Succeeding in China: Solutions to Business Operating Issues October 10 th 2007 Boston David K.Y. Tang Clifford Ng Yujing Shu Howard Chen

Succeeding in China: Solutions to Business Operating Issues

October 10th 2007Boston

David K.Y. Tang

Clifford Ng

Yujing Shu

Howard Chen


China in ContextOctober 10th 2007Boston

David K.Y. Tang

K&L Gates

UPI/Zogby Poll

China’s Growing Economy and Trade

55%

20%

25%

Threat Benefit Not Sure

9%

61%

21%

9%

HelpsHurtsLittle to No ImpactNot Sure

Impact of China’s Growth on US Job

Market

UPI/Zogby Poll

US Companies Opening Plants in

China4%

20%

36%

31%

9%

Strongly SupportSomewhat SupportSomewhat OpposeStrongly OpposeNot Sure

35%

24%

15%

10%

8%

8%

Trade DeficitChina's Growing Economic PowerLoss of US Jobs/CompetitionPolitical DifferencesHuman RightsMilitary threat

Most Important Issue in US-China

Relations

$4.46

$7.82

$13.25

$0.30$0.86

$2.68

1986 1996 2006

US China

Sources: US DOC, IMF, PRC National Bureau of Statistics, Xinhua News Agency

The US Economy Is Five Times Larger Than China’s The US Economy Is Five Times Larger Than China’s

The US and China In Context

GDP, $ trillions

The US addedtwo China’s to our economy over the

past decade

Sources: US Dept of Commerce, International Monetary Fund

GDP Comparison (2005)

China’s Economy Is Equivalent To Two StatesChina’s Economy Is Equivalent To Two States

US ChinaCalifornia & Florida

The US and China In Context

$12.46 trillion

$2.30 trillion $2.23 trillion

$0

$10

$20

$30

$40

$50

$60

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 GrowthChina’s WTO Entry Has Accelerated US Export Growth

Sources: US Dept. of Commerce, US Dept. of the Treasury, US ITC

US Exports to China ($ billion)

China’s WTO Entry

China Is Now Our 3rd Largest Export MarketChina Is Now Our 3rd Largest Export Market

Top 10 US Export Markets in 2006 ($ billion)

Sources: US Dept. of Commerce, US Dept. of the Treasury, US International Trade Commission (ITC)

230.6

134.2

73.059.6

45.4 41.3 32.5 31.1 24.7 24.2

0.0

50.0

100.0

150.0

200.0

250.0

Canad

a

Mex

ico

China

& Hong K

ong

Japan

Unite

d Kin

gdom

Germ

any

South

Kore

a

Neath

erla

nds

Singap

ore

France

240%

-9%

42% 41% 39%31%

20% 20% 16%9%

Based on 2006 market size Sources: US Dept. of Commerce, US Dept. of the Treasury, US ITC

ChinaThe

Netherlands

GermanySingapore

CanadaMexico

FranceS Korea

UK

Japan

US Exports To China Are Growing Far More Rapidly Than To Other MarketsUS Exports To China Are Growing Far More Rapidly Than To Other Markets

Growth In US Exports To Top 10 Markets, 2000-2006

The Increase In The US Trade Deficit Has Largely Come From Outside China & East Asia

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

27% 28%

17%

43%

30%

55%

0%

25%

50%

75%

100%

1997 2006

Rest of World

Rest of East Asia

China

Composition Of The US Global Trade Deficit

22.3% 22.4%

21.1% 17.8%

4.2% 8.0%

52.4% 51.8%

0%

100%

1995 2005

Share Of Global Manufacturing Output

US Share Of Global Manufacturing Steady;China Taking Share From Japan

US Share Of Global Manufacturing Steady;China Taking Share From Japan

US

Japan

China

Other

Source: Unido; 2005 estimated

US Manufacturing Output Continues To GrowUS Manufacturing Output Continues To Grow

Sources: BEA, Oxford Economic Forecasting

US Manufacturing Output, 1979-2005 ($ billion)

$0

$500

$1,000

$1,500

1980 20052000199519901985

Long Term Employment Shift From Manufacturing To ServicesLong Term Employment Shift From Manufacturing To Services

Sources: BEA, Oxford Economic Forecasting

Manufacturing Share of US Total Employment, 1979-2005

8%

10%

12%

14%

16%

18%

20%

22%

1980 20052000199519901985

China’s Top Sources Of FDI ($ billion)

Numbers Reflect Shift Of Asia Export Manufacturing To ChinaNumbers Reflect Shift Of Asia Export Manufacturing To China

Source: Ministry of Commerce, China

2006

20.2

11.3

4.6 3.9 2.9

0

5

10

15

20

25

HongKong

BVI Japan SouthKorea

US

Cumulative

309.2

64.3 58 57.335.2

0

50

100

150

200

250

300

350

HongKong

Taiwan Japan US SouthKorea

“Protectionism”: Three Voices

Vice-Premier Wu Yi, CIFIT Opening Speech, 9/8/2006 “Reform and opening up is the fundamental national policy of China.”

Commerce Minister Bo Xilai, China Development Forum Speech, 3/18/2007 “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


Clifford NgK&L Gates

Legal Aspects of M&A and Reorganizations

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 ThresholdsCategory Total

InvestmentApproval Authority

Encouraged and Permitted

<US$100 million Local DRC & local MOFCOM

>=US$100 million

NDRC & MOFCOM

>=US$500 million

State Council & MOFCOM

Restricted <US$50 million Local DRC & local MOFCOM

>=US$50 million NDRC & MOFCOM

>=US$100 million

State Council & MOFCOM

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

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 foreign-owned enterprise that is held by the offshore SPV

Major M&A Legislation

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

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

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

Royalties

Interest

Capital Gains

PRC domestic withholding rate

0% / 20%

10% 10% 20%

Hong Kong domestic withholding rate

Nil 5.25% Nil Nil

Hong Kong-China Treaty rate

5% / 10%

7% 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

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

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


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


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


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%


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 non-enforcement

Transfer pricing and business models


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


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


Environmental Environmental impact assessment required for developing land and refurbishing existing facilities

Permits required to discharge pollutants

Fixed Assets


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

China Legal Updates for Foreign Investments

Yujing ShuK&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


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 System-Bifurcated 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

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

Gillette

Recent Cases-Copyright

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

ETS v. New Oriental English School

Recent Cases-Patent

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

Yibin Siliya v. Shangdong Weifang Hailong

Recent Cases-Patent

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

Hermans Boada (Spain) v. Jinhua Huaxin Gear

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

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 activitiesControl the supply of critical components

The Technology Transfer

Thank you