China Compliance Issues For Foreign Investors

December 12, 2014 Posted by China Briefing Reading Time: 7 minutes

As has been extensively reported in the media, the Chinese government has indicated it will be ‘cracking down’ on non-compliant foreign investors during 2015. In actual fact, this has always been the case – foreign investors are under the highest level of scrutiny by the Chinese authorities in everything from adherence to business scopes to payment of tax. They exist under a “Level One” platform of systematic checks by the Chinese tax bureau. At the opposite end – Level Four – are China’s State Owned Enterprises – with the minimum level of scrutiny. Why? Because CCP logic dictates that Chinese SOEs are owned by the Government and therefore abide by the rules. Accordingly, this division of levels of scrutiny can be abused in a number of ways familiar to all who have been conducting business in China for a number of years – and especially those larger foreign corporations who compete with Chinese SOEs for market share.

However, compliance in China is a serious matter for foreign investors. The problem with China compliance is that many of China’s laws are so opaque that much can be left to interpretation. This applies to Chinese nationals as much as it does to foreigners, and is one method via which the CCP can always find a transgression should they wish to target you or your business and make an example. This happened on two notable occasions last year. The pharmaceutical giant GSK was fined for gross breaches of law that involved giving doctors incentives to prescribe their drugs, and had their China CEO deported. No matter that the entire industry is run on this basis (and still continues to be so) – it was a shot across the bows not to compete too hard with Chinese companies. The second was the consultant Peter Humphrey, jailed for three years for obtaining personal information about Chinese nationals. It has yet to be fully established what precise laws Peter broke, but the Chinese Government were not happy with his methodology of obtaining sensitive data and exacted retribution to dissuade others from doing the same. I have no doubt that privacy laws will be tightened up in China as a result. What these two cases demonstrate is that just because “everyone” does it, and an entire industry can be based upon illicit payments, does not mean you are out of the woods when it comes to getting into trouble. Nor does it mean that engaging in grey areas of the law can be disregarded. And this becomes a problems when trying to identify acceptable parameters of what is permissible. It is a moving target. When discussing the crackdown on corrupt Government officials in China by President Xi Jinping, I was recently told that actually all this had effectively done is to “raise the price of bribes, as the risks are now greater.”

So where does this leave the foreign CEO or CFO trying to ensure their China subsidiary plays by the rules? It can be tough, as mentioned, China itself makes the rules and if they suddenly decide you are in the wrong, then that is all there is to the matter. However, it is also true to say that the vast majority of foreign investors do not operate at the high levels of competition with Chinese SOEs that GSK does, or operate as undercover sleuths as Humphrey did. This means – and it is good news – that the Chinese Government, provided you try and run your business sensibly and honestly, is not going to come looking for you. But small details can be picked up on and create headaches from time to time, even for the most diligently run companies. Below are a few examples common to most foreign investors in China.

Legal Compliance

Most transgressions here result in inadequate scopes of business that no longer cover your activities. This can be due to organic growth and forgetting that everything your business does needs to be written and clarified on your business license. Some adjustments may require not just an additional phrase, but an increase in your registered capital as well. If you are not sure that your actual scope of business and registered capital are now sufficient to justify your current or intended activities, you need to get this changed. This also applies for businesses that have moved location or changed their Legal Representative. Did you formally and legally change your business license details to reflect this?

Human Resources

Being out of compliance in HR can be a very expensive business in China. China’s employment law is very much in favour of the employee – and he or she absolutely knows that. Issues such as the term and length of employment contracts, if you are not aware of them, can end up being very expensive if you are not familiar with the regulations and how employment works in China. It is a complicated subject, summarised in one of our previous articles: Designing a Labour Contract in China. Termination of an employee can also be a traumatic experience for the company, and especially so when there are disciplinary issues or disputes. In fact it can often be a better solution just to pay up and get them out of the door rather than litigate. Termination however follows precise rules, as we also summarized in this article. If you are not on top of your HR compliance, the results can be immensely stressful and demoralising, as well as expensive.

Financial Compliance

This is a huge subject and incredibly diverse. China’s financial systems are also obtuse and some official procedures so arcane they actually encourage non-compliance. Here, care needs to be taken to identify whether non-compliance issues are actually a result of incompetence, systematic problems, or fraud. The first two can be fixed, the third is a serious issue. An example is company money being found in the CFO’s personal bank account. On the face of it, it appears to be theft. Yet the CFO may actually have been trying to save the company money by diverting part of the payments for goods to clients away from the company for awhile to offset VAT payments. There is no doubt it is out of compliance, yet the motives may not have been driven by fraud. These sorts of issues can often turn up in M&A where the foreign company buys out a Chinese entity or JV partner. As already stated, foreign-owned businesses are at the highest level of scrutiny, and practices carried out by previous Chinese owners and deemed “acceptable” will not pass muster under foreign ownership. In cases such as these, it is wise to get in a team of due diligence personnel familiar with these scenarios to assist and clean up such operational waywardness.

Tax Compliance

The majority of foreign investors are already in tax compliance, they exist under Level One scrutiny at the tax bureau anyway. But this doesn’t mean that mistakes don’t happen. In my experience, the Chinese tax bureau is relatively straightforward to deal with as long as you have the intent to pay them. Mistakes, if put right, usually go unpunished. But the tax bureau has the authority to levy fines of up to five times any unpaid tax amount due, plus the unpaid tax portion. It makes sense to ensure you are in compliance and to have a good accounting firm run the rule over your books and operating procedures. Even if you do have a competent internal system in place, it is always good for them to be subject to a twice annual review by a third party – mid year through the tax year as well as at annual audit.

Summary

Foreign investors running their businesses to international standards should have nothing to fear from China’s intent to ‘crack down’ on compliance. However, gaps can appear due to misunderstandings of local regulations and operating procedures, with this sometimes being further aggravated due to the opaque nature of many of China’s laws. However it is very possible to operate a business in China without getting into trouble. Chinese government departments, including the tax bureau, are typically reasonable to deal with. It does make sense to have a third party firm conducting an overview if you need an annual check up, or feel that certain operational or financial procedures are not quite right. In which case, hiring of a China based professional firm to assist on a project basis to examine compliance remains a good solution.

Chris Devonshire-Ellis is the Founding Partner of Dezan Shira & Associates – a specialist foreign direct investment practice providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in emerging Asia. Since its establishment in 1992, the firm has grown into one of Asia’s most versatile full-service consultancies with operational offices across China, Hong Kong, India, Singapore and Vietnam, in addition to alliances in Indonesia, Malaysia, the Philippines and Thailand, as well as liaison offices in Italy, Germany and the United States. For further information, please email china@dezshira.com or visit www.dezshira.com.

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