China Profits Can Be Hard to Bring Home

This is a reprint of an article by Vipal Monga.

U.S. companies have plowed a lot of money into China with high hopes of capitalizing on the country's fast-growing economy. Few of them, however, contemplate the flip side: getting that money back out.

Big corporate investors including General Motors Co., industrial-equipment maker Emerson Electric Co. and fast-food restaurant operator Yum Brands Inc. have long counted on China to fuel their growth. The country now is GM's biggest market, and the auto maker plans to invest as much as $7 billion more there by 2016.

But, as their Chinese profits accumulate, some companies are finding that bringing that money home is a costly and time-consuming process. "It's like the 'Hotel California,' " said Daniel Blumen, co-founder of consulting firm Treasury Alliance Group. "Everybody goes into China in a hurry, but then they find it's not so easy to get out."

Most countries regulate big movements of corporate cash. But in countries with a freely convertible currency that often requires little more than routine approval from tax authorities. In China, which closely regulates the conversion of its yuan into dollars or euros, the hurdles to withdrawing profits include an array of taxes and regulatory gray areas.

Some companies have risen to the challenge, but most have been tight-lipped about how they are coping with it.

The process can be especially frustrating for those who might need the money most urgently. Cash- strapped Eastman Kodak Co., which recently filed for protection under Chapter 11 of the U.S. Bankruptcy Code, has about $320 million in China, and it is likely to need at least some of it to pay its creditors.

The company declined to comment for this article. But Antoinette McCorvey, Kodak's chief financial officer, said during a conference call in November that the photography icon wanted to remove as much of its China cash as it could "once various government requirements are met," according to a transcript of the call from FactSet. Ms. McCorvey said it would take several months for Kodak to repatriate its money.

That's because China, which has gradually been deregulating foreign investment since the 1980s, has put up barriers to limit the sort of capital flight that occurred in countries such as Thailand, Indonesia and Malaysia during the Asian currency crisis of the late 1990s.

"Trapped cash will always be a concern," said Sam Xu, executive director in J.P. Morgan Chase & Co's treasury-services group, which advises companies on cash management. He added that recent steps China has taken to loosen its currency controls, aimed at promoting the yuan as a global currency, haven't made it easier for foreign companies to extract their profits. "It is very likely that it will take a long time before China's capital account is completely open," Mr. Xu said.

In fact, the problem could get worse. China's slowing economy might encourage authorities there to make it more difficult for companies take out profits, said Wei Shu, lead economist of Deloitte Touche Tohmatsu's transfer-pricing practice in China, which advises companies about cross-border transactions.

Corporations that want access to their China cash have a few options, according to several experts. None is very straightforward, but the least complex is for a company's Chinese unit to pay dividends directly to its foreign parent. First, however, the subsidiary has to put aside about 10% of its profits in a so-called enterprise reserve, capped at 50% of a company's total investment in the country, to protect against future losses. That can be a substantial sum for a company such as GM, which has invested billions in China.

That means a foreign company with the yuan equivalent of $300 million in Chinese profits would only be able to pull out roughly $170 million, after accounting for taxes and reserve-fund requirements, assuming a 25% corporate tax rate and 5% employee-welfare-fund setaside.

A company also can lend money from a Chinese-incorporated unit to an overseas affiliate by using a registered bank as a broker. Choosing that route can help the company use its Chinese profits to manage its cash flow but ultimately keeps the money in China.

China's State Administration of Foreign Exchange, which oversees foreign investment, closely regulates such transactions and requires that they be treated as true loans, paid back at interest rates comparable with similar loans by banks. Cross-border loans out of China generally are made in U.S. dollars, so the rate is based on the London interbank offer rate, said J.P. Morgan's Mr. Xu.

Another way to move money: Foreign companies can charge their Chinese subsidiaries royalty fees and charge them for services. China also taxes those transactions, and it insists that they have a legitimate business purpose that is supported by documentation.

"It's a cumbersome process and not exactly tax-efficient," said Herbert Parker, chief financial officer of stereo-equipment manufacturer Harman International Industries, which has been investing in China since 2000. He said the process is manageable, but that companies need to plan in advance.

One reason why is that the rules companies must follow to get government approval to repatriate Chinese funds can be a bit of a moving target.

"There's a difference between the regulations as written and the laws and regulations as they are practiced," said George Kelakos of Kelakos Advisors LLC, which advises companies in distress. He recently acted as trustee for Terra Nostra Resources Corp., a bankrupt holding company that owned a majority interest in two Chinese joint ventures that operated steel and copper companies. Mr. Kelakos said that Terra Nostra sold its Chinese interests as part of its Chapter 11 process, but closing the transactions and recovering the money took two years.

"It was a good result, [if only] because there was a result," he said. He declined to disclose terms of the transactions.

Then, the company must set aside another, unspecified percentage of profit for employee welfare. The amount is based on a number of factors, some of them murky. "It's a little bit of a gray area," said Alvin Chan, a director at tax and accounting advisory firm Nair & Co. The remainder, already taxed at China's corporate rate of 15% to 25%, is subject to an additional 10% withholding tax.

Outsourcing's Two Evils

In this article by Ernie Zibert, outsourcing’s two main evils are discussed. The two evils are:

Paying for Nothing

Paying Twice for Something

Paying for Nothing

Nobody wants to ‘pay for nothing’. Yet, firms enter into contracts with pricing models that reinforce this evil. For example, many contracts have minimum volume requirements. Once the firm goes below the minimum volume then they might have to pay for a proportion of the cost even though they no longer require that service volume.

High-risk areas where firms can pay for nothing are:

Strategic Services. Examples of strategic services are innovation and architectural services. These offers simply do not warrant pre-payment in any outsourcing relationship. If they are included in your deal then sit down with your provider and ask them to value it and remove that cost from your agreement.

SLAs. Service Level Agreements (SLAs) represent another area where, almost without exception, the firm is paying for nothing. The business need might need 99.9% uptime on servers but the firm is paying for 99.99%. Agreements which automatically/formulaically ratchet up SLAs as part of the yearly review have no value. If these are in your agreement get them removed and save yourself some money.

Development and Test environments – These environments are sometimes not differentiated from the production environments. That is, you are paying the same service cost for a development/test environment as you are for a production environment. Even when the cost of supporting these dev/test environments is differentiated and less, they have the same level of SLAs as production servers. If this is in your agreement get it removed and save your firm money.

Pre-paid Services. The golden rule of any effective outsourcing relationship is not to pre-pay for any Services. The worst offender tends to be paying for Professional Services. Simply avoid this. If the provider tempts you with a discount then negotiate a rate discount following a review of the annual spend for professional services. This way, the firm gets a discount on actual costs incurred and the provider bases the discount on actual revenue and not smoke and mirrors.

Messaging Services. Many Service Agreements require the customer/firm to pay by the Active Directory (AD) account. When staff leave they are not removed from the AD and when groups are added the costs for the Service keep going north. To alleviate this cost inflation, ensure you have a bullet-proof policy to clean up AD accounts when staff leave the firm. Also, ensure you have a policy for the creation of distribution lists or generic accounts or apply a different and cheaper price for these accounts. This same principle applies to all billable objects in your Services Agreement.

The ‘paying for nothing’ pitfall in many outsourcing agreements has been recognised by most Vendor Managers and CIOs. XaaS solutions (e.g., IaaS, SaaS) alleviate some cost traps, but not all. For example, many SaaS providers require you pay by the account. On the surface this is quite fair and reasonable. It is aligned with the ‘pay for what you eat’ model. The problem resides in the fact that with this cost structure the providers are not incented to inform you that accounts have not been used or that you are creating billable accounts that serve no value. So remain vigilant and ensure you have the processes in place to mitigate this cost inflation.

Paying Twice for Something

Nobody wants to ‘pay twice for something’. Yet, firms continue to enter into contracts that expose them to this evil.

High-risk areas where firms can pay twice for the same thing are:

Operating Systems. Many outsourcing relationships include an equipment refresh service. Most providers include the Operating System (OS) in the price of the refreshed kit (laptops, PCs, servers), which in turn is bundled in the monthly managed service fee. Yet, neither providers nor firms re-use the OS, despite the fact that most OS licenses are perpetual. So if you have a refresh service in your agreement, check that it uses existing OS and that you are not paying for a second OS.

Software Maintenance/Extended Warranty. Many outsourcing relationships include the supply of software by the provider as part of the Service offering. Yet many firms do not terminate their existing software maintenance contracts when they enter into a managed service agreement. Ask your provider to take over your maintenance and any fees you have pre-paid and reduce the cost of your service. The same principle applies to all your extended warranty on items which are managed by your service provider, including your servers. As a rule, never enter into extended warranties in a managed services environment.

Desktop refresh. Many outsourcing relationships include an equipment refresh service. Ensure that you have a clear policy of decommissioning refreshed assets. Don’t leave them in drawers/cupboards/filling cabinets and furthermore reuse the office application (e.g., MS Word, MS Excel) licenses. Otherwise, your provider will rightly charge you twice for the one staff member. Check that your ratio of billable units to headcount is 1.

Server monitoring. Many outsourcing relationships include a monitoring service. The provider will use their monitoring agents. Ensure that you have the minimum number of agents on your servers and convey this policy to your service provider. Ideally, if you have agents installed sell them to your provider.

Backup strategy. Many outsourcing relationships include a Backup Service. This is has evolved to become the most apparent area of duplicate cost for the firm. Many providers will simply execute the firms existing backup strategy. And good luck to them. Most firms have a backup policy which is outrageously costly and silly. For example, the firm performs snapshots, mirroring, backup to tape (daily, weekly. monthly, quarterly, annually, etc), and off-site backup storage. Multiple backups that afford the firm no additional risk mitigation are simply the firm paying twice for the same thing. Bottom line is clean up your backup strategy and ensure that you ask your provider for the most efficacious backup solution for your firm. Ensure that your backup strategy aligns with your business needs and not simply time-honoured IT tradition. ( see http://en.wikipedia.org/wiki/Recovery_point_objective)

The moral is to ensure you are clear on what is included in your outsourcing deal. Then and most importantly, cancel your overlapping agreements. In this way, you will extract more value from your outsourcing agreement. Avoiding these outsourcing evils is of benefit to both the firm and provider. It ensures the long-term health of the relationship. There are numerous other areas where firms are exposed to outsourcing's twin evils. To get a health check of your outsourcing agreement, see the contact details below.