China FDI: Beware of Local Governments Bearing Gifts

China Joint Ventures

Recent news reports suggest Foxconn is having trouble securing investment benefits promised by the Zhengzhou government. The rumor is Foxconn was lured to Zhengzhou with promises of over 5 billion RMB in tax benefits and related incentives. These incentives were granted in direct opposition to central government policy. Beijing found out and laid down the law and now the Zhengzhou government is backing down. Construction of a major factory is being delayed as the issues are being sorted out.

Whether true or not, the basic story is a standard in China, describing a practice that has been going on since the beginning of China’s opening up to foreign businesses in 1979. From the very start of opening up, the regions and the center have struggled over investment incentives. Local governments have always offered incentives to encourage foreign investment and jobs in their own backyard. The primary incentives typically consist of tax breaks and a reduction in land prices. The central government has consistently opposed these incentives. The center is the “owner” of both the taxes and the land. In Beijing’s view, local governments have no right to give away what rightly belongs to the center.

For this reason, the center has always issued clear rules, stating how much by way of tax reductions and land pricing incentives is permitted to be provided by local governments to encourage investments. The rules provide for a level playing field: no local government can legally offer any more than any other local government. Under this system, there is general encouragement to invest in China, but the decision on where within China to invest is based on the overall investment environment of a local region, rather than on the benefits provided. This also allows the center to favor particular regions it deems need help in securing foreign investment.

But what do local governments do when they are located in a region that is not terribly attractive to foreign investment? The standard response is to make their region more attractive by improving local infrastructure, education levels and institutions. This sounds good, but it takes time and for many local governments this approach is simply impossible. For example, Zhengzhou is located in central China, with all the weaknesses this location implies.

So what we have seen since the 1980s is disadvantaged regions seek to compete for foreign investment by offering incentives substantially in excess of that permitted by the central government. To be blunt, they have offered illegal incentives. Where this works, these illegal incentives can make a bad investment more attractive. However, the risk is considerable, as the report on Foxconn in Zhengzhou makes clear.

Our China lawyers have seen the following investment incentive disasters:

— One client went to rural Sichuan in the 80’s and worked for almost three years on a complex trucking industry joint venture. When it finally came time for this client to sign the final investment documents, they were not met by the local party secretary who had been the leader in the project. Instead, they were greeted by a new party secretary and when our client asked about the set of documents they were there to sign the new party secretary told them there were no documents. “The former secretary has been removed in disgrace. I have been assigned to replace him. His crime was to offer illegal incentives to foreign investors. I am here to clean up. Your project is one of the projects I am targeting. We are pleased to do the investment, but only on the basis of what is permitted by the central government. If that will not work for you, you will have to just go home.” The U.S. company went home, with three years wasted.

— In a different project in Sichuan at about the same time, a U.S. company made the investment. Under the central government rules, the project did not “pencil.” However, with the generous incentives offered by the local government, there was some chance of success. In year two of the investment, when it was too late to back out, a new party secretary arrived. The new secretary revoked the tax incentives and dictated that the joint venture would now be required to pay for the land and buildings at their current market value, not at the reduced price (essentially free) previously negotiated with his predecessor. These changes crushed the venture financially and it fairly soon had to shut down.

— On an aquaculture project in Shandong, the local government offered the standard illegal incentive of low to no taxes and free land and buildings. We advised this company not to go forward with the project since these incentives were clearly illegal. Our client insisted that the laws were not relevant in China; “all that matters is who you know. We have the support of the local party secretary, Mr. X, and he has approved all of these benefits.” The company then headed off to a small coastal town in Shandong for the signing ceremony. On the day before the ceremony, representatives from our client company were eating breakfast in the party-owned and operated hotel, watching the national news playing on the TV. They looked up and saw Mr. X being led from his office in the custody of two policemen. He was arrested and imprisoned for corruption. That doomed the project.

— On a manufacturing investment project near Shanghai, we advised our client not to go forward because the incentives offered were clearly illegal. The client gave us pretty much the same “You do not understand China” speech and then went ahead and made the investment at significant cost. As the project proceeded, the company made a small profit, entirely due to the benefits provided by the incentives. However, after the Hu Jintao government took control of the center, the entire upper layer of officials in this region were replaced for having engaged in — your guessed it — corruption. All the special benefits were quickly revoked and this company rapidly spiraled down into bankruptcy.

What should a potential investor take from all this? The alleged situation faced by Foxconn in Zhengzhou is not an exception. This sort of thing is standard practice in China. But that does not make it legal or safe or wise. If you are getting incentives, you should should evaluate your China investment in accordance with the central government’s investment rules. These rules (at least in Chinese) are easy to find and are quite clear. If your project makes financial sense under these rules, move forward. If the project does not make financial sense under these rules, you probably should stop or at least be cognizant of how you could at any time lose all of your special incentives.

You should never make China investment decisions solely based on local investment incentives that violate central government rules. These incentives can be evaluated and accepted as a sweetener, making an already profitable project even more attractive. However, if your project hinges on such incentives, your risk will almost always be too high.

Beware of local governments bearing gifts. Look what happened to the Trojans. It could happen to you.

2 responses to “China FDI: Beware of Local Governments Bearing Gifts”

  1. All very true. Client of mine in the countryside outside of Qingdao was promised a tax break for the corporate income tax when they set up their company. A few years later nobody has heard of that agreement and the tax bureau wants the tax for several years plus fine for not paying. It can easily ruin the company. When no records of the incentive exist then the risks will indeed be high and the incentive is never guaranteed.

  2. All very true. Client of mine in the countryside outside of Qingdao was promised a tax break for the corporate income tax when they set up their company. A few years later nobody has heard of that agreement and the tax bureau wants the tax for several years plus fine for not paying. It can easily ruin the company. When no records of the incentive exist then the risks will indeed be high and the incentive is never guaranteed.

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