China Watch – A foreign lawyer’s view from the inside

Christmas is behind us, the new year is upon us and new leadership has taken the helm here in China, so it seems to be a good time to take a look at what the foreign firms in China may have on their regulatory wish-list for the coming year.

Robert Lewis
Robert Lewis

Spoiler alert: the wish list has remained unchanged for the last decade or so, and the prospect of major change in the regulatory environment applicable to foreign law firms in China has not improved dramatically over that period. Still, it is useful to review again what items are on the list and assess the medium-term prospects for future changes.

A couple of months back I was invited to a roundtable discussion at the UK ambassador’s residence here in Beijing. It is not entirely clear why I was on the invite list since the topic of discussion was efforts to open up the China legal services market more for UK law firms, and I obviously am no longer a partner in a UK firm, having crossed to the ‘other side’ more than two years earlier. Perhaps my well-documented reputation as a contrarian on all matters relating to regulation of foreign law firms in China merited the invite, just to spice up the conversation perhaps.

All of the top London law firms were represented at the meeting, but no one could come up with any burning regulatory issues that required immediate redress by the UK trade officials present. There are probably a couple of reasons for the relatively contented attitudes of the UK lawyers in attendance:

  • By and large, the top UK firms have a pretty strong market position vis-à-vis other foreign law firms in China. About five years ago, when I was still with Lovells, I did a cumulative ranking of foreign law firms in China using a combination of the main directory rankings and found that six of the top seven foreign firms in China were all UK-headquartered (the other was Baker & McKenzie, which arguably is not really a US firm any more). Things may have shifted a bit around the margins, but I suspect that this overall market positioning remains largely unchanged today. So while the UK firms have for the most part had to retrench in China somewhat in the aftermath of the global financial crisis, they are still in a leading market position, so there is no real reason to agitate for change.
  • To be perfectly frank, foreign firms have it pretty good as a regulatory matter in China, with a fairly wide scope of permitted services and lax enforcement around the very fuzzy regulatory edges. I will hit on some of the high points of the regulatory scheme below and in my next blog, but suffice it to say that overall it is a reasonably friendly environment for foreign law firms, all things considered. In contrast with their US cousins, UK law firms tend to see the regulatory glass as more than half-full (which is probably explained in part by point 1 above), so (again in contrast with the typical US approach) historically have not aggressively complained about the remaining unresolved issues on the basis that if one complains too much it may invite actual enforcement of some of the existing regulatory restrictions, which would be seriously counter-productive. (Actually, this is the view I championed while at Lovells, and so it is possible that I have simply projected my biases on the other representatives of UK firms in attendance.)
  • Finally, there is probably little point to complaining about the remaining regulatory constraints under the present circumstances. The Chinese government appears to be unmoved by lobbying efforts on the part of the foreign bar here (in no small part because they apparently are of the view that they are already giving the foreign firms more than a fair shake), and even if they flung the door wide open, foreign law firms could only take advantage of any new regulatory opening if they could make a compelling business case to the home office. And there’s the rub; it was already difficult to make the business case for dramatic expansion in China when conditions were much better five-plus years ago, but it is even more difficult given current economic conditions. There is no compelling reason to clamor for big changes that the Chinese side is not eager to give if one cannot take full immediate advantage of the changes demanded.

Here’s an example. A foreign law firm can apply to open a second office in mainland China only after its first office has been set up for at least three years, and can apply for a third office only after three years following establishment of the second office, and so on. The application process is cumbersome and slow, and approval may be subject to the MoJ’s unfettered discretion in that it can take into account vague considerations such as the ‘development needs’ of the local legal services market. It is not the most open, transparent or efficiently administered process, but it also does not appear that this has been a significant impediment to the establishment of foreign law firm offices in China. There are now nearly 220 foreign law firms that have registered offices in China (double the number of 10 years ago), with another 60-plus China offices of Hong Kong law firms. Of these, more than 50 foreign and Hong Kong firms have multiple offices, almost without exception in Beijing and Shanghai (in most cases in addition to Hong Kong, which is under separate regulatory supervision and control by the Hong Kong Law Society).

But the key point to keep in mind is that although almost all of the top international law firms have two offices in mainland China, and it has been more than three years since the establishment of the second office, none of the top foreign firms have applied to open a third office (DS Law Firm from France is the exception, with offices in Beijing, Shanghai and Guangzhou). If the MoJ allowed foreign firms to open as many offices as they wished, with no time or other restrictions, we would still not see a flood – or even a trickle – of applications for third, fourth or fifth offices in China for one very good reason: you can’t make a solid business case for offices outside of Beijing and Shanghai.

The first threshold issue is that most China offices of foreign firms already are not profitable, so there is no appetite for further expansion for these firms. If you ask partners in most foreign firms whether they are profitable, you will likely get one of the following responses:

  • No (meaning they do not cover even local costs), but with a quick defence that no foreign firm is profitable in China (rationalisation in numbers).
  • Yes (with fingers crossed, meaning they cover local costs but not partner drawings or profit shares).
  • Yes (with no qualification, meaning they achieve PPP at roughly the firm average).

In some recent conversations with legal market professionals who have done a fairly comprehensive survey of the financial results of the China offices of foreign firms, I ventured an estimate that the breakdown of foreign firms in China among the above three categories was 50 per cent not covering even local costs, 30 per cent covering local costs but not partner drawings or profit shares, and 20 per cent profitable in line with global firm averages. Both thought I was overly optimistic and that the actual breakdown was more in the range of 70/20/10. Whatever the actual figures, 80-90 per cent of foreign firms’ offices in China are still in the dreaded ‘investment’ mode. If you already have one or two loss-making offices in China, there is little hope to push through a proposal for a third one.

But even if you are in the profitable 10-20 per cent of foreign firms here, there is no reason to venture beyond Beijing and Shanghai because the economics make no sense in the second- and third-tier cities. Even for local Chinese firms there is a substantial drop-off in fee rates and revenues outside of Beijing and Shanghai. Tianjin lawyers can charge only about half of what local Beijing lawyers can, while (at least as of a few years ago) the total revenue of the third largest firm in Chongqing was about half of what a top local partner in a leading Beijing or Shanghai firm could earn on his or her own. At Zhong Lun we have six domestic offices – the standard big three offices in Beijing, Shanghai and Shenzhen (home to the second domestic stock exchange) and then Guangzhou, Chengdu and Wuhan, but our offices in these latter three regional cities are still relatively small, and there is no immediate appetite to open any other regional offices. It is hard to imagine that a leading foreign firm, with their higher rates and higher cost bases, will want to rush out to open a third office in any of these regional cities any time soon. The one or two foreign law firm offices in cities such as Qingdao, Guangzhou or Tianjin have been notable for their complete absence of profile in the broader market.

Even with all of the practical constraints described above, complaints about the regulatory limitations on the opening of additional China offices continue to be highlighted in white papers drafted by the US law firms in China. I always found it hard to feel much sympathy for this position even while at Lovells, and it seems that the representatives of the top UK law firms who attended the event at the UK ambassador’s residence a couple of months ago felt much the same way.

Another regulatory issue regularly raised by the US (and perhaps also the UK) law firms in China relates to the preferential tax treatment afforded to local law firms. There is some merit to this complaint, but there is no realistic expectation that the tax situation for the foreign law firms can be changed for the better; the only thing that can happen (and many in the market expect this to happen in the medium term) is for the preferential tax treatment currently afforded to local law firms to be discontinued and brought into line with the more standard tax treatment applied to the foreign firms.

The basic facts are not in dispute. China offices of foreign law firms pay tax on profits at a rate of 25 per cent and then distributions of profits out of China are subject to withholding tax of 5-10 per cent. This, of course, assumes that the China office is profitable from an actual operating perspective (see above) as well as a tax-reporting perspective (as there should be ways to pay at least some part of partner compensation locally to be claimed as a deduction, although this has to be balanced out against the fact that this exposes all such locally paid partner compensation to local individual income tax, which is not terribly favourable for the particular partner).

By contrast, local firms pay a flat 8.75 per cent tax on total revenue as opposed to net profits. But this is not all good news for the local firms as expenses are not deductible from taxable income, which creates problems when collecting fees as lead counsel for work done by a separate firm on a coordinated cross-firm basis. This tax scheme essentially treats the big Chinese law firms as a collection of sole practitioners, which in reality all but the top several Chinese law firms are, and it is clearly advantageous for partners in local law firms (not applicable to yours truly since I cannot be registered as a partner in a local Chinese firm, at least at this stage), but it is not a great way to run a big law firm, and I know senior partners in various top Chinese law firms who will be just as happy to see this regularised and brought in line with the standard tax treatment applied to foreign firms’ China offices.

Once that happens – and I share the assumption that it will happen at some point – the playing field will not immediately shift in a manner that is dramatically more favourable to the foreign law firms solely as a result of such a change. Yes, the local firms that are profitable will have to pay tax at a higher rate, but they will also have more tools available to them to manage taxable income when calculated on a net profit basis. In any event, many of the top Chinese firms run pretty tight ships in terms of expense management and can achieve gross profit margins of well over than 60 per cent. In sum, local Chinese firms will always enjoy a substantial cost advantage over their foreign law firm counterparts in Chinese independents of the applicable tax scheme, while the foreign firms have no obvious upside potential on the tax side and continuing challenges on the costs side. Evening out the tax rates will have an impact, but it will not be a panacea for the unprofitable China offices of the majority of the foreign firms if their business models remain unchanged.

There are a number of smaller administrative quibbles that foreign law firms have with respect to registrations of foreign lawyers, work visas and the like, but these are not so different from what I encounter now at a Chinese law firm, so these are equal opportunity irritants.

The big regulatory issues for the foreign law firms, which I will address in my next blog posting, relate to limitations on the permitted scope of legal practice, the rights to hire Chinese lawyers to provide Chinese legal services, and the rights to appear before various government agencies. One of these issues is a legitimate complaint, another is a red herring, and the last is a bit of wishful thinking, at least in the near term. In my next blog I will identify which description applies to which issue. Another spoiler alert: more than one description may apply to each issue listed above.

In any event, none of these issues affects the real market opportunities that are available for foreign law firms in China. Again, that probably explains the apparent level of contentment of the representatives of the top UK firms who participated in the meeting at the UK ambassador’s residence a few months back – they have a workable business model. Somehow, it seems that those who complain the most about an allegedly uneven playing field are those whose real problem is not the regulatory environment but their business plan. More in the next instalment.

Robert Lewis is international managing partner at Zhong Lun Law Firm. He is based in Beijing