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China is vast, and its annual economic growth rate has been holding steady at around 8-9% in recent years. It has a population of some 1.3 billion people, 94 million of whom are already online users (a number that is expected to exceed its US equivalent by 2009), and its daily TV audience reportedly amounts to a staggering 1 billion people.
While actual penetration rates are hard to determine, China's people own 66% more mobile phones than their US neighbours - with 4-6 million new subscribers added every month - and 50% more TV sets. It is also estimated that 45% of the gross national income is generated by a mere 20% of the population (which amounts to some 240 million people - almost the entire population of the United States.)
How developed is this market? Whilst difficult to measure, it surely has a long way to go. Today, the wealth impact from successful economic reform is mainly generated at the major cities in China along the coastal areas, and this phenomena has the potential to repeat in many more cities as China deepens its economic reform in the Central and Western regions.
| Foreign companies with good products may not necessarily have an effective distribution network within China, especially in previously protected sectors. |
Tapping into the China's domestic markets
China has been protective in opening its trading and distribution services sector. Prior to 11 December 2004, when the 3-year transition period lapsed, foreign investors wanting their own distribution vehicles in China had to resort to trading companies established in free trade zones, minority-owned joint ventures, or China investment holding companies (for some 250 investors who are big enough to afford them). None of these structures were able to serve the full needs of foreign investors, due to restrictions imposed on geographical presence, source of products, import/export rights, business scope limitation etc.
A significant breakthrough came last year when the Ministry of Commerce ("MOFCOM") issued its Administrative Measure for Foreign Investment in the Commercial Sector ("the New Measure"), commonly referred to as Circular 8. Circular 8 enables a foreign investor to establish a wholly-owned company anywhere in China, with full-fledged trading and distribution rights for as little capital as USD4,000, subject to approval.
The key barriers mentioned above have also been removed, and there is no longer a distinction made between foreign and domestic trade. As a result, companies are no longer required to segment their marketing efforts and can present a single, coherent "face" to the marketplace.
A regulation with such a far-reaching impact as Circular 8 does come with a unique set of implementation issues, and there is clearly a need for proactive dialogue and ongoing clarification from the Chinese authorities. Despite these implementation challenges, the issuance of Circular 8 makes tapping the domestic market a real possibility for many smaller to medium size companies who wish to exert direct control over their China business activities.
Circular 8 has also prompted existing investors to review the effectiveness of their current business models, and make their distribution structures more streamlined and tax-effective. Based on their specific commercial needs, these investors might now consider:
- Replacing their current, limited-function representative offices with full-fledge distribution vehicle.
- Upgrading their trading companies in free trade zones to a full-fledge distribution vehicle or migrating their trading companies to outside the free trade zones and establishing a network of branches throughout the Mainland cities.
- Redesigning the role of Chinese holding companies so that they can function as fully national distribution vehicles.
- Expanding the business scope of existing manufacturing or service companies to encompass trading and distribution services.
M&A trends
Besides setting up green-field operations, M&A has become an increasingly popular way of accessing China's domestic market. Foreign companies with good products and services may not necessarily have an effective distribution network within China, especially in previously protected sectors. In the banking sector, for instance, HSBC spent over US$1 billion to acquire a 19.9% stake in Bank of Communications, China's fifth-largest lender (with some 2,700 branches).
| China's preferential income tax policies - designed to attract foreign direct investment - is now bearing fruit. |
HSBC also paid $600 million for a 10% stake in China's No.2 life insurance company, Ping An Insurance and has announced to acquire additional 9.91% stake. In the beverage industry, we also saw America's Anheuser-Busch spend $650 million to acquire Harbin, China's fourth-largest beer producer. In the retail market, the UK's Tesco PLC - the world's No.3 retailer - has acquired a 50% stake in a chain of 25 hypermarkets in China, at a cost of $260 million.
The tax landscape: complex and ever-changing
China's long-established preferential income tax policies - designed to attract foreign direct investment - is now bearing fruit. From a base rate of 33%, generous tax holidays and reduced rates were offered for a wide range of activities, resulting in foreign investors paying on average an effective tax rate of about 10%-15% in China (whereas domestic companies are generally taxed at 33%).
Tax holidays have been further extended for export-oriented or technologically advanced enterprises. Plus, China does not levy withholding tax on dividends remitted abroad.
Despite these tax advantages, a recent tax survey conducted by PricewaterhouseCoopers nevertheless ranked China number one in the list of Asian countries that pose the greatest tax challenge. This is not unexpected. A country like China, with its high investment growth, invariably presents significant tax challenges.
China's tax and investment regulations are constantly changing, and often lack interpretive clarity and consistency in implementation. China also adopts a fairly aggressive audit approach, and a hefty penalty and surcharge regime. Worst of all, China's current legal system does not provide an effective appeal process.
Foreign investors also have to contend with a rather complex turnover tax regime in China, which includes a production-based VAT system, an irrecoverable service tax called business tax, consumption tax, and an unusual VAT tax for exported goods.
In addition, China imposes individual income tax on a graduated scale, with a maximum rate of 45%. Employers face serious penalties if they fail to properly withhold individual income taxes.
China also requires the payors to go through various strict tax-clearance procedures, prior to each overseas remittance of fee, so as to ensure that the remittances are legitimate and relevant taxes are collected.
| Faced with the challenges of a vast, but fragmented market, and the strong protectionist barriers that still exist, foreign investors need to consider their entry plans carefully. |
Also adding to the tax challenges is the fact that the income tax preference package for foreign investment is going to tighten in future tax reform efforts. When it comes to its business and tax environments, China is clearly intent on creating a level playing field for both domestic and foreign companies alike. This would likely result in higher income taxes for many foreign investors; hence the need for them to re-examine their tax planning strategies.
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Making it work
There is no magic formula. For companies contemplating a move into China, they must do their homework and should seek out reliable and authoritative guidance. Faced with the challenges of a vast, but fragmented market, and the strong protectionist barriers that still exist, foreign investors need to consider their entry plans carefully.
For instance, is a Chinese JV partner needed and will the Chinese partner be able to deliver the business benefits expected from them? Should a company grow via an organic approach, or through acquisitions? Have the investors consider the enormous cultural differences that exist in terms of doing business in the East and in the West, and how such differences may impact on the market approach, business practices, people strategy, and interaction with government bodies in China.
From the tax and regulatory perspectives, investment holding structure, financing arrangements, profit repatriation strategies have to be considered at the inception of each investment as they impact directly on after-tax return on investment, ability to restructure in the future and ability to repatriate hard-earned cash out of China.
Investors need to become familiar with national and local regulations as well as local practices governing the use of loans, royalties, interest charges, etc. This is especially important in a country like China where enterprises have to deal with authorities to implement the structures.
Effective tax planning has to be able to consider indirect tax implications in China, whether this is customs duty, business tax, and value added tax. It is a complex tax area. Additionally, transfer pricing is often the centerpiece of all tax planning as well as scrutiny by tax authorities.
| China offers huge opportunities for those willing to rise to the many challenges, [but] never go it alone - talk first to the experts on the ground in China who "know the ropes". |
It is essential to apply a balanced view on transfer pricing matters and support the same with documentations. The PRC tax authorities are determined to regulate this area with rules expected on documentation in the near future.
Looking to the future . . .
China offers huge opportunities for those willing to rise to the many challenges that exist, and they are many and various: business, political, cultural, social, economic, and linguistic. However, the rewards are commensurately high, provided foreign investors and companies take a well considered and circumspect approach to entry and to grow. So, never go it alone - our advice would always be to talk first to the experts on the ground in China and who therefore "know the ropes".
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