Chris Devonshire-Ellis On The Communist China Price

July 21, 2010 Posted by Chris Devonshire-Ellis Reading Time: 9 minutes

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.