How Does A Foreign Investor Avoid the Hidden or Contingent Liabilities when Acquiring a Chinese Company

When a foreign investor acquires a purely domestic Chinese company, they are usually concerned that the hidden or contingent liabilities might arise after they acquired the target company. For example, those Chinese companies usually have two or more sets of account books in order to understate tax exposure, which would violate PRC transfer pricing laws and the company may therefore have to pay back taxes and penalties after a foreign investor acquire the target company.

A foreign investor usually finds it difficult discovering such hidden liabilities before they take over and manage the target company. Then how does a foreign investor avoid such liabilities when acquiring a Chinese company?

One of the solutions is to arrange an earn-out payment when the buyer pays the purchase price to the seller in a M&A transaction. Under earn-out arrangement, the buyer and seller can reach agreement that the buyer will make an additional payment to the seller several years after the closing, provided that the venture achieves a specified earning target and there has been no material breach of representations and warranties of the seller contained in the equity transfer agreement.

However, if an earn-out is treated as part of the purchase consideration, such earn-out would be challenged by PRC laws. The PRC laws regarding acquisition of domestic company by foreign investor requires the foreign investor to pay the purchase price in full within 3 months after the issuance date of the business license of foreign-invested enterprise established after acquisition, and, in special circumstances requiring an extension, and subject to the approval of the examination and approval authority, the foreign investor should pay at least 60% of the purchase price within six months after the date of issuance of the foreign-invested enterprise’s business license and pay the balance in full within one year.

Thus, if an earn-out is treated as part of the purchase consideration, the earn-out payment will have to be made within 3 months or one year under PRC M&A rules, which might not be long enough for the buyer to discover contingent or hidden liabilities. In order to avoid such scenario, the foreign investor should be very careful in drafting earn-out clause in an equity transfer agreement. The description on earn-out arrangement should not make the approval authority treat such earn-out as part of the purchase consideration, otherwise it would trigger PRC M&A rules in respect of time line of consideration payment. Alternatively, the foreign buyer may instead craft a consulting agreement in place, which will serve as mechanism of earn-out arrangement, i.e. the buyer agree, under consulting agreement, to pay a consulting fee to the seller if certain liabilities are not triggered within two years after the closing.  However, in scenario of consulting agreement, the tax inefficiency will become issue.

By Adam Li

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