Investors beware

According to a survey conducted by PricewaterhouseCoopers Australia in 2001, ?when investing in China…tread carefully.? The survey evaluated 35 countries in terms of corruption, legal and regulatory structures, accounting standards and business regulations. It also examined the cost and availability of capital. China was followed by Russia and Indonesia as the least attractive places to do business, while Singapore was rated the best.

Despite the negative findings in the survey, a growing number of foreign investors are eager to set up shop in China. For example, in Shanghai foreign investment reached an all-time high of US$6.4bn in 2000.

China is still very much a developing country and inevitably its system is evolving. The on-going programme of economic reform has stirred up an unstoppable force for change. In order to prepare for its accession and to fulfil its commitments, China is making various changes to its policies, as well as to laws and regulations that are not in compliance with World Trade Organisation (WTO) provisions and requirements.

As a result, there are serious inconsistencies in the application and enforcement of
the laws and regulations. However, it does not mean that the law is irrelevant. A well-prepared foreign investor can navigate through these inconsistencies and persuade officials to adopt a practice or interpretation that is favourable to the investor.

There has been a rapid surge in growth of domestic merger and acquisition transactions in China due to the restructuring of state-owned enterprises. Anticipation of China's entry into the WTO has also spurred a rise in M&A activity by foreign investors, while other factors include:

-de-regulation in areas such as energy, telecoms, financial services, automotive and service sectors
-privatisation of state-owned companies
-rich supply of venture capital funds to fuel higher-growth investments
-consolidation of industry as a defensive strategy to gain further market shares
-trend towards technology convergence reduction of duplicated functions to increase efficiency, and
-facilitation of future listings.

Two types of merger
Generally speaking, there are two ways of effecting a merger in China. One is merger by `re-establishment,? whereby a new company is established and the pre-merger entities are automatically dissolved by the operation of the law. The other is merger by `absorption,' whereby existing entities are merged into a surviving entity and the entities absorbed by the surviving entity are also dissolved automatically.

Following a merger, the surviving foreign-investment enterprise (FIE) will take over all the existing assets and liabilities of the merged companies and will be entitled to continue its original preferential business. It will retain tax and customs treatments avail-able to the pre-merger FIEs, provided that the foreign ownership of the surviving FIEs? registered capital after the merger is at least 25 percent. In no event may a merger result in foreign majority or a sole foreign shareholding position where it is not permitted under the foreign investment industrial guidelines and other investment regulations.

Acquisitions can be accomplished by either a share or asset deal. Under a typical share deal, foreign investors can buy the equity interest in an FIE directly from the seller or from the holding company that owns the target FIE.

An asset deal normally involves the formation of a new FIE or the use of an existing

FIE to acquire the selected assets, liabilities and business operations of the target. This method has been used frequently in transactions involving the purchase of assets of state or privately-owned businesses in China.

Deciding upon an asset or a share deal for an acquisition in China depends greatly on the business, tax and other objectives of the investor. By purchasing the assets instead of the equity interest, an investor may avoid the contingent and hidden liabilities of the target company. An investor may also be eligible for a new set of business and tax incentives by establishing a new company to hold the assets.

In an asset deal, the buyer will need to consider how the target business operations may be transferred, including existing sales or purchase contracts, distribution networks, supply chains and employment of staff. An asset deal will generally be costlier to the seller, who will need to consider both the business and tax costs of transferring the assets and the costs of winding down or liquidating the operations after the asset transfer. These costs will generally be passed on to the buyer.

A share deal is much simpler and less time-consuming to complete. It will also bring less disruption to the existing business of the target. The buyer will simply step into the shoes of the seller, inheriting all existing assets and liabilities. Assuming the business and tax considerations are neutral for both an asset and share deal, most investors will opt for a share deal.

Effective September 1, 2000, FIEs are permitted to directly establish or invest in limited liability companies or companies limited by shares in China. In order to do so, an FIE's registered capital must be fully funded, it must be making a profit and there should be no record of breach of laws in China. The aggregate investment amount by the FIE cannot exceed 50 percent of its net assets. Due to these restrictions, this type of acquisition has limited use.

In anticipation of China's accession to the WTO, many foreign investors are considering new or expanded investments in China. As a developing country, China's system is in a state of flux. Although regulations have developed rapidly in recent years, there remains a gap between theory and practice. In order to avoid any unpleasant surprises, it is essential to commission experienced professionals to perform due diligence reviews encompassing legal, financial, tax and regulatory aspects of a Chinese target.

Due diligence findings
Potential investors should be aware of the following common legal, financial and tax due diligence findings.

Legal
-Land-use rights have not been converted from allocated land to granted land, which effectively precludes the target company from transferring the land-use rights.

-Activities conducted are beyond the target company's permissible business scope. The target company does not have legal title to some assets recorded in its books or does not have sufficient documents to sup-port the book value of the assets.

-Loans to shareholders or related parties have not been properly documented.

-Foreign currency loans or payables have not been properly registered. Consequently, repayment of these loans, interest and payable are questionable.

-Intangibles, such as patents and trade-marks, have not been properly registered with the relevant authorities.

-No employment contracts are in place.

-Representative office licence is used for branch office operations.

Financial
-Financial statements are unreliable or of poor quality, especially for private or state-owned enterprises.

-Social welfare costs have been understated.

-Idle or under-utilised assets have not been properly accounted for on the books.

-Trading results are manipulated through incorrect sales cut-off, special subsidies from the parent or related-party transactions.

-Financial information needs to be converted into international accounting standard format in order for the potential buyer to have a better understanding of the target's operating results.

-Access to information is limited, particularly in areas of competitor intelligence.

-Future business projection is based on unsound assumptions.

Tax
-The target company has adopted aggressive tax schemes or made verbal special arrangements with local authorities without any legal basis.

-Capital equipment imported under a duty-free quota is used by a related or unrelated entity. This gives rise to potential claw-back of customs duty and import VAT.

-Tax compliance status of the target is weak, especially in the areas of VAT, individual income tax, withholding tax on foreign contractors and stamp duty on purchase and sales contracts/orders.

-Mandatory social welfare contributions are not fully funded.

-Unsupportable transfer pricing policy is adopted to shift profits overseas or to related Chinese affiliates to which a lower income tax rate is applicable.

This article was written by Billy Hsieh, partner, and Diana Jen, senior manager, of PricewaterhouseCoopers' mergers and acquisitions team based in Shanghai, http://www.pwcglobal.com/cn.