One of the most interesting things about representing foreign companies that do business in or with China is how Chinese companies all seem to operate from the same playbook. Our China lawyers can go years without a Chinese company doing XY and Z and then all of a sudden, we will have five deals in a row where the Chinese company does XY and Z. Right now we are seeing a slew of Chinese companies seeking to become distributers of American products via Joint Ventures. Though this post focuses on this one sort of transaction, it has lessons about China company negotiating tactics that have universal value.
We represent many foreign companies that have their product made in China under a contract manufacturing arrangement. At the start, the foreign company targets its product sales in the North American and European markets. But as China’s consumers grow wealthier and more sophisticated, it often happens that the foreign company is approached about selling its products in China to Chinese customers.
When the foreign company investigates the situation, it turns out that such sales are more complex than they seem. Since the foreign company does not own the product until after the product is shipped outside China, sales within China involve a complex process of exporting out of China and then selling back into China. This results in the potential for VAT to be paid twice: once on the export and again on the import. As a result, the U.S. buyer of the contract manufactured product will often be approached by Chinese companies with elaborate schemes designed to avoid such taxation. Such schemes should virtually always be avoided.
Often the Chinese side will try to convince the foreign company to enter into a complex “partnership” or joint venture arrangement, so that the foreign entity participates in the conduct of the distribution business in China. Entering into such a partnership is almost always a mistake. Operating a distribution and sales business in China is complex and it rarely makes sense for a sensible Western company to get involved in this kind of business in China, particularly when tax avoidance and “incentives” for making sales is the major objective.
Instead the foreign product buyer should insist on operating via the standard distribution model used throughout the world. The foreign company should purchase its product from its Mainland China manufacturer, receive that product outside of China (in an export processing zone or when shipped) and then sell that product to a qualified PRC distributor. The distributor can be located in China, or in a PRC export processing zone or in Hong Kong. The foreign company buyer should earn its profit from that initial sale, freeing it from concerns with the financial side of the Chinese operation. On the other hand, the foreign company buyer should strictly monitor the operations of the Chinese distributor through a standard distribution agreement.
If the foreign company buyer wants to support its PRC distributor, it is free to offer incentives, such as the following:
- Not charging the distributor for product that will be used as samples.
- Reducing prices for a certain number of products
- Providing cash incentives for advertising or seminars and/or to partially/completely cover the cost of registrations.
However, such incentives should be offered to a distributor that operates under a standard distribution agreement that allows the foreign company buyer to terminate the agreement if the distributor does not perform (which is common) and gives the foreign company buyer the absolute right to audit the performance of the distributor on an arms length basis and to terminate if the China distributor engages in irregular conduct such as bribery or kick backs (which are common). One major defect in any kind of partnership/joint venture approach is that it is difficult to hold the Chinese side to a tight performance standard when there is a business ownership relationship. It is like a marriage: easy to get into, but hard to get out of.
Due to the need export from China and then ship back into China, it often happens that the distributor will establish an entity in Hong Kong to handle the operations. If the foreign buyer wants to take an ownership interest in the Hong Kong distributor, it can do that, but the basic rules remain the same: The Hong Kong distributor should be treated as an arms length third party, operating under a standard distribution agreement with the foreign company buyer earning its profits from sales to the distributor (profits now), rather than from the very uncertain and tax disadvantaged distribution of profits from the distributor at some unknown inherently uncertain later date. The foreign company buyer should also understand that it is a myth that they will be able to exercise more control in a joint venture setting. The truth is exactly the opposite: joint ventures are nearly impossible to control by a foreign entity located thousands of miles away with no right to make a quick and decisive contract termination decision.
It is rare for Western companies to want to get involved in the business of distribution in a vast and complex market like the PRC. This is why so many major multi-nationals hire Chinese distributors to do the work. It is even rarer for Western SMEs that understand the issues to take on this difficult burden. However, it is inexperienced SMEs and start-up companies that get approached with these ill-conceived concepts, for obvious reasons. You should asses any such proposal by applying the three basic rules set forth below, which rules apply to just about any project concerning China:
- If the proposal is complex, don’t do it. You should be able to understand the proposal in a first reading.
- If the proposal involves an equity joint venture business, be very wary. Avoid China business relationships that you cannot terminate by a simple contract termination notice.
- If the proposal is not supported by a legitimate financial projections, don’t do it. A “business plan” full of fluff and fancy jargon that no one really understands does not count. What counts is a set of standard financial projections (hard numbers, not jargon) with each assumption clearly spelled out and supported with facts.
If you follow these rules you will save yourself time and money in doing business in China.