Above The Law Article: The Joys Of Buying A China Company

Another great post by Dan Harris for ATL


Buying A Chinese Company? Why China Deals Don’t Get Done
99 Shares / May 11, 2015 at 10:02 AM
US china flagsWe lawyers are known as deal-killers. Most lawyers get offended by that moniker and vehemently deny it. Me, I am proud of every deal I killed when killing the deal meant I was doing right by my client, who makes the decision in the end anyway. When my clients come to me all excited about their China deals, I see it as my job to point out the risks, and to explain which of those risks can be mitigated and which cannot.

The following is an amalgamation of several potential China acquisitions my firm has worked on, absent any identifying details.

A U.S. company had been receiving its product from the same China manufacturer for about 15 years. The Chinese manufacturer had been providing about 90 percent of its output to this one U.S. company and according to the latter, the two companies had a “fantastic” relationship. The owner of the Chinese manufacturer had done very well over the years, but he now wanted to retire and sell his manufacturing business to the U.S. company.

In theory, this sale made complete sense.

The U.S. company told me of its plans to buy its Chinese manufacturer and we briefly discussed some terms and “the numbers.” My client said that the Chinese manufacturer was clearing about “a million dollars a year” but that was not why the U.S. company wanted to buy it. The purchase was solely because the U.S. company wanted to be sure it could keep getting the same product.

I then laid out for my client the likely reality of what was to come. I told them that if they bought the Chinese manufacturer, their profits (if any) would be considerably lower because they would have to operate as a WFOE, and not cut all of the corners that made the Chinese manufacturer profitable in the first place.

For instance, the Chinese manufacturer has probably been paying half of its employees completely under the table and reporting to the government only half of what it was paying the other half of its employees. Also, the Chinese manufacturer has probably been underpaying its corporate income taxes, and paying rent under the table at a discount to assist the landlord in committing tax fraud.

The above may be relatively commonplace for Chinese-owned companies, but if an American company were to buy this manufacturer, it would need to do so as a WFOE and would suddenly be on a “whole ‘nother level” in terms of tax scrutiny.

A new WFOE owner would need to bring every single employee onto the payroll, which would nearly double the payroll expenses. All of the wages now being paid under the table would need to be paid above the table and that means that the WFOE would, in turn, need to pay all sorts of employer taxes, pensions, and insurance, to the tune of 40% of all wages. An employee who was getting $1000 a month under the table would likely require that my client pay $400 to the government.

But it gets worse. Much worse.

That employee receiving $1000 under the table is quite happy getting paid under the table. So when you tell that employee you are now going to report his or her wages to the government, that employee will demand a raise. The employee has not been making employee contributions, and if my client reports him or her to the Chinese government as a wage-receiving employee, that employee’s tax-free ride is going to end. I told my client to expect to need to raise employee salaries by maybe 40 percent. So now the employee who was getting $1000 is getting $1400, and you as the employer are going to need to pay an additional 40 percent to the government, or around $560. So all of a sudden, the employee that cost the Chinese manufacturer $1000 a month is going to cost you pretty close to $2000. In other words, double.

Let’s also consider rent. The Chinese manufacturer may be paying the landlord under the table and the landlord is not reporting those payments as income. Heck, there is a good chance the landlord is not even legally able to lease out the property, but for the sake of the numbers, let’s assume that the landlord is actually authorized to lease it. If you are going to buy the Chinese manufacturer’s company, you are going to have to do so as a WFOE and to get a WFOE approved, you will likely need to show the Chinese government that you have a legitimate lease. That means that before you buy this Chinese manufacturer, you are going to need to put your landlord-tenant relationship “on the grid,” and that means the existing landlord must register your lease with the appropriate China authorities.

The landlord will likely call me an idiot (trust me on this) when you say you are merely doing what your lawyer is telling you to do. You will then need to explain that you absolutely must get the lease on the grid and that you are prepared to cover the landlord’s increased costs to do so. Figure on this raising your rent by around 25%. Again though, this assumes that you will even be able to stay at this facility.

Now, let’s talk about income taxes. You are going to have to pay income taxes on all profits made by your China WFOE, even though the Chinese manufacturer almost certainly never did. Figure on 25% of your profits going to income taxes. And if you think you can price the products your China manufacturing company sells to your U.S. entity to avoid profits flowing to your China company, you should forget about that, as China now has quite sophisticated transfer pricing laws. If your China WFOE has no profits, the Chinese tax authorities will figure that is because it is intentionally underpricing the products it sells to your United States operations and it will impute a profit to your Chinese company.

In other words, you need an accountant who understands China to look over the Chinese manufacturer’s books and to run the numbers to see if this deal is going to make sense.

The below is a very slightly altered email I received from one of our clients looking to buy its China manufacturer after I gave them the analysis above:

Here is where we stand:

Our accountant is in the process of remodeling the business from a top-down perspective, in an effort to clarify what the numbers would be for our China WFOE, while complying with the rules. We have good history on the revenue and most of the operating costs.

As you guessed, we will need to apply roughly a 2x factor to the labor costs the Chinese manufacturer is showing, so as to properly book all of the official upcharges.

Also, as you suggested might be the case, the landlord of the factory space is not properly registered, so we will be increasing the booked rental costs as well.

The reality is that we probably will not be purchasing the Chinese manufacturing company and that did not sit well with its owner. He was offended when I reiterated my stance that I wouldn’t operate the business in the same manner as he has. He lost face.

A few weeks after that, I received the following email from the client (again slightly doctored):

It is now clear that we shouldn’t consider buying [the Chinese manufacturer]. [The owner of the Chinese manufacturer] had previously indicated that there were “a couple” more issues related to the accounting procedures. I pressed him to explain if there were any others. Of course, you know the answer to that.

In summary, it is becoming clear that we cannot be profitable in China if we follow all the rules. It is not completely clear this is really the case, since we can’t tell if [the owner of the Chinese manufacturing company] really understands the rules. What is certain is that the numbers on which we had been basing our valuations are simply not valid. The “profits” that the Chinese manufacturer was claiming to have achieved are not valid under our business model.

Amazingly enough, in one of the scenarios this amalgam is based on, my client ended up lucking out when the manager of the Chinese manufacturer stepped in and bought the Chinese manufacturer and ran it just as before. Last time I checked in with my client, it still had a “fantastic” relationship with its China manufacturer.