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It is important to know when to “kill” a deal in China

Foreign companies may be attracted to interesting acquisition deals in China, especially at a time when local entities may be facing cash-flow and capital difficulties due to the COVID-19 pandemic or the global economic slow-down. However, as attractive as the deal may be, it is critical to hire an expert who will assist you with the necessary due diligence.

In China, it is common to find companies that run part of their business under the table. An expert, such as a lawyer or an accountant, can help you identify the risks and decide which ones can be mitigated and which ones cannot. An in which case, the deal should not proceed.

In many cases, this type of due diligence can be seen as a deal-killer, but it can ultimately save you a lot of money and headaches.

A foreign company may be tempted to buy its Chinese supplier, if the opportunity arises, to ensure the continuity of the manufacturing and delivering of their product. If both companies have had a long and good relationship in the past, the deal can seem like a good idea. They know and trust each other, the numbers look right, and the acquisition appears promising.

Everything makes sense in theory. This is when the experts come in.

To ensure a stable supply of their product, the foreign company wants to move forward. At this point, the Chinese manufacturer must disclaim details such as how much they pay their employees, their social insurance contributions to the government, the payment of taxes and other costs including rent.

It is not uncommon to find that Chinese manufacturers pay a significant number of their employees under the table and under-report the government about the payments. They may be underpaying its income and social benefit taxes, while the rent is also paid under the table.

Chinese companies sometimes get away with this type of noncompliance, but when a foreign company runs a business in China, it usually gets scrutinized but Chinese authorities. The change in ownership would trigger multiple governmental reviews with respect to China’s various tax authorities. This would be the case even if the Chinese manufacturing entity remained the ultimate owner due to a stock purchase deal.

In this case, the profits that the Chinese company is showing are not reflecting the reality and would likely be considerably lower once all the costs are factored in.

Normally, when a foreign company buys a Chinese entity, it must bring all its employees onto the payroll and that would double the payroll expenses. All the wages not reported in the past, would have to be official, and that would mean that the foreign company would need to pay employer taxes, pensions, and insurance.

An employee who is now getting $1,500 a month under the table and you report it, represents an additional $600 that the company must pay to the government. However, that employee may not be happy that he or she needs to pay his/her share in income tax and contributions to the authorities and may request a raise to compensate the difference and take the same amount home as before.

The foreign company should expect to raise employee salaries by about 40 percent. So now, the employee who was getting $1,500 is getting $2,100 and the employer is going to pay an additional 40 percent on that, which equals around $840.

In this case, the employee that was paid $1,500 monthly by the Chinese manufacturer will cost the foreign owner close to $3,000.

On the issue of rent, chances are the Chinese manufacturer is paying the landlord unofficially, and the landlord is not reporting it. In some instances, he may not even have the permits to lease the property. But when a foreign entity buys a company, the rent must be legitimized and reflect a market rate. Before doing the acquisition, the landlord will have to register the property with the authorities and the lease contract should be done legally.

There is a good chance the landlord will refuse, and you will have to offer to cover the costs to do so. This could represent a 25% increase in the rent.

Another important consideration is income taxes. The foreign owner needs to pay income taxes on the money it makes. Approximately 25% of the profits will go to income taxes. Even if the company makes no money, the Chinese tax authorities will figure that it is because the Chinese subsidiary is intentionally under-pricing the product is selling to the foreign operations and it will then impute a profit to the Chinese subsidiary. This is called transfer pricing.

It is necessary to hire an accountant who understands China to look over the Chinese manufacturer’s books and to run the numbers to see if the acquisition is going to make sense.

Operating a business in China is very different than in Western countries. When you have a legitimate, compliance-focused business model, having a profitable enterprise can be challenging but not impossible. Understanding the rules clearly, will give you a better perspective on what makes more sense for your business and if acquiring a company in China is what you want to do.

If that is still the case, you should take your time and reinforce your due diligence. You should also request a NNN agreement from the prospective seller (“NNN” is short for Non-Disclosure/Non-Use/Non-Circumvention agreement, which means the information cannot be shared with anyone, it cannot be used in any way, and “behind-the-back” or design around tactics are forbidden). This way, you can go over every detail before making a final decision.


To learn more about our services in China, contact our Head of Business Advisory - Ms. Kristina Koehler-Coluccia at kristina@woodburnglobal.com.



DISCLAIMER: All information in this article is verified to the best of our ability and is assumed to be correct at time of release; however, Woodburn Accountants & Advisors does not accept responsibility for any losses arising from reliance on the information provided within. The information provided is for general guidance and does not replace specialized advice.


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