Dr. Stephane J. Grand

Business in China:

Modes of Entry

Dr. Stephane J. Grand

BACK TO THE BASICS

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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

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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

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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

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1. COMPANY SETUP

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CONFIDENTIAL 6

ENCOURAGED INDUSTRIES“The most favored category”

SJ GRAND Financial and Tax Advisory

CHINA’S FOREIGN INVESTMENT CATALOGUE

Examples of “Encouraged” industries:

Water conservation technology;Intellectual property services;Mining;Manufacturing;Transportation;Warehousing;Sanitation, fitness, and social welfare industriesEducation, 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 7

PERMITTED INDUSTRIES“The standard category”



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 8

RESTRICTED INDUSTRIES“The category subject to high scrutiny”



Examples of “Restricted” activities:

Certain agricultural, forestry, animal husbandry and fisheriesMining of precious metal and certain oresCertain manufacturing (tobacco, certain textiles)Electricity (adoption of low capacity generator)Certain telecommunicationsCertain wholesale and retail tradeElectricity, gas, and water productionBanking and insurance industriesReal estate in high end propertyGolf coursesProduction and distribution of radio and TV programming

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 9

PROHIBITED INDUSTRIES“The disbarred category”



Examples of “Prohibited” activities:

Mining of radioactive materialsArms and ammunition manufacturingAir traffic controlPostal ServicesFutures tradingSocial researchGamblingPornographyPublication of books, magazines, and newspaperConstruction and operation of villas.Breeding and growing of precious, high quality breeds of animals

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

LIMITATIONS TO LIMITATIONS

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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

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COMPANY REGISTRATION IN CHINA

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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.

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PREPARATION CHECK-LIST

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BEFORE MAKING YOUR INVESTMENT

Define precise business scope and assess feasibility/regulatory requirements.

Analyze set up costs in detail.

Be cost-skeptical and approach income and growth estimates conservatively, planning for several foreseeable results (Low/Med/High).

Develop company financing plans with and without the support of foreign & local loans.

Address main tax concerns and expenses in consultation with a tax professional: Business Tax, Income Tax, Tariffs, VAT, and other local taxes.

Pay attention to suppliers’ hubs and distribution centers, client bases, export/import logistics, regional and local tax rebates, and staff residence and employment options.

Inform yourself about China’s social welfare and insurance systems as many of these charges are the responsibility of employers.

Have management team in place and start local recruitment.

Most importantly, brace yourself for unexpected events and obstacles.

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1. Representative Office ("RO")

2. Wholly Foreign-owned Enterprise ("WFOE")

3. Equity Joint Venture ("EJV")

4. Contractual Joint Venture ("CJV")

MOST COMMON FIE STRUCTURES

CONFIDENTIAL 13

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.

DECIDING ON STRUCTURE

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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

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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.


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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

DISADVANTAGESLengthy registration and licensing processLack of established connections of joint venture partner

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Quick Comparison RO WFOE

Registration Procedures Incorporation documents, bank statements of credit

Business plan, name approval, corporate documentation such as Articles of Association

Time Required 1-2 months 3-5 months

Capitalization No registered capital required Minimum registered capital depending on industry and locality; minimum investment RMB 100,000

Business scope Cannot engage in profit making activities (except law firms)

Can engage in direct business operations as listed in Articles of Association

Liability NOT legal person; liability assumed in parent company

Legal person; limited liability company; parent company liability limited to WFOE registered capital

Regulatory Requirement No MOFCOM approval for most industries; registration with AIC

MOFCOM approval and registration with AIC

Tax Method Cost + or Actual method Actual taxation method

Adaptability to demand Cannot establish subsidiaries or branches

Can establish subsidiaries or branches

Staff Cannot employ directly; must use registered employment agencies

Can employ directly

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JOINT VENTURES

A 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

1.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


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STRATEGIC ADVANTAGES

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TYPICAL WFOE REGISTRATION PROCESS

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1. Submit your name for pre-registration2. Open a temporary account (optional)3. Approval by relevant ministries for restricted activities

(education, law, medical and other fields)4. Submit Articles of Association for approval5. Approval by the Ministry of Commerce6. Organization Code7. Corporate Certificate of Approval by the Ministry of Commerce8. Issuance of the Business License by SAIC9. Capital injection10. Capital verification report issued by CPA firms11. Registration with Public Security Bureau12. Production of company, finance and legal representative seals13. Organization code certificate14. Open basic RMB bank account15. Tax Bureau Registration16. Open Foreign Currency Capital Account17. Foreign Exchange Registration18. Tax Machine Setup19. Statistics Registration Certificate20. Finance Registration Certificate21. Customs Registration Certificate (import/export companies)22. Registration with social insurance institution.

TIME:

12 weeks – 5 months

(longer for some

industries)

TIME:

12 weeks – 5 months

(longer for some

industries)

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• 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

WFOE FINANCING – REGISTERED CAPITAL

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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).

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SPECIFIC ACTIVITIES: IMPORT AND EXPORT

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.

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EXPORTING TO CHINA

EXPORTING TO CHINA

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For an exporter looking to enter China market, it can be intimidating to know exactly where to begin.

THINGS TO DO BEFORE EXPORTING TO CHINA

EXPORTING TO CHINA

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EXPORTING TO CHINA

2. SPECIAL CASE: ACQUISITIONS

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ACQUIRING A CHINESE COMPANYIS THIS REALLY WISE?

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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.

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.

DUE DILIGENCEACCOUNTANCY

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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?

DUE DILIGENCETAX

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DUE DILIGENCEOPERATIONAL

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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.

DUE DILIGENCELEGAL

30S.J. GRAND

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.

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.

DUE DILIGENCEENVIRONMENTAL

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POST-MERGER INTEGRATION

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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

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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 RMBWE ARE STILL IN A COMMUNIST COUNTRY

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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:


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Total investment RC/TI RC as % of TI

<= USD 3M At least 7:10 70%

USD 3-10M At least 1:2 50%

USD 10-30 M At least 2:5 Higher of USD 5M or 40%

> USD 30M At least 1:3 Higher of USD 12M or 33.3%

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


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37SJ GRAND Financial and Tax Advisory

“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

Two pioneers in the globalization of the retail industry


China’s Economic History


China’s Consumers


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.

The shopping experience in China has evolved dramatically over the past decades.

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

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€86,6 billion

77%

Stores openings by year

Total annual sales in Asia and €55,83 billion total annual sales in China.

Represents sales in China among total Asia sales.


Carrefour Success Story

1989

1995

2006

First settlement of Carrefour in Taiwan, helping to get into Chinese market.

Settlement of Carrefour in China. First group which set up hypermarkets in the country.

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 ADVANTAGE and 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

Dr. Stephane J. Grand

Q & A

Dr. Stephane J. Grand

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