Regulatory Climate in South China: Not All Investment Is

UNCLAS SECTION 01 OF 02 GUANGZHOU 000790

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E.O. 12958: N/A
TAGS: EINV ECON ETRD WTRO CH
SUBJECT: Regulatory Climate in South China: Not All Investment Is
Created Equal

REF: Beijing 912

(U) This document is sensitive but unclassified. Please protect
accordingly.


1. (SBU) Summary: Regulatory issues, particularly those relating to
administrative discretion, are the biggest impediments to foreign
direct investment (FDI) in South China, according to legal
professionals and businesspeople. Foreign investors encounter more
obstacles when establishing local operations than their domestic
counterparts. This trend is likely to continue in 2008, despite the
recent adoption of equal-treatment tax regulations. Environmental
regulations, in contrast, are expected to be enforced, without
discrimination, between domestic and foreign enterprises. End
Summary.

Equity to Debt Limitations
--------------


2. (SBU) According to David Buxbaum, a long time resident of South
China, managing partner of Shenzhen-based Anderson & Anderson LLP
and one of the most savvy lawyers on China's legal framework,
foreign companies in the Pearl River Delta are granted fewer
benefits, and this is less consistency in their treatment, than
their domestic counterparts. The discriminatory treatment is
particularly evident in the implementation of equity-to-debt
regulations. Buxbaum said Chinese corporations can negotiate and
meet registered capital requirements much easier than foreign
companies, both at the local and provincial levels. Furthermore,
the recently adopted real estate regulations targeting foreign
investors have been consistently enforced, thus requiring all
foreign-invested enterprises' (FIEs) property investment to be
capitalized at a minimum of 50 percent of total estimated costs.
Buxbaum noted that since foreigners comprise such a small segment of
the real estate market, the actual effect of this measure on the
entire market is primarily psychological. Essentially, the
government is trying to signal - especially to those who don't
understand how the market is segmented - that the blame for recent
real estate hikes lies with foreigners. In so doing, it has added
another unnecessary layer of discriminatory regulation to foreign
investment.

Tax Regulations
--------------


3. (SBU) On January 1, 2008, the income tax rate for all companies
in China, both foreign and domestic, will equalize at 25 percent.
Most domestic enterprises will see a tax cut, while most FIEs will
see their taxes increase. To prepare for the change, many large and
already established FIEs and potential FIEs in the Pearl River Delta
(PRD) have re-structured their operations to ensure their income is
taxed as that of a Hong Kong entity this allows them to qualify for
the lower tax rate of 17.5 percent. As reported in its May 2007
issue of China Briefing, the regional consultancy Dezan Shira &
Associates expects that many foreign small-to-medium enterprises
(SMEs),in contrast, may look to invest in other countries because
they are unable to meet the tax burden.


4. (SBU) Although business tax regulations will soon be uniform on
paper, enforcement will likely remain uneven, according to Vivian
Desmonts, regional partner for South China's leading European Law
Firm, DS Law Firm. Despite recent improvements, said Desmonts, tax
fraud remains a popular national "sport." Foreign investors are not
particularly inclined to participate, however, because they are
investigated with far more scrutiny. In south China, where central
investigatory bodies have only an indirect influence, local
relationships can rather easily lead to the acceptance of "cooked"
accounting books, since the company representative will often have a
relationship or indirect connection with the auditing body.
Domestic firms, therefore, will often retain an advantage by
consistently underreporting taxable income.

Tax Incentives - Not Yet Westward Bound
--------------


5. (SBU) China's underdeveloped western regions will likely continue
to use preferential tax policies to attract FDI, despite the
expiration of most other tax holidays, according to Dezan Shira.
Nevertheless, legal experts and business professionals in South
China remain skeptical that these incentives will lure investment
out of Beijing, Shanghai, and Southeast China. A local
businessperson and several legal experts said China is ten or more
years removed from being able to attract large foreign investment

GUANGZHOU 00000790 002 OF 002


into its western provinces.

Mergers & Acquisitions (M&A)
--------------


6. (SBU) Many foreign invested companies in the PRD are now
attempting to tap directly into the China market instead of simply
re-export. This development has been accompanied by an expansion in
M&A activity, designed specifically to open up distribution
channels. Although the M&A regulations issued by the Chinese
government in September 2006 helped to facilitate this transition,
legal experts in south China still complain of discriminatory
treatment. This includes a lack of transparency in the
interpretation and enforcement of specified restrictions with regard
to Chinese-targeted asset acquisitions, as well as unclear
prohibitions on merger agreements. And while at least one
practitioner of a well-established law firm in the region attributes
this to the natural growing pains of a law in its infancy, others
are more critical and believe it to be yet another indication of
centrally-driven protectionism (reftel).


7. (SBU) According to Xinhua News, the second draft of the
Anti-Monopoly Law was recently submitted to the National People's
Congress Standing Committee and calls for the examination of all M&A
cases related to national security. This marks the first time that
such a provision has been enshrined in law. Consensus among
business and legal professionals is that this is retaliation for
CNOOC's failed bid of UNOCAL in 2005. Harley Seyedin, President of
AmCham/South China and CEO of First Washington Group - which
established the first Western majority-owned power plant in South
China - worries about the potential for selective enforcement. The
broad language of the law neither stipulates what "examination"
entails nor does it specify which cases might qualify as "related to
national security". All told, it appears to provide little
encouragement to foreign investors planning to engage in large M&A
transactions, particularly in those sectors currently controlled
(and likely held for continued domination)by big state-owned
enterprises.

Environmental Regulations
--------------


8. (SBU) Although enforcement of environmental regulations remains
uneven at the local level, officials are paying increasing attention
to the issue. According to Chun Hua Li, Chief Representative for
McCandlish Holton PC, the promotion of government officials is now
correlated, at least in part, to their work in promoting
environmental policies. This has led to more consistent
pre-assessment reviews for all investors, both foreign and domestic.
Some companies, though, have had to alter previously compliant
operations to reach present standards. Mr. Li and other attorneys
in the PRD counsel their clients to exceed all necessary regulations
to ensure long-term compliance.

Comment: Challenges Still Lie Ahead
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9. (U) Although the regulatory climate in the PRD has improved
significantly, numerous challenges remain. Foreign investors
continue to encounter discriminatory treatment in areas such as real
estate and equity-to-debt ratios. Ironically, the emergence of an
equal-treatment business tax will likely prove discriminatory to
foreign enterprises because domestic companies are less compliant
and it's easy for the government to point to foreign companies to
deflect their own inaction on domestic concerns. Companies, many of
which will probably continue to shift to Hong Kong corporate
residency in 2008, will need to consider long-term compliance in an
increasingly sensitive environmental regulatory climate, a trend
which has already begun to take shape within the region.

GOLDBERG