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Nov 16, 2011

Enter Hong Kong - then China

I have been advising anyone who would listen, and for quite a few years, that Hong Kong was the place to structure both outbound (from China) and inbound (to China) investment, whether via China public equity markets, private debt or equity, joint-venture or merger or acquisition.  As I referenced in an earlier posting Register your Company in Hong Kong and then Enter the Chinese Market: Hong Kong Phooey Way has one of the most reliable legal systems in the world, low and flat corporate and personal tax rates at 16.5% and 15% respectively, no taxes on capital gains or dividends and no death or inheritance tax – just to name a few benefits.   

In fact, Hong Kong was rated number one by the Heritage Foundation and the Wall Street Journal in their 2011 Indicator of Economic Freedom with the United States lagging behind (and slipping) at number 9.  Hong Kong has been ranked in the top spot for the past 16 years.

I was explaining to a new associate lawyer why we use Hong Kong law for cross border (into and out of China) corporate structuring and investment.  While the tax advantages are obvious, one of the most important is the reliance on Hong Kong law which is based upon British Common law and similar to the legal systems in most developed countries in the world.  Not only is the law clear, simple and reliable, but, more importantly the courts are independent and can generally be counted on to produce fair results.  

This is different than in China where the law is relatively clear and straight forward, although at times probably not broad enough, but, the courts cannot be relied upon to produce fair results.  There are many reasons for this one of which is the development of the legal system and the education and frame of reference of judges.  Another is the overriding obligation of mainland lawyers and judges first to the State and the Party, then to ensure a “harmonious society” and then finally to the litigants.  This is not meant to be a criticism of the legal system, but, in fact this is the way it is in many Socialist systems.

The new associate understood my lesson and then asked what is the most difficult thing for foreign (non Chinese) clients to understand about the legal system in China.  Well, in addition to what I mentioned before, the most difficult is the unwritten practice of deciding cases based upon comparative responsibility.  Judges in China will most often apportion fault, liability and damages, even where one party is clearly in breach, based upon comparative terms. 

I have seen too many cases where a Chinese factory or supplier is sued by a Western company for breach of contract (and the Western Company is clearly deserving of a 100% recovery) and after lengthy arbitration and litigation the judge determines that the Chinese company is 60% liable and the Western Company 40% liable.  The reasoning astonishes most Western lawyers and company executives as it is often based upon maintaining a “harmonious society”.  It can leave a bad taste in their mouths and perhaps deter them from further investment in what is the fastest growing economy in the world.  

by Frank Caruso
Chair, China Practice Team