China Law Blog

Fascinating post, Dan. I think you implied this, but I would like to clarify my understanding.

What you're saying is that foreign and Chinese companies are all subject to the same laws, but different levels of enforcement. The fact that some (maybe all?) Chinese companies are able to negotiate lower taxes with local authorities gives them a natural advantage over foreign companies competing in the same market segments.

Is that about right?

I have a question: in your discussion with Mr. Perkowski, what does the term "testers" refer to?

About the employee taxes: is there anything like a Chinese equivalent to the "independent contractor" here in the U.S.? Someone who works for a company but not as an official employee, and who must handle their own taxes? Maybe this is more a tax question than a legal question, but it also leads me to wonder: if this small, successful company has been operating "off the grid" for years, is it really unfair that they now comply? Even if they never suspected that this particular bill would come, that might not be so bad if they are being allowed to get up to speed rather than just having their accounts frozen or being bounced out of the business altogether.

Maybe I am missing something obvious, but is it a bit odd that so many "western" companies (at least the ones that have been in China for awhile) that benefited from lax (or no) enforcement or enactment of labor laws become so upset when asked to pony up. Wasn't it this same, somewhat freewheeling environment that allowed companies to come in and prosper? It is not as if the gravy train has been completely derailed.

"What you're saying is that foreign and Chinese companies are all subject to the same laws, but different levels of enforcement."
For me that is the same as being applied different laws.

"Chinese companies are able to negotiate lower taxes with local authorities gives them a natural advantage over foreign companies competing in the same market segments."
Or, effectively, no taxes at all.

As far as I can see it, low end market is effectively closed for foreign firms.
What is the function of foreign firms in China's market? To provide a model, incentive, target, improve competence of future modern chinese companies.

As Chinese companies climb at the ladder, many foreign firms will be progressively squeezed out of the market. What will remain? Some big corporations, Join companies and some strategic companies.

China is a hard market, not only due to its inherent competitiveness but also to the fact that your Chinese opponents, if you play at its same level, uses trumped cards.

While the level of most Chinese companies is low there will be room enough for foreign companies, as the level raises. Who can tell?

A couple of years ago when I came across Pierre Cardin t shirts in a Jinkelong in Beijing I thought they were just knock offs that picked a foreign name to slap on cheap clothes. Later on I ran into someone who works for Pierre Cardin who told me that no, they're authentic. PC looked at the size of the high end vs. the low end market and decided that they really had to stake out some market share in the low end of the market.

I don't really know how well they're doing, but I found it fascinating that a brand which caters to the luxury market in the West would dip into the mass market in China.

why not register the company in HK and set up an office in China to do the business ? I heard that works. foreign companies stands for high end products in most people's opinion, so why bother in low end industry.

What concerns me is that the contributions of the Western company would be negligible in most cases, and any Chinese manager good enough to run your low end in China should probably be an entrepreneur (or might leave soon enough to start his/her own business). The staff and management would have to be wholly Chinese. Any Westerner on staff would be dead weight because they'd command too high of a salary while not being able to understand the low end market (at least as well as a Chinese manager for a comparable salary). The only real contribution the Western company could make is cash and a TM, and in limited cases a patent. All significant, but the banks are being encouraged to lend, low end economically exploitable patents I presume are rarer, and the use of your mark might dilute your quality in the eyes of the consumers (Buick, anybody?).

In the face of naysayers like me it is helpful to remember the words of businessmen. Before Tesco entered the largest market in the world with Fresh&Easy, they conducted years of research on their target country's eating habits, developed superior logistics lines, and imported their unique computer software which tracks and responds to customer purchasing habits unlike anything else in the country. The CEO said that it only cost $1 or $2 billion, and if they fail they can easily afford it. So, maybe it's time a Western company gave it a whirl.

In any local market, if you do not possess a competitive advantage or technology that is foreign-- you are going to be at a disadvantage vis-a-vis local players.

They know the markets better than you do and can act faster, with more precision. However, if you are willing to take the time to understand local rules and practices-- you will be able to compete eventually.

The problem is, of course, this is a process of unpredictable length. In China, it might take your company a couple years-- which means losing money and which means it might be poison for your career.

To answer the question, I believe it's possible for Americans or other foreigners to compete in the low end markets-- but they better bring some type of technological advantage into China if they want to bypass the years of experience it takes to actually adapt to that market.

If they don't, they have to try, fail and try again. The local tax policies will always favor local chinese companies, but logically, one must assume Western companies actually have advantages over their Chinese counterparts and any local government will be subject to pressure to protect their industries.

No sense in complaining, because everyone knows it's not going to change anything. It's just the rules of the game right now.

All companies, regardless of nature of ownership (foreign or Chinese) are subject to the same laws in China. They all pay the same rate of sales tax (5.5%) and corporate income tax (25%). There are some expceptions, for example, Chinese companies in the high-tech industry in some specific areas are entitled to enjoy some tax exemption. However, these companies have to apply for the status (qualification) and continuously prove they are genuinely engaged in the high-tech industry to get the tax exemption.

Chinese companies are not able to negotiate lower taxes with local authorities. If they pay less taxes than they should have, then they are evading taxes illegally. Once found, they will be punished. So the problem is not with the system. I assume the Chinese competitors of the American company are evading taxes illegally or the American company need to look at itself to find out if its cost per unit product/service is too high that makes it less competitive.

Also, I wonder what the nature of the entity of the American company operating in China is? If it is not a WFOE, how can it get revenue without paying taxes? It sounds to me like illegal operation. The American company definitely need to operate legally! How to compete with your Chinese competitors? 1. Be legal; 2. Localize your company (including staff salary, etc. With too many foreign employees, it is hard to keep the salary down) 3. Alway improve your product/service.

Why did Henry Kissinger ever even start playing ping pong with these people? And who decided to let them into the WTO?

How can foreign companies "play legal" in China when Chinese companies do not? I admire any foreigner trying to run a small business in China.

But you wouldn't catch me dead trying to do it. I'd rather starve in the West. And by the way, there are plenty of authentically legal and reasonable ways to make lots of money in countries where "rule of law" actually means something.

Somehow, business in China is more intense than most other places in the world. Foreign WFOE type companies might have an advantage, in being closer to their end customers - while native Chinese companies might have the advantage of having closer relationships with local government officials, and perhaps a better understanding of how to manage a local workforce.

After those considerations are taken into account - you generally need to keep improving your product and productivity if you want to remain competitive in most industries nowadays - high end or low end.

@Hang

"If they pay less taxes than they should have, then they are evading taxes illegally. Once found, they will be punished"

I am not so sure about that!!

The real question is the willingness of local governments with close and many time financial and familial relationships with local businesses to actually enforce the National Laws coming out of Beijing (de jure vs de facto).

A Chinese professor of economics at an MBA program here (Harvard Phd - US MBA teaching experience)summed this up wonderfully about how China used to have very high corporate tax rates with a knowing "wink" about enforcement, and now that they have reduced the rates they are trying to increase enforcement, but the nature of local govt/private collusion is such that this is very difficult (it took Zhu Rongji 2 years of effort to take Fujian province back from Lai)

I once was hired by a smart and astute German GM to recruit a new Financial controller for a German family owned mfg company that competed very successfully in the low end. They had 95% equity, but the operation was essentially run by the local Deputy GM (5% equity j/v)with the previous German GM's being totally unaware of what was actually going on (family members in key positions and non-compliance with PRC laws - employees intimidated by the DGM).

This Financial Controller came out of a major multinational and found out that the company which was "profitable" for 10 years of operations wasn't as they had never paid social insurance for their workers, and that with those payments they would be in the red (a huge liability requiring re-working years of financial statements)

After 2 months of being stymied with every effort she initiated to reform the system, she finally gave up and said "Wo gai ge bu liao" (I can't reform this operation).

The Deputy GM was really running the company like the pure local companies they were competing with the aura of German engineering/patents giving the product a superior position in the market. (it was later discovered that he also was running a parallel company using the company's sophisticated machine tools as well).

The moral of the story in my mind is that the odds are stacked against you on the low end if you as a foreign company must be in compliance with every very admirable law that is promulgated from Beijing due to both your status as a "guest" and as a matter of home country regulations (thinking US FCPA here).

I have heard similar stories from many other sources over my 13 years here.

By the way, purchasing is one area where the greatest amount of kickbacks and corruption occurs in China as sales people are always offering "advantages". I have had many a client over the years who have hired us to find an "incorruptible" purchasing manager (not easy!!) and have even heard stories of local headhunters being in cahoots with those they place!!! from a private investigator friend who was routing out fraud in foreign companies.

Is the enforcement environment improving? yes
Is it strong enough to provide a fair playing field in the lower end market? not at this point.

Oh and foreign local salaries are in many cases these days much lower than top Chinese manager salaries and actually are not a big % factor of overall costs unless you have 10 expats!!

@ Terry

In my view, local governments are willing to enforce the tax laws, otherwise they would be the victim of their reluctance. Tax income is important to local governments. Punishment for tax evading is not uncommon in China.

Regarding the problem of the German family company mentioned in your post, I don't doubt it at all. Because personally, I have seen a similar case with a British company in China. My blame goes to both the German owner/GM and the Deputy General Manager(DGM) in your case. This will take a really long paragraph to explain, which I do not intend to do here. I blame the GM for 1) using the wrong person; 2) leaving the managment of the company to the wrong person; 3) failing to establish effective communication with managers working under the DGM at the beginning. I understand how the Financial Controller must have felt when she gave up and said "Wo gai ge bu liao" (I can't reform this operation). Remember she is not in full charge of the company. However, she's working to change some routines of the company, which was established under the current DGM who is still in charge and I assume he is resistant to the changes.

The case you mentioned seems to be a typical case for many foreign companies in China to study.

Also, I cannot agree more with what Danny said in his post that Chinese companies have a better understanding of how to manage a local workforce. I'd like to say that Chinese companies also have a much better understanding of their consumers (especially in the low-end market). Just look at how yahoo, ebay and amazon,etc. lost their grounds and were overtaken by their Chinese competitors, you'll know what I am saying. Are they localized companies? You may say 'yes' but I would say 'no'. Localization is more than employing local people.

Dan.

Were foreign firms not so afraid of diminishing the brand, entering China's low end market would not be a problem.

But they are afraid of diminishing their brand, and 9 times out of 10 that means that regardless of the proven market potential or local executive buy in, the folks back home are just not going to sign off.

R

Terry: The moral of the story in my mind is that the odds are stacked against you on the low end if you as a foreign company must be in compliance with every very admirable law that is promulgated from Beijing due to both your status as a "guest" and as a matter of home country regulations (thinking US FCPA here).

It's really a supply/demand thing. Ten years ago, people were willing to either explicitly or implicitly waive rules in order to get capital whether foreign or local. Today capital is no longer in short supply, and the Chinese central government has no particular reason to be "nice" to foreign companies. For that matter local companies are also in the same situation.

Foreign companies are finding it increasingly difficult to compete in low end manufacturing, but so are local companies. I was at a talk in which it was pointed out that toy manufacturers in southern China were going bankrupt left and right even before this current crisis.

What's happened is that the central government has made an decision to get China out of low end manufacturing so a lot of the "breaks" that people used to get in that area are disappearing. This decision was partly forced by recent events. As long as low end exports were providing jobs, the people would be willing to look the other way, but it's not any more. There are many more export factories than there is demand, so now is a good time to start tightening the rules to see who survives.

Also, the central government is facing huge social service costs dealing from the unemployment of people as factories close and a general desire to improve social services. This means more emphasis on tax collection.

Finally, compliance isn't a US/China thing. Go into a small construction business in the US. Do you really think that everyone has legal immigration status and all of the required taxes are being paid? As long as money is being made, people will look the other way, but you are in big trouble once the music stops.

...and another way to benefit from the economic growth of China but without having to put up with actually doing any business there is to buy shares in those foreign companies that benefit from Chinese growth... but are not based in China. (i.e. invest in all those cargos and cargo ships steaming out of Perth and nearby ports and heading north)

Such as Rio Tinto and Oz Minerals. This of course will work only provided the Aussies are smart enough not to sell their mineral assets to the Chinese during these temporarily difficult times.

And the Australian parliament and Foreign investment Board and the Aussie political parties certainly DO seem smart enough but not necessarily the CEO's and the boards of the companies involved.

Mr. Albanese in particular should be thrown out of Australia or put in prison. (not to mention also for the sheer stupidity of not accepting the earlier BHP Billiton offer) (wasn't there enough in it for him maybe?)

And Min Metals has just come back with another offer to buy up some of the best assets of Oz Minerals....(both in and out of Australia, incidentally, and for a measly 1.2 billion) (and it looks like either the deal has gone through or it will soon on this second round)...(the first attempt was blocked by the Foreign Investment Board for security reasons) And if anyone in Australia could still manage to block it, wake up mates.

The Australian government should also maybe take a hint from the U.S. Fed. Use the Central Bank balance sheet to temporarily buy up debt off of companies balance sheets. They can always pay it back with interest later, over time. But once the Chinese get their foot in the door, they will never let go of the bone.... and will instead smile all the way to the bank as they own more and more of Australia's mineral wealth. (and the next step will be to just move in)

So wake up Aussies, speak less Mandarin, and don't forget the "RRR". (Real Rugby Rules)....(which are to play to win)