M&A in China: Preparatory documentation, Due Diligence and tax considerations

Advisors should map data flows, structure data rooms compliantly, and plan IT integration early to ensure group reporting without breaching compliance. Combining these reviews ensures that legal, regulatory, and operational risks are captured in one integrated approach.

Hydro-Wolf is considering accepting Mr. Wang’s offer regarding the Share Deal. The next steps for Hydro-Wolf are therefore to ensure that Mr. Wang is committed to proceeding with the Share Deal, to gather further information on Hydro-Dragon in order to evaluate potential risks and develop a comprehensive understanding of the contractual agreements necessary to formalize the Share Deal. These steps are outlined in Part 3.

Part 1 of this series article provides an overview of the key advantages and potential challenges that foreign investors should consider when engaging in M&A transactions in China. Part 2 compares Share Deals and Asset Deals and examines the respective advantages and disadvantages of each. Part 3 – this article – addresses preparatory documentation, due diligence, and tax considerations related to M&A transactions.

Letter of Intent (LoI) / Memorandum of Understanding (MoU)

To demonstrate their commitment and specify the roadmap and milestones for negotiations in more detail, parties to a share or asset deal typically sign a Letter of Intent (LoI) or Memorandum of Understanding (MoU) at an early stage of the transaction. These documents provide a basis for the following steps, while allowing for detailed negotiations in subsequent definitive agreements. The main elements may contain, among others:

• An accurate reflection of the intended transaction roadmap, e.g., a timetable for the transaction,
• Right to conduct, timeline, scope of and cooperation during the desired due diligence,
• Valuation principles,
• Proposed structure of the deal, e.g., asset purchase, share purchase, merger, or joint venture, and the key points of future cooperation or corporate governance in the case of a joint venture or the takeover of an existing management team,
• Price considerations, indicative offers, and adjustments based on due diligence findings,
• Potential conditions to complete the transaction, e.g. obtaining regulatory approvals or any other “homework” to be done,
• Confidentiality,
• Non-binding nature of the LOI/MoU except for specific clauses such as, e.g., exclusivity, confidentiality, governing law, and dispute resolution.

The German Hydro-Wolf and Mr. Wang, as the sole shareholder and seller of the Chinese Hydro-Dragon, intend to sign an LoI. Hydro-Wolf should be aware of potential risks when entering an LoI with a Chinese party.

During contract negotiations with potential business partners in China, foreign companies often assume that the negotiation of an LoI or MoU cannot lead to liability, especially if drafted as non-binding. But under both German and Chinese law, there may be instances already during a contract negotiation stage that can result in liabilities. Trust can be established through the initiation of a contract or comparable business behavior. Breaching a duty arising from this relationship of trust can therefore lead to the breaching partner becoming liable for damage caused to the other party.

Although LoI or MoU are often intended to have a non-binding nature, specific clauses should be carved out: they can be made legally binding in order to protect the legitimate interests of the parties concerned, such as confidentiality, exclusivity, etc.. Already an LoI / MoU should be written with the utmost care in order to mitigate potential risks. Hydro-Dragon has enlisted the expertise of its advisors, who have amassed considerable experience in M&A deals in China, including those involving European investors.

Due Diligence

Conducting due diligence in an M&A deal is a fundamental measure. Depending on the nature of the transaction, in addition to financial, tax and legal due diligence, technical due diligence, commercial due diligence and, increasingly, environmental due diligence may be carried out. When planning a due diligence exercise in China, it is essential to consider several key points in order to ensure a thorough and effective process. Key areas to focus on include:

General Corporate and Investment Compliance

In addition to national laws and regulations, local laws and regulations at the seat of the target must also be taken into consideration. Such local laws and regulations can sometimes stipulate more detailed or stringent rules. There may also be discrepancies between national laws and local implementation, leading to inconsistencies. It is also essential to check industry-specific regulations. Certain industries are heavily regulated or may still be restricted for foreign investment. Purchasers also need to verify that the target company has all the necessary licenses and permits to operate legally.

Finance, Tax and Social Insurance Compliance

Financial due diligence involves a series of checks to ensure that the target company’s financial statements are accurate and up-to-date. This process usually involves reviewing at least the past three to five years of financial statements, identifying any outstanding tax liabilities or disputes with tax authorities, and verifying assets. It is important to confirm ownership and accurately value key assets, including land-use rights, building ownership, and intellectual property. Discrepancies between Chinese accounting standards and international accounting standards (e.g. IFRS) have the potential to engender complexity in financial analysis. Tax evasion, or non-compliance with local tax and social insurance laws, is a prevalent issue that necessitates meticulous scrutiny.

Business Operation Compliance

This aspect focuses on the supply chain and vendors, assessing their reliability and stability, as well as related contractual agreements. It may also cover manufacturing and operations, evaluating the efficiency and compliance of manufacturing processes and operational practices. Environmental compliance may involve assessing adherence to environmental regulations and identifying potential environmental liabilities.

HR and Labor Compliance

To ensure compliance with national and local labor laws and regulations, a review of employment contracts, employee handbooks and other internal regulations, and labor practices is necessary. Special attention may focus on key managers whose post-deal support is needed for a successful transaction. A clear understanding of the structure and obligations relating to employee benefits is required. Ongoing or potential labor disputes and their related potential financial impact should be identified.

Market Analysis

A comprehensive analysis of the target company’s market position is imperative. This may involve its market share and the competitive landscape. Specialized advisors may support to gain a thorough understanding of the composition and stability of the customer base. It is also important to consider current and future industry trends that could potentially impact the business.

Intellectual Property

Verifying the ownership and registration of the target company’s patents, trademarks and copyrights is essential. Any risks of IP infringement or disputes also need to be assessed. In case the target company does not own the intellectual property in use, the requirement of registrations, licenses and their financial impact should be identified. Chinese targets are sometimes found to use pirated software. Also in this case, the financial impact of corrective measures needs to be established.

Information Technology

Sometimes, there can be conflicts. Hydro-Wolf’s desire to obtain as much information as possible about Hydro-Dragon may collide with China’s strict data related legal regime. Hydro-Dragon might also refuse to disclose certain sensitive data, citing these regulations.

Hydro-Wolf’s advisors should accompany and manage the due diligence process, ensuring that data is collected and processed in accordance with data protection laws, and preparing it for Hydro-Wolf in Germany. Hydro-Wolf’s advisors should also provide support to ensure that IT systems and all necessary data are integrated in compliance with data security and protection laws.

Further Background Checks

Another fundamental component of a comprehensive due diligence is conducting thorough background checks on the target company and its key executives. From examination on media reports and public records to discussions with local staff: goal is to thoroughly identify any negative information, such as in the Corporate Social Credit System or on “blacklists” maintained by relevant authorities. Also corruption risks should be investigated which may vary depending on the target’s business model.

Performing due diligence presents Hydro-Wolf with some notable challenges. One of the major issues is the language barrier. The purchaser should try to ensure that all relevant documents and correspondence are translated with accuracy. Hydro-Wolf’s advisors therefore have native-speaking professionals on hand to ensure accurate translation and who have interpretation expertise. The use of supporting AI tools for translation purposes must comply with all applicable statutory laws and contractual duties.

Another major challenge can be transparency and access to information due to limited public records, and inaccurate information. But in general, the Chinese public databases are a good starting point. Information provided may not always be accurate or complete, necessitating independent verification. Hydro-Wolf’s advisors plan to thoroughly check not only the available public records, but also the documentation provided by Hydro-Dragon. Hydro-Wolf’s advisors may also visit Hydro-Dragon’s premises for on-site inspections and review of originals (e.g., key licenses) and for interviews with responsible managers where necessary.

Hydro-Wolf’s advisors thoroughly and systematically record and make readily accessible for future reference the results of the due diligence, providing a report that highlights key risks but also solutions and recommendations. Hydro-Wolf’s advisors may also draw attention to any cultural differences that may exist in business practices, communication styles, negotiation and negotiation tactics. Where appropriate, they will provide clarifications and recommendations.

Tax consideration

Due to the complexity and evolving nature of China’s tax laws, M&A transactions in China raise several key tax issues that require careful consideration to effectively manage and ensure compliance with all relevant regulations. Key issues include:

Value-added Tax

Whether VAT is incurred in an M&A transaction depends in particular on the nature of the transaction, namely whether it is an asset deal or a share transfer. The transfer of certain assets, such as inventory, machinery and equipment, may be subject to VAT at the standard rate of 13%. However, the transfer of real estate and intangible assets may be subject to different VAT treatments. On the other hand, the transfer of equity interests is generally not subject to VAT, but there are exceptions, particularly for equity interests in certain types of companies.

Stamp Duty

M&A transactions commonly encompass a multitude of contracts and agreements, which are subject to stamp duty. The applicable rate is contingent on the nature of the document, ranging from 0,05% to 0,1%.. The calculation of stamp duty is based on the consideration or the value stipulated in the documents, whichever is higher.

Land Appreciation Tax (LAT)

In the event of a transaction involving the transfer of real estate, LAT may be applicable. The tax is levied on the appreciation in the value of the land, calculated as the consideration received minus the allowable deductions (e.g., original cost, improvement costs). Certain transactions, such as mergers and spin-offs, may qualify for LAT exemptions or reliefs if meeting certain conditions.

Individual Income Tax (IIT)

When cross-border transactions involve individual shareholders, IIT would be applicable. Individuals transferring equity in a Chinese company must file and pay IIT in China on the capital gains from the property transfer. When a company increases an individual shareholder’s equity using undistributed profits, retained earnings, or capital reserves, the shareholder shall still pay IIT on the “interest, dividends, and bonuses” even if no cash is received at the time. Addressing IIT issues in cross-border transactions hinges on accurately defining the transaction’s nature, clearly identifying the taxpayer’s status, and paying attention to the credit for taxes already paid back in the individual’s home country.

Withholding Tax

In the event of cross-border transactions, income of non-resident entities derived from China may be subject to withholding tax. The standard rate is 10% for dividends, interest, royalties, and capital gains, but this can be reduced under applicable tax treaties.

Tax Incentives

Certain regions of China, including Free Trade Zones and High-Tech Development Zones, offer preferential tax policies that may be advantageous for M&A transactions. Specific tax incentives may also apply to qualifying reorganizations, such as mergers, spin-offs, and debt restructurings, provided certain conditions are met.

Tax Avoidance

It is vital that transactions between related parties comply with transfer pricing rules, ensuring that the pricing is at arm’s length. Furthermore, the tax authorities may challenge transactions that are deemed to be primarily tax-driven rather than for genuine business purposes.

Customs Duties

In the event of a transaction involving the importation of assets, there is a possibility that customs duties and import VAT may be applicable. The rates for these duties and taxes are subject to variation depending on the classification of the asset in accordance with the customs tariff.

Tax Priorities Across the M&A Lifecycle

There are three stages of cross-border mergers and acquisitions: pre-transaction, during transaction, and post-transaction, each with distinct tax priorities. Pre-transaction involves structuring arrangements that determine future tax liabilities and capital flows; during transaction requires handling due diligence and payment methods to avoid hidden liabilities; post-transaction entails integrating group taxation and strategically planning profit repatriation.

Summary

Letters of Intent (LoI/MoU), a structured due diligence process, and well‑designed tax planning are essential elements for any M&A transaction in China. An LoI/MoU provides an early roadmap for the deal, defining responsibilities, timelines, valuation principles and binding core clauses such as confidentiality or exclusivity.

Due diligence in China must be tailored to the local legislative landscape and regulatory practices, covering corporate, financial, tax, operational, ESG and data‑related aspects. Particular attention must be paid to data protection requirements and restrictions on cross‑border data transfers, as well as to verifying compliance with national and local tax and social‑insurance regulations. These factors can materially influence risk assessment, valuation, and deal structure.

Tax considerations also play a decisive role at every stage of an M&A transaction. Depending on the deal structure, VAT, stamp duty, LAT, IIT, withholding tax, incentives or customs duties may apply. Pre‑transaction planning shapes tax exposure and capital flows; during the transaction, payment structures and liability allocation are central; post‑transaction, integration into a group tax environment and repatriation strategies become relevant.

With comprehensive preparation, accurate risk identification and the support of experienced advisors, foreign investors can navigate the necessary documentation, due diligence procedures and tax implications effectively. This enables informed decision‑making and reduces uncertainties throughout the M&A process in China.