- China's challenging environment experienced significant infra-structure and regulatory improvements recently, enabling better cash management by multinational corporations (MNCs).
- Structures such as holding companies, foreign-invested companies limited by shares, and entrusted loans offer other treasury alternatives, subject to approvals and taxation regulations.
- Corporate restructuring through centralised functions has also proven effective for many MNCs, as has the relocation of regional headquarters and shared service centres to China.
- As one of China's largest investors, Philips has considered these techniques to better its treasury team, corporate structure, and management of group liquidity.
Cash and treasury management in China has never been easy, even for top-tier multinational corporations (MNCs). Complex regulations, foreign exchange controls, a lack of tax and treasury consolidation mechanisms, limited investment products, unique operating conditions, and a developing banking and clearing infrastructure are all factors inhibiting the implementation of effective cash management techniques widely used in other countries.
Nevertheless, the financial system in China has seen significant development over the past few years, and many techniques that were once considered unfeasible or difficult to implement are now possible. For example, the prohibition of inter-company loans once made cash concentration impossible in China, and caused many MNCs to have massively inefficient cash management structures where excess cash in one group entity cannot be used by another. However, the introduction of entrusted loans has now made indirect inter-company loans (through banks) possible and quasi-pooling arrangements feasible. Furthermore, where renminbi (RMB) overdrafts were once prohibited, since mid-2002 local banks have been permitted to offer this service. By 2003, selected foreign banks such as HSBC were also allowed to offer RMB overdrafts.
Further developments to China's banking infrastructure and regulatory framework are expected. These will certainly make the job of a corporate CFO or treasurer easier.
Impact of Corporate Structure on Cash Management
In China, cash management cannot be looked at in isolation, but instead should always be considered along with other legal and tax issues, in particular the corporate structure of the MNC. The need to form separate joint ventures (JVs) with different partners at different locations, limitations on business scope approvals and local registration requirements have caused MNCs with sizeable operations in China to have complicated corporate structures. In certain cases, some corporates have over 50 separate legal entities; some in the form of majority- or minority-owned JVs, others as wholly foreign-owned enterprises (WFOEs). In addition, while some entities are held directly under a China holding company, others may be held by offshore special purpose vehicles (SPVs).
This fragmented structure presents a massive challenge to a CFO in centralising and coordinating finance and treasury management initiatives, as well as standardising practices across group entities. Furthermore, the duplication of most core business functions - such as marketing, finance, IT, procurement and administration - is also costly and inefficient. In terms of dealings with banks under a decentralised set-up, each separate entity may have negotiated independently with separate banks for facilities and services, resulting in different pricing and varying standards of services provided, with no central coordination of cash management initiatives.
From legal and tax perspectives, group entities are also considered to be separate, and there are no arrangements for centralised invoicing and shared services. Transactions between group entities are considered external and subject to value-added tax (VAT) or business tax (BT). As such, a number of leading MNCs in China have explored alternative structures to consolidate the management of their legal entities and, since 1995, a number of MNCs have established holding companies for this purpose.
Holding Companies
Foreign-invested investment companies (more commonly known as holding companies) refer to enterprises set up with limited liability status that can engage in direct investment activities in China. Unlike other manufacturing and trading foreign companies, which are restricted to conducting business in the place of its business registration, holding companies are permitted to invest in projects all over China. The establishment of holding companies was permitted in 1995 and, since then, over 200 foreign-invested holding companies have been established in China, mostly in Beijing and Shanghai.
In 2003, the newly-established Ministry of Commerce took up the governance and regulation of holding companies, and in June 2003 issued its first regulation - the "Provisions on the Establishment of Investment Companies by Foreign Investors". Essentially, this regulation consolidated several pieces of previously issued regulations into one. Compared with regulations in 2002, while the conditions for forming holding companies remain unchanged, the permissible business scope has been expanded and foreign investors are now allowed to establish holding companies in a broader range of industries.
There are many requirements for establishing a holding company in China. In addition to a number of conditions on financial strength and investment capital contributed, foreign investors also have to commit USD30m in fresh capital, to be paid up within two years after the issuance of a business licence. Compared with previous regulations, the use of the USD30m capital, however, has been expanded to include the purchase of stock rights of domestic companies in China.
Aside from being the investment vehicle for foreign investors in China, holding companies can also be engaged in the provision of centralised management and shared services to investee companies (with at least 10% holding). These rights, however, can only be provided subject to the unanimous approval of the board of directors of the investee company. Based on these rights, a number of MNCs are looking to expand the scope of operation of their holding companies to include trading as well as treasury and cash management activities.
For example, holding companies are now able to conduct domestic and international trading by selling products manufactured by its investees in domestic and foreign markets, and by providing after-sales services. By acting as a principal in selling investees' products, holding companies can now centralise the sales and invoicing of group products and present a "single face" to customers. This also enables companies with the right structure to manage and centralise their cash at the holding company through leading and lagging techniques. Other MNCs have also taken advantage of the right to export products (for goods that are not subject to export quota and licences) by establishing an export procurement centre under their holding company. On the import side, the holding company can import up to 35% of its capital for the purposes of system integration and trial sale.
On the financial services side, holding companies can also provide operating leases of machines and office equipment to their subsidiaries. Provided consent from the relevant authorities is given, the holding company can conduct intra-group lending and balance foreign currency among investee companies. However, in reality, such intra-group lending and balancing of transactions are often not easy to execute. It should be noted also that holding companies are usually taxed at the full statutory rate of 33%, whereas manufacturing foreign-invested enterprises (FIEs) are usually taxed at much lower rates.
Improving Cash and Treasury Management through Corporate Restructuring
Although the holding company presents a number of benefits in terms of centralised management and services, there are still limitations, including difficulties in conducting inter-company finance and treasury activities, as well as other tax issues. As a result, a number of MNCs, even with holding companies, are still exploring means to improve their intra-group cash management activities by streamlining their legal structure and consolidating the number of legal entities.
Ideally, the objective of many MNCs is to merge their entities into a single legal entity with underlying operating branches. With this structure, as the various branches and the main entity are within the same legal entity, funds can be pooled and moved freely within the structure. If the entity is located in an area where foreign banks are permitted to offer RMB services (e.g. Shanghai), it is also possible to have a foreign bank as a full service partner by consolidating loans and cash management services to the foreign bank.
However, to merge different JVs with different local partners to form a new JV can be cumbersome and complex. As a result, some foreign companies have formed foreign-invested companies limited by shares (CLS) as an alternative.
Foreign-invested Companies Limited by Shares
A CLS is an enterprise with the status of legal person established in accordance with the 1995 "Interim Regulations on the Establishment of Foreign-Invested Companies Limited by Shares". In essence, a CLS is a joint stock company, with its capital divided into shares of equal amount and its shareholders bearing liabilities to the extent of the shares they hold. The minimum paid-up registered capital of a CLS is RMB30m (this does not need to be fresh capital) and the establishment of a CLS requires a minimum of five promoters or shareholders, with at least one foreign shareholder holding at least 25% of the capital (to maintain its status as foreign-invested). The establishment of any CLS, regardless of the amount of registered capital or foreign investment, requires approval by the Ministry of Commerce.
Unlike other forms of limited liability companies such as JVs, a CLS may provide improved corporate governance and control to investors. For example, in a JV, the minority investor has pre-emptive rights in respect of the transfer of shares by the other investor(s) and its consent is required for certain key decisions, such as the increase and assignment of registered capital, merger and dissolution. The passing of these would require unanimous board approval by all directors present at a board meeting. However, for a CLS, the body with the highest authority is the shareholders' general meeting (SGM), and there are no issues that require unanimous approval - in fact, two-thirds of shareholders' votes decide issues on the increase or assignment of registered capital, merger, and dissolution. In reality, however, the protection of minority shareholder interests can be negotiated and contained within the Articles of Association of the CLS.
Therefore, for corporate groups with multiple JVs with multiple partners, merging the different JVs to form a CLS is therefore more viable and beneficial than establishing a multi-party JV. In this regard, Kodak and Unilever were the first movers in establishing CLS with local partners in China. It should be mentioned that tax implications and obtaining the necessary approvals involving cross-provincial mergers could be potential stumbling blocks for this initiative, nevertheless the CLS is an increasingly popular corporate structure.
Subject to the relevant regulatory approvals, the form of a CLS would allow it to list on China's domestic stock market and issue corporate bonds. It should be noted, however, that for US-based multinationals, a CLS is not a flow-through vehicle for US tax reporting purposes.
Liquidity Management: Other Alternatives
For MNCs that are not prepared to undergo complex and time-consuming restructuring, there are other liquidity management tools available to improve their cash management. As discussed, the prohibition of inter-company loans has limited the implementation of liquidity management arrangements, resulting in inefficient use of cash, unnecessary borrowings, and an increase in the overall funding costs for a corporate group.
The situation improved significantly with the introduction of entrusted loans in 2000. Entrusted loans are indirect inter-company loans, using banks as intermediaries. The entrusted loan does not sit on the balance sheet of the bank and, in return, the bank levies a fee for the service. Other products that are variations on the entrusted loan legal framework have since been developed to offer MNCs even more convenience in the administration and management of their liquidity.
For example, HSBC has developed the group entrusted loan, which is a simple extension of a plain vanilla entrusted loan arrangement, where the bank would be able to provide corporate groups with a single multilateral entrusted loan arrangement to cover all its intra-group entrusted loan arrangements. The initiation of entrusted loans is done by the customer and sent to the bank via electronic banking, fax (where fax indemnities are provided), or paper drawdown notices. This reduces administration by eliminating the need to have separate entrusted loan legal agreements prepared each time a transaction is executed, as well as to consolidate the payment of stamp duty on the entrusted loan master agreement. In addition to group entrusted loans, other MNCs have also executed USD entrusted loans between their group entities in China.
Relocation of Regional Headquarters and Shared Service Centres to China
In a landmark move in 1999, Alcatel moved its regional headquarters (RHQs) in Asia from Sydney, Australia to Shanghai. Since then, China has seen the establishment of a number of Greater China or Asia-Pacific RHQs from leading MNCs, including Honeywell, GE Plastics and Siemens Mobile Communications.
To encourage MNCs to establish RHQs, the Shanghai Municipal Government issued the "Interim Regulations to Encourage the Establishment of Regional Headquarters by Foreign Multinational Companies in Shanghai" in July 2002. These regulations offer a number of financial incentives to foreign investors to establish regional or global procurement and logistics centres, as well as possible expanded rights in cash and treasury management. At the time of writing, 41 MNCs, including Honeywell, Kodak, Exxon Mobil, GE and Delphi and other MNCs from the US, Europe, Japan, Indonesia, Hong Kong and Taiwan have received this official RHQ status.
In March and August 2003, the Shanghai government released further implementation guidelines on the interim regulations. These guidelines encourage commercial banks in Shanghai to provide financial services (such as settlement and foreign exchange) and more importantly, actively seek ways to support the cash management requirements of RHQs.
Along with the relocation of RHQs and regional functions to China, other MNCs have also relocated their shared service centres (SSCs) to China. These centres support the payment, treasury management and accounting operations for multiple countries in Asia. Other data-processing and call centres are also becoming a trend among corporate groups.
For example, a US MNC set up an SSC in Shanghai, supporting the payments, financial reporting and cost accounting for 17 countries. Another MNC has set up an accounting centre in Tianjin that supports accounting and payments functions for 13 countries in Asia.
There are three main reasons behind the relocation of such functions to China. First, for a number of MNCs, their business in China already represents a significant portion of their Asian or global sales. Some MNCs also see China as their most important growth market. Therefore, relocating such regional functions to China allows them to be close to their key or strategic market. Second, incentives offered by the Chinese government are an important factor in relocating RHQs or SSCs. Lastly, whereas finding the right staff for such servicing centres in the past was difficult, there is now an availability of skilled, multilingual labour (e.g. English-speaking staff in Shanghai, and Japanese- and Korean-speaking staff in Dalian) at comparatively low costs.
From a corporate point of view, there are issues to be considered before an SSC can be properly set up, as the State Administration of Industry and Commerce may query whether the entity housing the SSC is engaging in activities outside of its permitted business scope. If holding companies are used, SSC services can only be provided to investee FIEs with at least 10% shareholding. Also, unanimous board approval from its investee companies is required.
Q&A with Leong Wai Leng, Vice President and Chief Financial Officer of Philips, China
What is the current size of Philips' investment in China?
Leong: Philips is the largest or second largest investor in China at the moment. Our business in China generated over EUR6bn in sales in 2002, and we have 30 JVs and WFOEs all over the country employing about 16,500 people. If you include the staff employed by our original equipment manufacturing (OEM) and original design manufacturing (ODM) suppliers, our business employs close to 40,000 people in China.
What is the role of the China corporate treasury team?
The corporate treasury team, under the Philips treasury management model, has three key functions, namely corporate finance, cash management and risk consulting. Our team in China looks after the treasury needs for all Philips consolidated entities.
We manage all banking relationships on behalf of our entities. When I relocated to China three years ago, we had a long list of banks. Given the geographical coverage of our business, you name a bank and we probably would be using it. One of our main initiatives was to consolidate our banking relationships and today, aside from our core global banking partners, we have only two core local banks supporting our business. We have also successfully negotiated two master credit facilities and service-level agreements across our entities in China, with standard pricing, terms and conditions.
On the cash management side, we manage liquidity centrally and standardise our cash management systems to be in line with our global platform, including investigating ways we can participate in our global netting scheme, possibly on a modified basis in China due to regulatory restrictions.
In risk consulting, we work with our product divisions on the measurement of foreign exchange risks and the implementation of forward hedging. We also wear a business development hat, in that we support our business in conducting analysis and due diligence on merger and acquisition transactions and divestments.
What are the key challenges in managing a corporate treasury operation in China?
First, we have 30 separate legal entities consisting of WFOEs and JVs across China. It is a huge challenge managing the large number of separate operational management teams, with JVs owned by different local shareholders in different locations. Our ideal structure would be one that allows us to have completely centralised functions, including finance, payments and collections, IT and human resources, all under one legal entity, and which would allow us to freely move resources internally. However, the restrictions of business scopes, trading rights and differences in tax incentives would make this difficult to achieve.
Second, although nationwide regulations are promulgated centrally, the different interpretation of such rules - including taxes, customs and foreign exchange regulations by the various provinces and cities - also make for differences and inconsistencies in the implementation of the regulations. As such, it is not feasible or practical to have full centralisation of foreign exchange (spot and forward contracts) among different entities in different cities.
Third, like many other MNCs with strong local sales in China, we face the issue of having a large amount of excess RMB liquidity in China. The question here is: how can you effectively mobilise the excess RMB for use, not in China, but for Philips globally? The question that I often get from our headquarters is how can we justify the situation where Philips globally has borrowing positions overseas, but yet we have a huge pile of RMB in China just sitting in bank accounts? This is an issue that I believe quite a few MNCs are facing, and with China opening up to the international business community, we can only hope that regulatory restrictions will be slowly lifted and there will soon be a solution to this issue. I must stress that we are not interested in simply getting our cash out of China. I see cash as a global commodity, and what we truly want is a structure or process that is flexible and allows us to manage cash on a global basis. As such, if there is excess cash, it can be brought out for use by overseas Philips group entities and, if our China entities need cash, our global liquidity similarly can also flow back into China. Our ultimate objective is to effectively manage our cash globally, rather than just within China.
Fourth, although the financial infrastructure is improving, there are still many areas for further development. For example, China still lacks a consolidated, nationwide clearing system, and getting good value on collections can still be difficult, depending on the location. The current segregated local tax jurisdictions can also create issues for invoicing and payment structures. For example, if you move goods between branches within the same legal entity, you still need to pay VAT. All these factors create complexities for the implementation of truly effective cash and treasury management practices for a corporate group.
You have mentioned issues regarding your corporate structure. Have you looked at the different ways of simplifying your legal structure?
Yes, we have explored ways to simplify our legal entity structure, and there are a few models for doing this. But in reality this is still difficult to implement. Our ideal situation would be to have all businesses, with the different business rights - such as manufacturing, research and development, domestic and international trading, and servicing - all in one company. However, this is often easier said than done.
In particular, we have looked at restructuring our legal entities under the CLS concept, by merging them into a single CLS with an underlying branch structure. However, at this point, we feel that the cost-benefit dynamics are still not too convincing. While there will be benefits from a treasury perspective (by enabling us to move liquidity freely) and in management (by avoiding minority veto rights from local shareholders), there are other issues that complicate the situation. For example, if we convert our legal entities into a CLS with branches, for Chinese customs however, import licences are only granted to first-tier legal persons (locally registered legal entities), but not to second-tier legal persons (branches). How can we operate then if our factories, as a branch of the CLS, do not have the right to import? Nevertheless, we are still exploring ways of how we can simplify our legal structure to further streamline our operations.
What have you implemented to improve the management of group liquidity within China?
First, we started doing entrusted loans in early 2001 for more effective balance sheet management. This resulted in a reduction of unnecessary borrowings and interest costs. We have done both RMB and USD entrusted loans.
Second, we have also worked to reduce our days receivables by partnering with banks in collection by converting inter-city payments into intra-city payments. The results were quite satisfactory and we were able to improve our overall days receivables by five to seven working days on average.
Third, we have also implemented an efficient dividend payment process. In other cases where there are tax incentives for the reinvestment of dividends into new investments, we have also taken advantage of them.
Lastly, a work-in-progress for us is to continue to lobby the State Administration of Foreign Exchange (SAFE) for more effective use of our RMB liquidity offshore.
What are the other future initiatives you are looking at now?
With sales at EUR6bn, China is already Philips' second-largest market globally. The question we are now asking ourselves is, given that a substantial portion of our revenues are derived from this country, should we also look at relocating our Asia-Pacific regional treasury centre to China, in particular, Shanghai? Realistically, there is no question that there have been significant developments and improvements in China's financial and banking markets over the past three years; however, it is also without question that the financial system is still not mature enough compared to other global financial centres of the world. Nevertheless, I believe in the need to be close to your market, and the overall direction China has taken in providing incentives to MNCs in relocating their regional headquarter functions to China will provide an interesting case on setting up our regional treasury centre in the country. In addition, we are also considering whether China is a possible site for our regional finance SSC.
A second project we are looking at is how we can make full use of the value of our holding company, Philips (China) Investment Co. Ltd. There have been interesting developments in the holding company over the past few years, including the new regulations recently issued by the Ministry of Commerce. How we can use the rights endowed to the holding company to add value to our overall business will be something we are looking at closely. For example, we are exploring ways to use our holding company as a treasury management vehicle in China, and to centralise our payments, collections and foreign exchange management. We are also looking at how we can use our holding company as a consolidation vehicle to participate in our global netting arrangement on a gross-in, gross-out basis. We will be interested in piloting these initiatives if these are supported by the authorities such as SAFE.
A third initiative, as we have discussed previously, is to investigate ways of simplifying our legal structure. This translates to reviewing the practicality of the CLS structure. However, issues such as the difficulty of executing cross-province mergers and limitations in the business scope of branches may again create complexities in this regard.
Lastly, seeking case-by-case approval from SAFE to facilitate more effective use of onshore RMB cash is also on the top of my list.
This article was originally published in "HSBC's Guide to Cash and Treasury Management in Asia Pacific 2004."
