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ZNR UUUUU ZZH
R 121001Z JUL 07
FM AMCONSUL GUANGZHOU
TO RUEHC/SECSTATE WASHDC 6254
INFO RUEHOO/CHINA POSTS COLLECTIVE
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RUEAIIA/CIA WASHDC
RUEKJCS/DIA WASHDC
RHHMUNA/HQ USPACOM HONOLULU HI

UNCLAS SECTION 01 OF 02 GUANGZHOU 000790 
 
SIPDIS 
 
SIPDIS 
SENSITIVE 
PACOM for FPA 
STATE PASS TO USTR-CHINA 
 
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 
----------------------------------- 
 
¶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