CFOs say MNCs have a bright future in China, but vigilance is required to resist a business-as-usual mentality when it comes to rapidly changing regulations, corporate integrity, and growth strategies.
The Asia CFO Peer Group met as an official group for the first time in Shanghai, China, where they were hosted by founding member, Gap, Greater China, and supported by partners from PwC. Members used the one-day meeting to cover tax developments, compliance practices, and growth management, among other topics. The ACFO group is easily characterized by high levels of energy and transparency, which resulted in an excellent day of knowledge exchange. Further highlights from the meeting included:
1) Effective Methods for Staying Compliant: The best tools for compliance are a strong culture of integrity that originates at the top, and a robust whistle-blower program.
2) Tax Developments You Need to Know About: Local tax incentives are being prohibited by the State Agency for Tax, which is going to create a budgeting challenge for companies that have relied on them historically.
3) What’s So Bad About Growth? Many companies have benefitted from rapid growth in China. This session featured one member company’s story after just four years in the market.
Fight Corruption with a Top-Down Culture of Integrity
Meeting participants agreed that corporate integrity has to start with the tone at the top and must be integrated throughout the organization with periodic training.
While a strong whistle-blower program is good for catching corruption, company philosophy and employee training, is the best defense against it occurring in the first place, noted Mr. Xu. Members agreed that this combination offers the best security against falling prey to temptations to corruption. Two members noted that sharing actual anonymous examples of integrity breaches and consequences is very effective in getting the message across. Many companies have also taken the extra step of communicating their values and their expectations concerning integrity to their suppliers and other key business partners.
But does integrity compromise the business? One member admitted that “integrity can slow you down in a new market,” but she believes it is the right approach in the long run. “Once you establish a reputation for not being milked, the fraudsters go on to the easier prey,” she said.
Effective Methods for Staying Compliant
The demands of regulatory compliance seem to top the list of challenges for finance leaders in general, but it is particularly true in China. While compliance means different things to different industries, this session, led by Jasper Xu, Risk Assurance partner with PwC, focused mostly on managing corruption both inside and outside the organization. Members also shared how they approach this challenge.
Mr. Xu noted that companies often deal with compliance in extremes, first by creating an environment for growth where they establish sales incentives and KPIs in a way that may result in problematic behavior. When this behavior occurs “they respond by undoing everything.”
Key Takeaways
1) FCPA China style. Mr. Xu began by noting that China has implemented its own version of the US’s Foreign Corrupt Practices Act (FCPA). Everyone has read of China’s intense crackdown on corruption within its own government ranks, with many of the guilty going to prison. Clearly anti-corruption is a key focus within the country at the highest levels. But because corruption has been so pervasive for so long it will be a while before the message is heard clearly in all areas of the business community.
Mr. Xu noted that companies can be cited for simply having weak controls in place even if no corruption has been identified.
2) There are many dark corners. Mr. Xu highlighted a sample of 17 common examples of where and how corruption and fraud are most likely to occur and points out that these examples are anchored in a culture that relies heavily on relationships in business, gift giving, hospitality and an influential supervisor/subordinate relationship.
3) You must understand the corruption landscape and areas of potential exposure. Given the long list of corruption examples provided by Mr. Xu, it begs the question of how knowledgeable your organization is about where these exposures lie within your own operations. A thorough review of the supply chain, buyers’ procedures, sales organization, agents, distributors and joint-venture partners, to name a few areas, is clearly a must in order to identify where your company could be at risk of being compromised. However, not all situations are black and white. These scenarios are described as “values challenges.”
4) There are practical tools to identify potential violations. Mr. Xu informed the group that there is a software program that performs margin analysis to look for high-margin sales transactions, a red flag for corruption. It can perform the analysis by product or region. Further, PwC is implementing an anti-corruption program for clients that might be worth a review. Finally, Mr. Xu noted that a properly structured whistle-blower program is the most effective tool for detecting corruption.
Outlook
With the increased scrutiny, new regulations and potentially severe consequences, there is plenty of incentive to stay clear of any violations. The temptation is great to over-manage the risk and cover every potential exposure. And there is no reason to believe the environment will become any less intense. Consequently, developing a culture of integrity that starts at the top and is communicated frequently throughout the ranks (and supplemented with periodic training) is a good starting place (see sidebar). The next step is to identify the right balance between detailed policies and procedures and a more principled and philosophical approach to managing the risk.
Avoiding and Responding to a Tax Audit
There is a multitude of types of tax audits in China, any of which can be triggered by a number of variables, noted PwC’s Alan Yam. He listed no fewer than 16 different types and sources of an audit, including transfer pricing and VAT tax from the state level and a host of others at the local level. Mr. Yam also provided key triggers for audits:
- Being listed as a key target based on the result of a Tax Evaluation.
- Falling within the scope of mandatory tax audit and investigation by the SAT.
- Periodic routine audit.
- Being reported or implicated.
In spite of all of this, added Mr. Yam, the government is raising its level of scrutiny on three specific areas of corporate activity:
- Corporate restructurings involving equity transfers.
- Cross-border remittances for service and royalty fees.
- Dividend payments to overseas investors.
Regarding service/royalty fees, Mr. Yam said the government is looking for fees that are not adding value: “They expect you to be able to prove substance and that you are really performing a legitimate service and not just a financing role. They can disallow the fee if they believe the service provides no legitimate value.”
The government targets specific industries and companies each year. It was advised that if you are approached for auditing, the best response is to give them 80 percent of what is requested, or enough to make them go away.
Tax Developments You Need to Know About
Running afoul of the State Administration of Tax (SAT) is clearly undesirable. But with new developments occurring frequently, it is easy to lose track of something important. This session was led by a tax partner at PwC, Alan Yam, who shared his views on some of the most important topics currently facing CFOs.
Most know that regulations change often and frequently are difficult to interpret. However, Mr. Yam brought clarity to a few of those tax regulations that are important to CFOs but that are also in a current state of flux.
Key Takeaways
1) Local tax incentives are going away — or are they? At the top of the list is Circular 62 from the State Council that is eliminating “unauthorized financial incentives.” Local governments in China compete for major companies to set up operations in their jurisdictions. As in the US, one of the tools they use is tax incentives in the form of subsidies. In China, local tax authorities are responsible for giving a portion of their tax revenue to the national government.
According to Mr. Yam, “The national government has taken the view that local decisions to give incentives to businesses are cutting into the national revenue, and they want that to stop.” However, many local officials are communicating that they will find “alternative” means to incentivize business to enter into and grow in their jurisdiction. But this is only verbal and is putting CFOs in the awkward position of having to negatively adjust budgets where those subsidies have been planned for but now may go away. Further, Mr. Yam notes that any moves from local authorities to continue the practice will likely wait a bit as the issue is currently too sensitive.
2) You want the CFO’s password? The era of “big data” is giving rise to an egregious overstepping of boundaries. Tax authorities have begun asking for the CFO’s password to the ERP system. When granted, this allows them not only to see large amounts of confidential data but also to copy the data onto a flash drive and walk away with it. Mr. Yam noted that these auditors and their staff are well-versed in Oracle and SAP. In response, he offered a few suggestions:
- Have a standard operating procedure for how to respond to this request and who should oversee the auditors.
- Try to limit their access to three pages of Excel spreadsheets.
- Ask them what they need and offer to provide it.
- Set a separate password for the CFO that limits access.
3) Good news for High and New Technology Enterprises (HNTE). If you are this type of firm the government has good news for you. First you will have a corporate income tax rate of merely 15 percent. Further, qualified R&D expenses can qualify for the “Super Deduction” of 150 percent. And, this particular benefit is not confined to just tech companies.
Outlook
There is no reason to believe tax regulations (and regulators) will become any less volatile or intrusive anytime soon. And the slowdown in the Chinese economy gives reason to believe they will continue to look for ways to further extract revenue and control outcomes through taxation. Understanding the triggers for audits, staying close to tax advisors (both internally and externally) and being prepared for their eventual arrival is the best way to stay on top of tax management.
Member Profile: Succeeding in China
One ACFO group member shared a profile of the company’s Greater China operation. She described her steep learning curve amid the rapid growth of the company since entering China four years ago.
The company, a retailer, opened its first store in China in 2011, which was its first new country since entering Japan 20 years earlier. Now with more than 100 stores currently, and consisting of only two of its four key brands, the company has managed to keep its legal entity count to a mere two. This has allowed the company to avoid a lot of extra work with compliance, documentation, tax filings, and intercompany transactions. Further, the company has no joint venture partners, which has allowed it to retain centralized control of the operation but, admittedly, has likely caused the company to make some mistakes and grow more slowly than it might have otherwise, due to its unfamiliarity with Chinese business processes.
The company’s original plan for entering China called for a combination of company-owned stores, franchised stores and wholesale stores. After becoming familiar with the market, that plan changed to having only company-owned stores in order to maintain brand control. The company’s current plans are to deploy all brands and all channels in China.
What’s So Bad About Growth?
Growth is always good — and certainly better than the alternative. But it can bring significant challenges, particularly in China. Once top-line growth begins to moderate, HQs begins to put further pressure on expenses, which in turn can further affect revenue growth. Having the proper resourcing to drive business growth is very important in China. Finding the right balance and ensuring that the given resources are properly allocated is difficult.
With this backdrop, one member described her experiences and challenges with the rapid growth trajectory she has been on since arriving four years earlier.
Key Takeaways
1) Adjust your model to the local environment. As this member company set up shop and began expanding its footprint, it quickly began learning about the local customs and opportunities it would be required to embrace if it were to be successful.
2) Leverage your identity. The member company is an iconic consumer brand in the US and is recognized in China as a US company. Rather than trying to make itself look like a Chinese company, the company embraces its history and identity as part of its appeal. Store employees are instructed to greet customers with “Hi.”
3) Shuffling leadership to achieve strategic goals. The company wants the China market to be its second-largest behind the US. To this end, it recently promoted its head of e-commerce to the role of China President and moved the former China president to the position of president of the marquee brand globally.
Outlook
China is an enormous growth market for many global companies, and this member company has only scratched the surface. The company elected to enter the market alone rather than with a joint venture partner, and it’s working well. With many years of rapid growth expected to be ahead, the next phase will require more automation and systems support, a larger and stronger staff, and robust analytical abilities to manage the business and its growth in a more methodical and nuanced way.
CONCLUSION
BIt was good to see participants engaging in an unbridled, open exchange of thoughts on the hottest topics for finance leaders. The combination of member experiences and the perspective of outside experts like PwC can help members find solutions, or at least improvements, to challenges. China will certainly remain in the forefront of MNC activities and expansion for the foreseeable future and will no doubt include a continuation of rapid changes in regulation, growth and opportunities. It is our hope that the Asia CFO Peer Group will become the members’ “go to” source for support and input.