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INVESTING IN CHINA – PRACTICAL DO'S AND DON'TS
- by Wong Mun Kit

Professionals in Singapore find themselves with an ever-increasing number of clients headed in the direction of China. Wong Mun Kit of the China Practice, Chio Lim Stone Forest, shares practical tips on the do's and don'ts for avoiding the many painful pitfalls on a journey that is characterized by as many opportunities……

Are you heading for China? Even if you are not, the likelihood is that your clients are. The question is: "Are you equipped to help your clients on their journey into China"?

Opportunities in China are plentiful. There is little need to elaborate. Pitfalls are of the same intensity, if not more.

Although issues that need attention may come across as rudimentary, however, when caught unaware, issues that are not properly addressed could cost your client time, money and the most damaging of all, lost opportunities.

Pitfalls await the uninformed. The following sets forth cautionary advice on three situations of common beliefs and pitfalls. Your clients count on you to caution them and set them off on a profitable and hassle-free journey in China. All of us professionals have the obligation to live up to this expectation.

You would have heard of businesses in China that made concerted efforts to lower the value of imports in order to lower the Value Added Tax ("VAT") and Custom Duty? Should you advise your clients to do so?

China levies VAT at 17% and Import Duty in varying percentages, on the value of imports. Not only would this increase the cost of imports , it would also give rise to the need to fund these payments until the goods are sold and receivables collected from customers. To reduce this expense and improve on cash flow, some businesses would under declare the value of imports. This would give rise to following issues:

Under declaration of the value of imports would mean that the costs of sale would be artificially reduced. This would translate to higher profits and hence higher Income Tax expense on such profits.

Although it may be argued that the importer would still benefit from the delay in payment of Income Tax as opposed to payment of VAT and Import Duty at the time of import, this does not detract from the fact that there was an under declaration of the value of imports that may potentially lead to investigation and the accompanying financial penalties that could result.

The imposition of financial penalties for an incorrect payment of VAT and Import Duty does not mean that the taxpayer is able to re-file its Income Tax and make a claim for a refund of overpaid Income Tax. This avenue is not open to the taxpayer. What this means is that the taxpayer would have incurred the financial penalties for the incorrect payment of VAT and Import Duty in addition to higher Income Tax due to the reduced amount of cost of sale recorded in its financial statements.

Even if a taxpayer is able to get away with under declaration of the value of imports, the taxpayer would still be exposed to contingent financial liabilities that could become real, when an investigation is undertaken by the relevant authorities, or when unscrupulous or disgruntled employees or business partners should use the situation to their advantage.

Your clients should be well informed of the problems and risks that could result from this "cost saving exercise" that is commonly believed to be workable.

Have your clients been financing their investments in China with funds from abroad? If so, do you know if your clients can repatriate these funds from China?

Many businesses that invest in China would find that their Wholly Foreign Owned Entity in China ("WFOE") needs funding in excess of their paid-up capital. Additional funding is usually made by remittance of funds into China from outside China by the holding company. Such remittances are made on a regular basis, as and when funds are needed in China.

Notwithstanding that the financial statements of both the WFOE and its holding company respectively reflect the parties as borrower and lender, the parties may encounter problems when the time comes for the repayment of the foreign loan. This is due to the fact that many foreign investors are ignorant of the need to properly register foreign loans with the Foreign Exchange Bureau, within a certain time limit. Failure to do so would jeopardize the ability to obtain foreign exchange approval for the remittance of funds for the loan repayment.

Foreign investors that finance their China investments with loan capital are advised to ensure the proper registration of foreign loans so that loan repayments can be effected without encountering problems. It would also be prudent to have loan documentation put in place to evidence the existence of a foreign debt obligation so as to provide additional support when a Foreign Exchange Bureau approval is sought.

When your client has a Chinese Joint Venture ("JV") partner, what are some of the precautionary measures that can be taken when structuring investments in China?

The obvious caution that you would alert your clients on, with respect to Joint Ventures in China, would be the need for a properly structured Joint Venture agreement. The following sets forth a less obvious matter for caution.

Some investors tend to replicate the same structure that had been in use in their home country for their investment in China. An example is when an investor is accustomed to using one and the same entity, both for the manufacture of products and distribution of the manufactured products in their home country.

When it comes to investing in China with a Chinese JV partner, the investor would inadvertently replicate the same structure to which they are accustomed. This would mean that the investor and their Chinese JV partner are invested in one JV vehicle which activities would encompass the manufacture and distribution of manufactured products. This may not be the wisest decision, especially when the JV relationship is a new one.

To penetrate the vast China market, a Chinese JV partner could bring valuable contribution by way of business contacts and market intelligence for the distribution of products. However, this does not mean that the Chinese JV partner would have the ability to make equally meaningful contribution in the manufacturing aspect of the business. In a majority of the cases, the Chinese JV partner has little to contribute in this respect, which is proven by the fact that the manufacturing know-how often belongs to the foreign investor.

In such a situation, a foreign investor should not merely replicate the structure that it is accustomed to in its home country, i.e., the use of one entity to take on manufacturing and distribution. The foreign investor should be aware of the possibility of structuring its investment in China by the use of two entities. The first entity is a WFOE for the manufacturing aspect of the business. The second entity is a JV with the Chinese partner. The JV purchases products manufactured by the WFOE and distributes these in the China market. This structure will have the effect of isolating the Chinese partner to that unit of the business that will benefit from their contribution.

From the perspective of a foreign investor, it would be strategically beneficial to confine the need to involve the Chinese JV partner to those areas that their involvement is critical. This is especially important for a new and yet-to-be tested business relationship.

Conclusion

The above are merely three of the many situations of do's and don'ts that your clients may encounter when they journey into China. For business people and professionals alike, to be successful in China, there is a constant need to remain vigilant and guarded, so as to avoid the many pitfalls in this significant journey that is characterized by as many opportunities.

Mun Kit may be contacted at 6531 1808 or email wongmunkit@stoneforest.com.sg