pwc:china compass Summer 2009 · On 16 March of this year, MOFCOM issued its Measures for the Administration of Outbound Investment, which became effective on 1 May 2009. According

Summer 2009

pwc: china compass News for experts

pwc

Hot topic China as global player? Chinese direct investment in Germany China’s health reform Implications for the pharma industry Investment and financing Business valuations in China Tax and legal New rules for restructuring and liquidation Economic spotlight: Asia Foreign direct investment in India

Contents

Editorial 3

Hot topic 4 China invests in Germany ............................................................ 4

Investment and financing 7 Investment: new powers to provincial governments should speed up process ......................................................................... 7 Business valuation in China: getting to grips with the problems and finding a solution.................................................... 9 Health care reform in China: what it means for the pharmaceutical industry.............................................................. 12 Acquisitions in China: effective protection against typical traps ........................................................................................... 14

Reporting and controlling 17 China introduces corporate governance regulations .................. 17 Economic crime during economic crisis: how to protect your firm ..................................................................................... 20

Tax and legal 22 Tax planning in the pharmaceutical industry � approach of increasing importance ................................................................ 22 Transfer pricing: Chinese administrative regulation sets new standards (Part 1) ............................................................... 25 New tax rules for corporate restructuring and liquidation in China.......................................................................................... 29 Driving � and taxing � vehicles in China..................................... 32 Tax presence in China: practical variations and applications ................................................................................ 35

Economic spotlight: Asia 38 Foreign direct investment in India: new rules for more transparency?............................................................................. 38

Portrait 40 Marc Wintermantel ..................................................................... 40

Publications 41 Investing in the Chinese pharmaceutical industry after health reform .............................................................................. 41 Economic crime during economic crisis...................................... 41 China news on the PwC Portal................................................... 41

PwC China Business Group 42

Imprint 43

2 pwc:china compass | Summer 2009

Editorial

Following the global economic crisis, we will be faced with a wave of crises in public finance. As a result, all sorts of creative answers to taxation questions are making the rounds in political circles. Jens-Peter Otto reveals what we can learn from the taxation of luxury cars in China � and what we shouldn�t do � in Driving � and taxing � vehicles in China (page 32).

Dear reader, You probably see it every day in the news. China�s interest in investing in Europe is steadily growing. Our colleague in Beijing, Dr Roland Spahr, brings you the latest on this hot topic, including a close look at current developments and difficulties, in his article China invests in Germany (from p. 4).

Do you know why a lucky bamboo plant should adorn the desk of every manager? Because it represents wealth, prosperity, health and success in business. With this in mind, I hope you enjoy this issue of pwc:china compass and wish you great success throughout the world!

China�s desire to invest in Germany follows a general trend that poses several important questions: Will China reshape the world economy as a global player? And how can we best work with Chinese investors? These questions are increasingly crucial for Western industrial nations as China is no longer just a seller�s market or an outsourcer�s paradise � it�s a strategic investor. Experience has shown that acquisitions by Chinese investors don�t always go smoothly. Not only do cultural differences affect negotiations, but so do different expectations of the outcome. For China, a nation with a long tradition of trade, the price of the target company is often the main concern. In contrast, strategy, risk management or a clear business plan as seen in the West are given less consideration. China has certainly grown from a trader into a global player, but its ambitious political goals are still a way off.

Yours, Franz Nienborg Member of the Executive Board PricewaterhouseCoopers AG Wirtschaftsprüfungsgesellschaft

There is some good news for foreign direct investment in China, as Jens-Peter Otto in Shanghai reports in his article Investment: new powers to provincial governments should speed up process on page 7. In direct comparison to these new measures in China, we also take a look at India in a piece by our colleague in the India Business Group, Iris Winkler, titled Foreign direct investment in India: will new regulations equal more transparency? (from page 38). On 30 April 2009, China�s Ministry of Finance published a much anticipated circular on restructuring, which follows on the heels of corporate tax reform in 2008. Two of our tax experts in Düsseldorf and Shanghai, Lea Gebhardt and Claus Schuermann, explain how this will affect your business activities in their article New tax rules for corporate restructuring and liquidation in China on page 29. Those of you who know China know that the country�s health care system is not up to par when it comes to efficiency. A health system reform aims to remedy the situation. Major investments and the development of comprehensive medical insurance should guarantee basic health care for the population of China. In addition, Beijing wants to reign in health spending. While this opens opportunities for international pharmaceutical companies and medical technology manufacturers, it also carries various risks. For more see the article by Dr Volker Fitzner, Health care reform in China: what it means for the pharmaceutical industry, on page 9.

pwc:china compass | Summer 2009 3

Hot topic


China invests in Germany China has long been a popular investment location but as it develops into a global player, it is becoming an active investor as well – reason enough for us to look at Germany from a new perspective: how does the country appear to potential Chinese investors? – For the answers to this exciting question, read on. The political and economic environment beyond the Great Wall In the late 1970s, when China began to open up and launch its first economic reform, Chinese investment abroad was limited to just a few countries and regions. Due to its strong economic standing, (West) Germany was one of the five initial target destinations. Since the end of the 1990s, however, the number of Chinese enterprises investing overseas has risen significantly – a direct result of the ‘go abroad’ policy advocated by the Central Committee of China’s Communist Party. In 2004, the Chinese Ministry of Commerce (MOFCOM) and Ministry of Foreign Affairs jointly published an industry-specific guide for investors, the Catalogue for the Guidance of Foreign Investment Industries. In issuing these guidelines, the Chinese government once again underscored the importance of Chinese investment activities abroad. The catalogue contained official recommendations for investments in particular economic sectors in various countries. Investment projects which followed these specifications and obtained official authorisation were entitled to tax deductions, subsidies and further privileges. In Germany, the following industries and sectors were recommended: electrical industry, mechanical and plant engineering, pharmaceuticals and chemicals, trade, logistics, transport (ships, aircraft, lorries, cars), finance, and research and development. On 16 March of this year, MOFCOM issued its Measures for the Administration of Outbound Investment, which became effective on 1 May 2009. According to MOFCOM, the new regulation aims to introduce further reform to China’s outbound investment system. For example, lower-level government bodies will now be responsible for authorising Chinese companies to invest abroad. In addition, the approval process will be simplified so that the majority of outbound investment applications will only require a single standard application form and can be approved within three working days. The new regulation places great emphasis on simplification and expeditiousness, and serves to encourage Chinese companies to increasingly ‘go abroad’. In addition to the new regulation, MOFCOM reported on the potential for foreign investment in different geographical locations. Germany was among the first 20 countries selected from around the world, including five in Europe. By choosing to include Germany, the Chinese government clearly emphasised its strategic importance as an investment destination.

This article explains: ● how Beijing is encouraging Chinese outbound investment. ● which obstacles potential Chinese investors must overcome. ● why the number of Chinese acquisitions will rise.

The report outlines Germany’s political, economic and social structures as well as giving practical advice for Chinese companies wanting to invest in Germany. By providing this information, MOFCOM aims to help Chinese companies better understand the German market and investment environment and take advantage of investment opportunities while avoiding potential risks. Although global financial flows have slowed dramatically since the beginning of the current economic crisis, China has continued to advance outbound investment. Finance industry data provider Dealogic reports that in 2008, the country’s M&A activities reached a staggering $52.1 billion. In the first two months of 2009 alone, Chinese domestic companies invested $16.3 billion abroad. If this pace continues, Chinese direct investment will double that of the previous year. The ongoing development of regulations for foreign investment coupled with investor education regarding activities abroad leaves no doubt that China is pursuing a long-term strategy. MOFCOM has also stepped up efforts to encourage Chinese companies to invest overseas, as Wu Xilin, a senior ministry official, stressed at a recent conference. By doing so, the Chinese government hopes to keep the country’s economy on course despite the global financial crisis. Chinese investments in Germany Economic strategies are not always easy to implement. And while governments can create a supportive legal framework, the decision to invest ultimately rests with individual companies. When it comes to engaging in transactions, many companies have learned from experience that differing cultural and historical backgrounds often present a significant stumbling block for a successful deal. Furthermore, it is not uncommon for each party to have completely different business practices and expectations. The Annual Global CEO Survey published by PricewaterhouseCoopers in 2009 identified cultural issues and conflicts as the most significant obstacle in cross-border M&A transactions. The managers participating in the survey named unexpected costs and failure to achieve expected value as the second-largest obstacle, suggesting that many companies – and Chinese enterprises in particular – often lack the experience needed to accomplish a complex merger or acquisition. Respondents also named post-deal integration issues, such as poor management of human resources, as a further challenge. It is likely that cultural differences and conflicting staff expectations play a large role here as well.

Hot topic

Hot topic

21

21

31

32

40

40

45

54

18

14

0 20 40 6

Unexpected costs

Trade barriers andprotectionism

Stakeholder opposition

Assessing financeat the right price

Assessing thetax implications

Conflicting regulatory requirements

Conflicting work-force expectations

Poor management of human resources

Realising the expected value of the transaction

Cultural issues/conflicts

Source: PwC Global CEO Survey 2009

0

Annual Global CEO Survey 2009 The study functions as a barometer of public opinion on the world economy. For the 12th consecutive year, PricewaterhouseCoopers (PwC) has asked Chief Executive Officers (CEOs) throughout the entire world for their perspective on the current economic situation and what they expect in the future. For the 2009 edition, a total of 1,124 CEOs from 50 countries participated. At the beginning of this year PwC presented the survey to the public at the World Economic Forum in Davos, where it was very well received. If you would like to know more about the study, please get in touch with one of the authors or download the document at: www.pwc.com/ceosurvey/

Assumptions can also lead to confusion. In Germany, for example, Chinese investors are often perceived to: ● ● ●

●

target companies that are bankrupt or have filed for bankruptcy; lack a detailed M&A strategy and post-deal integration plan; focus primarily on the mechanical engineering, toolmaking and automotive industries; forego actively seeking acquisition targets, for example with investment brokers, in favour of waiting for the right opportunity to present itself.

A closer look at the Chinese business mentality sheds some light on these tendencies. When a Western company has a failing business model and goes bankrupt, a Chinese investor may consider this an attractive opportunity because he can utilise existing assets, save on labour and be subject to fewer environmental requirements. They also generally make fewer demands in terms of product quality. Moreover, the low transaction price typically seen in bankruptcy cases does not represent a large investment risk and so the negotiations between all parties generally run more smoothly. Finally, if the transaction involves only assets, there is no chance of encountering the kinds of cultural conflict that may arise when managing the German employees. From a Chinese perspective, then, acquiring bankrupt companies and their technologies has many advantages, including the expectation that due to bankruptcy the company�s value � and thus the acquisition price � will be lower.

Key obstacles for cross-border M&A One example is the successful acquisition and integration of WALDRICH COBURG, which was acquired in October 2005 by the Beijing No. 1 Group, the city�s largest machine tool manufacturer. The deal became a case study of sorts for other Chinese companies and was copied many times in acquisitions in the two years afterwards. Two things stand out: Chinese state-owned companies often have a lot of liquid capital, but at the same time they are less active than private firms. This in turn has two reasons. Firstly, there are not so many large � and thus interesting � acquisition targets in Germany. Secondly, the decision-making process in state-owned companies is very time-consuming and generally not transparent. Thus the negotiations require a great deal of patience from the seller. And when other potential investors enter the picture, Chinese state-owned enterprises hardly stand a chance. They are often simply too inexperienced with acquisitions and have difficulty meeting deadlines and fulfilling common requirements, such as developing a strong business plan that will convince the target company�s shareholders.

In the past, however, the lack of M&A strategies and post-deal integration plans has proved itself to be a significant obstacle when Chinese companies attempt to acquire foreign companies. Generally speaking, Chinese investors tend to adhere to the following procedure: first, the enterprise engages in relatively small transactions to test markets and gain experience with integration. If the acquisition becomes problematic for some reason, the low investment sum makes it easy for the buying company to quickly pull the plug without any real consequences. On the other hand, if the transaction goes well and the subsequent integration is successful, it strengthens the investor�s reputation and contributes to growth and profitability. Other companies observe the success of the pioneers and adopt a similar strategy.

One relevant case here is the acquisition of the sewing machine manufacturer Pfaff, which filed for bankruptcy in 2008 and was an ideal target for Chinese investors. It had 300 employees, making it a relatively low risk investment; it had a strong reputation in the sewing machine industry; and after the successful acquisition and integration of Dürkopp Adler by the Shanghai-based SGSB Group, it looked like a very promising candidate. Three Chinese companies bid for Pfaff, but in the end the German company


http://www.pwc.com/ceosurvey/

Hot topic

Joachim Richter Systeme und Maschinen e.K. won in spite of a higher Chinese bid. The decisive factor was the German company�s convincing long-term strategy and more solid and transparent business plan. Chinese companies have only recently started to show interest in larger and more complex acquisitions in Germany. Last year, for example, China Development Bank announced its intentions to acquire Dresdner Bank, and since the end of May this year, the Beijing Automotive Industry Company has been attempting to purchase Opel. Conclusion Careful observation of more recent M&A activities gives us good reason to believe that Chinese companies will continue to focus on uncomplicated, low-risk deals and probably ignore long-term investment analyses. At the same time, they are gradually starting to enter the market for more complex and large-scale transactions. Judging by the development dynamics seen in the past few years, we expect Chinese companies to quickly learn how to handle the transaction process more effectively, resulting in a rising number of successful acquisitions as well as the development of increasingly sophisticated acquisition strategies and concepts for long-term growth and profitability. The most crucial issue, however, remains: how can Chinese companies manage cultural differences and improve the integration process? The answer can be observed in companies from other Asian countries, such as Japan and Korea. Their experience has shown that while the differences arising from different approaches, business conduct and expectations may not be resolved completely, they can be overcome � something which Chinese companies with global aspirations will achieve, just as their Japanese and Korean counterparts have. Outlook Change is coming to the market and Chinese investors have become important participants. With time, cultural conflicts will certainly be transcended. Lots of signs point to increased Chinese investment in Germany, including the low valuations of many German companies resulting from the current tense financial situation. These companies offer China the opportunity to acquire new knowledge and technologies and gain access to international brands. It remains to be seen, however, how well Chinese companies will cope with the question of integration. Looking at the past 30 years, China has made great strides in opening up and becoming part of the world economy. Chinese companies are now on the cusp of understanding the essential aspects of developing sustainable business concepts and successfully closing deals. And in the current environment of relatively low-cost German companies available for purchase, the conditions for Chinese

investment are better than ever � the opportunity is simply too good to pass up. If you have any questions or would like more individualised information, please give us a call or send us an e-mail.

Contacts [email protected] Phone: +86 10 6533-7124 [email protected] Phone: +86 10 6533-5736 [email protected] Phone: +49 711 25034-3226


mailto:[email protected]



Investment and financing


Investment: new powers to provincial governments should speed up process The resourcefulness of the Chinese and their ability to adapt to new circumstances are legendary. Yet today routine approvals for businesses are burdened with conditions reminiscent of the Ming Dynasty. For this reason five new administrative directives with which the Ministry of Commerce recently delegated new powers to provincial governments deserve attention. They have two major goals: to revive the high level of foreign investment that China formerly enjoyed and to make it easier for the Chinese to invest abroad. Can the directives do this? In a free-market economy one of the most important prerequisites for successful entrepreneurship is the ability to make free and fast decisions about investments. Just how little decision-making freedom entrepreneurs have in China is reflected in the numerous approval hurdles potential investors must clear. One lesson to be learned from this is that China is still a long way from ridding itself of the fetters of the planned economy. Entrepreneurs need a great deal of patience to struggle through the bureaucratic restrictions China has placed on its economy. The 2007 edition of the Catalogue Guiding Foreign Investment in Industry ranks high among these. It divides the economic activities of foreign businesses into four categories: encouraged, permitted, restricted and prohibited. These categories determine in which industries foreign investments are possible and actively supported. Here it is important to take note of the restrictive foreign exchange controls for businesses with foreign and domestic investors. – More on this issue can be found in the article by Jens-Peter Otto and Anselm Stolte in the fall/winter 2008 edition of pwc:china compass (available in German only). Faster approvals by way of directive? Rendered wary by the cumbersome approval process and a flood of guidelines, businesses regard all undertakings of the Chinese economic authorities with a certain scepticism. – Whether or not the most recent steps in support of quicker investment decisions on the part of the Chinese ministerial bureaucracy will have the intended effect is best determined by taking a look at the regulations themselves. By means of five administrative directives the Ministry of Commerce recently transferred foreign investment approval authority to the provincial governments. What does this mean in practice? – Perhaps most importantly, threshold amounts have been introduced that determine whether an investment must be approved by the central government in Beijing. All investment projects that fall short of these amounts will be subject to the provincial authorities. With these measures Beijing is seeking to reduce administrative burden and thereby significantly cut down the time it takes for businesses to go through the approval process. Another goal is to encourage foreign companies to

This article explains: ● what approvals provincial governments will assume from the central

government. ● what lawmakers expect to achieve with this delegation of authority. ● what exceptions there are.

invest strongly in China again, as the level of foreign investment in China has dropped significantly since the end of 2008. All of the provisions of the directives discussed below are already in effect. Circular 50/2008 Increases in capital registered when establishing a foreign-invested enterprise (FIE) originally approved by the Ministry of Commerce can now be dealt with by provincial authorities as long as they do not exceed the following thresholds: ● up to $100 million for FIEs that had been approved by the

Ministry (this only applies to enterprises in the encouraged and permitted industries)

● up to $50 million for FIEs in the restricted industries Until now all capital increases had to be approved by the same authorities who approved the founding of the FIE. Circular 7/2009 The power of provincial governments to grant approval has been extended to the following: ● imported machinery and other equipment ● the establishment of FIE branches in and outside China ● increases in registered capital in order to expand the capacity

of automobile manufacturers (In China foreign automobile manufacturers – but not their suppliers – are limited by the provision that foreign ownership may not exceed 50 percent. Automobile manufacturing is generally included in the encouraged category of industries.)

● all other business matters, except changes in registered capital exceeding the aforementioned thresholds and the sale of a controlling share of an FIE from a Chinese entity to a foreign entity

● merger and acquisition transactions with a transaction value equal to or less than 100 million renminbi (RMB, about €10.9 million; in industries identified as encouraged and permitted) or RMB50 million (in the restricted industries).

Certain industry sectors have their own regulations, which are not affected by the new provisions and must still be adhered to. Circular 51/2008 The establishment of a commercial FIE will now fall under provincial jurisdiction. However this only applies if the commercial FIE does not deal in certain media (eg, televisions, audiovisual materials, telephones and the Internet) or distribute its products through these media.



Do you know that Baron de Rothschild is opening a vineyard in China?

The French wine producer is planning a 25-hectare vineyard on the Penglai peninsula in Shandong province. The Chinese will surely enjoy the wine, not only because of the tannins which are also found in their beloved tees, but because of its colour. For the Chinese, red is the colour of good luck.

Weinwelt, June 2009, Meininger Verlag (pub.)

你知道了吗

Circular 8/2009 Provincial governments are now responsible for approving the establishment and changes in registered capital of foreign-invested holding companies (FIHCs) that do not fall under the restricted and prohibited categories, as long as: ●

●

the initial capital or one-off changes in registered capital amount to less than $100 million changes in registered capital amount to less than $100 million for FIHCs originally approved by the Ministry of Commerce.

Circular 23/2008 The issuance of various approvals to real estate FIEs was simplified in June 2008 by the transfer of this authority to the provinces. Analysis and prospects

Any change that improves the climate for foreign-invested enterprises in China must be welcomed. However if Beijing really wants to create a level playing field for both foreign and domestic investors, it must do away with approval requirements as well as with the Catalogue Guiding Foreign Investment in Industry. Moreover, as in any other country, but especially in China, one has to wait and see how developments unfold in real life. Only this will show whether processing times actually become shorter under provincial jurisdiction. The new provisions do not contain any specifications on shorter time periods. But in many instances the delegation of power to provincial governments removes a level of bureaucracy, as provincial authorities and provincial departments of the Ministry of Commerce were previously involved in preparing for decisions.

Foreign investment by Chinese companies China�s currency reserves currently add up to over $2 trillion. Around $700 billion of this is invested in US government bonds (as of 31 December 2008). By contrast Chinese foreign direct investment was barely $52 billion in 2008. By delegating the approval of Chinese investments abroad not exceeding $100 million, the Ministry of Commerce hopes to stimulate foreign investment by Chinese companies. Prices for businesses have sunk considerably around the world as a result of the current economic crisis, making investment attractive despite the risks involved. Do you have questions or would you like to learn more about the new directives? Then call us or simply send us an e-mail.

Contact [email protected] Phone: +86 21 2323-3350





Business valuation in China: getting to grips with the problems and finding a solution In business valuation, certain methods have become established both in theory and practice on the global level. The theoretical concept underlying these valuation methods has also been adopted in international accounting standards to determine fair value. At the same time, these methods can be quite difficult to apply in practice – especially for young, regulated capital markets such as China. – The following article focuses on select aspects of common problems and reveals how best to overcome these challenges. Valuation practice Since the opening of the Chinese market at the end of the 1980s, the valuation practice has experienced dynamic development. The China Appraisal Society (CAS), founded in 1993 and supervised by the Ministry of Finance, has now become the pacesetter for national standards, as you may have already read in New standards and practices in valuation in China, from page 29 in our 2008 summer issue (available in German only). Today, there are approximately 3,500 locally licensed valuation firms organised under the CAS. As can be expected from such a large number of local appraisers, the spectrum of valuation procedures and results is very wide indeed: while the CAS Standards and the Generally Accepted Accounting Principles of the People’s Republic of China (PRC-GAAP) are consistent with international accounting and valuation standards in theory, their interpretation is far from consistent in practice.

Approach Chinese

Market approach 市场法 (Shi Chang Fa)

Income approach 收益法 (Shou Yi Fa/Shou Ru Fa)

Cost approach 成本法 (Cheng Ben Fa)

Valuation Valuation methods There are two methods that have come to dominate everyday practice in valuation: the market approach and, primarily, the income approach. The cost approach, on account of its focus on past events, is rarely preferred. The International Financial Reporting Standards (IFRS) exclude this approach entirely in its guidelines on testing for impairment (IAS 36.BCZ29). Similarly, the net asset value and liquidation value approaches, both related to the cost approach, are also only applied in exceptional cases. Market approach The market approach is particularly popular in Anglo-Saxon countries. The reasons for this lie in these countries’ strong focus on capital markets, the size of their markets and the markets’ influence on the national economy. In Germany, the multiples

This article explains: ● which valuation methods are preferred in Germany and China. ● where the strengths and weakness lie in market and income

approaches. ● how trading, transaction and IPO multiples effect the value of a

company in different methods.

approach only has limited use in valuation, especially when it is necessary to define a business value for certain kinds of legal appraisals or for financial reporting purposes. Indeed, the Institute of Public Auditors in Germany (Institut der Wirtschaftsprüfer, IDW) in its Principles for the Performance of Business Valuations (IDW S1 new version) regards market valuation using share price as merely a way to validate the results of the income approach. Approach Application in Germany Application in China

Market approach Entity and equity multiples: limited use

Entity and equity multiples: equal use

Income approach ● Discounted cash flow before and after personal taxes

● Capitalised earnings value before and after personal taxes

● Discounted cash flow before personal taxes

Valuation methods in China and Germany In China, on the other hand, valuation practice is more aligned with Anglo-Saxon procedure: the market approach is seen as an alternative in its own right which is often used in conjunction with the income approach to establish an average value. Generally speaking, trading, transaction and IPO multiples are considered differently. Still, the individual results can vary considerably according to the valuation method and actual procedure used. Trade multiples This valuation technique uses the market capitalisation and accounting ratio values of a group of listed peer (that is, generally similar) companies to estimate the target’s value. With Chinese companies, however, comparing market capitalisation is not entirely without its problems: the shareholders’ equity of companies listed on Chinese markets comprises a mix of A, B and H shares as well as restricted shares (please see box). Depending on the class of stock, there can be enormous differences in the valuation of shares – in fact it is not uncommon for A, B or H shares of the same company to be traded at significantly different prices even though they are otherwise equal in terms of voting rights, dividend payout and profit expectations.

Restricted shares Insider holdings that may not be traded at all, or may only be traded after a specified period of time has elapsed. – Additional assumptions must therefore be used in the valuation of these shares.


Shares are classified A, B and H according to the currency they are traded in and which stock market they are traded on. A shares are traded in Renminbi and B shares in US dollars or Hong Kong dollars (HK dollars) on the Shanghai and Shenzhen exchanges; H shares are only traded in HK dollars on the Hong Kong exchange. A and B shares are often traded at a (sometimes large) premium to H shares. Still, the difference in pricing is not a result of the different currencies or markets but rather of capital market restrictions for investors: Chinese citizens are only allowed to invest in A and B shares while foreigners were, for a long time, restricted solely to H shares; several years ago, the regulations were altered to include B shares as well. Transaction multiples When performing valuations using transaction multiples, it is important to remember that detailed information about the transactions is often not available. In addition to this general limitation, transactions in China are often executed according to political motives, making it essential for appraisers to carefully scrutinise the published price of a transaction before using it as the basis for comparison. Furthermore, in the majority of cases the purchase price reflects a value that includes buyer-specific synergies, which may not be considered in the financial reporting. IPO multiples Valuation using IPO multiples is largely dependent on the date of the IPO in question. In view of the extremely volatile stock markets of the last years, peer groups for comparison should only include companies with IPOs which occurred at approximately the same time. Furthermore, the admission of shares is controlled by the Chinese exchange supervisory authority and the influence of political interests cannot be discounted entirely. This is especially true for the IPOs of state-owned enterprises. In the past years, the first stock market valuations were sometimes far higher than the issue price � and that was not due to the high demand alone. In this type of environment IPO multiples can produce low business values and therefore should be interpreted as a lower value limit. In all three approaches the denominator is taken from reference values based on accounting information. These include turnover, earnings before interest, taxes, depreciation and amortisation (EBITDA), or earnings before interest and taxes (EBIT) for the gross method, based on the total business value including liabilities (entity multiples); or on the annual net income for the net method, based on the shareholder�s equity used (equity multiples). In order for the multiples to provide an accurate estimation, it is imperative that the object of valuation and the peer companies use the same accounting policies. All the same, the different options for drawing up the balance sheet and profit and loss account allowed by PRC-GAAP, IFRS and US-GAAP do complicate a comparison across the group, making it necessary to adjust or reconcile the values to the actual balance sheet and profit and loss account. Of course, this step assumes that all

necessary information is available from the peer companies. If it is not, then the differences in accounting policy can produce business values that are not suitable for comparison. Financial crisis As the financial crisis has thrown capital markets throughout the world into a downward spiral, additional limitations of the market approach have surfaced in the past few months. A tightening of the credit approval process, dwindling liquidity and steep drops on the stock markets have caused slumps and, in many places, total stagnancy in transactions and IPOs, making a prompt valuation using transaction and IPO multiples temporarily impossible. Sharply declining prices on the stock exchanges in Shanghai and Shenzhen often resulted in a market capitalisation value which was beneath the equity book value of the companies. The figure below shows the development of the Shanghai Composite Index over the last 10 years.

1.000

2.000

3.000

4.000

5.000

6.000

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

0

16

32

48

64

80

Shanghai Composite IndexPrice-earnings multiple

Sha

ngha

i Com

posi

te In

dex

Pric

e-ea

rnin

gs m

ultip

le

+482

.38%

+60.

18%

�70.

71%

Shanghai Composite Index, 1999�2009 Income approach In addition to the internationally accepted discounted cash flow (DCF) analysis, the income approach is generally preferred in Germany and is also applied in the majority of valuations performed for corporate or general law purposes. Both of these approaches focus on the future profitability of the company where the business value is calculated as the net present value of the future expected surplus. Income tax is � without exception � taken into account when calculating the company�s surplus. When appraising the business at shareholder level (equity value), it has become established in German theory and practice to consider the net inflows after personal taxes at shareholder level (and consequently to proceed in the same manner for the discount rate). For the valuation of equity holdings and other investments for the annual financial statements as required by commercial



Balancing approaches and valuation law, IDW RS HFA 10 still stipulates that surpluses be considered before personal income tax. In the past, the Chinese GAAP have come close to agreeing with

the IFRS. For listed companies the new PRC-GAAP went into force on 1 January 2007; exactly one year later, they were also made applicable to large state or financial service companies. This harmonisation implies some changes that could be relevant for valuation, for example, development costs can now be capitalised and amortised for the rest of their useful life. Furthermore, fixed assets can now be given a residual value of zero; previously this value was fixed as 10 percent of the acquisition costs. Both of these changes effect the income statement of a company and, particularly in the market approach, will lead to different valuation results. The introduction of balancing sheet accounting at fair value for receivable and liabilities will raise or lower the net current assets of a company, something which must be considered when calculating the free cash flows in the DCF approach.

As mentioned earlier, Chinese valuation follows the Anglo-Saxon approach to valuation, which, in turn, in the application of the income approach is confined to DCF analysis. Generally speaking, the income approach is not applied. In addition, the personal income taxes of the shareholders are not considered during valuation. In calculating the future surplus, called free cash flow in the DCF method, the underlying budget review should be carefully checked against the annual financial statements of the past fiscal years to confirm its feasibility. In doing so, it is important to remember that, just like in the market approach, different accounting policies and interpretation can result in different value assessments. In quickly growing industries and businesses like those in China, for example, a different interpretation of revenue recognition can produce a misleading value.

Moreover, not all companies in China have implemented the new standards. Some companies, for example, record advance payments as sales revenue, which means they are reporting inflated revenues and results. Consequently it is necessary to perform a critical analysis of the company�s historical performance and make any necessary adjustments to arrive at an accurate assessment of the budget review.

In checking the feasibility of budget reviews, particular attention must be paid to the consideration of revenue growth, profit margin, and capital requirements for current assets and investments. Here it is important to note that in China expectations are significantly higher and companies often expect to see a two-figure growth rate for the next three to five years. For appraisers, it is then important to make sure that these expectations are in line with both the company�s historical growth and the middle-term expectations for individual sectors and the market as a whole. Then they must also verify that the company�s budget review appropriately reflects the capital requirements for current assets and investments which would be necessary to achieve the targeted growth. Finally, it is important to discuss with the company which long-term expectations are to be applied in terms of perpetuity. Experience has shown that growth assumptions for perpetuity are often 2 to 3 percent higher than in longer established economies in, for example, Central Europe or North America.

Conclusion Business valuations are extremely important: they influence the pricing and value assessment for transactions or any other case where a valuation is required by corporate law; and they also become relevant in financial reporting when fair value-oriented accounting standards are applied. Theoretically, many different valuation methods can be used. In practice, however, certain methods have by now come to the fore in China (as shown in the figure). For this reason, the question of which valuation method to use is not of central importance. Instead, priority should be given to compiling the necessary information and ensuring its reliability. In addition, it always important to take into consideration the different classes of stocks owned by a company when performing a valuation. And finally, when evaluating the cost of capital, it should be kept in mind that the Chinese market is still relatively young and regulated.

A further challenge in the income approach is the calculation of a risk-adequate discount rate. In practice, no other parameter is more critically regarded than this one: its leveraging effect means that even minor adjustments can disproportionately influence the business value.

Our experts are happy to help you further. You can reach them by phone or e-mail.

In calculating the cost of capital in China, country-specific capital market risks, currency exchange risks and differences in inflation rates must be considered. Reflecting these risks regularly leads to higher capital costs that in, for example, Western Europe or North America � the market risk premium for China has proved to be 3 to 4 percent higher than in Western Europe of North America. Additionally, it is important to determine how much inflation expectations have been reflected in the planned cash flows and, if necessary, to adjust the discount rate.

Contacts [email protected] Phone: +65 6236-7378 [email protected] Phone: +86 21 2323-2632






Health care reform in China: what it means for the pharmaceutical industry The Chinese government has announced sweeping reforms of the country’s ailing health care system. Two major steps are being taken to insure affordable basic health care for all Chinese: a high level of investment in the medical infrastructure and the development of comprehensive medical insurance. At the same time the government wants to exercise more supervision of and control over health care expenditures. These reforms offer both opportunities and risks for pharmaceutical manufacturers. Only those companies that adapt quickly to the new distribution and pricing policies will profit from growth in this area. The Chinese government has been grappling with the weaknesses of the health care system for some time. The current medical infrastructure is insufficient in large part because when the state greatly reduced its involvement in health care during the 1980s, it did not take steps to set up private financing of the system. A major problem is that there are few doctors and hospitals to be found in rural areas. Moreover, only a small portion of the Chinese population has medical insurance. According to the Ministry of Health, patients have to pay for almost 50 percent of treatment and drug costs out of their own pockets. Key aspects of the reform programme 2020 is the target set by the government and the Central Committee of the Communist Party for completing reforms that will lead to an effective nationwide health care system. The first stage alone – through 2011 – will cost the government the equivalent of about $124 billion. The blueprint for this reform (Opinions on Deepening Pharmaceutical and Health System Reform, draft dated 14 October 2008, as well as Implementation Plan of the Ministry of Health dated 21 January 2009) put forth five major initiatives: ● providing some form of medical insurance for 90 percent of the

urban and rural population by 2011 ● developing a national system to regulate drug selection,

prescription, distribution and reimbursement ● building a nationwide infrastructure to provide basic health care ● promoting equal access to basic medical services in rural and

urban areas ● increased government funding of hospitals If the reforms are successful, the demand for medical services and drugs will undoubtedly rise. However this does not necessarily mean increased turnover for pharmaceutical manufacturers. This is because it is still unclear what regulations will be implemented to govern the allocation, control and pricing of drugs, and what the relationship will be between traditional Chinese medicine and Western pharmaceuticals.

This article explains: ● what is wrong with China’s current health care system. ● what role traditional medicine plays in China today. ● how the reforms will affect the pharmaceutical industry.

Greater transparency in distribution The distribution of pharmaceuticals in China is highly complex. There are few pharmacies, and generally only in the cities. Patients buy about 80 percent of Western drugs from hospitals, which in turn are supplied by thousands of intermediaries. Clinics refinance themselves primarily through the profits they make from selling medicine, so they often prescribe more – and more expensive – medications than necessary. In addition, the system is susceptible to corruption. The temptation is great for manufacturers to pay doctors to prescribe their products over those of their competitors as much as possible.

Pharmaceutical manufacturers

Intermediaries

Clinics (share of turnover:

about 80%)

Pharmacies (share of turnover:

about 20%)

Patients

Source: Business Monitor International

Distribution of drugs and pharmaceuticals in China To combat this problem, the government wants to wean hospitals off their reliance on drug sales revenue. Doctors are to earn more money from actually treating patients and the costs that arise are to be covered by medical insurance. Pharmacies will take on new importance as the government tries to restructure hospital financing and separate drug prescription from drug dispensation. Companies in the pharmaceutical industry must prepare themselves for these developments. The biggest task will be making necessary changes in distribution networks. One the one hand, they must secure market access. On the other, they must overcome logistical challenges such as, for example, uninterrupted cooling of medication transported over long distances to rural regions. Prices will continue to be regulated Even after the reforms, manufacturers and distributors of pharmaceuticals will have to abide by government price controls. While exceptions will certainly be made for innovative new drugs,


there are as of yet no concrete proposals or regulations that could provide guidance. The state currently regulates the price of around 2,400 pharma-ceuticals. About 60 percent of drug sales are subject to such controls. In practice, however, they have not led to a drop in prices. Although there have been 24 rounds of price-cutting in the past 10 years � with categories of drugs reduced in price by around 20 percent � the average price of medication only dropped 2.8 percent between 1996 and 2007. What actually happens is that price controls lead to lower revenues for the pharmaceutical manufacturers affected. When the sale price for a particular drug is lowered, the intermediaries and hospitals switch to other, more expensive ones. Moreover, many manufacturers respond to price controls simply by taking the respective drug off the market. They then introduce a slightly altered version under a new name, one that is no longer subject to price controls. The National Development and Reform Commission is responsible for drug price controls and aims to implement more effective rules by 2011. In all likelihood the authorities will set maximum drug prices for each step of the supply chain � from manufacturers to clinics and pharmacies. In addition, there is talk of introducing a flat rate dispensing fee instead of the price-based reimbursement that pharmacies can currently claim for the sale of medications. With the introduction of this reform, doctors in clinics would no longer have incentive to prescribe unnecessarily expensive medications. Competition from traditional medicine The Chinese pharmaceutical market will remain a special challenge for foreign drug manufacturers, even if health care reform eventually leads to a distribution and payment system similar to that found in Western industrial nations. This is due primarily to the popularity enjoyed by treatments used in traditional Chinese medicine (TCM). Two out of every three medications sold now come from TCM. Turnover from TCM in 2007 was around $21 billion; that amounts to 40 percent of all turnover in Chinese pharmaceuticals. According to some experts, the market volume for such treatments could increase to $28 million by 2010. One factor to take into account in such predictions is the explicit support given to TCM prescriptions within the reform programme. Until now foreign manufacturers have hardly been represented in the TCM segment. Things may well change if Western investors take advantage of the expected consolidation of this sector as a way into the market. At present the market for traditional Chinese medications is fragmented. Around 1,100 providers are registered with the Chinese authorities, of which only 300 meet official quality standards. Many manufacturers lack the capital to

modernise production equipment and introduce control processes. This situation offers Western companies numerous opportunities to invest. The next edition of pwc:china compass will keep you up-to-date on further developments. � To learn how corporate tax reform will affect the pharmaceutical industry please read the article by Claus Schuermann und Ralph Dreher on page 22 of this issue. If you would like further information, please call us or simply send an e-mail.

Contacts [email protected] Phone: +49 69 9585-5602 [email protected] Phone: +49 69 9585-5604

Do you know what �Chinoiseries� are?

In the 18th century, an art form became popular in Europe that was modeled on Chinese examples and influenced by motifs of a supposed Chinese utopia. The image of a massive yet peaceful empire whose population - down to the lowest classes - was educated in literature and philosophy triggered a considerable pro-China zeal in many European countries.

China Takeaway, Hans Hauenschield, Ullstein (pub.), 2007

你知道了吗






Acquisitions in China: effective protection against typical traps Local and international companies are trying ever harder to position themselves as best they can on the rapidly expanding Chinese market, and consequently the number of mergers and acquisitions are on the rise. Nevertheless, most European investors still find Chinese transactions hugely challenging. – This article by our Swiss expert team Ralph Schlaepfer and Jia Ye You sheds light on the background as well as the stumbling blocks for European investors planning an acquisition in China’s incredibly dynamic marketplace. 1. The marketplace Challenging and conservative Although the Chinese government is anxious to reconcile the needs and issues of parties in a transaction, the latest amendments to merger and acquisition (M&A) regulations and their strict implementation have only served to increase the parties’ sense of insecurity. Furthermore, official regulations are constantly evolving, providing a steady stream of questions the Chinese government needs to address. Finally, many initiatives in this area are influenced by national interests, which tend to give them a more conservative character. As a result, European investors need to closely monitor developments in the regulatory environment, as well as any amendments to regulatory statutes arising from these developments, and integrate the changes into their decision-making processes. It is highly beneficial to have a flexible attitude which allows for quick adaptation to the latest regulatory developments. Discrepancy between local and national interpretations of law Even though China has a reputation for being very centralised, the Chinese administrative system grants local authorities considerable leeway when it comes to the implementation of national directives at the local level. Local officials sometimes interpret official laws in a manner that benefits one party over another, or enforce national legislation in a way that is not always entirely appropriate. European investors need to realise that the national government always has precedence in the interpretation of law. Should there be any discrepancies, this can lead to high follow-up tax demands or even fines. Compliance Chinese companies of particular local significance occasionally engage in certain business practices that, strictly interpreted, violate the already loosely enforced laws. Well-intentioned advice from business partners and other industry insiders on how to best exploit such grey areas is to be treated carefully. European investors must always remember that just because a practice is common in a local market does not mean it is legal or not subject

This article explains: ● what typical traps can befall foreign companies trying to acquire a

holding in a Chinese company. ● how Chinese and European expectations differ during acquisition

negotiations. ● why due diligence is almost always advantageous.

to penalty. It is therefore very important to determine whether a custom is simply tolerated or whether it is actually in compliance with Chinese law. In addition, European investors need to carefully consider their own domestic legal system before deciding to take advantage of more dubious interpretations of Chinese law. Personal relationships: ‘guanxi’ We should never underestimate the extent to which cultural differences can effect our interactions. Personal relationships are a central aspect of Chinese business culture. Without them, it is almost impossible to successfully close a deal. All the same, one should never rely entirely on personal relationships during a transaction – the terms of any agreement reached orally should always be put in writing. Integrity of local business partners China is sometimes referred to as the ‘Wild East’ on account of the questionable practices adopted by some individuals to close transactions or achieve personal gain. When working with local business partners a certain level of caution is necessary to keep risks to a minimum. 2. Systemic inefficiency Processes Compared to their European counterparts, Chinese companies do not place as much emphasis on such topics as confidentiality, privacy and due diligence. Declarations of intent are usually signed relatively early on and are often based on vague and non-binding ideas. In light of this, parties should not expect their Chinese transaction partners to place much importance on written agreements; even signed memorandums of understanding are still not viewed as binding. Before a transaction can be carried out the partners also have to obtain regulatory approval from various authorities, which makes the entire process very time-consuming. European investors have to realise that it is very important to maintain continuous communication with the authorities. Chinese companies may also change their mind at the drop of a hat. The resulting delay in a project can be very stressful for Europeans. Perseverance is therefore one of the most important factors in the successful closing of a transaction.


Information In many aspects, the quality and availability of information is often poor and does not live up to the standards that European investors have come to expect. This is accentuated by two additional factors: ●

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There are hardly any public sources that can be used to verify information. Many companies either have never been audited, or have merely had a poor quality audit.

Chinese companies traditionally tend to concentrate on day-to-day operations rather than on administrative processes and proper accounting. Consequently, business decisions are seldom made based on accounting records. Poor accounting systems may also contribute to insufficient budgeting or a complete lack of budgetary controls. Moreover, many Chinese companies keep two or even three different books:

one for the tax authorities one for internal use one for the bank

Financial statements may also be manipulated for several reasons. Europeans can minimise the resulting risk with an early and extensive implementation of due diligence processes. Since many Chinese companies tend to emphasise daily operations, they often do not understand or even know about due diligence, making it absolutely vital to thoroughly explain the process to the Chinese seller. Experience has shown that it is best to focus due diligence on the most important factors for the viability of the company after the acquisition. Valuations Buyers and sellers often have very different price expectations for entirely different reasons. One reason is that differing valuation methods are used. The Chinese prefer valuation methods which diverge from international standards, for example the net asset valuation method compared to the internationally preferred discounted cash flow method. Chinese sellers with little experience in transactions also tend to have price expectations that are more closely related to general market conditions than to their company�s actual facts and figures. According to Chinese law, state-owned enterprises are also subject to a statutory valuation, which is conducted by a state-licensed expert appraiser usually selected by the target company. While the qualifications of these �experts� are often dubious, their valuations are very significant since the Chinese government must approve sales prices that are below 90 percent of the statutory valuation. Two further circumstances make it difficult for European investors to determine the value of a company. There is usually neither

reliable data for comparison nor key figures for the market. Therefore buyers, especially those who do not know much about doing business in China, are at risk of paying too much for their acquisition. European investors thus need to remain involved in the complete valuation process and follow it closely.

Typical problems Accounting practices Although Chinese accounting principles increasingly adhere to the International Financial Reporting Standards (IFRS), they are sometimes incorrectly applied in practice � whether out of ignorance or intentionally. The most common deviations are:

incorrect revenue recognition policy; sales which were not invoiced or recorded; inadequate recording of accruals and deferrals (eg, of discounts granted, product guarantees or severance payments).

The financial implications of such irregularities are often difficult to estimate since the information needed to do so is generally unavailable. Group transactions Many Chinese companies are bound up in complicated corporate structures and often earn a large percentage of their revenue from sales to affiliated companies. Should a company be acquired from this type of affiliated group, it is very important for the European investor to be able to precisely follow transactions with affiliated companies, the fundamental agreements behind these transactions and their financial impact. Assets

Unclear ownership: It is often difficult to discern property rights to assets in China, which is why they should be thoroughly analysed. For example, the same assets could be used as collateral to back up obligations to several third parties. Land-use rights: The transfer of land-use rights needs to be closely examined during due diligence because, depending on the nature of the land-use rights (whether land was granted to the company, or allocated, or is collectively owned by the groups of farmers), the state can demand significant or financial compensation for authorising a transaction or completely refuse the rights transfer. External assets: Domestic companies, especially state-owned enterprises, often function as a sort of social community and thus frequently own assets such as employee accommodation, hospitals, schools and restaurants. Their value is usually fairly low for the buyer; however the Chinese transaction partner will sometimes expect the foreign investor to purchase them and continue providing the social services.



Liabilities Chinese companies� books often do not include all of the debts and other liabilities. This is especially true for the disclosure of contingent liabilities and bank guarantees, which were issued for other companies within the group or for third parties. Chinese companies, especially state-owned enterprises, often have higher reserves than are needed in order to cover such employee-related obligations as contributions to social security, pension obligations or obligations arising from the conversion of a non-cancellable employment contract into a cancellable one. In addition tax law violations may lead to higher taxation risks for which no reserves are available. For that reason it is important to perform an extensive audit of the company being acquired to uncover all possible hidden or contingent liabilities. Based on the due diligence results and the buyer�s readiness to assume risk, a decision must be made as to whether the company should be acquired through equity or asset acquisition.

Equity and asset deals Equity is capital brought into a company by one or several proprietors. An asset deal is a basic form of acquiring a company where the assets are individually transferred.

Further aspects A few other issues pose typical problems for M&A transactions in China. When dealing with Chinese companies it is very important to keep an eye on: ●

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non-compliance with safety, health and environmental regulations; unnecessary personnel (especially in state-owned enterprises); unclear sales channels; diverging business interests for the joint venture partners; how much the commercial success of the company is dependent on key personnel (ie, because of their relationships).

Conclusion

Chinese M&A transactions follow their own rules. That is why PricewaterhousCoopers recommends that all companies planning such a transaction proceed systematically and align their transaction goals with those of local interest groups from the very beginning. It is especially important to:

emphasise the advantages of the transaction for all stakeholders from the get-go; quickly take control of the acquired company after the transaction is finalised; quickly introduce one�s own business culture.

Most European investors appreciate receiving regular advice from a qualified, locally based team which understands the industry of the target company as well as the M&A market in general, and

can closely follow negotiations to guarantee a successful acquisition. If you have any questions or would like advice, please feel free to contact us by phone or e-mail.





Reporting and controlling


China introduces corporate governance regulations As of 1 July 2009, China’s Basic Standard for Enterprise Internal Control (‘China SOX’ or ‘C-SOX’) is in effect. For more background, see the article China introduces legislation on internal controls in the spring edition of your pwc:china compass. While C-SOX applies to all companies listed on Chinese stock exchanges, all large and mid-sized non-listed companies are also being encouraged to adopt the Standard. Foreign companies active in China are no exception, meaning that joint ventures with domestic-listed companies are now subject to the regulations as well. To find out what all companies should keep in mind, read this article by Roland Spahr and co-author Anna-Katharina Viessmann . In 2002 the US government set new standards for corporate governance when it passed the Sarbanes-Oxley Act (SOX) in the wake of several major accounting scandals. Mandating a system of internal controls in companies, SOX places additional responsibility on both executive boards and auditors and obligates them to improve the company’s financial reporting practices. Other countries have followed America’s lead in the mean time: ● South Africa passed The King Code in 2002. ● Hong Kong issued the Hong Kong Code of Governance

Practice in 2004. ● Japan enacted its Financial Instruments and Exchange Law

(J-SOX) in 2006. ● Canada introduced National Instrument 52-109 in 2008. ● In March 2004, the European Commission published a

proposal, known as E-SOX, to modernise the 8th EU Directive and set down basic principles similar to those of the Sarbanes-Oxley Act. The bill has yet to be passed, meaning that German companies are still subject only to the German Corporate Governance Code of 2002, which covers similar content but is less extensive in scope.

Purpose After the fall of Guangxia Industry Co. Ltd., dubbed ‘China’s Enron’, and a string of other corporate scandals in 2001, the Chinese government also took a stand against corruption. In accordance with the instructions of China’s State Council, the Enterprise Internal Control Standard Committee was founded in 2006. It consists of the Ministry of Finance (MOF) and several other important government authorities. The Basic Standard was jointly released on 28 June 2008 by: ● the MOF; ● the National Audit Office; ● three of the largest economic regulatory authorities; ● the China Banking Regulatory Commission; ● the China Securities Regulatory Commission; ● the China Insurance Regulatory Commission; ● the Ministry of Commerce.

This article explains: ● which documents detail the new Standard. ● what C-SOX does and which companies it affects. ● how the regulations differ from those in other countries.

The Standard was officially published on 22 May 2008 in Caikuai No.7 (The Circular), which contained instructions for facilitating the introduction of C-SOX and outlined its regulatory requirements for internal controls. To further assist companies in implementing the Standard, three more documents were issued in September 2008: ● Guidelines for Evaluation and Assessment of Effectiveness of

Enterprise Internal Control ● Implementation Guidelines for Enterprise Internal Control ● Guidelines for Performing Assurance Engagements in Relation

to Assessing Effectiveness of Enterprise Internal Control Please refer to the appendix for more on these three documents and other documents which helped prepare for and guide the implementation of C-SOX. Structure and Applicability C-SOX contains seven chapters, a total of 50 articles. The first chapter defines the purpose and applicability of the regulations and lays down the guidelines for a company’s annual audit. Chapters 2 to 6 address the five elements of internal controls, such as risk assessment. The last chapter contains the date when the regulations come into force and advises of possible future amendments that may be added by the financial authority or other government-related organisations in addition to the Standard. C-SOX is in effect since 1 July 2009, initially applies to approximately 1,700 companies: 900 companies listed on the Shanghai Stock Exchange and about 800 listed on the Shenzhen Stock Exchange. C-SOX aims to protect stock market investors and to this end demands the provision of more precise information and specifies stricter regulations for corporate financial reporting. In light of the extensive and complex scope of the Standard it seems very likely that it will be implemented in unlisted large and mid-sized companies in the long term, even though the Enterprise Internal Control Standard Committee has not set a specific date. As such, businesses are well advised to integrate the Standard into company policy as soon as possible – and since the regulations do not differentiate between domestic and foreign enterprises, compliance is also mandatory for German companies that are traded on Chinese exchanges. US role models C-SOX combines the basic principles from both of the following publications issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO): ● Internal Control – Integrated Framework (1992) ● Enterprise Risk Management Framework (2004)



While the 2004 publication focuses on processes, most notably the steps in registering a stock corporation, the 1992 publication was chiefly concerned with establishing definitions for fundamental concepts such as the five elements of internal control. These elements � internal environment, risk assessment, control activities, information and communication and internal monitoring � also form the backbone of the Chinese Basic Standard, meaning they must also be included in any effective internal control. Furthermore, the Standard requires that every company listed in China establish the conditions necessary to introduce embezzlement controls and draft a company procedural code for the case that any fraud does surface. International comparison C-SOX is significantly more complex than its foreign equivalents. One of the most fundamental differences is the very definition of �internal control�: China�s Standard clearly and precisely defines it by listing the five elements. SOX and J-SOX, on the other hand, name no specific points, instead leaving it up to the companies to establish their own relevant areas. Another central difference is the scope of the companies affected: SOX focuses on external accounting procedures, an aspect of the regulation that was developed primarily for listed companies. In China, however, the Standard is designed to make possible the later implementation in unlisted companies as well. To this end C-SOX not only regulates external accounting but also transactions, and specifies the procedures to be followed. The safeguarding of assets and implementation of fraud prevention controls are described in particular detail. Other elements are similar to the international SOX standards: ●

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The Board of Directors is responsible for implementing and monitoring C-SOX compliance. The supervisory board in turn shall monitor the Board of Directors� actions in those areas. Company management is responsible for organising controls in daily operations.

Furthermore, the Standard also requires the implementation of an auditing committee to monitor compliance and effectiveness. Focal points China�s Standard supports the use of information technology and automated monitoring. This also includes the monitoring of electronic information, as has occurred in the United States since 2002, and in particular the archiving of e-mail. Possible remuneration, bonuses and penalties are to be clearly defined beforehand and anchored in company guidelines to facilitate the further integration of the Standard into internal enterprise controls. A second focal point is the role of external consulting firms. The Standard obligates every company listed on a Chinese stock exchange to engage an external consultancy to monitor internal

controls and, just as in the United States, statutory and tax audits must be conducted by two different organisations, namely an auditing firm and the tax authority. Neither the Circular nor the Standard requires an auditor�s report on the effectiveness of internal controls, so this point remains a matter of personal preference. Deadlines and required actions All companies are encouraged to implement C-SOX as soon as possible so that it can take effect in all areas. Starting in the summer of 2009, listed companies are obligated to submit on annual report on the progress and handling of the Standard. As you have already read, the rules will affect very broad operational areas in companies and in light of the experience gained during the introduction of the American equivalent, the implementation period for C-SOX seems extremely optimistic, at least if the goal is an effective application of the new rules. Many experts have already voiced their doubts about the punctual introduction of C-SOX in July 2009. In contrast to the United States, where companies had a lead-time of almost four years, Chinese enterprises have only had about one year between the publication of the Standard and its compliance date. It is absolutely vital that executives are supported in the process by having relevant, high-quality information about their companies. To ease implementation, we recommend a staggered introduction of the new guidelines. It is also advisable for companies to avoid implementing completely new rules and instead build upon those already in place. If companies are interested in proceeding in this manner, then they should become familiar with the subject as soon as possible, both for their own information and to quickly set up special training courses in external account management and IT. Outlook With C-SOX, China has made a clear statement on how it plans to introduce international standards of governance in Chinese companies. It is designed to lower the risk posed to companies by poor or absent governance and thus protect investors and improve the stability of Chinese companies and markets. C-SOX is an important step in introducing international governance standards in Chinese companies and the regulatory authorities are called upon to carefully monitor the implementation of the rules. The companies in questions have been asked to comply with C-SOX regulations by this summer, although unconfirmed information indicates that this date will be pushed back. A delay in introduction, however, should not detract from the importance of these rules: with the Chinese government currently supporting a �go abroad� strategy, C-SOX definitely has full political support. Nevertheless, it will realistically take some time before the new rules can take full effect. On the one hand, experienced foreign companies may have an easier time implementing C-SOX since



they are already familiar with similar regulations in other countries. On the other hand, foreign companies will have to deal with Chinese regulators without the benefit of having the state � as a supportive owner � behind them. In any case, PricewaterhouseCoopers is looking forward to support you and your company in meeting full compliance with C-SOX. If you have any questions or would like advice, please feel free to contact us by phone or e-mail.


Three guidelines to help with the introduction of the Basic Standard ●

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Guidelines for Evaluation and Assessment of Effectiveness of Enterprise Internal Control Implementation Guidelines for Enterprise Internal Control Guidelines for Performing Assurance Engagements in Relation to Assessing Effectiveness of Enterprise Internal Control

Other relevant restrictions for enterprise control in China

Guidance on Internal Accounting Control Basic Standards (six documents covering money stock, procurement and payment, sales and income, expansion projects, foreign investments and notes of surety; MOF, 2001 to 2004) Guidance on Initial Public Offerings of Listed Companies (Article; China Security Regulation Commission, 29 May 2006) SSE Guidelines for Internal Control of Listed Companies (Draft; Shanghai Stock Exchange, June 2006) Central State-owned Enterprises Comprehensive Risk Management Guidance (China�s State-owned Asset Supervision and Administration Commission, June 2006) SZSE Listed Companies Internal Controls Guidance (Draft; Shenzhen Stock Exchange, September 2006) Insurance Risk Management Guidance (China Insurance Regulatory Commission, April 2007) Commercial Banks Internal Control Guidance (China Banking Regulatory Commission, July 2007)





Economic crime during economic crisis: how to protect your firm The financial crisis is certainly not limited to the major industrial nations. Emerging markets like China have also been badly hit, and the consequences have probably been deeper and more widespread than initially expected. Yet the dramatic rise in business closures often obscures a danger even more worthy of attention: growing pressure on businesses and the introduction of state rescue packages considerably increase the likelihood of economic crime. Businesses must therefore ensure effective internal controls and procedures, and make clear to personnel, service providers and customers how this challenge is to be met. Economic crime in developing nations and China Three key factors make emerging markets susceptible to economic crime. Firstly, supply chains are often more complex and subdivided in emerging markets like China than in industrialised countries. China’s size and geographic diversity compound this situation. Little takes place in this nation without sales agents, dealers, representatives and other middlemen. It is therefore difficult to comprehensively monitor production from raw materials to end product – which increases the opportunities for manipulation. Secondly, maintaining close personal relationships is essential to business life in China. Of course a good relationship with customers and suppliers is part and parcel of doing business all over the world. However in China there is the danger that these relationships – known as ‘guanxi’ – will take precedence over the initial business objective. One cause for this is to be found in the attitudes toward business remnant from the time of the state-run planned economy. The China expert Jack Perkowski notes: “In essence, the entire welfare system in China had devolved to the work unit. (...) Employees were beholden to the leaders of their work for nearly every aspect of their lives. The factory leaders themselves had strong vested interest to protect, and the cultivation of local government officials was one means by which they protected them.” (Jack Perkowski, Managing the Dragon: How I’m Building a Billion Dollar Business in China, New York: Crown Business, 2008) Until recently, practically the only way to get ahead in China was to cultivate the relationships outlined above. This mentality continues until today. It survived the dissolution of the traditional employment system and the opening-up of the economy. Thirdly, China saw a period of enormous economic growth that eclipsed that of the rest of the world. Investors pumped capital into the country with the expectation that they could permanently maintain high returns. For this reason many businesses are extremely sales orientated and set growth targets that could place employees under extremely heavy pressure.

This article explains: ● why emerging economic markets are susceptible to economic

crime. ● what types of economic crime occur most frequently in China. ● how businesses can protect themselves.

The growth rate has at times been so rapid that effective procedures and controls could not be introduced quickly enough. The development of the legal system has also not kept up with economic growth, with the result that officials find themselves swamped with cases involving the prosecution of economic crimes. Special crisis-related factors Experts refer to the so-called fraud triangle, a model that requires the presence of three key factors in order to trigger an economic crime: ● the assumption that there is an opportunity for criminal activity ● incentive (or pressure) ● the perpetrator’s subjective justification for his deed (he

portrays it as a mistake or he does not view it as reprehensible because he thinks he is being treated in an unfair manner).

In tough times employees make more frequent use of opportunities for economic crime. In many businesses staff cutbacks may impair the effectiveness of monitoring systems. Risks increase when businesses are prepared to reach sales and profit goals at any cost or to circumvent monitoring systems to move things faster. Both cases raise the risks and can lead to an increase in the number of economic crimes. Around the world and in every sector, the difficulties encountered by businesses during the financial crisis have increased pressure on all employees to meet their commercial and personal goals. As noted, this danger is particularly high in China, as aggressive growth targets and a focus on profit more or less compel managers to use any means they can. Caught up in the recession, businesses are often forced to operate in a marketplace characterised by shrinking sales and profits. As job security is threatened and cost-cutting measures limit the scope of decision-making, employees may see themselves justified in committing crimes involving business assets. An economic downturn influences the lives of many; they lose money or income. When faced with desperate circumstances people are more likely to take risks in order to recover lost assets or income. Usually honest individuals may turn to bribery or other forms of economic crime. Two examples of situations that can increase pressure on employees: ● a plunge in share prices causes savings to lose value ● a partner or spouse loses his or her job


Avoid risks The most important types of economic crime The Economic Crime Survey 2007 released by PricewaterhouseCoopers, based on a survey of 5,400 businesses in 40 nations, lists the five most frequent types of economic crime: ● ● ● ● ●

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In today�s tough times companies that operate internationally � especially those active in China � must place both the prevention and detection of economic crime high on their list of priorities. With increasing rationalisation and cost cutting, transactions and procedures need to be examined with special care in order to quickly identify any irregularities. Management would be well advised to put forth clear guidelines for responsible behaviour across the business. These should provide for:

embezzlement falsification of balance sheets corruption and bribery money laundering copyright infringement

effective methods of communication simple procedures for reporting incidents Although most respondents thought copyright infringement the

most frequently occurring economic crime in China (23 percent of those surveyed), there were actually more cases of embezzlement reported (25 percent). In fact only 14 percent of reported crimes involved copyright infringement. The survey thus brought an important discrepancy between perceived and actual problems to light.

investigation of all cases of economic crime appropriate punishment for the wrongdoer

All are aspects of an effective strategy for combating fraudulent practices in good economic times � their importance has only increased during the current crisis. PricewaterhouseCoopers� Investigations and Forensic Services teams have a wealth of experience in investigating suspicious activities in the Asia-Pacific region. For years they have been working with clients to develop efficient and effective solutions to their problems. In addition, they help clients review existing programmes for combating economic crime in light of the current economic atmosphere and provide recommendations for adapting them to the new realities.

Over-complexity of the legal system and the suspicion of corruption were the problems most frequently mentioned by respondents in relation to economic crime in China (83 percent and 92 percent respectively). The five types of economic crime listed above are found in all developing countries. China in particular is susceptible to the following problems:

corruption or bribery (secret agreements between purchasing departments and suppliers to inflate prices and split profits) If you have questions or would like advice, please call us or

simply send an e-mail. improper procurement practices giving preferential treatment to certain suppliers copyright infringement and failure to record all licensing fees due Contacts

[email protected] money siphoning (failure to record earnings covered up by falsifying balance sheets) Phone: +86 21 2323-3988

bribery and corrupt practices in order to obtain orders (including excessive demands made to favour certain suppliers and improper bidding practices

[email protected] Phone: +86 21 2323-3350 For developing countries like China, the United States� Foreign

Corrupt Practices Act (FCPA) is an even more current and widely discussed issue. This federal statute applies to both individuals and firms that are registered in the US or that have businesses or assets there. It prohibits the payment of bribe money to foreign officials � regardless of where in the world this takes place. This makes matters especially risky in China, where it isn�t always exactly clear who an �official� is. The lack of clarity stems from the fact that many sectors � for example health care and energy � are still primarily in the hands of the state. A secret commission or bribe may therefore not only violate local law but also the FCPA. Many companies that are subject to the FCPA are not clear as to what their duties are under the statute.




Tax and legal


Tax planning in the pharmaceutical industry – approach of increasing importance With a 17 percent growth rate for the industry, China has become one of the most important nations for pharmaceutical manufacturing. Yet, although it contains a fifth of the world’s population, only 2 percent of world pharmaceutical production takes place there. These figures illustrate the complex interrelationship between the pharmaceutical industry and China. The most recent changes to the nation’s tax structure will greatly affect this industry. Here you will learn about measures you can take in this difficult environment to ensure your business is tax efficient. Corporate tax reform: a policy watershed with many repercussions The introduction of the new Corporate Income Tax Law (CIT Law) on 1 January 2008 signaled a turning point in China.

For a detailed look at corporate tax changes and their practical implications see the article Reform of corporate tax law in the summer 2008 edition of pwc:china compass (available in German only).

You may well know that the nominal corporate tax rate has dropped from 33 percent to 25 percent. But what seems to be a change for the better is just one side of the coin. By abolishing or strictly limiting regional tax breaks that had been widely available in, among others, the former Special Economic Zones and New and High-Tech Development Zones, the tax reform actually increases the effective corporate tax rate for most foreign investors. Related measures such as limiting operating-cost deductions – for example, for advertising – lead to tax increases or limit the opportunities for tax planning. Morever, the distribution of dividends to foreign shareholders is now subject to a 10 percent withholding tax (WHT) in China that first applies to profits earned after 31 December 2007. This is particularly of disadvantage for German shareholders because, as in most European countries, foreign dividend income is tax-exempt (except for 5 percent treated as non-deductible operating expenses). As a result, it is not possible to claim credit for WHT paid on dividends outside the country. The WHT on dividends to German investors therefore means an after-tax reduction in earnings at the level of the holding company. Special characteristics of the pharmaceutical industry The Chinese government has recognised the importance of the pharmaceutical industry. Its November 2008 economic stimulus package to the tune of 4 trillion renminbi (RMB, about €480 billion) expressly mentions the ‘further development of medical treatment and health care’ and the ‘building of a foundation for medical and sanitary services’. Prime Minster Wen Jia Bao has

This article explains: ● why corporate tax reform in China signals an important change in

the business environment. ● which new regulations threaten to undermine tax benefits under the

reform. ● what (pharmaceutical) companies can do to minimise their tax

burden.

also announced additional reform measures, including basic national health care and an ambitious program of new state hospitals. The five steps of health care reform that he has referred to are to be implemented between 2009 and 2011. It is estimated that the government will spend an additional RMB850 billion.

You will find critical information on the Chinese pharmaceutical market in the article Health care reform in China: what it means for the pharmaceutical industry on page 9.

In addition to government support measures, the nature of the industry itself leads to other requirements and options for a tax-efficient organisation. One particular challenge is the commitment of capital to long-term projects – for example, when planning manufacturing. Often licenses are required for the local manufacturing. Such licensing arrangements are generally associated with a 10 percent WHT and an additional 5 percent business tax. Where companies in China undertake research in addition to manufacturing and distribution, this is generally done by separate business entities, often at different locations. There are historical reasons for this practice. Under prior law, incentives were tied to company type (eg, a business engaged solely in manufacturing) and location (eg, special development zones), and were only given to companies that met these criteria. Over-the-counter drugs often come with high advertising costs. The advertising deduction allowed by the corporate tax reform was originally limited to 15 percent of sales revenue. According to Circular [2009] 72, dated 6 August 2009 the cap has been increased to 30 percent for certain industries, including the pharma industry. Costs that exceed this amount do not reduce the tax base, but can be carried forward to future fiscal years. However it is important to keep in mind that the relationship between such costs and sales revenue varies from product to product. It is also fairly uncertain whether operating expenses that are carried forward will be of any tax use in the future. Tax incentives for new and high-tech enterprises, and ‘super operating costs’ The tax authorities grant the largest nominal tax breaks to enterprises holding the new and high-tech status. The corporate tax rate is reduced from 25 percent to 15 percent during the period when the status is accorded – generally for three years with an option to extend. In order to receive the tax break, the

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applicant must own the intellectual property (IP) rights for the core technology behind their main products. These rights can have been acquired within the previous three years through proprietary development, transfer and acquisition, as well as in other ways. An enterprise is also eligible if it has licensed the rights exclusively for at least five years. Enterprises should be aware that cross-border intercompany transfers of IP rights may be taxable for the licensor.

Criteria

Without new/high-tech status, super

operating costs,

R&D bonus

With new/high-tech status, Super

operating costs,

R&D bonus

Sales revenue 500 500

Operating costs (incl. 20% for R&D) 400 400

Profit before taxes 100 100

R&D super operating-cost deduction � 10

Taxable income 100 90

Corporate tax rate 25% 15%

Corporate tax 25 13.5

After-tax profit 75 86.5

Withholding tax on dividend distribution 10% 10%

Withholding tax on dividends 7.5 8.65

Repatriated profit 67.5 77.85

Total tax burden 32.5 22.15

Effective tax rate 32.5% 22.15%

China imposes additional requirements. For example, a certain percentage of the total staff must hold a degree, as must research expenses account for a certain portion of the total budget. The exact values depend in part upon the size of the enterprise. Enterprises with a turnover of less than RMB50 million must spend at least 6 percent of their total revenue on research and development (R&D). If turnover is between RMB50 million and RMB200 million then 4 percent is the minimum amount for R&D; for higher turnover it is 3 percent. Furthermore, at least 60 percent of the applicant�s turnover must come from new and high-tech products. These criteria are relatively new and, even though their wording reflects stricter requirements, there has been a surprisingly high approval rate, especially for the first wave of applications. There are several possible reasons for this. The first round included many enterprises that already had this status under the old law. Another factor is that, due to the challenging economic environment, local authorities tended to be lenient in granting approvals. It remains to be seen if investors will continue to find the going easy and if current practices will be upheld by supervisory bodies.

Tax advantages for new and high-tech enterprises with super operating costs Financing and holding structures As already noted, many investments are characterised by decentralised structures where production and distribution occur in independent legal entities. (The various production sites may also have independent legal statuses for political reasons.) These entities are often held directly by the German holding company or by a regional intermediate holding company outside of China. This set-up limits the opportunities for inter-company financing � in other words the use of profit and cash flows of one company to finance the cash flow needs of another.

In addition to lowering the corporate tax rate the new legislation continues provisions for deducting eligible expenses. Accordingly enterprises may deduct � and thereby reduce their tax base by � 150 percent of eligible R&D costs. So for a general corporate tax rate of 25 percent the tax break amounts to 12.5 percent. This super operating-cost deduction is not limited to enterprises with the new and high-tech status. Either way it would be wise for enterprises to clearly distinguish R&D costs from other operating costs and to document them fully.

In the past, a proven and effective way to meet intercompany financing needs was through entrusted loans from local financial institutions. This is still possible but the new provisions on shareholder debt financing (thin capitalisation rules) limit the debt-to-equity ratio to 2:1. Interest on additional financing is generally not tax deductible. Given the current tax limitations on shareholder debt financing, financing can be secured on an equity basis with a Chinese holding company. If a German company uses a Chinese holding company instead of financing through a German shareholder, the 10 percent WHT on distributed dividends can be avoided and registration requirements and associated administrative costs reduced.

Cross-border cost-sharing arrangements (CSA), especially for R&D activities, have for the first time in China found a legal basis under the new law. Although there are high requirements and bureaucratic hurdles to clear in order to obtain approval for a cost allocation plan, there are also substantial advantages to be had � in particular, a WHT exemption for contributions to a CSA.

Case study This would entail a substantial new investment of $30 million. But despite the high amount, this should not be a reason to forgo a capital-intensive investment. Under this structure, the dividends of profitable Chinese subsidiaries can be distributed to the Chinese

The following table illustrates the tax advantages for new and high-tech enterprises in connection with super operating costs.


Tax and legal

holding company, whereby WHT does not apply to intra-country distribution. The Chinese holding company can then use these earnings to provide additional capital to companies with financing needs. If profit repatriation is planned, the receiving company should reside in a country that has a double taxation treaty with China. That way the regular WHT on distributed dividends can be reduced from 10 percent to 5 percent. As it is not possible to claim a tax credit for WHT paid on dividends outside the country, it is a cost. Therefore using an offshore holding company can increase the amount of after-tax income. Hong Kong and Singapore are typical Asian jurisdictions with a favourable 5 percent WHT rate for dividends. Be aware that to set up an intermediate holding company it has to be demonstrated that a reasonable economic purpose and substance exist. Certain supporting documents are also required in order to benefit from this privilege. Also bear in mind: the restructuring usually involves the disclosure and taxation of the Chinese company�s hidden reserves. A tax-neutral restructuring is only possible if certain criteria are met. For more see the article New tax rules for corporate restructuring and liquidation in China on page 29. Liquidity has taken on growing importance in the current economic climate. Many investors are withdrawing assets from China. However the opposite approach can have its advantages, too � for example, lowering your tax burden in China by using the interest costs from a loan taken out to increase liquidity. In the context of thin capitalisation rules, interest costs reduce the taxable income for Chinese borrowers, with the regular tax rate of 25 percent. So if the creditor�s interest income is subject to a lower effective tax rate, the result for the group will be positive. This can be achieved, for example, when the creditor carries forward tax losses or by tax-sparing credits for interest income as per the double taxation treaty between Germany or another European country like Belgium and China. Even though China only imposes a withholding tax of 10 percent on interest paid, the person receiving interest income in Germany can get a national tax credit of 15 percent. It is important to bear in mind that China imposes a 5 percent business tax on cross-border interest payments. Other options may be the use of financing companies or perhaps even structures where interest income can remain tax exempt. The tax structures described and illustrated here should be carefully prepared and conscientiously employed, as the complexity of the material and the detailed requirements are more than meets the eye. The current corporate tax law contains for the first time anti-avoidance rules, as well as general provisions to prevent abuse of the tax laws. If a tax structure lacks reasonable business purpose, the Chinese tax authorities may well assume that it was mainly introduced to evade, reduce or delay tax payment. Such illegitimate benefits � as from a fiscal perspective � could then result in corrective adjustments. The

rules are not explicit, and it is unclear if they will only be applicable to related-party transactions or to transactions with unrelated parties as well. The key focus is on the commercial reasonableness of the tax structure. In most cases it is not easy to assess clearly, and there will certainly be controversial decisions. Two recently published rulings from central China are cases in point: the new rules are in effect, even in part for the time before the official regulations were published. Summary For most German investors, the corporate tax reform of January 2008 means an increase in their effective tax burden. A company run from Germany can count on paying taxes of 32.5 percent (25 percent corporate tax and 10 percent WHT on dividends paid). As you have read in this article, there are various ways for companies to react to these circumstances. As the laws are new and the preparedness of local tax authorities varying � sometimes even influenced by special interests � diverging interpretations and applications of the law are more likely to be the rule than the exception. Therefore investors are strongly advised to discuss and reach agreement on planned restructurings with the relevant authorities early in order to avoid risks during implementation. Just what steps should you take? Let the experts at PricewaterhouseCoopers help you. Do you have questions or would you like to find out more? Then call us or simply send an e-mail.





Tax and legal


Transfer pricing: Chinese administrative regulation sets new standards (Part 1) The government in Beijing has established further regulations regarding transfer pricing. The new directives introduce many new concepts and tighten regulations on transfer pricing documentation and procedures. Since the new rules will have a big impact on international companies doing business in China, the experts at PricewaterhouseCoopers will analyse the most important features for you in this and the next edition of pwc:china compass. – First, we hear from Xiaojun Chen and Lea Gebhardt as well as Nikolaus Thoens from our team of experts in Düsseldorf. On 8 January 2009, China’s State Administration of Taxation published its long-awaited administrative regulation governing transfer pricing (henceforth: the administrative regulation), which is retroactively effective as of 1 January 2008. Based on the draft published at the end of March 2008, the final version of the administrative regulation contains 13 chapters and 118 articles. – We first reported on it in the autumn/winter 2008 edition of pwc:china compass (available in German only). All statements of the administrative regulation refer to Chapter 6 of the implementation provisions of the new corporate income tax law and cover various aspects. – The last edition of your pwc:china compass (spring 2009, page 30) tells you about the important changes to the final administrative regulation. 1. Annual disclosure of related-party transactions 1.1 Introduction of disclosure forms In December 2008, the State Administration of Taxation published nine forms regarding related-party transactions instead of the original 10 prescribed in the draft regulation. Article 11 of the new administrative regulation divides the forms as follows: ● Form 1: Related-party relationship ● Form 2: Summary of related-party transactions ● Form 3: Purchases and sales ● Form 4: Services ● Form 5: Intangible assets ● Form 6: Fixed assets ● Form 7: Financing ● Form 8: Foreign investment status ● Form 9: Foreign payments Enterprises are required to confirm the existence of contemporaneous transfer pricing documentation in the forms and provide detailed information on each type of related-party transactions, as well as the transfer pricing methods used.

This article explains: ● which topics are included in the new disclosure forms. ● which new provisions govern transfer pricing documentation. ● which eight recommended actions will allow you to best prepare for

the new provisions.

The administrative regulation considers enterprises that fulfil at least one of the following eight criteria as related parties: ● One party directly or indirectly owns at least 25 percent of the

other party’s shares, or a third party owns at least 25 percent of both parties’ shares.

● Loans between the two parties account for at least 50 percent of either party’s paid-in capital, or at least 10 percent of one party’s liabilities are guaranteed by the other party.

● More than half of one party’s senior management or at least one senior board member with influence over the board’s decisions is appointed by the other party, or in both cases by a third party.

● More than half of one party’s senior management is also part of the senior management of the other party, or at least one senior board member with influence over the board’s decisions is also a senior board member of the other party.

● Rights to industrial property, proprietary technology etc necessary for carrying out one party’s operating activities are provided by the other party.

● One party’s purchases and sales activities are influenced or controlled by the other party.

● The services that either party receives or offers are influenced or controlled by the other party.

● Other relationships, including relationships with family and relatives, exist which enable one party to influence or control the production or operations of the other party.

Please note: Compared with standard international regulations, these criteria are wide-ranging and vague. In other words, a lot of enterprises will be subject to the disclosure requirements. 1.2 Application areas and deadlines for disclosure forms The new rules expand the disclosure requirements, as not only China-resident enterprises are required to report transfer pricing annually using the new forms, but so too do non-resident enterprises with establishments in China that are taxed on an actual profit basis. Enterprises must submit information on related-party transactions as required by the forms to the tax authorities with their corporate income tax return. The 2008 forms had to be submitted by 31 May 2009 at the latest, whereby the local authorities were able to issue different deadlines. The regulation generally does not permit deadline extensions, but it does in undefined special cases.

Tax and legal

2.

2.1

2.2

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●

●

2.3

● ● ● ● ●

● ●

● ● ●

●

● ● ● ●

2.4

3.

3.1

cost plus method Provisions for contemporaneous transfer pricing documentation transactional net margin method profit split method Preparation and submission

As you read in the article New notice of specific tax adjustments and the trend towards more stringent measures to combat tax abuse (pwc:china compass, winter/spring 2008/2009 edition, available in German only), many enterprises are required by the new administrative regulation to prepare contemporaneous transfer pricing documentation by 31 May of the following year at the latest. Upon request the documentation is to be submitted to the tax authorities within 20 days. In order to ease implementation for the enterprises affected, the deadline for the preparation of transfer pricing documentation (TPD) for 2008 was extended to 31 December 2009. The documentation must be compiled in Chinese and signed by the legal representative of the respective enterprise. If a TPD has been prepared in a foreign language a Chinese translation of the TPD has to be enclosed in accordance with Article 19 of the administrative regulation. Foreign documents should be notarised. The documentation is to be retained for 10 years.

The administrative regulation specifies in detail the criteria that need to be observed in selecting a transfer pricing method. When selecting an appropriate method, a comparability analysis covering the following five aspects should be carried out:

characteristics of the assets or services involved in the transaction functions and risks of each party engaged in the transaction contractual terms economic circumstances business strategies

Should the comparison between related-party transactions and unrelated-party transactions reveal significant differences, then reasonable adjustments must be made to account for these differences.

Penalties An enterprise that fails to fulfil its TPD requirement may be subject to a fine of up to RMB50,000 (about �5,500) and a targeted transfer pricing audit. Additional corporate income tax payable following adjustments made by the tax authorities will be charged at the base interest rate published by the People�s Bank of China. In addition, the administrative regulation imposes a non-deductible interest penalty of 5 percent of the transfer pricing adjustments. Since the punitive interest rates are not classified as tax under the German-China double taxation treaty, it is not possible to deduct the penalty abroad, even if a double tax treaty applies the credit method.

Exemption from the documentation requirement Article 15 of the administrative regulation exempts enterprises from the documentation requirement provided that they fulfil one of the following three criteria:

The annual amount of related-party purchases and sales of tangible goods is less than 200 million renminbi (RMB, about �22 million), and the annual amount of all other related-party transactions is below RMB40 million. These amounts do not include transactions covered by cost-sharing arrangements (CSA) or advance pricing arrangements (APA). The related-party transactions are covered by the scope of an APA.

The punitive interest rate of 5 percent for transfer pricing adjustments will no longer be levied if the audited enterprise can present transfer pricing documentation within a specified period upon request.

The foreign shareholding of the enterprise is below 50 percent, and the enterprise transacts only has domestic related party transactions. This does not include from the special administrative zones of Hong Kong, Macau and Taiwan.

Transfer pricing audit The Chinese tax authorities will use the TPD submitted by taxable

enterprises as the basis for targeting enterprises for tax audits in 2010.

A whole chapter of the administrative regulation is dedicated to transfer pricing audits and special tax adjustments by the tax authorities, as well as procedures an enterprise can use to defend its transfer pricing system. This includes the process of carrying out a transfer pricing audit and the opportunities for appealing a negative outcome.

TPD content

The documentation must contain the following categories: information on organisational structure description of business operations

description of related-party transactions Audit targeting criteria comparability analysis or benchmarking study

The administrative regulation lays out seven criteria for targeting enterprises for a transfer pricing audit. The criteria are similar to those in the draft. However, in contrast to the draft, profitability lower than related parties in a group is no longer a criterion for carrying out a transfer pricing audit.

details on applied transfer pricing methods The Chinese corporate income tax law allows for the following five transfer pricing methods:

comparable uncontrolled price method resale price method


Tax and legal

The first three criteria are: ●

●

●

●

● ●

●

3.2

●

●

●

●

3.3

a significant amount of related-party transactions (�significant amount� not defined); continuous losses or highly fluctuating profits (time or amount limits not specified); profits lower than industry standards (no further information provided).

Enterprises will also be audited (criteria four to seven)

whose profits do not correspond to the functions performed and risks assumed. which enter into transactions with related parties in tax havens. which fail to submit the required contemporaneous transfer pricing documentation. which violate the arm�s length principle.

The audited enterprise, related parties and other enterprises affected by the transfer pricing audit � including comparable enterprises � must submit all relevant documents and information upon the tax authority�s request. �Comparable enterprises� are those with similar business objectives and activities. The law gives the enterprise to be audited 30 days to submit all of its documentation. The period for related or comparable enterprises is 60 days at most. However, the information obtained from comparable enterprises is not to be used to audit the comparable enterprises themselves. The authors find it concerning that comparable enterprises can be compelled to participate in a transfer pricing audit, as this exceeds international standards and could open the door to abuse of power on the part of the tax authorities. In addition, it is probably not possible to assure the collected information will not be used to audit comparable enterprises.

Implementation of audits and special tax adjustments During an audit, the Chinese tax authorities may use both public information and non-public information (secret comparables) to evaluate the arm�s-length nature of related-party transactions. If information from abroad is needed, the tax authorities may initiate information exchange procedures under the relevant tax treaties or request it from overseas authorities. They can also demand notarisation of documents concerning related parties overseas. Articles 38 to 41 of the administrative regulation contain precise instructions for four audit cases:

Adjustments to differences in operating profit resulting from differences in working capital employed by the enterprise under audit and comparable enterprises shall not be made without express approval of the State Administration of Taxation. Manufacturing or processing enterprises that do not perform functions like product development or marketing generally do not bear the risks and losses associated with such functions (eg, due to strategic mistakes). They are therefore expected to maintain a certain profit level. Should such an enterprise occur

losses, then the tax authorities shall identify appropriate comparable prices or enterprises in order to determine an appropriate profit level. If receivables and payables are offset between the enterprise and related parties, then such offsets shall in principle be reversed by the tax authorities for the purposes of the comparability analysis and tax adjustments. An adjustment resulting from this reversal can lead to an additional VAT or corporate income tax burden for the enterprise if two transactions are subject to different tax rates. When analysing and evaluating an enterprise�s profit, an adjustment to taxable profit should be made to no lower than the median if profitability is less than the median of the comparable enterprise.

After the initial audit the taxable enterprise will be presented with a draft of the tax adjustments to review and discuss. Should the enterprise refuse to accept the adjustments, it can submit further documentation and evidence to defend its tax position before the tax authorities issue a preliminary adjustment notice. A final adjustment notice shall follow if the enterprise does not raise any objections within seven days. The enterprise affected by the tax adjustment shall then be subject to follow-up monitoring for the next five years. During this period, the enterprise must not only prepare its annual transfer pricing documentation by 20 June of the following year but also submit it to the tax authorities regardless of whether it is requested to do so.

Corresponding adjustments and international mutual agreement procedures

Should a transfer pricing audit (in China) lead to a tax adjustment for one party, the administrative regulation allows the other related party (domestic) to make a corresponding adjustment to avoid double taxation. If the corresponding adjustment involves a related party in a state (or region) with which China has signed a double taxation treaty, the State Administration of Taxation shall, on application of the enterprise, engage in discussions and negotiations with the other state pursuant to the mutual agreement procedures in the tax treaty. Enterprises are to submit a written application for a corresponding transfer pricing adjustment or mutual agreement procedure within three years of receiving the transfer pricing adjustment notice. Corresponding adjustments are not applicable in cases of interest, rent or royalty payments to overseas related parties for which the tax authorities have imposed withholding taxes. Due to this rule, almost all foreign companies doing business in China face double taxation if they are subject to a corresponding adjustment to taxable profit. Thus a tax adjustment itself has a �punitive character�.


Tax and legal

4.

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Conclusion Contacts [email protected] The introduction of the new transfer pricing provisions

demonstrates the tax authorities� intent to more closely control transfer pricing than in the past. Some observers assume that transfer pricing audits will in the future be expanded to include transactions involving, for example, royalty payments and management fees. In light of the current financial crisis, the tax authorities will increasingly pay attention during transfer pricing audits to whether a foreign enterprise has used transfer pricing in violation of the arm�s length principle to shift losses to its entities in China.

Phone: +49 211 981-7223 [email protected] Phone: +49 211 981-7255 [email protected] Phone: +49 211 981-7429

Do you know when and at which university the field of Sinology was first established?

It was in 1814 at the Collège de France in Paris. The first professorship for Sinology was established in 1837 at University College in London.


你知道了吗

Here the authors provide you with eight suggestions to prepare for a transfer pricing audit and subsequent negotiations with the tax authorities:

Prepare contemporaneous transfer pricing documentation in order to avoid as much as possible an audit. Make sure that no inappropriate transfer pricing systems are used within your group. Be sure to retain relevant contracts, invoices and other documents. Cultivate and maintain a professional cooperative relationship with the auditor from the beginning. Document all of the information that the tax authorities require of you. Designate a contact person for questions from the auditor who is extremely familiar with both your business and the potential danger of an audit. This person shall then be responsible for all discussions with the auditor.

Bring in an expert experienced in transfer pricing matters to detect potential dangers early on and to prepare key arguments and supporting documents in advance.

Ensure that the related-party transaction forms you completed for 2008 correspond with the relevant TPD despite its extended due date in 2009.

Check to see if you are able to make corresponding adjustments under an international mutual agreement procedure, should such findings be made. As you read in the introduction, this article shall be continued in the next edition of your pwc:china compass. The fall edition will contain detailed information about the possible application of Advanced Pricing Agreements and Cost Sharing Agreements, as well as the practical implementation of the transfer pricing provisions. Would you like more information about this topic? Then call us or simply send us an e-mail.





Tax and legal


New tax rules for corporate restructuring and liquidation in China The introduction of the new corporate tax law on 1 January 2008 overturned several tax regulations concerning corporate restructuring that had applied to domestic and foreign-invested enterprises under the old law. After lengthy discussion, China’s Ministry of Finance and State Administration of Taxation issued two new circulars. Both are retroactively effective for transactions occurring from 1 January 2008. - This article gives you an over-view of the main provisions, as well as changes to previous drafts. The initial drafts were presented in June and November 2008. Discussion surrounding these drafts is reflected in the final versions. Officially they are known as: ● Circular on Several Questions about Corporate Income Tax

Treatment for Corporate Restructuring – Cai Shui (2009) No. 59 (henceforth: restructuring circular)

● Circular on Several Questions about Corporate Income Tax Treatment for Corporate Liquidation – Cai Shui (2009) No. 60 (henceforth: liquidation circular)

Restructurings According to the restructuring circular, all transactions outside the normal course of business that significantly change an enter-prise’s legal or economic structure are considered restructurings. In particular, they include the following six forms: ● change in legal form ● debt restructuring or debt rescheduling ● equity acquisition ● asset acquisition ● merger ● spin-off The restructuring circular governs the individual tax treatment of the six forms of restructuring listed above. In this context it is important to differentiate between general and special restructurings. Only special restructurings are eligible for preferential tax treatment. General restructurings Restructurings that do not meet the conditions for special restructurings are subject to general tax treatment; in other words, without tax breaks. Taxable gains and losses from the disposal of relevant assets shall be subject to corporate tax at the time of the transaction but can also be offset against current profits or losses from normal business activities. The valuation related to general restructurings should the reflect market, or rather the fair market value. A change in the legal form (defined in the circular as a change of registered name, address or legal type) from a legal person to another kind of entity, such as a sole proprietorship or partnership

This article explains: ● how the circulars govern restructurings and liquidations. ● the difference between general and special restructurings. ● when cross-border transactions are tax-exempt.

enterprise, or a move its legal seat abroad (including to the special administrative zones of Hong Kong, Macau and Taiwan) is always considered a liquidation with full asset distribution at fair market value. Other simple changes in legal form, which the circular does not define more closely, result only in a change in tax registration. Corporate tax matters, such as tax loss carry-forwards, tax obligations and tax incentives, are inherited by the new enterprise. Special restructurings Should the criteria for a special restructuring be met, the relevant transactions can be partially or wholly treated tax-neutral or a tax deferral can be claimed. The following list summarises the basic and transaction-specific criteria for claiming tax benefits for special restructurings: ● The restructuring has reasonable commercial purpose.

Unfortunately no further details were provided as to what ‘reasonable commercial purpose’ constitutes. The Chinese tax authorities thus have plenty of room for interpretation.

● There needs to be a significant change in structure whereby certain minimum requirements related to the restructuring type (generally defined by key figures in the circular) have to be met. The minimum requirements will be laid out in detail at the end of this list.

● There is no change in the original actual business activities within 12 consecutive months after the restructuring.

● The consideration for the restructuring should be mainly in shares and meet the ratio set out in the circular.

● The acquired equity cannot be transferred within the 12 months after the restructuring.

The following minimum requirements have been set for the individual types of restructuring: Debt restructuring or debt rescheduling Debt restructuring is when the debtor is in financial trouble and the creditor and debtor agree a debt concession. According to the circular, when the income derived from debt restructuring exceeds 50 percent of the enterprise’s total taxable income in the restructuring period, it can be evenly spread over five years (ie, 20 percent a year) for tax purposes. The financial difficulties underlying debt restructuring make it fairly easy to circumvent this obstacle. Equity and asset acquisition Equity and asset acquisitions can be treated as tax-neutral only if at least 75 percent of the shares or assets of the enterprise concerned are acquired. In addition, the non-equity consideration

Tax and legal

A

C

Abroad

China

Before transfer

A

C

Abroad

China

After transfer

B

100%

cannot exceed 15 percent of the total consideration of the acquisition. Merger Favourable tax treatment of mergers is only possible if all assets and liabilities of the pre-merger enterprise are transferred to the merged enterprise. In addition, as above, the non-equity consideration cannot exceed 15 percent of the total consideration of the acquisition. A merger within an group company can be tax-neutral under the same conditions, but does not require that a consideration is paid. Tax loss carry-forwards from before the merger can be utilised up to the pre-merger enterprise�s net assets (assets minus not equity-related liabilites at market value), multiplied by the interest rate of the Chinese government bond with the longest period to maturity as of the time of the merger.

Case 1 Case 2 A non-TRE (A) transfers its equity interest in a TRE (C) to another TRE (B) in which A has a 100 percent direct ownership.

Spin-off A tax exemption shall be granted if the non-equity consideration does not exceed 15 percent of the total consideration of the acquisition.

The restructuring circular does not lay out restrictions on C�s capital structure, and so in all likelihood C can also be a joint venture (JV) with a Chinese or another foreign JV partner.

Tax loss carry-forwards from before the spin-off are to be pro-rated and shared by the spin-off enterprises according to the market value of their spun-off assets. The spin-off enterprises can then use the portion assigned to them in the future.

This case mainly covers the creation of domestic Chinese holding companies.

A

C

Abroad

China

Before transfer

A

C

Abroad

China

After transfer

D

100%

Where a spin-off does not fulfil the above requirements for a special restructuring, only the enterprise being spun off can use previously existing tax loss carry-forwards, not a new spun-off entity. Tax exemption for cross-border transactions Cross-border transactions are tax-exempt only if they satisfy the above basic criteria for special restructurings and fall under one of the three types of restructuring described in the circular: Case 1 A non-tax resident enterprise (non-TRE, referred to as A) transfers its equity in a tax resident enterprise (TRE, referred to as C) to another non-TRE (B) in which A holds a 100 percent direct ownership.

Case 2 A tax exemption is granted only if A and B are subject to the same withholding tax rate on capital gains and dividends. Furthermore, A undertakes not to dispose its shares in B for three years.

Case 3 A TRE (C) uses its equity or assets to invest in a non-TRE (A) in which C has a 100 percent direct ownership. Capital gains arising from the transfer of equity or assets can be spread over 10 years (10 percent a year) for tax purposes.

This case mainly covers the creation of international holding companies.

The Chinese tax authorities can grant tax exemptions for cross-border restructuring, independent of whether the basic criteria and case constellations apply at their own discreation.


Tax and legal

A

C

Abroad

China

Before transfer

A

C

Abroad

China

After transfer

100%Shareholder

Investment by means of equity/assets

Case 3 Further aspects concerning the tax treatment of restructurings According to the circular, essential related transactions such as the transfer of equity or assets or the sale of assets undertaken in multiple steps within 12 months before or after a restructuring are to be treated as a single restructuring transaction. This new regulation reflects the �substance over form� principle and complies with standard international practices. The circular stipulates that enterprises that fulfil the criteria for a special restructuring must document the transaction and submit the documentation � together with their corporate tax filing � to the tax authorities after the fiscal year in which the transaction took place. Should documentation not be submitted, the preferential tax treatment will not be recognised. Taxing liquidation

Liquidation Liquidation refers to the process by which an enterprise is brought to an end and by which receivables are collected and debt paid off. Then any assets remaining after payment of liabilities and expenses are distributed among the shareholders.

The liquidation circular lays out the tax treatment of the liquidation of an enterprise as follows: Treatment of the liquidated enterprise: ●

●

●

●

Total assets, whether sold or distributed directly to the share-holders, shall be deemed to have been sold, whereby the realisable value or transaction price will serve as the sale price for corporate tax purposes. Regardless of its duration, the entire liquidation period shall be treated as a tax year.

Treatment of the shareholders:

The residual assets distributed to the shareholders are to be taxed as dividend or investment income to the extent of their

individual share of the undistributed profits and retained earnings of the liquidated enterprise. If the residual assets minus the dividend income are more or less than an individual shareholder�s investment, they will be treated as a gain or loss from the liquidation for tax purposes.

The same is found in the implementation provisions of the new corporate tax law. Conclusion Given that the circulars cover complex matters and that many of their provisions are being implemented and interpreted for the first time, we can expect further circulars to clarify questions that arise. On the whole, the restructuring circular opens the door for a number of tax-favourable restructuring measures, which we believe to be sustainable in practice. Only the vague legal concept of reasonable commercial purpose gives reason for doubt. It remains to be seen how the tax authorities will apply this concept. Furthermore, the legal consequences and possible exceptions in cases where a criterion for special restructurings is later not met need to be further clarified � for example, when holding periods are unexpectedly not adhered to. The rules concerning cross-border transactions have also been scaled back compared with previous drafts. In some cases it might prove worthwhile to apply for preferential tax treatment of cross-border restructurings not addressed by the circular. Here, too, we will have to see how this will work in practice. If you have any questions or want to find out more, simply call us or send an e-mail.

Contacts [email protected] Phone: +49 211 981-7255 [email protected] Phone: +49 211 981-7429 [email protected] Phone: +49 211 981-7223 [email protected] Phone: +86 21 2323-2372






Tax and legal


Driving – and taxing – vehicles in China Here’s some advice, if you plan to get behind the wheel and drive in China: Don’t! First of all, traffic in large cities like Shanghai and Beijing is so chaotic that it will take the fun out of driving. Secondly there is no guarantee that you will be afforded your legal rights if you are involved in an accident. – If this warning is not enough to scare you away, read on. This article will provide you with some information about the Chinese auto market. Before anyone can dream of driving his own car, he will have to jump through a number of hoops unfamiliar to foreign buyers. Keep in mind that cars are considered luxury goods in China and taxed accordingly. The tax rates have been changed many times – including recently – for political reasons as lawmakers move further and further away from taxing automobiles as luxury goods. Nevertheless buying a car is China is an expensive affair. Vehicle acquisition tax A consumption tax known as the vehicle acquisition tax is levied on the purchase of vehicles. The tax rate is based on engine size and was adjusted on 1 September 2008 as follows:

Engine size Tax rate up to 30 August 2009

Tax rate after 1 September 2009

Up to 1 litre 3% 1%

1 to 2 litres 5% 5%

2 to 3 litres 9% 9%

3 to 4 litres 15% 25%

over 4 litres 20% 40%

Vehicle acquisition tax as of September 2009 The larger tax gaps were introduced to boost sales of more efficient vehicles and thereby reduce environmental pollution. The vehicle acquisition tax is levied at the time of sale or import and paid by the manufacturer. The tax rate is to be applied to the sale price (minus VAT), or to the import value (incl. duty) when importing a vehicle. Vehicle purchase tax The vehicle purchase tax rate is 10 percent. It was reduced to 5 percent for vehicles with engines smaller than 1,600cc to help stimulate the economy between 20 January and 31 December 2009. Although it was intended mainly to help the Chinese auto industry, the reduction also applies to imported vehicles. Value added tax VAT is 17 percent and also levied on vehicle sales. License plates You have to register your vehicle with the Municipal Public Security Bureau. There you will receive a license plate. Be aware that if you want to register your vehicle in Shanghai, you will have

This article explains: ● how the costs for purchasing a vehicle are calculated in China. ● what taxes are levied on car owners in China. ● what to keep in mind before driving off with a car purchased in

China.

to pay a handsome price for your license plate as the city sells them at the Shanghai International Commodity Auction Co. in an attempt to limit the number of vehicles. A batch of about 5,000 are auctioned every month, with the average price in February at 33,394 renminbi (RMB, roughly €3,680). There were 16,848 bidders at that auction, meaning less than a third could get their hands on a license plate. In 2008 a total of 84,500 license plates were auctioned off in Shanghai. Beijing has introduced temporary driving bans in order to reduce air pollution. At first, during the Olympics, vehicles were banned from the roads on alternate days – depending on whether their license plates were odd or even. Since October they are banned one day a week on a rotation basis according to license plate numbers: Day Number ending in

Monday 1 and 6

Tuesday 2 and 7

Wednesday 3 and 8

Thursday 4 and 9

Friday 5 and 0

Driving ban based on license plate numbers in Beijing Import duties You can also purchase imported vehicles in China, on which a duty of 25 percent is levied. But as measured by total sales very few vehicles are imported to China, and they are usually in the upper price range. As a result of this high import duty, foreign manufacturers are increasingly forced to produce vehicles intended for the Chinese market in China. Production has not, however, been completely moved there; a lot of parts are still imported from abroad. Automotive parts are subject to a 10 percent import duty. This difference in import duty aims to encourage production in China. That said, it is not possible to import and assemble finished parts at the lower import duty rate. If the proportion of parts produced in China is too low (under 40 percent), retroactive duties will have to be paid on the imported parts. A surcharge of 15 percent is then due. In 2008 automotive parts valuing $16.3 billion were imported, as were 410,000 vehicles valued at $15.1 billion. It may also interest you to know that China prohibits the import of used vehicles!

Tax and legal

Do you know that car sales is women�s domain in China?

Around 70 percent of car salespeople in China are female.


你知道了吗

A real-life example Let�s assume you want to buy an imported vehicle that was valued at the time of import for tax purposes at �20,000. Its net retail price (excl. VAT) is �35,000. The vehicle has a 2.5-litre engine, and you would like to register it in Shanghai. How much will you have to pay before you can get behind the wheel?

Expense Taxpayer

(responsible person)

RMB

Import value 200,000

Import duty (25 percent of RMB200,000) Importer 50,000

Vehicle acquisition tax (9 percent of import value [incl. duty] of RMB250,000 plus acquisition tax [excl. import VAT])

Importer

24,725

Importer margin 25,275

Price for dealer 300,000

Vehicle purchase tax (10 percent of RMB350,000 [excl. VAT])

Dealer representing the customer 35,000

Dealer margin 15,000

Net retail price (excl. VAT) 350,000

VAT (17 percent of RMB350,000) Dealer 59,500

Retail price (incl. VAT) 409,500

License plate (Shanghai) Customer 33,500

Customer�s total acquisition costs 443,000

These prices include one RMB of duty tax per litre of unleaded (RMB0.8 per litre of diesel). Taxes were raised sharply on 1 January 2009; until then they were only RMB0.2 (unleaded) and RMB0.1 (diesel). The amounts are very low compared to the taxes levied under the German Energy Tax Act, which charges �0.6545 euro per litre of unleaded and �0.4704 euro per litre of diesel. So petrol prices in China are made up of only about 36 percent duty tax � in Germany it�s now around 70 percent! Driving license

Total acquisition costs for a vehicle purchase (RMB443,000 is about �48,800)

Driving a vehicle without a valid license is a punishable offence. Foreign driving licenses and the international driving permit are not recognised. Foreigners who would like to acquire a Chinese driving license and posses a foreign or international driving license have only to pass a theory test; the driving element is waived. The theory examination can also be taken in English

As seen here the taxes, fees and import duties lead to a mark-up of 86.1 percent of the value added (import value plus margin). If you were to buy a vehicle manufactured in China with imported parts valued at �10,000, this figure would be reduced to about 61 percent.

Traffic laws

In China you�ll find the standard international traffic signs. Penalty points are assigned for violating traffic laws, and anyone who accumulates too many points within a given period of time must retake a road test. As you of course know, Germany has a similar point system.

Vehicle and vessel use tax This is an annual tax levied by municipalities. It usually lies between RMB60 and RMB320; the municipalities are permitted to set the tax rate themselves. Vehicle and vessel license plate tax Alternatives to driving Municipalities also levy this type of tax annually. It usually lies between RMB15 and RMB80; the municipalities are permitted to set this taxation rate as well.

Whether or not this article has raised doubts about sitting behind the wheel in China, there are of course several alternatives available.

●

●

Public transportation such as trains and buses is very cheap compared to Germany. However the public transportation network is very patchy, even in large cities.

Petrol prices Petrol prices are controlled by the National Development and Reform Commission. Taxes are also levied on petroleum products. China now needs to import almost half of the eight million barrels of petroleum it uses every day. One-litre prices at the pumps are as follows in Shanghai:

Taxis are a comfortable, flexible and affordable alternative to driving on your own. For example, a taxi ride from Shanghai�s Pudong International Airport to the domestic Hongqiao Airport 60 kilometres away costs about �20 (the late-night rate between 11pm and 5am is more expensive). Taxi drivers have a driving style that takes some getting used to, however, and

● ●

Unleaded: around RMB4.55 (about �0.51) Diesel: RMB4.71 (about �0.52)


Tax and legal

the taxis look like they�ve been on the road for decades. This appearance is deceptive as most taxis are less than five years old.

● Many foreigners therefore prefer to use a chauffeur service, for which employers cover the expenses for safety�s sake: employers do not want to expose their employees to the legal uncertainty of a possible traffic accident. A driver costs between RMB2,000 and RMB3,000 a month. The complete package � vehicle and operational expenses including petrol and driver � cost between 1,000 and 2,000 euros a month depending on the vehicle type.

If you have any questions, call us or simply send an e-mail.




Tax and legal


Tax presence in China: practical variations and applications Many European companies maintain extensive business relations with China without having an own subsidiary on site. Such business relationships can be of a highly varied nature and range from the purchase and sale of products through representative offices to providing local services and labour. These enterprises need a solid understanding of what constitutes a tax presence (permanent establishment) in China and which taxes it is subject to. - This article advises on the regulations which apply to your company and the best way to proceed. Chinese authorities have made considerable changes to tax laws over the last few years; in January 2008, a unified tax code was introduced which applies to both Chinese and foreign companies and is thus in compliance with the regulations of the World Trade Organization. Tax residents and non-residents Despite the extensive changes to Chinese tax laws, the term ‘permanent establishment’ has yet found its way into law – tax laws speak only of ‘establishments’ without providing a concrete interpretation. While it is true that the term is included in the double taxation agreements that China has ratified, it is still not automatically applicable under domestic Chinese tax law. Chinese tax law does however differentiate between tax residents and non-residents. The former are defined as companies which were founded in compliance with Chinese law or have their management (head office) in China, although the definition of ‘management’ is not entirely identical with the definition of ‘effective management’ found in the model agreement of the Organisation for Economic Cooperation and Development (OECD). A company founded in compliance with foreign laws is considered a resident for tax purposes if the company is controlled in China, that is if the staff, accounting department and the majority of assets are located in China. These tax resident enterprises (TRE) are subject to unlimited tax liability in China. Non-tax residents may have limited liability, whereby income allocated to a tax presence (permanent establishment) is subject to the standard 25 percent corporate tax rate. In China, the double taxation agreement is the only document to include a definition of permanent establishments, and even there it is closer to the United Nations’ model agreement than to the one of the OECD. As such not only the effective place of management, a subsidiary, a branch office, a factory or other points listed in the OECD agreement are considered permanent establishments but also those sites where services are provided. As a consequence, even the supervisory activities connected with construction sites or installation projects can result in a permanent establishment when the project lasts for six months or more.

This article explains: ● how Chinese law defines a permanent establishment. ● what a representative office is. ● which of the three methods you can use to calculate the profit of a

permanent establishment in China.

Project duration A project is considered to begin on the first day of the month in which the first foreign employee starts work in China and to continue until the last day of the month in which the last employee leaves the country. This means that even if a worker is only in the country for one day, it will still count as an entire month. A month may be subtracted from the total project duration when foreign employees are out of the country for at least 30 consecutive days in between visits.

Representative offices In practice, foreign companies mostly become subject to limited tax liability in China when they establish a representative office (RO) or work on a project in China for more than six months. A true representative office does not qualify as a permanent establishment under the Chinese double taxation agreement. However, after gaining some first market experience many representative offices expand their activities to conduct business themselves or act as a broker between other transacting parties. These activities are not only more extensive than those foreseen in the initial business licence but also go beyond the scope of mere representation. While the sites are considered ‘representative offices’ on paper, they are in reality permanent establishments and therefore subject to taxation under both Chinese tax law and the applicable Chinese double taxation agreement. In such cases the company’s home country will take steps to assure that no double taxation occurs, such as waiving taxes or giving tax credits for taxes paid abroad. The obligation to file a tax return Any foreign company with limited tax liability is required to file a tax return. To do so, it must first register its Chinese offices with the local Administrative Bureau of Industry and Commerce (ABIC) before it can register with the local tax office. Once registered, the company is obligated to file a tax return in its own name and declare the revenue earned by the permanent establishment. The methods used to do so are outlined further on in this article. In the two cases mentioned above – the foundation of a permanent establishment through an RO or through activities connected with a specific project – registration with the ABIC is guaranteed, since the ABIC will apply the standard procedure in both cases. If on the other hand a permanent establishment is triggered through some other activity then there may be no way to register at the ABIC, which in turn will make registration with the tax office more difficult or even impossible. The process can be held up for

Tax and legal

a number of reasons, ranging from the absence of registration forms to the refusal to allow registration due to deviation from procedure. The tax authorities tackle these problems with a good dose of pragmatism, usually by obligating the Chinese business partner to pay taxes for the foreign company. Even today, there are still no national guidelines on how to treat cases like these in China, although there are some regional standards. Consequently, it is usually up to the local authorities to find a way to register these permanent establishments for taxation. Taxation usually takes the form of a withholding tax for taxable income. The standard corporate tax rate here is 25 percent. Calculating taxable profits Foreign companies with limited tax liability in China are obligated to pay corporate tax on the profits earned by their tax presence (secondary tax domicile). Taxable income is calculated using one of the following three methods: ● ● ●

deemed income method cost plus method actual profit method

In practice, the deemed profit method is the most important since it calculates profit based on the turnover generated in China. This method is often preferred because the tax authorities can verify the turnover generated in China relatively easily and can determine the profit (third-party comparison) without needing access to information from the permanent establishment�s headquarters abroad. The following sections will explain in detail how profits are calculated in each of the three methods. Deemed income method This is the method preferred by the Chinese tax authorities. It determines the tax burden for a permanent establishment using gross revenue as a basis. The formula is:

Corporate Income Tax (CIT) Gross revenue x deemed profit rate x 25% (corporate tax rate)

The deemed profit rate is between 10 and 40 percent of revenue depending on which category of activity the tax authorities assign to the permanent establishment.

Business Tax (BT) Gross revenue x BT rate

The applicable BT rate depends on the type of service or activity and is usually somewhere between 3 and 5 percent, whereby

services provided by foreign companies usually have a tax rate of 5 percent. Cost plus method The cost plus method is primarily used when the cost base for the tax presence is relatively easy to determine. The costs are calculated and then an appropriate profit margin, generally 10 percent of the total costs including BT, is added. The tax burden is calculated as follows:

Gross Revenue Total expenses before BT : [BT tax rate � 10% (estimated profit margin)] CIT Gross revenue x 10% (estimated profit margin) x 25% (CIT) BT Gross revenue x BT rate (5%)

The total tax burden (CIT and BT) is thus 8.82 percent of total operating costs. The cost plus method is usually used for businesses that earn their income with transactions or by providing agency services (closing or brokering). In order to apply this method, the permanent establishment must be able to provide proof of all costs and expenditures in China. This information must then be confirmed at the end of the year by an auditing firm licensed in China. Actual profit method In theory, any Chinese permanent establishment may elect to use this method to calculate taxable profits. That said, it is extremely difficult for Chinese tax authorities to verify a permanent establishment�s effective profits, especially since it depends on how the company is structured, and on how the permanent establishment is linked to the foreign head office. As a consequence, Chinese tax authorities seldom accept this method and prefer the deemed income method. Generally the actual profit method is only used in a few regions in southern China (eg, in Guangdong Province), while it is hardly used in the north (eg, in Beijing) or in central China (eg, in Shanghai). Conclusions Foreign companies usually establish a tax presence in China through a representative office or work carried out in connection with a project. In the majority of cases, the taxable profits from these types of permanent establishments are either based on turnover or expenditures and can thus deviate from the actual profit. This can result in double taxation, especially in the case of a true representative office, in spite of double taxation treaties concluded by China.


Tax and legal

In practice, however, it is difficult in most of China to obtain an assessment based on effective profits. Most foreign companies therefore try to structure their Chinese operations in the most tax-effective manner possible using the methods for determining taxable income preferred by the Chinese authorities. Would you like to know more? Then give us a call or send an e-mail and we will be happy to provide you with further information.

Contacts [email protected] Phone: +86 21 2323 2372 [email protected] Phone: +41 58 792-4482

Do you know what �Chinglish� is?

The term refers to the Chinese�s creative use of the English language. Here are four real-life examples:

Take care of your slip (Slippery when wet) No entry on peacetime (Emergency exit) Question authority (Information booth) Please take advantage of the chambermaids (Feel free to call the room service)

So krummes Englisch sprechen die Chinesen, www.welt.de

你知道了吗




http://www.welt.de

Economic spotlight: Asia


Foreign direct investment in India: new rules for more transparency? We see the effects of the economic and financial crisis every day – for example, the decrease in foreign direct investment in many countries. China and India have certainly not been shielded from this downturn. In order to counteract it, both countries have spent the past months revising the rules governing foreign investment. The governments in Beijing and New Delhi hope to thereby rekindle the interest and enthusiasm of foreign investors. – What new rules has India in particular introduced? Here we take a look over China’s border to find out. India issued numerous guidelines at the beginning of 2009 to unify regulations on foreign investment, thereby, among other things, increasing transparency. Prime Minister Manmohan Singh’s government, which was recently re-elected, is expected to take further measures in the direction of liberalisation. After the victory of his Indian National Congress Party (Congress Party) in March, he has a broad base of support in Parliament with which to enact his political agenda. The following sections guide you through the rules governing foreign direct investments (FDIs) and highlight recent changes. The article then ends with a look at further developments expected in India.

China has simplified approval procedures. For more information read the article by Jens-Peter Otto on page 7 titled Investment: new powers to provincial governments should speed up process.

Current rules on foreign direct investment in India The activities of non-resident entities are subject to various legal conditions and approval requirements. Most of these are provisions of either the Foreign Investment Promotion Board or the Foreign Exchange Management Act. The establishment of the Foreign Investment Promotion Board and the passing of the Foreign Exchange Management Act were two essential steps to liberalising the market for foreign investors. They are clear signs that the government in New Delhi is interested in FDI and has been following a course of opening up its market for the past 10 years. It is thus possible to invest in the majority of sectors without prior approval. This can occur by the so-called automatic route. However, there are still sectors for which prior approval is required, meaning that licenses must be obtained (eg, for the cigarette and arms industries). Foreign investments are prohibited in areas such as gambling and betting, lotteries, nuclear energy, and – with some exceptions – agriculture.

This article explains: ● which rules apply to foreign direct investments in India. ● how guidelines issued in February have changed the foreign

investment climate. ● what further steps to liberalise foreign direct investment are on the

horizon.

The following are excluded from the automatic route: ● sectors reserved for small-scale enterprises ● sectors in which the foreign company has an existing venture ● sectors with foreign investment caps (eg, civil aviation, ground

services, telecommunications, banking, insurance, radio, television, satellite technology and single-brand retail)

In practice, investment is typically made directly by a non-resident entity in an Indian operating company or indirectly through an Indian investing company, whose shares are bought by the foreign investors. For sectors like telecommunications and radio, which are subject to restrictions on direct and indirect investments, there were guidelines for computing foreign investment. Uniform rules for all sectors did not exist until now.

Foreign Investment Promotion Board The Foreign Investment Promotion Board is a body founded to increase foreign investment inflows into India. All matters regarding FDI fall under its jurisdiction. It has been a part of the Ministry of Finance since 19 February 2003 and is responsible for: ● developing proposals on how to attract new investors to India; ● evaluating which measures are best suited to meet this goal; ● initiating directives to make India more attractive for FDI; ● advising the government on its efforts to promote foreign

investment. Foreign Exchange Management Act Passed in 1999, this law has been in effect since 2000. Its scope is to lay out rules for currency transactions and further develop the country’s exchange-rate policy and legislation. It replaced the 1973 Foreign Exchange Regulation Act in a move to bring India’s until-then restrictive foreign-exchange policy into line with the World Trade Organization. This was intended to facilitate trade and incorporate the Indian economy into the world market system. You can access the Foreign Exchange Management Act at: http://finmin.nic.in/the_ministry/dept_eco_affairs/america_canada/ fema_acts/index.htm

New methodology for computing foreign indirect investment In issuing various directives at the beginning of 2009, the government sought to make regulations for foreign investments simpler and more transparent as well as to establish a uniform methodology for computing actual investment in sectors with investment caps. The directives also provided clarifications for cases of indirect investment through an Indian holding company. Under the new rule, foreign indirect investment in sectors with investment caps will only be considered when the non-resident


http://finmin.nic.in/the_ministry/dept_eco_affairs/america_canada/


entity holds more than 50 percent of the Indian investing company or controls that company. Here �control� means the right to appoint a majority of the directors of the investing company. If, for example, the investing company is only 49 percent owned by foreign investors but controlled by them, the 49 percent holding in the investing company is not relevant in determining the cap on investment. Instead, the investing company�s holding in the Indian company is of significance. Investment caps and prohibitions do not apply in cases of foreign investment through an investing company that is more than 50 percent owned or controlled by resident Indian citizens. Should the Indian investing company have 100 percent ownership of the operating company then � in contrast to the case just described � the investment of the non-resident entity in the Indian investing company is used as the sole basis for determining the cap on investments. Investments include not only equity investments, but also: ● ● ● ● ●

portfolio investments by financial institutions; investments through American or global depository receipts; foreign currency convertible bonds; convertible preference shares; convertible currency debentures.

Investments made before the new directives are protected by a grandfather clause. That is, such cases do not need to be adjusted to the new directives. On the other hand, however, prior approval from the Foreign Investment Promotion Board is required for transfers of ownership or control (eg, through a sale or merger) from an Indian investor to a non-resident entity or foreign-owned or -controlled Indian company in sectors with investment caps or approval requirements. The directive has thus opened the door for foreign investment in an Indian investing company by way of a joint venture in restricted � that is, where a license is required � and prohibited sectors, for example, retail, telecommunications, arms, print media and radio. This is possible only if the Indian joint-venture partner owns a majority of or controls the investing company as described above. This is currently not the case for investments in the insurance sector, which has its own investment restrictions. In addition, the directives foresee additional restrictions in the print media and radio fields, as well as in the arms sector. Prospects for India The prospects for further reform have improved. The parliamentary elections in India have stabilised the government, as the Congress Party made notable and largely unexpected gains. Now that power has shifted, reformist Prime Minister Manmohan Singh�s government can take up reform that has been planned for years but could not yet be achieved. According to

observers, the caps on foreign direct investment in certain sectors could be progressively abolished, for example, in insurance, retail, arms and education. Budget proposals have been published. They are a moderate but important step to stimulate the economy. The stimulus package could be a hint of reforms to come. Look to pwc:china compass for up-to-date information on developments in China�s most populous neighbour. If you have any questions or want more information, please call us or simply send an e-mail.





Portrait

Marc Wintermantel Marc Wintermantel joined our Singapore office in April 2008. He began his career with PricewaterhouseCoopers (PwC) in 1996 in Stuttgart, where he was a part of our Transactions Advisory and Valuation and Strategy teams for nine years. Before moving to Singapore Mr Wintermantel spent three years on assignment in New York. There he worked with the US firm to further grow their Valuation Group. He is a trusted partner of our Transaction Services team in Singapore and his expertise lies in the assessment of mergers and acquisitions. Through many years of experience he has a deep understanding of Deal Advisory projects, including, for example, due diligence and purchase price allocations. He advises clients in Europe, the United States and Asia. Mr. Wintermantel is currently the East Cluster leader for valuations. Strongly committed to his new tasks, he works to expand and develop the staff of the East Cluster Valuations team and to facilitate networking among regional assessment experts. One of his primary focuses is European and American PwC clients planning or currently engaging in cross-border transactions in the Asia-Pacific region. He accompanies them and brings them together with the appropriate PwC experts, ensuring that each client is served by the most suitable team.

Personal details Marc Wintermantel, Partner Advisory, Singapore; born 1971, at PwC since 1996; member of the China Business Group since July 2008; hobbies: tennis, running, wakeboarding.


Publications

Investing in the Chinese pharmaceutical industry after health reform

Economic crime during economic crisis

China news on the PwC Portal

As you may have read, the article on page 13 headed Health care reform in China: what it means for the pharmaceutical industry describes the challenges that pharmaceutical companies in the Chinese market will face after national health reform. This reform will fundamentally change conditions for the pharmaceutical industry. For example, it foresees a central authority that will be responsible for the approval and control of drugs and oversee reimbursements through medical insurance. At the same time, China wants to encourage pharmaceutical research by alleviating taxes. So what�s in store for international pharmaceutical companies and medical technology manufacturers? A new study by PricewaterhouseCoopers� Global Pharmaceutical Team answers just that.

Investing in China�s Pharmaceutical Industry, 2nd Edition Published by PricewaterhouseCoopers, April 2009 Download www.pwc.de/de/pharma-china Contacts [email protected] Phone: +49 69 9585-5602 [email protected] Phone: +49 69 9585-5604

The economic downturn has turned up the heat and increased pressure on businesses and their employees. In the daily struggle for survival the line between proper and improper conduct is blurred, and it becomes easier to justify fraud. Is economic crime different during times of economic crisis? And if so, what does it mean for business in China? The piece on page 23 titled Economic crime during economic crisis: how to protect your firm tells you why emerging markets are more susceptible to fraudulent practices and what types of economic crime occur most frequently in China. PricewaterhouseCoopers China addresses the same topic in a new study which outlines potential risks and the strategies businesses can use to protect themselves.

Fraud in a downturn. A review of how fraud and other integrity risks will affect business in China Published by PricewaterhouseCoopers, June 2009 Download www.pwccn.com/home/eng/ cn_fraud_downturn_jun2009.html Contacts [email protected] Phone: +86 21 2323-3988 [email protected] Phone: +86 21 2323-3350

The China Business Group also regularly updates you on economic, tax and legal developments in China as well as in Hong Kong and Singapore at www.pwc.de. In addition, all editions of pwc:china compass are available for download on our site.

Download www.pwc.de/de/china Contacts [email protected] Phone: +49 40 6378-1600 [email protected] Phone: +49 40 6378-1337 [email protected] Phone: +49 711 25034-3226


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PwC China Business Group

Germany

Franz Nienborg Leader China Business Group Partner Assurance Phone: +49 40 6378-1600 [email protected]

Nikolaus Thoens Partner Tax Phone: +49 211 981-7345 [email protected]

Volker Fitzner Partner Advisory Phone: +49 69 9585-5602 [email protected]

Katja Banik Operations Manager Phone: +49 40 6378-1337 [email protected]

Beijing

Hong Kong

Ling Chen Operations Manager Phone: +49 711 25034-3226 [email protected]

Roland Spahr Associate Director Advisory Phone: +86 10 6533-7124 [email protected]

Dirk Bongers Senior Manager Tax Phone: +86 10 6533-3316 [email protected]

Björn Vogt Manager Process Assurance Phone: +852 2289-1907 [email protected]

Shanghai

Singapore

Claus Schürmann Director Tax Phone: +86 21 2323-2372 claus.wp.schuermann @cn.pwc.com

Jens-Peter Otto Partner Assurance Phone: +86 21 2323-3350 [email protected]

Ralph Dreher Senior Manager Tax Phone: +86 21 2323-2723 [email protected]

Marc Wintermantel Partner Advisory Phone: +65 6236-7378 marc.wintermantel @sg.pwc.com









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Imprint

Publisher PricewaterhouseCoopers AG Wirtschaftsprüfungsgesellschaft New-York-Ring 13 22297 Hamburg www.pwc.de Managing editor Katja Banik [email protected] Phone: +49 40 6378-1337 www.pwc.de/de/china Subscriptions and address changes [email protected] Fax: +49 69 9585-902010 Translation transparent Language Solutions Berlin Typesetting Nina Irmer, Digitale Gestaltung & Medienproduktion Frankfurt am Main The articles herein are intended as information for our clients. For resolution of relevant issues, please refer to the sources provided or to the China Business Group in your local PricewaterhouseCoopers office. No portion of this publication may be reproduced or duplicated without the express prior written consent of the publisher. The opinions expressed herein reflect those of the individual authors. © August 2009 PricewaterhouseCoopers refers to the German firm PricewaterhouseCoopers AG Wirtschaftsprüfungsgesellschaft and the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity.


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Documents

pwc:china compass Summer 2009 · On 16 March of this year, MOFCOM issued its Measures for the Administration of Outbound Investment, which became effective on 1 May 2009. According