BizChina

Shanghaiist just posted my list of "China’s top 5 business law trends of 2010," which list included China stepping up its tax collection efforts. Drastically.

Speaking of drastically, I just read a really excellent article by a swarm of O'Melveny & Myers lawyers, entitled, "China Adopts Controversial Vodafone-style Extraterritorial Tax and Disclosure Rule," discussing China's just circulated Circular 698. The O'Melveny article summarizes an "amazing" part of that circular as follows:

However, Article 5 of Circular 698 then takes an amazing leap. It [Article 5 of Circular 698] states that foreign entities are required to disclose all indirect transfers of PRC resident enterprises to the PRC tax authorities in cases where an intermediate holding company through which such transfers are made are located in a low tax jurisdiction or such jurisdiction exempts income tax on foreign-sourced income. In this case, the foreign enterprise making the indirect transfer must disclose the following documentation to the PRC tax authority in the location of the PRC resident enterprise within 30 days of executing the transfer contract:

i. Equity transfer agreement/contract;

ii. Representations regarding the relationship between the foreign entity and holding company being transferred in terms of “capital, operation, sales and purchase etc.”;

iii. Representation regarding the operation, employees, bookkeeping, and assets of the holding company being transferred by the ultimate foreign entity;

iv. Representations regarding the relationship between the holding company being transferred by the ultimate foreign entity and the PRC resident enterprise, in terms of “capital, operation, sales and purchases;”

v. Representations regarding the reasonable business purpose with respect to the transfer of the holding company; and

vi. Other materials requested by the tax authority.

The article then very nicely lays out some truly extreme examples of where foreign companies may be required to report to China on their foreign M&A activity and then asks the following series of questions relating to whether the circular is "even legal:"

(1) Is there a legal basis under any validly promulgated PRC law or administrative regulation which imposes information reporting obligations and tax with respect to such indirect transferors? How does an interpretive circular like 698 derive its PRC legal authority?

(2) Does the PRC general anti-abuse rule (“GAAR”) in the EIT grant virtually unlimited power to the PRC tax authorities concerning transactions, including matters of extraterritorial jurisdiction? How does one sentence in a quasi-civil law statute encapsulate an entire doctrine?

(3) Is there a colorable theory under international legal principles to assert extraterritorial jurisdiction over the numerous parties potentially described in Circular 698?

(4) Will the enormous administrative complexities and burdens created by the disclosure mean erratic compliance and result in grossly unfair application of the rule? Can most foreign entities comply?

(5) Will local PRC tax bureaus be staffed with the resources, training, and other administrative infrastructure to deal with those disclosure actually submitted?

This circular is so far out of the norm and so likely to cause an uproar I suspect much of it will never come to pass. No matter what though, it is a great indicator of China's strong desire to increase its taxing powers, especially with respect to foreign companies.

For more on Circular 698, check out the following:

-- Detailed Analysis of of Circular 698, on the China Tax Insights Blog.

-- "China Reinforces Tax Administration of Share Transfers by Non-resident Enterprises," by the Mayer Brown law firm.

-- Tax Alerts by PriceWaterhouse and Deloitte.

UPDATE: China Tax Insight just did a new post on Circular 698, entitled, "One Last Post on Circular 698," taking Deloitte to task for saying "Circular 698 creates some legal questions as to whether the Chinese government has the right to tax foreign companies."

With few exceptions, the business law trends I see for China in 2010 are not all that different from what I would have seen last year or even the year before. The Chinese government’s primary goal is to stay in power (I think this is true of virtually all governments) and that goal usually drives the enactment and enforcement of its laws. The big, overarching trend I see for China in 2010 is its continuing to more strictly enforce its laws, particularly those that apply to business, and even more so those that apply to foreigners.

The Chinese government wants to satisfy its own citizens so as to maintain its own legitimacy and one of the best ways to do that is to show a desire to protect the citizenry against foreigners. China’s current economic strength is leading many in its government to believe China has little to no need for foreign investment and so I see law enforcement against foreigners continuing to increase.

I see the following five key things happening on China’s business law front in 2010:

1. China will step up even further its crackdown on foreigners in China violating its visa/immigration laws. If you lack an employee visa, you may be at risk.

2. China will increase its efforts to root out and shut down illegal and unregistered foreign businesses. I have seen ample evidence of this already happening in the last 3-6 months and I have no doubt this will continue. Providing jobs to Chinese citizens does not let you off the hook.

3. China will increase its tax collection efforts. This has been going on at a rapidly accelerating pace over the last six months or so. If your China operations are not making a healthy profit, do not be surprised if the government imputes healthy profits to it. In particular, the government will look very closely at your transfer pricing and in many cases it will not like what it sees.

4. China now sees itself as a full-fledged economic power and with that perception we can expect it will be stepping up its anti-monopoly monitoring of mergers and acquisitions. I predict China will seek to impose at least some conditions on all mergers and acquisitions that touch on China, if only just to show that it can.

5. The number of cases brought by employees and resolved in their favor will continue rapidly increasing. This will be particularly true with respect to foreign companies as this will be a great way for the government to show its willingness to protect its own.

* This is my December 31, 2009, post on Shanghaiist.

Just finished a very interesting and very nicely done three part series over at the brand spanking new View to China blog, written by London based lawyer, Geraldine Johns-Putra. The series is on the five big issues confronting China in its ascension to superpower status and it is entitled, "China as the next Superpower? Top 5 Make or Break Issues." Part 1 is here, part 2 is here and part 3 is here.

I recommend it.

Excellent podcast/article up on on Technomic Asia's Business Blog and Podcast, entitled, "Ding-dong … China calling: Direct Sales in China," on how direct sales just seem to correspond naturally to the concept of guanxi in China:

Historically, sales in China have been based on this guanxi … I get the sale, not necessarily because I have the best price or the best quality product, but because I have good guanxi with you. However, this is rapidly changing in China: while good guanxi is a necessary condition to successful sales, it is by no means a sufficient one — I now have to bring good products to the market at good prices. And for most industrial and consumer products companies, this is a good thing because it means that they can develop more “professional” distribution channels and get a broader sales footprint in China.

So let’s go back to the direct-sales model … this is a model that leverages (and even celebrates) guanxi-based sales. Sales most often are made to friends and family (or the friends and family of other friends) and, while these product suppliers are certainly concerned to bring good quality products to market, I would argue that they are relying even more on the strength of their sales teams’ guanxi in their local area. The strength of the direct-selling model is that it goes with the flow of traditional Chinese culture, not against it, by making each sale personal. And all you have to do is multiply the large number of people in China by their growing disposable income and you understand why executives at companies such as Mary Kay, Amway and Avon are having a hard time controlling their excessive drooling.

One of the toughest things about selling a consumer product in China is getting it into distribution. The post nicely sets out how the choice is often between the traditional and more modern models:

This is a topic too large for one blog post but suffice it to say that China is in the midst of a sea-change in its retail channels, moving from a “traditional” model — dominated by mom-and-pop stores and small specialty stores — to a “modern” model dominated by the larger hypermarkets, “Big Box” and grocery chains. If you look at China as a whole, a slight majority of consumer products are sold through traditional channels; however, the growth is in the modern channels and particularly in the so-called “hypermarkets”, chains such as Wal-Mart, Carrefour, Rt-Mart, etc.

Both methods have their "issues." Distribution through mom and pops can be, as one would imagine, difficult to institute, and sometimes even chaotic. But distribution through the hypermarkets is also definitely not without its own set of problems:

However, what everyone is realizing is that these modern chains, while good looking on the outside, are often very difficult to work with simply because they are so big and wield so much power. The cost of doing business with them — what consumer products companies call “trading terms” — are often quite high in China compared to the rest of the world so while consumer products companies are often happy with the volume that moves through modern channels, they are not as happy with the margins (and multinational consumer products companies are ALL about the margins!). These companies are often finding that the hypermarkets are not all that good at merchandising and marketing themselves so consumer products companies often feel that they end up paying a lot in terms of marketing fees and not getting all that much for it.

The thought is that direct sales may be the best way to get certain products into consumer hands and that direct sales may make better sense in China than elsewhere. Because my law firm just started working on a very sensitive direct sales matter, I am going to bite my tongue on the legal issues surrounding direct sales in China and merely state that many in China's government are not terribly comfortable yet with this method.