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Due Diligence in China: Why & How You Should Conduct It

Posted by: Fabia Meinhold
Category: Business in Asia
Due Diligence in China - SJ Grand

Are you planning a Joint Venture, M&A, partnership, investment, or hiring new staff in China? In all these cases, it is highly recommended to first and foremost conduct due diligence to obtain key intelligence on crucial business aspects. This will enable you to make well-informed investment decisions and to protect your company.

Have  a look at our article on Mergers and Acquisitions in China: An Introduction

Learn more details about how to conduct due diligence in China.

What is Due Diligence?

Due diligence is all about investigating a company, potential investment, product, or staff to confirm all facts that have been provided by the counterpart. It is usually conducted before entering into an agreement with a third-party. The type, complexity, and size of the transaction determine the content and thoroughness of the investigation.

Due diligence can either be conducted internally – when hiring new staff for example – or externally when targeting another company. In this article, we will focus on externally conducted due diligence.

There can also be another distinction in due diligence, especially in the case of Merger and Acquisitions: the hard type and the soft type. Hard due diligence is driven by mathematics and focuses on quantifying organizational data. On the other hand, soft due diligence captures information on “human capital” such as corporate culture, employee motivations, and relationships. Conducting both types of due diligence is crucial for achieving a successful M&A.

Why is it so important in China?

In general, due diligence enables you to exactly know who or what you are dealing with before closing an important deal. Therefore, it may protect your company from many risks.

More specifically, many companies are facing difficulties or unexpected problems when doing business in China. The United States Commercial Service particularly advises conducting more due diligence in China than foreign companies would usually need in other markets. Foreign companies may also feel particularly targeted by audits and reviews, which reinforces the case for compliance.

Be aware: Even though the business environment improved in China, it is still difficult to get all the information you need. Laws and regulations are often unclear and they change regularly. Additionally, as most of the documents are in Chinese and the Chinese counterpart does not necessarily speak English, you may face huge language barriers. Therefore, you should consider getting in touch with professionals who will be able to support you in this process. Contact us if you need to get going with this.

How to Properly Conduct Due Diligence

Due diligence is a wide-ranging topic, and the questions to ask may vary depending on the nature of your projects in China. However, you will find below a list of some aspects you should check before closing a deal. We will focus here on due diligence conducted by a WFOE (Wholly Foreign-Owned Enterprise) before cooperating with a Chinese partner.

Registration examination

First, you have to make sure that you are dealing with a legitimate company. This means that the Chinese company has to be registered with the State Administration for Market Regulation (formerly the State Administration of Industry and Commerce) or local SAMR. You should be able to verify information such as the registered capital, the registered legal person, scope of activity, registered address, and the business license validity.

Financial examination

If the Chinese counterpart is a listed company, we recommend you check:

  • The equity structure
  • Shares Percentage
  • Main shareholders
  • Capital availability ratio
  • Types of investments
  • Bank statements, loans, and credits
  • Government grants
  • Subsidies
  • Debt records
  • Others

Accountancy examination

It is advisable to get 3 to 5 years of historical records from the Chinese counterpart. You should especially verify the reliability of the information concerning the following aspects:

  • Receivables
  • Fixed assets
  • Other payables and liabilities
  • Accordance with Chinese Accounting Standards (e.g. accounting on an accrual basis)
  • Income and costs
  • Supporting documents for authorized payments
  • Authenticity of invoices

Tax examination

You should also consider tax-related details such as whether the company:

  • benefits from preferential tax rates
  • is compliant with foreign exchange regulations
  • is compliant with tax regulations regarding the tax filing

Be careful: If a company refuses to show you the required documentation, you should think twice before closing the deal. Most legitimate companies won’t deny access to these kinds of documents. If the company hands over the information, you should let a professional review it for you to be sure the documentation is authentic.

Learn more about Corporate Income Tax in China: A Full Guide to Tax Deductions

Operational examination

  • On-site visits: After checking the relevant documentation, you should verify the information by visiting the company on site. Take a look at the premises, stocks, production area – if any – and talk with employees. Try to interview lower-level staff who may more easily reveal sensible information than senior managers.
  • References: Trustworthy companies will agree to provide references for due diligence. These may include clients, suppliers, partners, or competitors. The more references you have about the Chinese company, the less risky it is for you. When contacting these references, you will be able to learn about their relationships, their quality, payments, number of customers, and much more. This will help you evaluate your Chinese counterpart.

Have you read? Joint Ventures in China: How to Make your Partnership Successful?

Contact us

S.J. Grand’s tax and accountancy services provide advisory on China’s tax and business regulatory environment and help foreign businesses conduct due diligence on their local counterparts. Contact us to get you started.

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Author: Fabia Meinhold

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