China have been unclear. These new requirements will specify what documentation is required to be kept and submitted and could be as comprehensive as those seen in other parts of Asia where taxpayers are required to submit full transfer pricing studies and related back up documentation with their tax returns.

The areas covered in this analysis are by no means the only issues facing investors in mainland China. Nevertheless they do reflect the growing trend of business wishing to invest in mainland China. The tightening of regulations in relation to transfer pricing is just one area where we have seen a move towards an enforcement and tightening of the taxation legislation and practice. This trend will undoubtedly continue.

michael.to@gthk.com.hk

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