A transaction involving a China business rarely acquires one company. It acquires a chain: an offshore parent, a Hong Kong or Macau holding company, one or more wholly foreign-owned enterprises or joint ventures on the mainland, and sometimes branches, variable interest entities or a separate trading company that handles imports.
That chain creates three categories of work that a single-entity diligence would miss: what is inside the perimeter and what is not, what the entities charge each other, and how cash reaches the buyer after closing.
The entity you buy is not always the entity that earns
Start with a structure chart down to the individual owners, and reconcile it against the contracts that generate the revenue. Where sales are invoiced by an entity outside the perimeter being acquired, or where part of the activity is contracted through an affiliate, the accounts understate what is actually being bought. This matters as much as overstatement: it changes the scope of the transaction, and it usually means the perimeter needs to be redefined before closing.
The practical test is to take the top customers and trace each one from contract to invoice to receipt, noting which entity appears at each stage. Where the three are not the same entity, the group is running a function — procurement, trading, IP holding — that the buyer may or may not be acquiring.
Where the seller is reluctant to produce the structure chart, that reluctance is more informative than the chart would have been.
Cross-border service charges and related party pricing
Service fees, royalties, management charges and cost recharges between the Hong Kong entity and the mainland operating company are a normal part of these structures. They are also where earnings can be moved, and where post-closing economics change.
Apply the four tests to each significant flow:
- Pricing — is the charge consistent with what unrelated parties would pay for comparable services on comparable terms?
- Substance — does the charging entity have its own people and operations, or is it a vehicle that exists to invoice?
- Survival — if the founder were no longer involved, would the arrangement continue on the same terms?
- Substitutability — could the service be sourced elsewhere, at what cost, and how quickly?
The common finding is a service that is genuinely provided but charged below market, or provided without any charge at all. After separation from the group, the operating company will pay market rates for finance, IT, HR, warehousing or logistics, and the cost base rises. Quantify that increase rather than treating it as a qualitative risk.
Where a charge is recorded in the mainland entity, check that the corresponding cost or income appears in the Hong Kong entity. A charge that exists on one side and not the other is either a consolidation error or a balance that has been building for years in other receivables or other payables.
Dividend routes and distributable cash
Reported profit is not distributable cash. The route from the mainland operating company to the holding company and then to the buyer's entity involves distributable reserves, withholding on dividends, and in some structures an additional layer of tax depending on how the holding company is organised.
Three things to establish:
- Distributable reserves at each level, determined under the local rules that apply to that entity — not simply the accumulated profit in the consolidated accounts.
- Withholding treatment on dividends from the mainland entity, which depends on the applicable arrangement and the holding level, and should be confirmed rather than assumed.
- Any restriction on distribution — pledges, guarantees, regulatory capital requirements, or undertakings given to lenders.
The output is a cash-availability analysis: how much of the profit can actually be moved, at what cost, and on what timetable. A business that generates earnings it cannot distribute is valued differently from one that can.
Listing structures and common control combinations
Where the group has been assembled with a listing in mind, the structure has usually been reorganised. Entities are inserted, businesses are transferred between companies under common control, and comparatives are restated.
Chinese standards require a receiving entity to record a business acquired from a common control party at the predecessor's carrying amounts, with comparatives restated as if the combination had always existed. IFRS 3 scopes out common control combinations and does not prescribe a treatment, so groups apply a predecessor-value approach by analogy. The two land in a similar place but not the same one — the differences usually surface in transaction costs, whether comparatives are restated, and how the resulting equity is presented.
Ask for the restructuring history, the entity-by-entity movement of each business, and the CAS-to-IFRS adjustment schedule for each period in which a combination occurred. A restructuring that is not documented is a diligence finding in itself.
Where the four diligence areas land
- Revenue — which entity contracts, invoices and receives; whether sales routed through a trading company sit outside the perimeter; and how intercompany sales are eliminated on consolidation.
- Cost of sales — transfer prices on goods bought from or sold to affiliates, imported inputs through a Hong Kong trading entity, and whether landed cost is consistent year to year.
- Operating expenses — service fees and cost recharges, shared functions provided without charge, and the market cost of replacing them after separation.
- Related parties — the full register, shareholder structure to individuals, loans and guarantees between affiliates, and fund flows recorded in other receivables and other payables.
What to request
- A group structure chart to the individual owners, with incorporation dates and ownership percentages
- Contracts, invoices and accounting entries for all intercompany service, royalty and recharge arrangements
- Intercompany balances by counterparty, with ageing
- Distributable reserves by entity, and any restriction on distribution
- Restructuring documentation for any common control transfer in the period
- The CAS-to-IFRS adjustment schedule and its underlying workings, not just the summary
- Bank statements for the Hong Kong and offshore entities, showing fund flows
The perimeter is usually the first question that needs an answer, because it decides what the rest of the analysis is about. Establishing it in the first week is worth more than any single procedure that follows.
This page describes a general approach. It is not accounting, tax, or legal advice for a specific transaction. Tax treatment depends on the specific structure and the arrangements in force, and should be confirmed with a qualified adviser. Views are my own and do not represent any firm.