The improved Chinese legal environment came with the development of the economy, which has created a numerous amount of potential domestic targets for foreign companies.
Regardless of the improved legal system, foreign companies willing to acquire a Chinese company shall perform due diligence specially tailored to China. This due diligence shall provide the buyer a view of the technical, commercial, HR, legal, tax and financing situation of the target.
Due diligence operations are particularly important in China because of the obligation for a buyer to pay the full acquisition price within a 3 months period. This obligation lowers the efficiency of the representations and warranties provided by the seller. Also, buyers still lack of reliable information on the Chinese target companies.
This article will provide a general overview of due diligence in China. In particular, it will focus on vital factors acquirers of Mainland domestic firms that shall not be overlooked.
Legal Due Diligence
Business scope and licenses – Companies are normally allowed only a narrow scope for business in their business license. Specific licenses may be requested from government agencies such as the FDA (Food and Drug Administration) for pharmaceutical products or the CAAC (Civil Aviation Administration of China) for aeronautical industry. Chinese law does not always permit the transfer of these licenses in M&A transactions. Foreign ownership can affect license applications when restricted activities are involved. The buyer shall check whether the license and approvals have been obtained through normal administrative channels or by public relations (guanxi).
Asset Ownership – Many newly-formed Chinese companies do not have adequate documentation to show what assets belong to them. Buyers should confirm the ownership of assets, investigate related companies, and ascertain whether acquired assets are subject to bank encumbrances such as pledge or mortgage.
Land Licenses – Titles to use a land are raising specific issues in China. Allocated land use rights entitle the Chinese authorities to terminate the use of land without notice period and without indemnification. Use of granted land in China will increase the value of the purchased assets and will allow the beneficiary to benefit from an asset that can be used as a security for bank loans.
The use of the land shall be done in accordance with the original administrative documentation. Failure to conduct due diligence on either of the above issues, may lead to an incomplete transfer of assets upon an equity takeover of the target.
Human Resources Issues – Risks related to payment of social insurance premium and personal income tax of the employees have to be verified. In China, the employer shall declare and pay social insurance premiums and personal income tax of the employees. Frequently, employers will pay a part of the salary in cash as refund of expenses.
Falsified transaction documents provided for audits purpose may still be produced. In most of the cases, the fraud is happening well below top management and even without its direct knowledge. Compliance procedures and standards shall be checked.
Commercial banking relationships – The due diligence shall provide guidance on the target’s ease of collusion with its financial institutions, and its ability to undertake excessive leverage through ‘mate’s rates. Acquirers should question large borrowings/capital raisings and ask the target’s management for an explanation when needed.
Financial Due Diligence
Accounting – Due diligence on such matters is easier said than done however. Availability of basic financial information can often be an issue, with some Chinese companies being unfamiliar with standard Western accounting procedures. For instance, keeping several sets of books and having little distinction between corporate and personal funds are just two issues acquirers may face during due diligence.
Basic Tax Issues – The due diligence shall be used to understand if specific tax arrangements have been negotiated with the local tax bureau. It should be verified if the economy resulting from tax advantages may be claimed back by the authorities under specific events. This is generally the case when the company moves its registered office. All the specific advantages obtained from the specific administration managing special development zones shall be identified.
The target company may operate under a shadow entity for the ownership of the assets and business used for its activity. The due diligence will stress the potential exposure related to inaccurate recording of revenues and expenses and risks related to the accuracy of their tax positions.
Tax compliance issues can be expected where the target has not made all of the necessary tax adjustments to the accounting book for computing its corporate income tax, reimbursement of expenses without official invoices (i.e. fapiaos), under-reporting VAT, customs duty and individual income tax liabilities, underpaid or unpaid social welfare contributions.
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