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Succeeding in China: Solutions to Business Operating Issues
October 10th 2007Boston
David K.Y. Tang
Clifford Ng
Yujing Shu
Howard Chen
Succeeding in China: Solutions to Business Operating Issues
China in ContextOctober 10th 2007Boston
David K.Y. Tang
K&L Gates
UPI/Zogby Poll
China’s Growing Economy and Trade
55%
20%
25%
Threat Benefit Not Sure
9%
61%
21%
9%
HelpsHurtsLittle to No ImpactNot Sure
Impact of China’s Growth on US Job
Market
UPI/Zogby Poll
US Companies Opening Plants in
China4%
20%
36%
31%
9%
Strongly SupportSomewhat SupportSomewhat OpposeStrongly OpposeNot Sure
35%
24%
15%
10%
8%
8%
Trade DeficitChina's Growing Economic PowerLoss of US Jobs/CompetitionPolitical DifferencesHuman RightsMilitary threat
Most Important Issue in US-China
Relations
$4.46
$7.82
$13.25
$0.30$0.86
$2.68
1986 1996 2006
US China
Sources: US DOC, IMF, PRC National Bureau of Statistics, Xinhua News Agency
The US Economy Is Five Times Larger Than China’s The US Economy Is Five Times Larger Than China’s
The US and China In Context
GDP, $ trillions
The US addedtwo China’s to our economy over the
past decade
Sources: US Dept of Commerce, International Monetary Fund
GDP Comparison (2005)
China’s Economy Is Equivalent To Two StatesChina’s Economy Is Equivalent To Two States
US ChinaCalifornia & Florida
The US and China In Context
$12.46 trillion
$2.30 trillion $2.23 trillion
$0
$10
$20
$30
$40
$50
$60
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
China’s WTO Entry Has Accelerated US Export GrowthChina’s WTO Entry Has Accelerated US Export Growth
Sources: US Dept. of Commerce, US Dept. of the Treasury, US ITC
US Exports to China ($ billion)
China’s WTO Entry
China Is Now Our 3rd Largest Export MarketChina Is Now Our 3rd Largest Export Market
Top 10 US Export Markets in 2006 ($ billion)
Sources: US Dept. of Commerce, US Dept. of the Treasury, US International Trade Commission (ITC)
230.6
134.2
73.059.6
45.4 41.3 32.5 31.1 24.7 24.2
0.0
50.0
100.0
150.0
200.0
250.0
Canad
a
Mex
ico
China
& Hong K
ong
Japan
Unite
d Kin
gdom
Germ
any
South
Kore
a
Neath
erla
nds
Singap
ore
France
240%
-9%
42% 41% 39%31%
20% 20% 16%9%
Based on 2006 market size Sources: US Dept. of Commerce, US Dept. of the Treasury, US ITC
ChinaThe
Netherlands
GermanySingapore
CanadaMexico
FranceS Korea
UK
Japan
US Exports To China Are Growing Far More Rapidly Than To Other MarketsUS Exports To China Are Growing Far More Rapidly Than To Other Markets
Growth In US Exports To Top 10 Markets, 2000-2006
The Increase In The US Trade Deficit Has Largely Come From Outside China & East Asia
The Increase In The US Trade Deficit Has Largely Come From Outside China & East Asia
Sources: US Dept. of Commerce, US Dept. of the Treasury, US ITC
27% 28%
17%
43%
30%
55%
0%
25%
50%
75%
100%
1997 2006
Rest of World
Rest of East Asia
China
Composition Of The US Global Trade Deficit
22.3% 22.4%
21.1% 17.8%
4.2% 8.0%
52.4% 51.8%
0%
100%
1995 2005
Share Of Global Manufacturing Output
US Share Of Global Manufacturing Steady;China Taking Share From Japan
US Share Of Global Manufacturing Steady;China Taking Share From Japan
US
Japan
China
Other
Source: Unido; 2005 estimated
US Manufacturing Output Continues To GrowUS Manufacturing Output Continues To Grow
Sources: BEA, Oxford Economic Forecasting
US Manufacturing Output, 1979-2005 ($ billion)
$0
$500
$1,000
$1,500
1980 20052000199519901985
Long Term Employment Shift From Manufacturing To ServicesLong Term Employment Shift From Manufacturing To Services
Sources: BEA, Oxford Economic Forecasting
Manufacturing Share of US Total Employment, 1979-2005
8%
10%
12%
14%
16%
18%
20%
22%
1980 20052000199519901985
China’s Top Sources Of FDI ($ billion)
Numbers Reflect Shift Of Asia Export Manufacturing To ChinaNumbers Reflect Shift Of Asia Export Manufacturing To China
Source: Ministry of Commerce, China
2006
20.2
11.3
4.6 3.9 2.9
0
5
10
15
20
25
HongKong
BVI Japan SouthKorea
US
Cumulative
309.2
64.3 58 57.335.2
0
50
100
150
200
250
300
350
HongKong
Taiwan Japan US SouthKorea
“Protectionism”: Three Voices
Vice-Premier Wu Yi, CIFIT Opening Speech, 9/8/2006 “Reform and opening up is the fundamental national policy of China.”
Commerce Minister Bo Xilai, China Development Forum Speech, 3/18/2007 “China’s utilization of FDI cannot be turned back.”
State Statistical Bureau Chief Li Deshui – Speech at the CPPCC Economic Work Conference, 3/4/2006
“If we allow malicious M & A by MNCs, the ability of Chinese industry to create brands and innovate will gradually disappear, and China’s leading enterprises… will probably be controlled by MNCs, to the extent that a large portion of the backbone Chinese enterprises required to be an innovative economy simply will not exist….. Because of this, in the overall international division of production and industries, we can only fill the role of a manual laborer.”
China Data Points
> 10% GDP Growth each year for the past 20 years
> US $1 trillion in foreign exchange reserves
Savings rate of > 45%
Second largest internet user market > 150 million
Middle class of > 300 million
GM’s best market
Succeeding in China: Solutions to Business Operating Issues
Clifford NgK&L Gates
Legal Aspects of M&A and Reorganizations
Key Government Agencies
Ministry of Commerce (“MOFCOM”) State-owned Assets Supervision and
Administration Commission (“SASAC”) State Development and Reform Commission (“SDRC”) State Administration for Industry and Commerce
(“SAIC”) China Securities Regulatory Commission (“CSRC”) State Administration of Foreign Exchange
(“SAFE”) State Administration of Taxation (“SAT”)
M&A Government Approvals Investment Guidelines and Catalog
Prohibited: radio and television broadcasting; distribution of motion pictures
Restricted: production and distribution of radio and television programmes, and the production of films; securities companies; securities investment fund management companies; production of chemicals that can be used in narcotics production; telecommunication services
Permitted: all activities and sectors not included in the catalog
Encouraged: energy and raw material-saving technology; development and manufacture of software products
Relevant for approval limits, equity restrictions and tax/customs incentives
New Approval ThresholdsCategory Total
InvestmentApproval Authority
Encouraged and Permitted
<US$100 million Local DRC & local MOFCOM
>=US$100 million
NDRC & MOFCOM
>=US$500 million
State Council & MOFCOM
Restricted <US$50 million Local DRC & local MOFCOM
>=US$50 million NDRC & MOFCOM
>=US$100 million
State Council & MOFCOM
Major M&A Legislation
Provisional Regulation on Mergers and Acquisitions of Domestic Enterprise by Foreign Investors Effective September 8, 2006 Review acquisitions based on the company and industry involved, national economic security
Endorsed by six governmental authorities, including MOFCOM, SAFE, CSRC, and SASAC
Cross-border share swaps Must pass a new and untested approval procedure within a strict time frame
“Round-trip” investments Additional review and approval by MOFCOM PRC residents moving ownership and control of PRC businesses or assets to an offshore holding company of the PRC resident by transferring those assets to a wholly foreign-owned enterprise that is held by the offshore SPV
Major M&A Legislation
New Tax Law
Enterprise Income Tax Law Effective January 1, 2008 Unifies corporate income tax rates for FIEs and domestic companies at flat rate of 25%
Unifies tax incentives for FIEs and domestic companies
Cancellation of some tax incentives for FIEs: “two-year exemption and three-year reduction” tax holiday for foreign invested enterprises
50% reduction for the export-oriented enterprises
Reduced tax rates applicable in “Special Zones” with limited exceptions
New EIT Law
Qualified tech enterprises eligible for key support from the State: 15% corporate income tax rate
Qualified small and thin-profit enterprises: 20%
New EIT Law
New EIT Law - Transitional Measures
Five-year transition period
Any unused tax holidays will survive until they expire
Holidays will be deemed to commence from January 1, 2008 for FIEs whose tax holidays have not commenced
New EIT Law – Industry Specific Incentives EIT exemption or reduction:
Agriculture, forestry, animal husbandry and fishery industries
Public infrastructure projects that are eligible for key support from the State
Qualifying environmental protection, energy and water saving projects
Qualifying technology transfers
New EIT Law - Tax Resident Enterprise
Non-Chinese companies can be subject to PRC income tax on its worldwide income “Effective management” in China Taxed as Chinese companies (25% effective January 1, 2008)
New EIT Law - Withholding tax
20% withholding tax on PRC-sourced income derived by a non-resident enterprise: Dividends Interest Rent Royalties Capital gains Others
Reductions and exemptions may be available under tax treaties
Popular Tax Treaty Jurisdictions Mauritius
Effective May 4, 1995 New protocol signed on September 5, 2006 Capital gains: 10% PRC has the right to tax capital gains of a Mauritian company from the transfer of any amount of shares in a PRC company where the Mauritian company holds at least 25% shares in a PRC company during the 12-month period preceding such transfer
Popular Tax Treaty Jurisdictions Barbados
Effective October 27, 2000 Dividends: 5% Interest: 10% Royalties: 10%
Popular Tax Treaty Jurisdictions Hong Kong
Effective December 8, 2006 Withholding Income Tax Rates:
Dividend
Royalties
Interest
Capital Gains
PRC domestic withholding rate
0% / 20%
10% 10% 20%
Hong Kong domestic withholding rate
Nil 5.25% Nil Nil
Hong Kong-China Treaty rate
5% / 10%
7% 0% / 7%
0% / 20%
Foreign Exchange Controls
SAFE Circular 75: Circular on Relevant Issues Concerning Foreign Exchange Control on Domestic Residents’ Corporate Financing and Roundtrip Investment Through Offshore Special Purpose Vehicles
Effective November 1, 2005
SAFE Circular 75
Permits PRC residents to establish or control offshore SPVs for the limited purposes of equity financing and return investment
Multiple approvals no longer needed Register with SAFE only
Detailed registration and disclosure required by relevant parties: Initial foreign exchange registration by PRC residents
Amendment to the foreign exchange registration by PRC residents
Foreign exchange control for foreign investment or foreign debt by PRC companies
Amendment to foreign exchange registration by PRC residents for material changes (must be done within 30 days of the occurrence of the event)
SAFE Circular 75
SAFE Circular 75
Officially legalizes offshore SPV structure
Narrowly defined scope
Foreign exchange obtained from profit, dividends and from sale of equity interest in a SPV must be remitted back to China within 180 days of receipt
Burdensome monitoring and filing requirements
Approvals “spotty”
M&A Challenges in China - Legal Complex rules and regulations – rapidly changing Unclear and unpublicized local rules Undervalued assets are not easily available or
accessible because of bankruptcy laws Control issues Government approvals required Arrangements for the Mutual Recognition and
Enforcement of Judgments between PRC and Hong Kong Covers final judgments in civil and commercial
matters Only money judgments will be recognized and enforced Recognized judgments will have the same force and
effect as a judgment of the enforcing court
M&A Challenges in China - Legal
Intellectual property rights Employees of target need to be taken care of – often a deal killer
Jurisdiction of agreements Lack of effective legal system Enforcement of judgments Environmental issues/liabilities
Challenges in China – Due Diligence
Business scope Can only engage in activities that are within their business scope (important when determining deal structure)
Differences in accounting standards and practices
Challenges in China – Due Diligence
Lack of corporate governance and internal controls Adherence to corporate governance uncertain
Internal control and financial reporting system may not be sophisticated
Mixing personal and corporate expenses
Challenges in China – Due Diligence
Independent investigation Independent assessments of the business reputation and connections of a potential partner and key employees
Revenue Recognition / Earnings
Tax Tax under reporting Three sets of financial statements:
tax authorities foreign investors reality
Challenges in China – Due Diligence
Complex Tax System Business tax Income tax Value-added tax Individual income tax Capital gain tax Land value appreciation tax etc. Stock Options
Individual Income Tax Up to 45%
Challenges in China – Due Diligence
Validity of tax incentives Various tax incentives granted by the local provincial tax bureau might not be allowed by the state tax bureau
Many tax “incentives” are “agreements” for non-enforcement
Transfer pricing and business models
Challenges in China – Due Diligence
Liability exposure Off-balance sheet items and contingent liabilities often arise, including cross-guarantees to third parties
HR Inadequate funding of social insurance contributions
Under reporting of staff quality and capability of management and staff unclear policies and lack of employment contracts
Challenges in China – Due Diligence
Related party transactions Some major customers and suppliers may be related parties and the transactions are not conducted on an arm’s length basis
Detailed inquiries on the existence and background of related parties and affiliates should be made
Challenges in China – Due Diligence
Environmental Environmental impact assessment required for developing land and refurbishing existing facilities
Permits required to discharge pollutants
Fixed Assets
Challenges in China – Due Diligence
Approvals from relevant authorities Ministry of Commerce: joint venture with registered capital exceeding US$30 million
Valuation of investment related to state-owned assets
Time-consuming
Foreign Exchange Transactions Approvals of loans from foreign investors with SAFE
Capital requirements
Key Success Factors for M&A in China
Know the stakeholders Know the market Set realistic expectations Have a robust due diligence process Impose and maintain governance and financial controls
China Legal Updates for Foreign Investments
Yujing ShuK&L Gates
Succeeding in China: Solutions to Business Operating Issues
FIEs – Major Employers in China
2006, more than 5000 cases involved in foreign invested companies in Shanghai, a 24% increase from 2005
2006, employees prevail in 86% of Shanghai arbitration cases
New Labor Contract Law
The new Labor Contract Law passed and will be effective from January 1, 2008.
Increased responsibility and liability for employers
New Labor Contract law
Applies to all employees in PRC Is more employee-centric Pre-existing disputes resolved per new law
Termination of employees requires more diligence
Old contracts should be revised
Advantages for Employees
Major employee Issues to be agreed by employee representatives
Employees have the right to revise inappropriate rules by negotiation
2 months salary to be paid to employee if no written employment contract is executed, 1 month from the formation of employment
Terms disputed shall be interpreted to benefit the employee
Non-compete Agreements
Specific geographic restrictions Employee in violation of NCA subject to penalties
Duration limited to 2 years Limited to - senior management- technical personnel- employees with a commercial secret
Probationary Periods
Probation period determined by the length of employment contract no more than 1 month for < 1 year employment contract
no more than 2 months for 1-2 year employment contract
no more than 6 months for 3 year or more employment contract
one-time probation Contract cannot be terminated without evidence
that the employee failed to meet hiring requirement. Employee free to terminate
Training Costs
Employer may require a fixed term of service from employee who receives training benefits
Employer may collect damages from employee if employee is in violation
Role of Labor Unions
A greater role in negotiations and decision-making
Employers are required to consult with their labor unions or "employee representatives" on an "equal basis" in setting policies regarding labor compensation, work hours, rest and leave, labor safety and health, insurance and benefits, training, and labor discipline and quotas, among other issues
Termination
Employer may terminate contract by: giving 30 days advance written notice 1 month salary in lieu of notice
Severance must be paid almost in all situations based on the length of service: 1 to 12 months salary bankruptcy closing of business fix-term expires and no equal or better term offer
What Do You as Employers Need to Do?
Redraft employment contracts Redesign the non-compete agreements Review employee handbooks and policies Document employee history and communications
Anti-monopoly Law
Issued on August 30, 2007 after almost 14 years drafting
The first comprehensive competition law in China It covers a wide range of anti-competitive
activities including monopoly agreements, abuse of dominant market position, concentration and abuse of administrative power
Substantial penalty for non-compliance (up to RMB 500,000 (approx. USD 66,600))
Affects both domestic and foreign invested companies and monopolistic activities outside China that have an effect in China
Effective from 1 August 2008
Prohibited Activities
Anti-competitive agreements: price fixing, restricting production or sales volume
Abuse of dominant market position or exclude competition
Concentration potentially affecting market competition subject to approval
Government authority abusing their administrative power
Wide Range Exemptions
Activities that are beneficial to the development of national economy and are in the public interest
Agreements for the purposes of improving operational efficiency
Agreements enhancing the competitiveness of small and medium-sized enterprises
Agreements for the purpose of protecting legitimate interests of international trade and foreign economic cooperation
Vaguely defined circumstance leads to uncertainty
Effect on Foreign M&As and New JV Establishments
An M&As that potentially effects competition must be filed with anti-trust authority for review
New JV agreements must be filed under the control regime
Effect on Contractual Arrangements
Agents v. Distributors Mandatory minimum sale price v. suggested price
Exclusive distributor - Large market share v. competition in market place
Investigations
The anti-trust authority has extensive investigative power to conduct on-site examinations, review contracts, correspondence, financial information and question the relevant parties
Non-cooperation with the anti-trust authority for such investigation will be subject to administrative penalties and even criminal liabilities if the activity constitutes a criminal offense
Anti-trust authority may impose fines for monopoly agreements and abuse of dominant market position of up to 10% of the relevant party’s annual turnover
Review Period
All filings are subject to an initial 30-day review period from the date of filing
In addition, filings that are not cleared within the first 30 days are subject to an additional 90-day investigation from the end of initial review period
The M&A transaction should be put on hold until it is cleared by the anti-trust authority
Implementing the AML
Will require the establishment of 2 regulatory bodies: - an anti-monopoly committee, responsible for drafting and coordinating relevant guidelines and policies- an AML law enforcement agency under the State Council, responsible for enforcement
Implementing regulations, or additional clarifications, will likely emerge over the next year
Companies will want to monitor how the law is implemented
Succeeding in China: Solutions to Business Operating Issues
Intellectual Property Challenges in China
Howard Chen
K&L Gates
The Leap Over the Pacific into Asia
“There is nothing…more ancient in my memory than the observation that arts, sciences, and empire had always traveled westward. And … that their next leap would be over the Atlantic into America.”
John Adams,1807
Business and Legal Considerations of IP Licensing and Technology Transfer The Mental State - Optimistic v. Pessimistic
The Business Environment - Jungle v. Zoo
The Legal Protection--IP Enforcement Mechanisms
The Practical Strategies Procurement Technology Transfer IP Litigation
The Mental State – Common Assumptions
“It is not an American system, therefore it cannot be good”
“Everyone says it is bad, therefore it must be bad”
“It is too much of a burden to deal with an unknown culture,
therefore it is easy to be cheated”
“It is hard to trust anyone, therefore it is hard to protect
your IP”
The Business Environment “Use Market To Exchange For Investment” “Use Market To Exchange For Technology” The Jungle v. The Zoo Labor Centric Economy vs. Technology Centric Economy
In need of Technology win Locked in Wal-Mart model Fierce Domestic Competition
The Legal Protection
China Patent Office, established in 1980, now with more than 5000 employees
Patent Law Enacted in 1985, most recently revised in 2001
German Style System-Bifurcated Proceedings
The Court decides the Infringement
The Patent Office decides the validity
“Two-Instance” System for judicating the infringement 50 courts designated as the courts for
the first-instance The Higher People’s Court for Appeal They are in the process of creating
something similar to our CAFC—Experimental in Shanghai
The Legal Protection
From 1985 to 2004, 2.2 million applications filed with a growth rate of 19% annually.
It took 15 years to reach the 1 million threshold, but only 4 years to double to 2 million
Foreign applications account for about 20%
In 2004, 5000 patent disputes are handled by patent administrative arm
The Legal Protection Jurisdiction
Domicile Infringing act Infringement
Consequences
Evidence No American Style
Discovery Evidence Preservation
Question the respondent Documents Infringing products
The Legal Protection Timing
Statue of Limitations: Two years
Preliminary Injunction available, but rarely successful
30 days for a foreign entity to appeal the ruling of the first instance court
Damages No limit on damages
theoretically Unknown user/seller is not
liable Actual loss suffered Unjustified profit Reasonable royalty (1-3 times) Quasi-Statutory <$60K
Recent Cases-Trademark
27,300 cases of Gillette products found in a single raid
Total of 650,000 cases were sold and exceeded $8 Million in value
Criminal charges filed against the fake manufacturer
Gillette
Recent Cases-Copyright
ETS had a contractual relationship with New Oriental English School to allow for internal use of TOEFL material
New Oriental put it on the web and sold it ETS won the first trial, and New Oriental
appealed The Appeal Court withheld the ruling of the lower
court
ETS v. New Oriental English School
Recent Cases-Patent
Both are Chinese companies 20 some infringers in the textile industry Notice letter sent by attorneys Plaintiff is in SiChuan Province and the infringer is in
ShangDong Province SiChuan IP Office accepted the case, and transferred to
ShangDong IP Office according to the “agreement of the association of 16 provinces and cities to execute the law”
Invalidity Claims made to SIPO, but failed Settlement reached with 3.5 million RMB paid by the defendant
Yibin Siliya v. Shangdong Weifang Hailong
Recent Cases-Patent
Spanish v. Chinese Evidence submitted to local provincial IP Office (in the form of
photos and videos) Huaxin produces similar product and sells abroad Settlement reached after IP Office’s intervention The defendant reports certain results to Trade Section of
Spanish Consulate General and the Provincial IP Office Spanish Consul General in Shanghai sent a telegram to the
Provincial IP Office praising its effectiveness The Chairman of Spain Export Enterprise Association visited
the Provincial IP Office and showed his appreciation
Hermans Boada (Spain) v. Jinhua Huaxin Gear
The Practical Strategy Patent Procurement
Get your patents filed if you can afford to Monitor your competitors filings File Hong Kong Patents Absolute Novelty
No publication prior to filing anywhere in the world
No public use or sale in China
No Protection Scientific discoveries Method for mental activities Diagnosis or treatment of
diseases Animal and plant varieties Substances obtained by
means of nuclear transformation
Get to know your Chinese partner well Get to know their financials
Get a big installment payment up front Get some money escrowed
Stage out the actual transfer of the technology Bundle software with the hardware
Monitor market activities and key employee activitiesControl the supply of critical components
The Technology Transfer
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