For most of the last decade, China seemed to take a light approach on regulatory enforcement; it worried that strict application of its many laws, rules, and regulations would scare off investors when the economy could not afford to lose foreign money and manufacturing.
Now signs are emerging that the days of benign neglect are ending. The government is cracking down on violators of existing regulations, issuing new guidelines and circulars to enhance what’s already on the books, and passing new, tougher legislation.
“Local laws are being stepped up,” says Scott Lane, CEO of the Red Flag Group, a governance, risk, and compliance advisory firm based in Hong Kong. “They are increasing in number and are being enforced.”
Companies have faced this before. China periodically improves enforcement, only to back off when the pain of its efforts becomes apparent; multinational corporations usually just wait out the storm. This time around, all indications are that Beijing isn’t going to retreat in a few months. The latest surge is aggressive and thorough; it also suggests that the new attitude is here to stay.
“With tax and customs, the push has been tremendous,” says Matthew Murphy, managing partner of the MMLC Group, a law firm in Beijing. “Enforcement penalties being placed on foreign companies have been huge. It’s all really taken off over the last 12 months. The customs guys are happy to roll up to a big Fortune 500 factory at 9:00 a.m. on a Monday in Wushi or Shanghai or somewhere and say, ‘This is a raid.’ And off they go.”
Tax compliance is the most tangible example right now. China’s long history of casual enforcement on tax bills has created certain expectations, and the crackdown has caught many foreign companies unprepared. According to Ernst & Young, the country’s State Administration of Taxation agency has assembled an “anti-avoidance tax team,” with several hundred employees. And beginning late last year, 10 foreign companies—including Walmart, McDonald’s, GE, and HSBC—were told by the SAT to begin a self-assessment and audit process, according to KPMG. One foreign accountant in China says his tax-related workload has doubled; a local lawyer dubbed it “the tax storm.”
The compliance push began at the start of 2009, when the SAT published guidance that called for individuals and companies operating outside China, but selling services into the country, to start paying China’s business tax. The SAT then followed up with several circulars requiring foreign companies undertaking engineering and service projects in China to register with the agency, even though the companies in question have no permanent presence in China.
Then local tax bureaus sought to charge corporate income and business taxes on parent companies seconding employees to China. Finally, in December, the SAT extended its jurisdiction—in a move called an “amazing leap” by one law firm—to transfer assets overseas. The SAT is showing no inclination to stop at water’s edge.
Specific examples are hard to find since China rarely discloses tax enforcement actions, but a few rumors have dribbled out. According to one tax accountant, a foreign company in Fujian province was fined $39 million last year in a settlement over transfer-pricing rules. And according to an internal document of the tax authorities in Shandong province, later obtained by KPMG, the Hong Kong subsidiary of a Belgian company was charged $66 million last year in withholding tax. The subsidiary sold shares in Tsing Tao Brewery to another foreign business, and the SAT decided that the transaction between non-residents outside of China was within its jurisdiction. It further concluded that the tax treaty with Hong Kong did not apply and would not protect the two parties.
The Hong Kong case is a telling example of China’s new attitude: that it will enforce previously dormant tax laws and will take the fight abroad. It also demonstrates a keen understanding of complex tax structures.
Merger Deals Under a Microscope
Much the same is transpiring in the world of mergers and acquisitions. While the Ministry of Commerce is getting high marks for its fair application of the country’s new Anti-Monopoly Law, observers wonder whether China isn’t again overstepping its bounds.
Yes, competition authorities worldwide examine transactions outside their borders—but China seems to be setting a low threshold for transactions it deems proper to review. Basically, any merger anywhere in which the new entity has more than $1.5 billion in total sales and more than $59 million of sales in China needs Beijing’s permission to proceed.
“There are a lot of people saying the regulations are another political tool that the government can use to control access to certain industries and to protect other industries.”
And China is already putting that anti-trust muscle to work on foreign companies. Last year it approved Panasonic’s purchase of Sanyo, on the condition that the merged business would sell several battery-manufacturing operations (most of which are outside China). It also approved Mitsubishi Rayon’s purchase of Lucite International Group, contingent on the new business divesting half its capacity in China. And when the Dutch-based InBev acquired Anheuser-Busch in 2008, China placed several restrictions on InBev-AB’s China investments.
“We are seeing a grab for jurisdiction,” Murphy says. “And the fact that they have been able to get away with being fairly aggressive in their decision making has given them the courage to stick their noses into other transactions.”
Fearing the long arm of the Chinese regulators, corporations are now scrambling to check their own operations and contracts, just in case they decide to merge or acquire. They are looking beyond total market size, to examine sales agreements, supply-chain relationships, and distribution arrangements.
“International companies are preparing, and we are doing a lot of anti-trust audits,” says Henry Chen, a partner at MWE China Law Offices. “I think [the Ministry of Commerce] will be more and more aggressive, more and more confident. The more confident it gets, the more aggressive it will be.”
While the regulators are going after foreign companies, they appear to be taking it easy on local enterprises. Some say this double standard may indicate that the great enforcement crackdown is as much a matter of industrial policy as it is an effort to raise taxes and prevent economic concentration.
“The Chinese are nationalistic. They want to see their state-owned enterprises and their companies perform well. They want to see their technology develop. And that is what is really behind a lot of the regulations,” Murphy says. “There are a lot of people saying the regulations are another political tool that the government can use to control access to certain industries and to protect other industries.”
The government does indeed seem to be giving the local companies a pass. While bureaucrats are raiding foreign-run factories, imposing sizable punishments on multinationals, and making demands on transactions that have little to do with China, enforcement of other domestic regulations come up almost comically short. China’s version of the Sarbanes-Oxley Act is one example: The regulation (which applies primarily to domestic companies) was supposed to go into effect last year. That deadline passed with scarcely any attention.
“There was a lot of bluster back in June of 2008,” says Alex Raymond, CEO of Vast Talent, a compliance consulting firm specializing in China issues. “The implementation deadline of the first of July 2009 kind of came and went, and we haven’t heard anything from the Ministry of Finance or any other sponsors.”
“There are basically now three different theories as to what is going to happen,” he says. “Theory number one is that it went into effect and nobody really knows about it. Theory two, which is the most popular, is that the implementation deadline has been shifted to January 1, 2010. And the third theory is that it is January 1, 2011.”