Accessing the Domestic Chinese Market: An Insider's Perspective
China is vast, and its annual economic growth rate has been holding steady at around 8-9 per cent in recent years. It has a population of some 1.3 billion people, 94 million of whom are already online users (a number that is expected to exceed its US equivalent by 2009), and its daily TV audience reportedly amounts to a staggering 1 billion people.
While actual penetration rates are hard to determine, China’s people own 66 per cent more mobile phones than their US counterparts – with 4-6 million new subscribers added every month – and 50 per cent more TV sets. It is also estimated that 45 per cent of the gross national income is generated by a mere 20 per cent of the population (which amounts to some 240 million people – almost the entire population of the United States).
How developed is this market? While difficult to measure, it surely has a long way to go. Today, the wealth impact from successful economic reform is mainly generated at the major cities in China along the coastal areas, and this phenomena has the potential to repeat in many more cities as China deepens its economic reform in the central and western regions.
China has been protective in opening its trading and distribution services sector. Prior to 11 December 2004, when the three-year transition period lapsed, foreign investors wanting their own distribution vehicles in China had to resort to trading companies established in free trade zones, minority-owned joint ventures, or China investment holding companies (for some 250 investors who are big enough to afford them). None of these structures were able to serve the full needs of foreign investors, due to restrictions imposed on geographical presence, source of products, import/export rights and business scope limitation etc.
A significant breakthrough came last year when the Ministry of Commerce (MOFCOM) issued its Administrative Measure for Foreign Investment in the Commercial Sector (the New Measure), commonly referred to as Circular 8. This enables a foreign investor to establish a wholly-owned company anywhere in China, with full-fledged trading and distribution rights for as little capital as US$4,000, subject to approval.
The key barriers discussed in this article have also been removed, and there is no longer a distinction made between foreign and domestic trade. As a result, companies are no longer required to segment their marketing efforts and can present a single, coherent ‘face’ to the marketplace.
A regulation with such a far-reaching effect as Circular 8 does come with a unique set of implementation issues and there is clearly a need for proactive dialogue and ongoing clarification from the Chinese authorities. Despite these implementation challenges, the issuance of Circular 8 makes tapping the domestic market a real possibility for many smaller to medium size companies who wish to exert direct control over their business activities in China.
Circular 8 has also prompted existing investors to review the effectiveness of their current business models, and make their distribution structures more streamlined and tax-effective. Based on their specific commercial needs, these investors might now consider:
Besides setting up green-field operations, mergers and acquisitions (M&A) have become an increasingly popular way of accessing China’s domestic market. Foreign companies with good products and services may not necessarily have an effective distribution network within China, especially in previously protected sectors. In the banking sector, for instance, HSBC spent over US$1bn to acquire a 19.9 per cent stake in Bank of Communications, China’s fifth-largest lender (with some 2,700 branches).
HSBC also paid US$600m for a 10 per cent stake in China’s second biggest life insurance company, Ping An Insurance, and has announced its intention to acquire an additional 9.91 per cent stake. In the beverage industry, we also saw America’s Anheuser-Busch spend US$650m to acquire Harbin, China’s fourth-largest beer producer. In the retail market, the UK’s Tesco – the world’s third largest retailer – has acquired a 50 per cent stake in a chain of 25 hypermarkets in China at a cost of $260m.
China’s long-established preferential income tax policies – designed to attract foreign direct investment – is now bearing fruit. From a base rate of 33 per cent, generous tax holidays and reduced rates were offered for a wide range of activities, resulting in foreign investors paying on average an effective tax rate of about 10-15 per cent in China (whereas domestic companies are generally taxed at 33 per cent). Tax holidays have been further extended for export-oriented or technologically advanced enterprises. Plus, China does not levy withholding tax on dividends remitted abroad.
Despite these tax advantages, a recent tax survey conducted by PricewaterhouseCoopers ranked China number one in the list of Asian countries that pose the greatest tax challenge. This is not unexpected. A country such as China, with its high investment growth, invariably presents significant tax challenges.
China’s tax and investment regulations are constantly changing, and often lack interpretive clarity and consistency in implementation. China also adopts a fairly aggressive audit approach, and a hefty penalty and surcharge regime. Worst of all, China’s current legal system does not provide an effective appeal process.
Foreign investors also have to contend with a rather complex turnover tax regime in China, which includes a production-based VAT system, an irrecoverable service tax called business tax, consumption tax, and an unusual VAT tax for exported goods. In addition, China imposes individual income tax on a graduated scale, with a maximum rate of 45 per cent. Employers face serious penalties if they fail to properly withhold individual income taxes.
China also requires the payors to go through various strict tax clearance procedures, prior to each overseas remittance of fee, so as to ensure that the remittances are legitimate and relevant taxes are collected.
Also adding to the tax challenges is the fact that the income tax preference package for foreign investment is going to tighten in future tax reform efforts. When it comes to its business and tax environments, China is clearly intent on creating a level playing field for both domestic and foreign companies alike. This is likely to result in higher income taxes for many foreign investors; hence the need for them to re-examine their tax planning strategies.
There is no magic formula. For companies contemplating a move into China, they must do their homework and should seek out reliable and authoritative guidance. Faced with the challenges of a vast but fragmented market, and the strong protectionist barriers that still exist, foreign investors need to consider their entry plans carefully.
For instance, is a Chinese joint venture (JV) partner needed and will the Chinese partner be able to deliver the business benefits expected from them? Should a company grow via an organic approach, or through acquisitions? Have the investors consider the enormous cultural differences that exist in terms of doing business in the East and in the West, and how such differences may affect the market approach, business practices, people strategy, and interaction with government bodies in China.
From the tax and regulatory perspectives, investment holding structure, financing arrangements, profit repatriation strategies have to be considered at the inception of each investment as they impact directly on after-tax return on investment, ability to restructure in the future and ability to repatriate hard-earned cash out of China.
Investors need to become familiar with national and local regulations as well as local practices governing the use of loans, royalties, interest charges, etc. This is especially important in a country such as China where enterprises have to deal with authorities to implement the structures.
Effective tax planning has to be able to consider indirect tax implications in China, whether this is customs duty, business tax or value added tax: it is a complex tax area. Additionally, transfer pricing is often the centrepiece of all tax planning as well as scrutiny by tax authorities.
It is essential to apply a balanced view on transfer pricing matters and support the same with documentations. The PRC tax authorities are determined to regulate this area with rules expected on documentation in the near future.
China offers huge opportunities for those willing to rise to the many challenges that exist, and they are many and various: business, political, cultural, social, economic and linguistic. However, the rewards are commensurately high, provided foreign investors and companies take a well-considered and circumspect approach to entry and to growth. So, never go it alone – our advice would always be to talk first to the experts on the ground in China.
Reprinted with permission. This article is reproduced from its original publication entitled “Accessing the Domestic Chinese Market: An Insider’s Perspective”. Copyrights 2006 PricewaterhouseCoopers. All rights reserved. PricewaterhouseCoopers refers to the China firm of PricewaterhouseCoopers or, as the context requires, the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity. The information in this article is not meant to be comprehensive advice. Readers should retain their own advisers and specific action should not be taken without consultation.