Succeeding in China:
Solutions to Business Operating Issues
October 10th 2007
Boston
David K.Y. Tang
Clifford Ng
Yujing Shu
Howard Chen
Succeeding in China: Solutions to Business Operating Issues
China in Context
October 10th 2007
Boston
David K.Y. Tang
K&L Gates
China’s Growing
Economy and Trade
Impact of China’s Growth
on US Job Market
9%
9%
25%
21%
55%
20%
61%
Threat
Benefit
Not Sure
Helps
Hurts
Little to No Impact
Not Sure
UPI/Zogby Poll
US Companies Opening
Plants in China
9%
Most Important Issue in
US-China Relations
8%
4%
8%
20%
35%
10%
31%
15%
36%
Strongly Support
Somewhat Support
Somewhat Oppose
Strongly Oppose
Not Sure
24%
Trade Deficit
China's Growing Economic Power
Loss of US Jobs/Competition
Political Differences
Human Rights
Military threat
UPI/Zogby Poll
The US and China In Context
GDP, $ trillions
US
$13.25
The US added
two China’s to our
economy over the
past decade
China
$7.82
$4.46
$2.68
$0.30
1986
$0.86
1996
2006
The US Economy Is Five Times Larger Than China’s
Sources: US DOC, IMF, PRC National Bureau of Statistics, Xinhua News Agency
The US and China In Context
$12.46 trillion
GDP Comparison (2005)
US
$2.30 trillion
$2.23 trillion
California
& Florida
China
China’s Economy Is Equivalent To Two States
Sources: US Dept of Commerce, International Monetary Fund
US Exports to China ($ billion)
$60
$50
$40
China’s WTO
Entry
$30
$20
$10
$0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
China’s WTO Entry Has Accelerated US Export Growth
Sources: US Dept. of Commerce, US Dept. of the Treasury, US ITC
Top 10 US Export Markets in 2006 ($ billion)
230.6
250.0
200.0
134.2
150.0
100.0
73.0
59.6
45.4
50.0
41.3
32.5
31.1
24.7
24.2
ea
t
ce
Fr
an
ap
or
e
N
Si
ng
ds
he
r
la
n
Ko
re
a
h
So
ut
m
an
y
in
g
K
d
ni
te
G
er
do
m
pa
n
U
hi
n
a
&
Ho
n
g
K
Ja
on
g
ic
o
M
ex
C
C
an
a
da
0.0
China Is Now Our 3rd Largest Export Market
Sources: US Dept. of Commerce, US Dept. of the Treasury, US International Trade Commission (ITC)
240%
Growth In US Exports To Top 10 Markets, 2000-2006
42%
41%
39%
31%
20%
China
Germany
Canada
The
Singapore
Mexico
Netherlands
20%
16%
France
9%
UK
S Korea
-9%
Japan
US Exports To China Are Growing Far More Rapidly Than To Other Markets
Based on 2006 market size
Sources: US Dept. of Commerce, US Dept. of the Treasury, US ITC
Composition Of The US Global Trade Deficit
100%
30%
Rest of World
75%
50%
55%
43%
Rest of East Asia
17%
25%
27%
China
28%
0%
1997
2006
The Increase In The US Trade Deficit Has Largely Come
From Outside China & East Asia
Sources: US Dept. of Commerce, US Dept. of the Treasury, US ITC
Share Of Global Manufacturing Output
100%
52.4%
Other
51.8%
4.2%
China
8.0%
21.1%
Japan
17.8%
22.3%
US
22.4%
0%
1995
2005
US Share Of Global Manufacturing Steady;
China Taking Share From Japan
Source: Unido; 2005 estimated
US Manufacturing Output, 1979-2005 ($ billion)
$1,500
$1,000
$500
$0
1980
1985
1990
1995
2000
2005
US Manufacturing Output Continues To Grow
Sources: BEA, Oxford Economic Forecasting
Manufacturing Share of US Total Employment, 1979-2005
22%
20%
18%
16%
14%
12%
10%
8%
1980
1985
1990
1995
2000
2005
Long Term Employment Shift From Manufacturing To Services
Sources: BEA, Oxford Economic Forecasting
China’s Top Sources Of FDI ($ billion)
Cumulative
2006
25
350
309.2
300
20.2
250
20
200
15
11.3
150
10
4.6
5
100
3.9
2.9
0
64.3
58
57.3
50
35.2
0
Hong
Kong
BVI
Japan
South
Korea
US
Hong Taiwan Japan
Kong
US
South
Korea
Numbers Reflect Shift Of Asia Export Manufacturing To China
Source: Ministry of Commerce, China
“Protectionism”: Three Voices

Vice-Premier Wu Yi, CIFIT Opening Speech, 9/8/2006


Commerce Minister Bo Xilai, China Development Forum Speech, 3/18/2007


“Reform and opening up is the fundamental national policy of China.”
“China’s utilization of FDI cannot be turned back.”
State Statistical Bureau Chief Li Deshui – Speech at the CPPCC Economic Work
Conference, 3/4/2006

“If we allow malicious M & A by MNCs, the ability of Chinese industry to create brands and innovate
will gradually disappear, and China’s leading enterprises… will probably be controlled by MNCs, to
the extent that a large portion of the backbone Chinese enterprises required to be an innovative
economy simply will not exist….. Because of this, in the overall international division of production
and industries, we can only fill the role of a manual laborer.”
Cities of over 1 million population
China Data Points
 > 10% GDP Growth each year for the past 20 years
 > US $1 trillion in foreign exchange reserves
 Savings rate of > 45%
 Second largest internet user market > 150 million
 Middle class of > 300 million
 GM’s best market
Lumps under Carpet
 Environmental Degradation
 Public Health
 Social Tensions
Investment Attractions / Challenges
 Talent
 Size of Market
 Prosperity
 Rapid Development
Succeeding in China: Solutions to Business Operating Issues
Legal Aspects of M&A and Reorganizations
Clifford Ng
K&L Gates
Key Government Agencies
 Ministry of Commerce (“MOFCOM”)
 State-owned Assets Supervision and Administration
Commission (“SASAC”)
 State Development and Reform Commission (“SDRC”)
 State Administration for Industry and Commerce (“SAIC”)
 China Securities Regulatory Commission (“CSRC”)
 State Administration of Foreign Exchange (“SAFE”)
 State Administration of Taxation (“SAT”)
M&A Government Approvals
 Investment Guidelines and Catalog
 Prohibited: radio and television broadcasting; distribution of
motion pictures
 Restricted: production and distribution of radio and television
programmes, and the production of films; securities companies;
securities investment fund management companies; production
of chemicals that can be used in narcotics production;
telecommunication services
 Permitted: all activities and sectors not included in the catalog
 Encouraged: energy and raw material-saving technology;
development and manufacture of software products
 Relevant for approval limits, equity restrictions and
tax/customs incentives
New Approval Thresholds
Category
Total Investment
Approval Authority
Encouraged and
Permitted
<US$100 million
Local DRC & local
MOFCOM
>=US$100 million
NDRC & MOFCOM
>=US$500 million
State Council &
MOFCOM
<US$50 million
Local DRC & local
MOFCOM
>=US$50 million
NDRC & MOFCOM
>=US$100 million
State Council &
MOFCOM
Restricted
Major M&A Legislation
 Provisional Regulation on Mergers and Acquisitions
of Domestic Enterprise by Foreign Investors
 Effective September 8, 2006
 Review acquisitions based on the company and
industry involved, national economic security
 Endorsed by six governmental authorities, including
MOFCOM, SAFE, CSRC, and SASAC
Major M&A Legislation
 Cross-border share swaps
 Must pass a new and untested approval procedure within a strict
time frame
 “Round-trip” investments
 Additional review and approval by MOFCOM
 PRC residents moving ownership and control of PRC
businesses or assets to an offshore holding company of the
PRC resident by transferring those assets to a wholly foreignowned enterprise that is held by the offshore SPV
New Tax Law
 Enterprise Income Tax Law
 Effective January 1, 2008
 Unifies corporate income tax rates for FIEs and
domestic companies at flat rate of 25%
 Unifies tax incentives for FIEs and domestic
companies
New EIT Law
 Cancellation of some tax incentives for FIEs:
 “two-year exemption and three-year reduction” tax
holiday for foreign invested enterprises
 50% reduction for the export-oriented enterprises
 Reduced tax rates applicable in “Special Zones” with
limited exceptions
New EIT Law
 Qualified tech enterprises eligible for key support
from the State: 15% corporate income tax rate
 Qualified small and thin-profit enterprises: 20%
New EIT Law - Transitional Measures
 Five-year transition period
 Any unused tax holidays will survive until they
expire
 Holidays will be deemed to commence from
January 1, 2008 for FIEs whose tax holidays have
not commenced
New EIT Law – Industry Specific Incentives
 EIT exemption or reduction:
 Agriculture, forestry, animal husbandry and fishery
industries
 Public infrastructure projects that are eligible for key
support from the State
 Qualifying environmental protection, energy and
water saving projects
 Qualifying technology transfers
New EIT Law - Tax Resident Enterprise
 Non-Chinese companies can be subject to PRC
income tax on its worldwide income
 “Effective management” in China
 Taxed as Chinese companies (25% effective January
1, 2008)
New EIT Law - Withholding tax
 20% withholding tax on PRC-sourced income
derived by a non-resident enterprise:






Dividends
Interest
Rent
Royalties
Capital gains
Others
 Reductions and exemptions may be available under
tax treaties
Popular Tax Treaty Jurisdictions
 Mauritius




Effective May 4, 1995
New protocol signed on September 5, 2006
Capital gains: 10%
PRC has the right to tax capital gains of a Mauritian
company from the transfer of any amount of shares in
a PRC company where the Mauritian company holds
at least 25% shares in a PRC company during the
12-month period preceding such transfer
Popular Tax Treaty Jurisdictions
 Barbados




Effective October 27, 2000
Dividends: 5%
Interest: 10%
Royalties: 10%
Popular Tax Treaty Jurisdictions
 Hong Kong
 Effective December 8, 2006
 Withholding Income Tax Rates:
Dividend
PRC domestic
withholding rate
0% / 20% 10%
Hong Kong domestic Nil
withholding rate
Hong Kong-China
Treaty rate
Royalties Interest
5.25%
5% / 10% 7%
Capital
Gains
10%
20%
Nil
Nil
0% / 7% 0% / 20%
Foreign Exchange Controls
 SAFE Circular 75: Circular on Relevant Issues
Concerning Foreign Exchange Control on Domestic
Residents’ Corporate Financing and Roundtrip
Investment Through Offshore Special Purpose Vehicles
 Effective November 1, 2005
SAFE Circular 75
 Permits PRC residents to establish or control
offshore SPVs for the limited purposes of equity
financing and return investment
 Multiple approvals no longer needed
 Register with SAFE only
SAFE Circular 75
 Detailed registration and disclosure required by
relevant parties:
 Initial foreign exchange registration by PRC residents
 Amendment to the foreign exchange registration by
PRC residents
 Foreign exchange control for foreign investment or
foreign debt by PRC companies
 Amendment to foreign exchange registration by PRC
residents for material changes (must be done within
30 days of the occurrence of the event)
SAFE Circular 75
 Officially legalizes offshore SPV structure
 Narrowly defined scope
 Foreign exchange obtained from profit, dividends
and from sale of equity interest in a SPV must be
remitted back to China within 180 days of receipt
 Burdensome monitoring and filing requirements
 Approvals “spotty”
M&A Challenges in China
M&A Challenges in China - Legal
 Complex rules and regulations – rapidly changing
 Unclear and unpublicized local rules
 Undervalued assets are not easily available or accessible because
of bankruptcy laws
 Control issues
 Government approvals required
 Arrangements for the Mutual Recognition and Enforcement of
Judgments between PRC and Hong Kong
 Covers final judgments in civil and commercial matters
 Only money judgments will be recognized and enforced
 Recognized judgments will have the same force and effect as a
judgment of the enforcing court
M&A Challenges in China - Legal
 Intellectual property rights
 Employees of target need to be taken care of –
often a deal killer
 Jurisdiction of agreements
 Lack of effective legal system
 Enforcement of judgments
 Environmental issues/liabilities
Challenges in China – Due Diligence
 Business scope
 Can only engage in activities that are within their
business scope (important when determining deal
structure)
 Differences in accounting standards and practices
Challenges in China – Due Diligence
 Lack of corporate governance and internal controls
 Adherence to corporate governance uncertain
 Internal control and financial reporting system may
not be sophisticated
 Mixing personal and corporate expenses
Challenges in China – Due Diligence
 Independent investigation
 Independent assessments of the business reputation
and connections of a potential partner and key
employees
 Revenue Recognition / Earnings
 Tax
 Tax under reporting
 Three sets of financial statements:
 tax authorities
 foreign investors
 reality
Challenges in China – Due Diligence
 Complex Tax System







Business tax
Income tax
Value-added tax
Individual income tax
Capital gain tax
Land value appreciation tax etc.
Stock Options
 Individual Income Tax
 Up to 45%
Challenges in China – Due Diligence
 Validity of tax incentives
 Various tax incentives granted by the local provincial
tax bureau might not be allowed by the state tax
bureau
 Many tax “incentives” are “agreements” for nonenforcement
 Transfer pricing and business models
Challenges in China – Due Diligence
 Liability exposure
 Off-balance sheet items and contingent liabilities
often arise, including cross-guarantees to third
parties
 HR




Inadequate funding of social insurance contributions
Under reporting of staff
quality and capability of management and staff
unclear policies and lack of employment contracts
Challenges in China – Due Diligence
 Related party transactions
 Some major customers and suppliers may be related
parties and the transactions are not conducted on an
arm’s length basis
 Detailed inquiries on the existence and background
of related parties and affiliates should be made
Challenges in China – Due Diligence
 Environmental
 Environmental impact assessment required for
developing land and refurbishing existing facilities
 Permits required to discharge pollutants
 Fixed Assets
Challenges in China – Due Diligence
 Approvals from relevant authorities
 Ministry of Commerce: joint venture with registered
capital exceeding US$30 million
 Valuation of investment related to state-owned assets
 Time-consuming
 Foreign Exchange Transactions
 Approvals of loans from foreign investors with SAFE
 Capital requirements
Key Success Factors for M&A in China





Know the stakeholders
Know the market
Set realistic expectations
Have a robust due diligence process
Impose and maintain governance and financial
controls
Thank you
Succeeding in China: Solutions to Business Operating Issues
China Legal Updates for Foreign Investments
Yujing Shu
K&L Gates
Topics Covered
 China’s new Employment Law and issues for
foreign investors
 Anti-Monopoly Law
FIEs – Major Employers in China
 2006, more than 5000 cases involved in foreign
invested companies in Shanghai, a 24% increase
from 2005
 2006, employees prevail in 86% of Shanghai
arbitration cases
New Labor Contract Law
 The new Labor Contract Law passed and will be
effective from January 1, 2008.
 Increased responsibility and liability for employers
New Labor Contract law





Applies to all employees in PRC
Is more employee-centric
Pre-existing disputes resolved per new law
Termination of employees requires more diligence
Old contracts should be revised
Advantages for Employees
 Major employee Issues to be agreed by employee
representatives
 Employees have the right to revise inappropriate
rules by negotiation
 2 months salary to be paid to employee if no written
employment contract is executed, 1 month from the
formation of employment
 Terms disputed shall be interpreted to benefit the
employee
Non-compete Agreements




Specific geographic restrictions
Employee in violation of NCA subject to penalties
Duration limited to 2 years
Limited to
- senior management
- technical personnel
- employees with a commercial secret
Probationary Periods
 Probation period determined by the length of employment
contract




no more than 1 month for < 1 year employment contract
no more than 2 months for 1-2 year employment contract
no more than 6 months for 3 year or more employment contract
one-time probation
 Contract cannot be terminated without evidence that the
employee failed to meet hiring requirement. Employee free to
terminate
Training Costs
 Employer may require a fixed term of service from
employee who receives training benefits
 Employer may collect damages from employee if
employee is in violation
Role of Labor Unions
 A greater role in negotiations and decision-making
 Employers are required to consult with their labor
unions or "employee representatives" on an "equal
basis" in setting policies regarding labor
compensation, work hours, rest and leave, labor
safety and health, insurance and benefits, training,
and labor discipline and quotas, among other issues
Termination
 Employer may terminate contract by:


giving 30 days advance written notice
1 month salary in lieu of notice
 Severance must be paid almost in all situations
based on the length of service: 1 to 12 months
salary



bankruptcy
closing of business
fix-term expires and no equal or better term offer
What Do You as Employers Need to Do?




Redraft employment contracts
Redesign the non-compete agreements
Review employee handbooks and policies
Document employee history and communications
Anti-monopoly Law
 Issued on August 30, 2007 after almost 14 years drafting
 The first comprehensive competition law in China
 It covers a wide range of anti-competitive activities including
monopoly agreements, abuse of dominant market position,
concentration and abuse of administrative power
 Substantial penalty for non-compliance (up to RMB 500,000
(approx. USD 66,600))
 Affects both domestic and foreign invested companies and
monopolistic activities outside China that have an effect in
China
 Effective from 1 August 2008
Prohibited Activities
 Anti-competitive agreements: price fixing, restricting
production or sales volume
 Abuse of dominant market position or exclude
competition
 Concentration potentially affecting market
competition subject to approval
 Government authority abusing their administrative
power
Wide Range Exemptions
 Activities that are beneficial to the development of
national economy and are in the public interest
 Agreements for the purposes of improving
operational efficiency
 Agreements enhancing the competitiveness of
small and medium-sized enterprises
 Agreements for the purpose of protecting legitimate
interests of international trade and foreign economic
cooperation
 Vaguely defined circumstance leads to uncertainty
Effect on Foreign M&As and New JV Establishments
 An M&As that potentially effects competition must
be filed with anti-trust authority for review
 New JV agreements must be filed under the control
regime
Effect on Contractual Arrangements
 Agents v. Distributors
 Mandatory minimum sale price v. suggested price
 Exclusive distributor
- Large market share v. competition in market place
Investigations
 The anti-trust authority has extensive investigative power to
conduct on-site examinations, review contracts,
correspondence, financial information and question the
relevant parties
 Non-cooperation with the anti-trust authority for such
investigation will be subject to administrative penalties and
even criminal liabilities if the activity constitutes a criminal
offense
 Anti-trust authority may impose fines for monopoly
agreements and abuse of dominant market position of up to
10% of the relevant party’s annual turnover
Review Period
 All filings are subject to an initial 30-day review
period from the date of filing
 In addition, filings that are not cleared within the first
30 days are subject to an additional 90-day
investigation from the end of initial review period
 The M&A transaction should be put on hold until it is
cleared by the anti-trust authority
Implementing the AML
 Will require the establishment of 2 regulatory bodies:
- an anti-monopoly committee, responsible for
drafting and coordinating relevant guidelines and
policies
- an AML law enforcement agency under the State
Council, responsible for enforcement
 Implementing regulations, or additional clarifications,
will likely emerge over the next year
 Companies will want to monitor how the law is
implemented
Thank you
Succeeding in China: Solutions to Business Operating Issues
Intellectual Property Challenges in
China
Howard Chen
K&L Gates
The Leap Over the Pacific into
Asia
“There is nothing…more ancient in my
memory than the observation that arts,
sciences, and empire had always traveled
westward. And … that their next leap would
be over the Atlantic into America.”
John Adams,1807
Business and Legal Considerations of IP
Licensing and Technology Transfer
 The Mental State - Optimistic v. Pessimistic
 The Business Environment - Jungle v. Zoo
 The Legal Protection--IP Enforcement
Mechanisms
 The Practical Strategies
 Procurement
 Technology Transfer
 IP Litigation
The Mental State – Common
Assumptions
“It is not an American system,
therefore it cannot be good”
“Everyone says it is bad,
therefore it must be bad”
“It is too much of a burden to
deal with an unknown culture,
therefore it is easy to be
cheated”
“It is hard to trust anyone,
therefore it is hard to protect
your IP”
The Business Environment
 “Use Market To Exchange For Investment”
 “Use Market To Exchange For Technology”
 The Jungle v. The Zoo
 Labor Centric Economy vs. Technology
Centric Economy
 In need of Technology win
 Locked in Wal-Mart model
 Fierce Domestic Competition
The Legal Protection
China Patent Office, established
in 1980, now with more than
5000 employees
Patent Law Enacted in 1985, most
recently revised in 2001
German Style SystemBifurcated Proceedings
 The Court decides the
Infringement
 The Patent Office decides
the validity
“Two-Instance” System for judicating the
infringement
 50 courts designated as the courts for
the first-instance
 The Higher People’s Court for Appeal
 They are in the process of creating
something similar to our CAFC—
Experimental in Shanghai
The Legal Protection
 From 1985 to 2004, 2.2 million applications filed with a
growth rate of 19% annually.
 It took 15 years to reach the 1 million threshold, but
only 4 years to double to 2 million
 Foreign applications account for about 20%
 In 2004, 5000 patent disputes are handled by patent
administrative arm
The Legal Protection
 Jurisdiction
 Domicile
 Infringing act
 Infringement
Consequences
 Evidence
 No American Style
Discovery
 Evidence Preservation
 Question the respondent
 Documents
 Infringing products
The Legal Protection
 Timing
 Statue of Limitations:
Two years
 Preliminary Injunction
available, but rarely
successful
 30 days for a foreign
entity to appeal the ruling
of the first instance court
 Damages
 No limit on damages
theoretically
 Unknown user/seller is not
liable
 Actual loss suffered
 Unjustified profit
 Reasonable royalty (1-3 times)
 Quasi-Statutory <$60K
Recent Cases-Trademark
Gillette
 27,300 cases of Gillette products found in a
single raid
 Total of 650,000 cases were sold and
exceeded $8 Million in value
 Criminal charges filed against the fake
manufacturer
Recent Cases-Copyright
ETS v. New Oriental English School
 ETS had a contractual relationship with New
Oriental English School to allow for internal use
of TOEFL material
 New Oriental put it on the web and sold it
 ETS won the first trial, and New Oriental
appealed
 The Appeal Court withheld the ruling of the lower
court
Recent Cases-Patent
Yibin Siliya v. Shangdong Weifang Hailong
Both are Chinese companies
 20 some infringers in the textile industry
 Notice letter sent by attorneys
 Plaintiff is in SiChuan Province and the infringer is in
ShangDong Province
 SiChuan IP Office accepted the case, and transferred to
ShangDong IP Office according to the “agreement of the
association of 16 provinces and cities to execute the law”
 Invalidity Claims made to SIPO, but failed
 Settlement reached with 3.5 million RMB paid by the defendant
Recent Cases-Patent
Hermans Boada (Spain) v. Jinhua Huaxin Gear
 Spanish v. Chinese
 Evidence submitted to local provincial IP Office (in the form of
photos and videos)
 Huaxin produces similar product and sells abroad
 Settlement reached after IP Office’s intervention
 The defendant reports certain results to Trade Section of
Spanish Consulate General and the Provincial IP Office
 Spanish Consul General in Shanghai sent a telegram to the
Provincial IP Office praising its effectiveness
 The Chairman of Spain Export Enterprise Association visited
the Provincial IP Office and showed his appreciation
The Practical Strategy
 Patent Procurement
 Get your patents filed if you can afford
to
 Monitor your competitors filings
 File Hong Kong Patents
 Absolute Novelty
 No publication prior to filing anywhere
in the world
 No public use or sale in China
 No Protection
 Scientific discoveries
 Method for mental
activities
 Diagnosis or treatment of
diseases
 Animal and plant varieties
 Substances obtained by
means of nuclear
transformation
The Technology Transfer
Get to know your Chinese partner well
Get to know their financials
Get a big installment payment up front
Get some money escrowed
Stage out the actual transfer of the technology
Bundle software with the hardware
Monitor market activities and key employee activities
Control the supply of critical components
Thank you