Joanna Doolan: Nine-step plan to success in China

Joanna Doolan

Those naive enough to think that business practices are universal should, for the sake of their company and their job, never venture offshore.

For the more savvy and adventurous who have tasted overseas success, beware of falling into a false sense of security if you're thinking of tackling the Chinese market. As much as there are opportunities, there are also many pitfalls.

When looking at the opportunities that China will present to New Zealand companies - with or without a free-trade agreement in place - it often pays to start with some questions that might make a difference.

1. What are the first things foreign investors should consider if they have China in their sights?

Firstly, abandon any presumption that it will be business as usual. For starters, due diligence (although you're not allowed to call it this) can take an enormous amount of time. Like anywhere, who you know - "guanxi" - can help smooth the process and open some doors. Nevertheless, being totally reliant on the efforts of apparent "insiders", in lieu of more conventional investigation and analysis, has the makings of a flawed strategy.

Be mindful, also, that because there are major differences in the way things are done, areas that might need special consideration include developing possible exit strategies for investors, transparency and corporate governance, and ensuring compliance and reporting procedures bear scrutiny back home.

2. Are there any particular investment vehicles that work best in China?

The answer to this question is, logically, connected to the objectives one might have in making an investment. For example, if the goal is a long-term one related to acquiring manufacturing capabilities or Chinese brands, there may be no need for anything special.

In contrast, if the game plan is an exit within a defined period (by IPO or sale) then setting up some sort of offshore investment holding vehicle could be a wise move. Such structures allow Chinese capital gains tax to be avoided plus they allow for rapid change of ownership without being bogged down. Offshore structuring also helps M&A undertakings to flow more smoothly.

Be aware, however, that the Chinese Government is keeping a watchful eye on overseas business dealings. Early last year, the brakes were firmly put on some corporate structuring used to take a company offshore and facilitate a listing on a foreign stock exchange.

The move was done purely to stop Chinese taxpayers from avoiding tax by structuring capital gains offshore. Draconian, perhaps, but the net effect was a major freeze in foreign venture capital investments as the door for effective exit strategies was abruptly closed.

3. What is the "right" time to put offshore structuring in place?

The best time, regardless of the end game plan, is to have any offshore structure in place before completing any financing arrangements.

It is possible to restructure later but this can be time, and money, consuming. Having the right structure in place at the outset means any exit goals are achievable and transaction risks reduced.

4. Who, at a Government level, might one encounter when opening, and closing, an investment deal?

Navigating the ever-evolving regulatory environment in China requires guidance and knowledge. Different agencies have jurisdiction over certain types of investment and in certain sectors. If you are a novitiate you will need help.

For example, the media sector, manufacturing and information technology all have different investment approval requirements. Similarly, look forward to working with national representatives as well as local government - both officially and unofficially - to ensure the right and proper relationships are put into place.

5. What domestic tax laws need to be planned for in setting up a company or venture?

As might be expected, China has a complicated tax system involving national, provincial, city (and even district) authorities - each with its own set or requirements and regulations. Major taxes that need to be considered are corporate income tax, business tax, value added tax, real property gains tax, stamp duty, deed tax and social security.

Again, how these are applied depends on the industry, the particular location and the operating structure that is in place.

A particularly interesting custom, given the predilection Westerners have with corporate governance, is the "tax avoidance" mindset that is sometimes apparent. This is manifested in preparing one set of books for tax authorities and another set of books for management. At any time, especially when preparing a company for launch or sale, such a discovery would be, at best, unsettling.

There is, also, no statute of limitation on transgressions. Misdeeds decades ago can still come back to haunt. The best advice is to conduct thorough tax "due diligence" before investing and make sure responsible and ethical compliance practices pave the way forward.

6. How can returns be best maximised in a liquidity event?

In China, there are two ways that foreign investors can beneficially position themselves for an exit.

First, the deal structure in China is critical for ensuring the right kinds of returns. We are most accustomed to the deal structure helping to maximise returns and provide any downside protection.

By contrast, in China the deal structure is fundamentally for facilitating an exit strategy as foreign investors don't want to be trapped in an on-shore investment that doesn't have a hard-currency liquidity outcome.

Second, employing the right tax strategy is imperative. Although it is complicated, Chinese tax law does allow foreign companies a certain degree of latitude in selecting where they establish their tax presence. This choice will have implications on bottom line results. There are numerous tax zones in China, each offering a different corporate tax rate that can be as high as 33 per cent or as low as 15 per cent. Similarly, tax holidays are the fashion in various industries and locations. Local government is also savvy enough, in competing with others to attract foreign investment, to sweeten deals with tax rebates or refunds.

7. What is the state of corporate governance in China for foreign investors?

The simple answer is that often it is weak. As a rule, financial and accounting functions are not highly rated. Businesses may have little regard for the sorts of disciplines we would expect to protect shareholder value.

It is also an environment where normal practices in day-to-day business may be considered unethical - or even illegal - in the West.

Putting rigorous systems in place is not impossible, but it does mean spending a great deal more in hands-on time nurturing an investment. The best solution is to start the process of creating a culture of strong corporate governance and financial reporting sooner rather than later.

8. How does one go about introducing a culture of corporate governance?

A sizeable chunk of any investment or operating plan should be dedicated to creating a strong accounting function from day one rather than later. Ideally, a qualified controller should be put in charge of this function from the outset to make sure the right systems are in place. It may seem like a major cost but the return downstream will be sizeable.

Once in place, continuing monitoring of corporate governance practices is also recommended. Remember that Chinese management teams are often not used to Western corporate culture and might be tempted to continue practices that put the company at legal risk and/or squander the returns on exit.

9. What is the universally most common mistake foreign investors make in China?

Without question, these come down to differences in language, culture and world views.

Regulations mean that in almost any business deal there will be Chinese investors involved. Understanding their needs, and viewpoint, are critical to success. Again, this can be time consuming and frustrating but is a reality that needs to be planned for and put into place.

* Joanna Doolan is a tax director with Ernst & Young