CHALLENGES FOR INVESTORS IN 2010

Richard Kimber

Managing Partner of RHK Legal

13 June 2010

in Shanghai

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◆ China- An Overview

Challenges and Risks for Investors in 2010◆

PRC Tax Regulatory Environment

IP Protection

Corporate Governance – Trade Secrets

Emerging Chinese Protectionism

Summary

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The Overview

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The Overview

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The Overview

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The Overview

Growth of Consumer Spending 2004-2007

[ US$ B ]

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Challenges and Opportunities for Investors in 2010

a. China evolving from a Production Economy to a Consumer Economy

b. Beijing priority now is to both encourage SME development and upgrade efficiency of tax revenue system  WHY（ i) 2009-2010 drop in FDI- alarm bells (ii) 2009-2010 Infrastructure Stimulus will end (iii) Continued weakness in US and Europe (iv) SME development encourages consumer spending ie consumption (v) SMEs operate in the goods and services sector e.g. retail, food and beverage, franchise, education, health and fitness, fast food (vi) SMEs create 85% of all new jobs

C. Social Pressures- Industrial Wage Claims ( Honda and Foxconn)

  

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PRC Tax Compliance

China is trying to streamline its tax assessment and tax collection

An uphill battle largely of its own making – SAT not computerized. A bonus in an export oriented economy, a

liability in a consumption based economy.

GFC inspired tax reform-– FDI dropped 22% in 2009 – Europe and US was main culprit for fall in PRC tax

revenues.

Representative Offices are discouraged now as an investment vehicle. New Circular in February 2010 will

operate to apply a deemed tax rate on ROs who do not keep adequate accounting records. SAT realizes a lot of

untaxed business activity was going on involving ROs.

The deemed profit rate for Ros raised to 15% from 10%- to increase tax revenues and also discourage use of

ROs.

WALKING A TIGHT-ROPE

Conflict between local tax bureaus and development zones giving unofficial and official tax incentives to attract

FDI and SAT stepping up assessment and collection of tax revenue

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Challenges

PRC Tax Compliance

Late 2009-2010- SAT has issued a raft of new circulars

Circular 18- aimed at Representative Office

deemed tax rate raised to 15% from 10%

tax can be assessed on actual income if records not kept by RO

Circular 601

Foreign investor can only rely on DTA with China if it satisfies “ substantial business” test

NEED TO SHOW:

Board meetings held offshore

Local Director

Registration as a Taxpayer

Independent Company Image

Office Lease

Third Party Contracts

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Circular 698 -- December 2009

- retrospective from 1 January 2008 and set alarm bells ringing

- Seeks to impose PRC capital gains tax on disposal by an offshore holding company of its shares in a

PRC subsidiary (direct transfer) or disposal of shares of the intermediate holding company (indirect transfer)

- requires disclosure to SAT of “offshore indirect transfers” of equity in a domestic enterprise.

- investors use offshore companies, e.g. BVI, Hong Kong, Seychelles, Caymans to avoid PRC tax

on capital gains by disposal of shares in the offshore holding companies.

- SAT will look at the “indirect transfers”

where the offshore holding company disposing its shares is located in a country with an offshore tax rate less of

than

12.5% or is not taxed on offshore income.

- obligation within 30 days of the execution of the equity transfer contract, for the foreign investor to submit

relevant

documents to local tax bureau where domestic subsidiary is located.

Note: If SAT decides the equity transfer has “no reasonable business purpose”, it may impose additional tax at

domestic level or deem the local PRC subsidiary not to be foreign owned.

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Therefore SAT now applies Substance Over Form “Principle”:

With more and more tax information exchange agreements being signed between China and BVI, HK etc it is clear full tax compliance is going to

be on the agenda for foreign investors and SMEs in the PRC in 2010.

Solution: (a)look carefully at how to structure investment into China.(b) Which DTA provides most benefit(c)Show “substantial business” of offshore investor.

BE AWARE THAT FOCUS IN 2010 IS ON TAX AVOIDANCE

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IP Registration---- Patent/ Trademarks and Copyright

More importance being attached to IP protection by both local and foreign enterprises.

— China now creating its own local IP and technology transfer from China due to increased offshore investment.

— Ever increasing need for clients to register copyright, patents and trademarks to operate in China.

— Too often clients don’t take action to protect brands and IP until after establishing China operations.

Now State Trademark Office has undertaken to shorten TM registration process from 26—32 months to 10 months.

Case Studies:

(a) Acted for Australian Olive Oil Manufacturer to advise on JVC for distribution. Negotiated Sales Agreement and TM License.

Client discovered JV partner had registered Client’s trademarks during negotiations. Increase costs for Client in obtaining re-transfer of IP right.

(b) Hong Kong based nightclub subject to copycat trademark registration in China

MANTRA: REGISTRATION BEFORE NEGOTIATION

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Trade Secrets- pre and post RioTinto

Pre- Rio Tinto

PRC Anti- Unfair Competition Law ( effective 1 December 1993) defines a trade secret as follows:

(1)It is not known to the public(2)It is practically usefully and may bring profit to its owner (3)Owner has taken measures to keep it confidential

PRC Courts have upheld trade secrets in the “ YSJ Co. Ltd” case. – proprietary customer management database.

Post- Rio Tinto

NOW: Interim Regulations for the Protection of Secrets in Centrally Administered Companies (SOES). – 26 April 2010

Now defines that …”any technological information or business information that falls within the realm of state secrets must be treated as such according to PRC state secret laws.

Note: Any foreign investor negotiating with an SOE should ensure they sign mutual non-disclosure and confidentiality agreements where there is an exchange of corporate information.

- Obtain written undertaking from SOE that information provided does not breach the April 2010 Regulations 23/4/8 14

Corporate Governance – post Rio Tinto

● Ensure that anti-bribery and anti-corruption undertakings are signed and accepted by all local employees and those

written

undertakings filed with HR.

● Obtain third party supplier undertakings whenever possible including an obligation to report employee misconduct.

● Not just a domestic issue, looks like ASIC in Australia will adopt stringent anti-bribery compliance regulations which

will no doubt extend to PRC operating subsidiaries.

Whistleblower phenomenon —ex-employees are now reporting tax and corporate compliance breaches for

reward

to local SAIC and tax bureaus and SMES are being increasingly subject to tax and labor audits with little or no

warning.

MANTRA: IN CHINA EVERYTHING IS NEGOTIABLE

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Internal Corporate Governance Trade Secrets (Intangibles, business processes, client databases, product specifications, price details etc. )

1. employees execute a separate detailed “Copyright and Trade Secret Assignment Agreement” and

“Non-Disclosure and Confidentiality Agreement”.

HOWEVER not enough to have handbooks and staff manuals.

(recent PRC court decisions place onus on employer to prove specific written notice to employees and have employees

sign

undertakings)

2. Prepare a Handover Checklist of items which must be delivered up by an

employee on finishing employment eg,

Hard drives

Communication Devices

Databases in all formats

Catalogues and Product Specifications

Technical Materials

3. Ensure both the employer and employee sign this Handover Checklist preferably when joining and also on ceasing

employment. Keep copies with human resources. 23/4/8 16

Chinese Protectionisma. PRC Indigenous Innovation Policy- Government procurement to be of locally developed products for following sectors:

(i): Computer Software

(ii): Telecommunication Product

(iii): Energy Conservation Product

has caused US great concern

b. Working Guidelines for Recognition of High and New Technology Enterprises- January 2008

-Tax preference only available to HNTE where the IP is owned by the FIE or Dom Co.

CONTRAST:

Circular No. 166- 31 December 2009

Income from a qualified environmental protection and energy and water saving projects

-Eligible for 3 year EIT exemption

Then – 50% reduction of EIT for 2 years

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SME Perspective

1. Expect increase in random tax or labor audits and requests by SAT for self

assessments of tax liabilities.

2. Increased tax incentives for SME set up, lowered capital requirements

and streamline application process.

3. Corporate Governance now a priority and review internal office procedures,

third party agreements and labor agreements.

4. SME financing should become easier – local PRC banks are establishing

SME loan departments and aggressively seeking FIE borrowers.

5. Be aware of the broad definition of “commercial and state secrets” when dealing with

SOEs and PRC private companies. Make your confidentiality and non- disclosure agreements

mutually binding.

6. Obtain written undertakings and indemnities

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SME Opportunities

1. Chinese Fast Food

2. Western Fast Food

3. Retail

4. Beverages

5. Gym, Fitness and Leisure

6. Auto After-Market

7. Luxury Retail

8. Education + Training

9. Furniture + Household Products

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Status of industry/ activity

Description Examples

Encouraged Special incentives possibleUsually high tech or agriculture industries

Manufacture of wind power turbines Agribusiness

Permitted All activities not mentioned in catalog are permittedBut may be difficult to get approval for uncommon activities

All sectors not mentioned in catalog

Restricted Special approval required- usually JV partner necessaryUsually are protected sectors

Production of cigarettesOperation of oil refineriesMedia production/ Publishing/ TV and Film

Prohibited Activities are disallowedHarms national interests or environmentally damaging

Arms manufacturingOperation of gaming industry

NATURE OF THE INVESTMENTForeign Investment Catalog

When considering setting up in China, first step is to check the catalog

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Total Investment Registered Capital Capital Contribution

Less than 3 million No less than 70% of total investment Complete injection within 6 months

Or

Capital contributed in installments: 20% within first 3 months with the remaining injected within 2 years

Currency: US Dollars

Between 3 and 10 million

No less than 50% of total investment with a minimum of 2.1 million if total investment is below 4.2 million

Between 10 and 30 million

No less than 40% of total investment with a minimum of 5 million if total investment is below 12.5 million

Between 30 and 36 million

No less than 1/3 of total investment with a minimum of 12 million

Capital Requirements Injection Methods

Doing Business in China

Opportunities in China do exist- country has been opening up, growth rates are impressive, population is getting wealthier, FDI has been pouring in …

However, competition is fierce; China market should be approached gradually, un-emotionally and with realistic expectations

Long-term vision is a must, quick profits are unlikely- time, money and effort are necessary

There is no such a thing as one China market, rather several regional/ provincial/ local markets

Gaining local knowledge is crucial- adapt your business practices to the local environment

Conducting proper due diligence, developing a sound strategy, and legal framework are key success factors

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Golden Rules for Success in China

Research your market

Spend time on partner selection

Seek the less travelled road- 2nd tier cities

Use agent and representative where appropriate

Ask for it all up front

BUT- always have personal involvement

Manage Risk- Political/ Economic/ Disaster/ Individual

Register IP and Copyright

Develop a strategy to protect your IP

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Thank You for you attention !

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RHK Legal

Shanghai Office Suite 507, Jingan China Tower No. 1701, Beijing West Road,

Jingan District, Shanghai, 200040 China

Tel: +86 21 6288 8821 Fax: +86 21 6288 8823

Hong Kong Office Room 2406, 24/F., Hopewell Centre,

183 Queen's Road East, Wanchai, Hong Kong

Email: info@rhklegal.cn

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