Chris Devonshire-Ellis On The Communist China Price

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Op/Ed Commentary: Chris Devonshire-Ellis

Jul. 21 – With recent headlines that the CEOs of Siemens and BASF have complained directly to Chinese Premier Wen Jiabao over the cost increases of doing business in the country, it is pertinent to dig deeper into evaluating the real price of doing business in today’s China.

BASF’s Juergen Hambrecht stated that foreign companies were being forced to give away business and technology to Chinese companies in exchange for market access, while Siemen’s Peter Loescher called for China to quickly remove trade and investment restrictions in the automotive, financial services and other industries. While foreign companies, especially MNCs, have long been well known for an aggressive approach in seeking concessions for their business interests, it has been some time since such an openly aggressive pitch has been made to a senior Chinese leader.

However, over the past twenty years, the pace of China’s reforms, including market access to foreign investors, has been remarkable. Back in 1990, the thought that China’s auto market would have overtaken that of the United States was inconceivable. Yet Siemens and BASF, along with countless others, have benefited tremendously during this period, during which China has delivered beyond their wildest dreams. So are the executives concerns a touch of sour grapes, a reflection of a slowdown, investor pressure to maintain growth at “China growth standards,” or an attempt to prize yet further concessions from a China market already saturated and internationally mainstream in global manufacturing?

A number of factors suggest not. Let’s look at the following events that have occurred over the past two years that have directly impacted on foreign manufacturers in China.

Tax holidays
Until 2008, foreign investors could unilaterally enjoy a standard of five years income tax breaks for investments. Given exclusively to foreign manufacturers, these were typically worth two years at 100 percent tax break and three years at 50 percent. These have now disappeared except for a very few specialist areas of industry.

Profits tax
Foreign companies setting up in a special economic zone could enjoy income tax (when it kicked in) at rates of just 15 percent per annum. Upon tax equalization in 2008, this increased for foreign investors to 25 percent (with a five year transitional period).

Dividend tax
A dividend tax was also introduced in 2008 that required foreign investors to part with an additional 10 percent of tax on profits made after January 1, 2008 prior to its repatriation back to the home domicile. While the impact of this has proven somewhat erratic due to IRS and related tax equalization policies, for some businesses that have engaged in tax efficient structures or whose parent domicile enjoys a lower rate of income tax than China’s current 25 percent, the impact has been negative as regards the direct profitability of the China investment.

Employment costs
With the introduction of the labor contract law in 2008, employment costs and the related mandatory welfare costs (typically a further 50 percent of salary) have risen sharply. Employers now are required to offer open term contracts to their employees at the conclusion of the employee’s second fixed term contract. Compensation for laid off workers also became codified and this strengthening of labor rights and the role of the labor union has also lead to a flexing of regulatory muscle, and strikes, previously unheard of at foreign-invested enterprises in China. It has now become very expensive to fire staff in China, even if they are in the wrong. Employment has become a state protected right for Chinese labor. The impact is still being felt and the longer-term repercussions are likely to further increase the cost of employing Chinese staff. This can be offset by relocating labor intensive industries elsewhere in China to less expensive regions, however relocation is expensive in itself and compensation for existing employees who do not wish to move still has to be met. Less expensive regions also tend to have greater challenges in labor management, training and overall infrastructure capabilities.

It means that just from the regulatory aspects, China has become considerably more expensive over the past two years.

How these regulatory changes have affected foreign investors differs on a case-by-case basis depending upon the business scope, numbers of employees, and profits repatriation amounts. However, it is not an unreasonable estimate to suggest that a minimum of 20 percent of profitability has been eroded over the past two years and in some cases, considerably more. When impacted upon the trade volume required to make up that 20 percent, businesses with thin profit margins will have found themselves with enormous business volumes to add to their bottom line just to make that up and maintain their profitability position as against the pre-2008 regulatory changes.

There have also been anomalies in how China effectively manages domestic companies against foreign investors. Some serious loopholes have opened up that effectively discriminate between them.

Sovereignty protection
This has started to arise as a serious issue in multilateral contracts, and not just with Chinese companies. As the global trade share for countries with effective single party states has arisen, so has the number of companies involved in such trade that are state owned and controlled. This has lead to an increasing number of situations whereby collusion between two effective one party states can avoid liability for debts due to a third, private company that does not enjoy the protection of the state. As things currently stand, nations themselves are effectively immune from prosecution in other nations courts. However, this picture becomes complicated when nations own businesses, as is the case of China’s state-owned enterprises. An increasing number of cases involving liabilities incurred by Chinese SOEs overseas has meant that such businesses have sought to renege upon payments or liabilities, often for amounts running into hundreds of millions of dollars. While this has always been an issue, the sheer numbers of Chinese SOEs that have been playing the game in seeking protection from under the skirts of the Chinese government has been increasing. This represents a huge potential risk for non-government protected businesses in partnership with them. The liability may not end up being a two-way deal. Such issues have to be solved at a governmental level through diplomatic negotiations, and not at a regulatory level through the courts. This represents a communist system risk appearing in global trade.

Using foreign governments as arbitration bodies
When rows over bilateral trade or agreements have occurred, and in particular when state-owned enterprises are involved, the Chinese government has often gotten directly involved, typically through the Ministry of Commerce. Disputes whose resolution has been unsuccessful are then held with diplomatic weight behind them. In encouraging this stance rather than seeing to it that disputes involving foreign trade and investment are carried through China’s legal and/or arbitration system, China is effectively taking out of the equation any legal recourse and aiming to settle the matter via diplomatic negotiations. This can backfire.

China has long shown it is prepared to use unrelated commercial activities to ‘punish’ a foreign government for a trade dispute that has arisen elsewhere. Canceled contracts for aircraft for example, or other contracts may be denied on this basis and not on any commercial considerations. What may in fact be a great commercial deal may still be thwarted through China’s use of commerce in politics. This is nothing new of course, and governments engage in such tactics all the time. What makes China unique in this regard is the sheer numbers of SOEs now getting involved in global trade, and the apparent preference of the Chinese to immediately politicize any disputes. This behavior also begins to drive a wedge between foreign private sector businesses and the interests of the state. Foreign private sector businesses often do not receive the same amount of support that would normally be forthcoming when the Chinese have politicized larger national commercial deals. Commercial consuls may wish to consider whether the correct thing to do is to wade into a dispute or to request China to beef up its legal protection for foreign investors.

Lack of integrity in audit
Foreign investors are placed at the highest level of scrutiny when it comes to compliance with China’s regulations, tax filings and audit. My firm handles hundreds of cases of compliance and audit assistance work each year, and we are also called in to provide due diligence on the credibility of Chinese company accounts. The differences between the standards engaged by most foreign investors and most Chinese domestic companies are huge. While it may well be the case that China’s tax bureau is understaffed and underpaid, the extent of “guanxi” that still goes on at audit to permit accounts to be filed with little relation to actual trade volumes is staggering. Deals are routinely done to “make it easier” for the government tax bureau to file an audit by pre-arranging the amount of tax that has to be paid and submitting a report written to that specification. It saves the tax bill of the domestic business, saves the time needed by the government to audit the accounts, and if targets are met all round, then who cares?

The truth is that tax avoidance by domestic businesses is rife and it creates an unlevel playing field with foreign businesses that are strictly monitored. Should China wish to seriously look at increasing its tax base, it would do well to expand that base by putting greater emphasis on collection from domestic businesses. The Communist thinking however dictates that such a measure won’t sit well with Chinese small businesses, and could lead to “social unrest.” Foreign businesses therefore continue to contribute far more in tax revenues than their Chinese equivalents despite the 2008 tax equalization specifying this should not be the case.

Domestic protection
Foreign investors are treated, according to China, in accordance with the law and enjoy the same protections as a domestic company. However, in numerous due diligence cases my firm has been involved in, we have found that in practice this is often not the case. One example I can provide is the Chinese domestic company operating 20 outlets on a national basis across China seeking to list in Hong Kong. As part of the team looking into liabilities, we came across a gross infringement of mandatory welfare payments, involving several thousand staff in nearly all of the businesses outlets. Staff simply had not been paid their complete mandatory payments, despite this being illegal. The potential liability ran into hundreds of millions of RMB. In discretely looking into the issue, we determined, in conjunction with another high profile China law firm, that the payments could in fact be legally negotiated at a local government level. This meant that the domestic company concerned, in the opinion of several prominent experts from my tax practice and the law firm, was in a position to negotiate locally what are termed by the state as “mandatory” payments to staff. Such capabilities are far beyond those enjoyed by foreign investors and again provide an unfair playing field in terms of Chinese domestic companies being able to circumnavigate China’s own state legislation.

Local manufacturing content requirements
Despite foreign Investors enjoying protection under Chinese company law, here too lie anomalies. In bidding for contracts, provision is often insisted upon that so much of the production must be “local content.” Yet here apparently, foreign invested enterprises do not qualify as being local. This scenario, whereby “local content” is either not available, or is substandard, has had a serious impact in several of China’s industries, and especially in areas such as wind power. It also calls into question the criteria for being designated “local” for which the goal posts constantly appear to move, often appearing designing to label foreign investors as ‘foreign’ and thereby excluded.

The communist price
These issues – and there are plenty of others – amount to what I would call the “communist price.” They remain ways in which because business in China is so intertwined with the state, foreign investors can be effectively shuttered out of the equation. That means both market access, and even getting paid after the event. Dealing with the issue, as BASF and Siemens have done through the remit of the German government, means accepting that the tried and trusted Western system of legal recourse and legislation is now merging with a more opaque system of government diplomacy in China business practice. China has not only increased its cost of business through tax and the regulatory environment, it is also prepared to flex the communist system muscles to its advantage, and is increasingly doing so.

Foreign investors already in the China market are having to recalibrate their business plans and models to cater for the 2008 regulatory changes and the increasing “communist” aspect that has crept back into China’s domestic and international trade. In my experience, the changes are having an overall negative impact on foreign investment in China. Quite simply, foreign investors are being asked to pay more, either through the regulatory system, or through the intangible aspects of an increase in communist style behavior in business. Businesses that are new to China will also need to review their business plans. I would recommend, once the financial research has been carried out, of adding at least another 30 percent of intangible costs to the bottom line, and preferably 50 percent. While that may seem a lot, the China communist price with its hidden costs and charges will haunt those who do not factor that in. Should this prove to be too much, then businesses should consider that the “Asia alternative” cost trigger has been reached and start instead to look at lower cost jurisdictions such as India, Vietnam and elsewhere in emerging Asia for their business domicile.

While it may be ironic that Messrs. Hambrecht and Loescher are using the mechanism of Government themselves to get their point across, they at least understand the game and are playing to China’s rules in taking trade aspects to the government. That is a million miles away from dealing with trade through legislation and reform, and it represents a regression of China’s overall policy of developing international trade and opening up. Siemens and BASF are right to be concerned. Foreign investors involved in China should look again at the math, inherent risk and the sustainability of their profit targets.

Chris Devonshire-Ellis is the principal of Dezan Shira & Associates, a foreign direct investment practice he founded 18 years ago. The firm provides corporate establishment, due diligence, and business advice, in addition to tax, accounting and audit assistance. The practice maintains ten offices in China, five in India, and two in Vietnam. Contact: info@dezshira.com.

Correction, July 22, 2010
An earlier version of this article stated that the tax holiday that foreign investors previously enjoyed was three years at 100 percent tax break and two years at 50 percent, this has been corrected to two years at 100 percent and three years at 50 percent.

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15 responses to “Chris Devonshire-Ellis On The Communist China Price”

  1. Chris says:

    An excellent post on these issues, certainly the best I’ve seen to date on this topic.

  2. The_Observer says:

    I think you nailed it on the head. Because China has a top-down system of government and that government owns a large number of corporations the negotiations are often done at a government to government level. This is not as uncommon as one might expect. The USA, UK, France, Russia and also the Chinese deal with Middle East countries on a government to government level for projects. Admittedly the British do it at a lower-key level but then they have a royal family to smooth things over with the sheiks and many of the countries there have ties to Britain.
    Siemens is an interesting case as they know China is an important market for them. In the Chinese market, they compete with other international telecommunication providers to supply equipment. The former also competes with the Japanese and French for selling fast locomotives and rail technology with Bombardier for carriages and communications. Bombardier in turn competes with Embraer in China for the small jet market in China, etc, etc. The Chinese market is cost sensitive and can be brutal. Any of these international companies are bound to feel the pinch when tax holidays are lifted.

  3. Carlos says:

    Excellent article, indeed. Very well written and researched. Thanks.

  4. Paul says:

    It is misleading to refer to these problems as a ‘communist price.’ These practices are illustrative of state capitalism.

  5. Daniel says:

    Very impressive post.

    1. What does it mean, though, in the larger sense for China’s own economy?
    2. Having said all that, should we expect MNC to reduce their investment in China or indeed move to other locations within the next 5 years?
    3. At what point would foreign governments actually put their foot down, or should this not to be expected considering the current economic situation? (thus China is the one who would laugh last).

    Thanks again for a very insightful post.

  6. Richard says:

    A very insightful article, thank you. Regarding the tax holidays however, my understanding is that they still exist for foreign enterprises in certain areas. The several development zones in the Tianjin Binhai New Area, for example, still offer such tax holidays regardless of industry.

  7. Cedric Woolley says:

    Well done on this. China Blog article of the year? Honest, insightful, balanced and well written. I’m impressed.

  8. Chris Devonshire-Ellis says:

    Thanks for your kind words and comments. Let me answer a few points raised:
    @Paul – “State Capitalism” could be used in some cases, however China is more complex. I didn’t go into great detail on this point, however the Chinese Communist Party sees the survival of itself as of a greater paramount importance than commercial policy and economic growth. This is impacting on various economic and trade policies which one does not find in a capitalist system. Hence my use of the “Communist” tagline.
    @Daniel – It’s reflective of China’s aging in the demographic sense, and that wages are bound to rise. China is ensuring that does not go hand in hand with layoffs. “Social Unrest” leading to criticism of the CCP is of great importance in this equation. The CCP is balancing mass socialism against captalism on a never yet seen scale. Strains are showing, and mistakes are being made – after all, no-ones ever doen this before. You will see MNC’s invest elsewhere (especially India) in the next few years, depending upon circumstances. Companies that remain will be in China for the domestic market. Export driven manufacturing will however eventually relocate elsewhere and this trend has already begun. It’s why my firm set up in India (see http://www.india-briefing.com) and Vietnam (http://www.vietnam-briefing.com) a few years ago. It’s better to be ahead of the curve than caught out behind it, and that balance enables us to write more objectively also about these markets as well as hedge against this evolution in servicing global manufacturing. I’ve matched my comments with investment dollars in these new emerging markets. Concerning foreign governments, I feel they have been naive in their dealings with trade disputes in China. In getting ‘ever so helpful’ commercial consuls involved (some of whom may not actually be good businessmen or lawyers) China has been able to divide and rule and manipulate disputes involving foreign investors in China away from legal action and pressure on a poor legal recourse system and into the diplomatic arena. That suits China just fine. It’s not however healthy for international standardisation of dealing with fraud or intentional misbehavior. Some of the conduct by certain businesses in China would, if in the US or UK, have lead almost certainly to convictions. In China, it’s ‘part of the government’ and has to be dealt with diplomatically. Its not a good trend and I’m not sure how much aware foreign Embassies in China are aware of it when jumping into intercompany bilateral disputes. They’d be better off pressurising China for legal reform and adherence to international standards.
    @Richard – Thanks, yes we know certain zones have incentives and I alluded to this. However the State prohibited blanket tax incentives for manufacturing enterprises nationally in 2008. Some local governments may well still offer them, in which case that money has to come from elsewhere and not State coffers. The bone fide incentives are authorised at State level only, most now only exist in very hi-tech industries.
    @General Comment: I’d like to reiterate that personally I’ve invested in many businesses in China over the past 18 years, including my own. I continue to do so – my practice Dezan Shira (http://www.dezshira.com) has just opened a new office in Qingdao for example. However, under the current climate I would not sign off on any China investment unless it contained an intangible provision for at least 30% additional cash over and above the identifiable business model requirements. That additional cash reserve, speaking as a businessman, is what I would determine as “The Communist China Price”. It’s 30% above what you think it is. – Thanks – Chris

  9. Gilbert says:

    Yes indeed very well written. Except for the comment on “local content”. The European Chamber has fought hard on this and we obtained the admission from Wen Jiabao and others that “domestic product is made in China, done by foreigners and Chinese alike”. Of course implementation is not perfect but we continue to monitor events in this respect.
    Gilbert Van Kerckhove, chair of the Public Procurement Working Group, EUCCC (domestic product definition & indigenous are monitored by our Group)

  10. Chris Devonshire-Ellis says:

    Good to hear that Eurocham are involved with ensuring compliance Gilbert. You probably have met then my colleague Alberto Vettoretti at Dezan Shira who is on the board. Keep up the good work. – Thanks Chris

  11. Casey says:

    Very interesting in depth material & oberservations. Thank you for this.

  12. As an adjunct to the comments about the increased cost of doing business in china, we are now seeing aggressive tactics by China and government companies to try and obtain new technologies from offshore JV partners before any binding agreements are signed.

    The pretence of needing to examine technology processes in order to value the technology process as a form of capital contribution is being used to try and obtain the technology for free.

    We are now advising clients to by all means show trial data of the efficacy of the technology but to insist on a prior sale of the IP/technology and for an upfront payment by the JVC for this IP and then a subsequent licensing of the process for royalties back to the offshore head company in order to protect the foreign investor.

  13. Chris Devonshire-Ellis says:

    That’s very good advice Richard. For those to whom this matters, get those IP technology agreements in place and a mechanism for upfront payments or royalties, and don’t hand over your technology without this. The suggestion by Richard to use trial data to illustrate technology value is very sound. See also the current issue of China Briefing Magazine on OEM Contracts and supplier/partner due diligence here: http://www.asiabriefingmedia.com/store/index.php?main_page=product_info&cPath=97_94_99&products_id=381 Thanks – Chris

  14. Thanks Chris. See also the link to a presentation on issues for Investors into China, with a mention of the IP challenges facing investors who wish to introduce new technology.

    http://www.rhklegal.cn/newsdetail.asp?newsid=40

  15. Indeed, the Chinese are technology hungry. Make sure you have that IP protected and you are introducing technology that is part of your business development, and not that necessarily of the Chinese partners development unless you are in agreement with such a strategy….
    Thanks – CDE

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