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Expanding into India and China: Key risks and opportunities for U.S. franchisors

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Grant Thornton International expansion for franchisorsTogether, China and India account for more than one-third of the world’s population — making them hard to resist for U.S. food and beverage franchisors searching for new customers. Both nations also have sizable and growing middle classes with strong interest in novel and high-quality products. Savvy franchisors are looking not only at large, increasingly cosmopolitan cities in these countries for expansion opportunities. They also look at second- and third-tier markets, where real estate and labor costs are lower and upwardly mobile consumers have a growing appetite for new food and drink options.

The rewards of capturing even a sliver of these markets can be significant. So too are the risks for companies unfamiliar with how tax, regulations and anticorruption laws differ in these markets and how local culture influences business practices. Royalty payments may be overtaxed, customs delays can leave gaping holes on menus or, worse, franchisors can find themselves in the crosshairs of a bribery investigation instigated by a foreign government. “To ensure success, franchisors need to plan carefully in these exciting but challenging markets,” says Jason Ramey, national managing partner of International Client Services at Grant Thornton LLP.

Top risks and how to turn them into opportunities

Risk #1: Brandjacking

Companies that spend tens of millions of dollars establishing brand through advertising and tightly honed operating practice can find this work undone in China and India, where rogue companies brazenly establish counterfeit versions of foreign brands. India has TGI Saturday’s and Ruby’s restaurants that operate along similar lines to the TGI Friday’s and Ruby Tuesday franchises, while China has lookalikes to McDonald’s and Starbucks. Their inferior products can tarnish an established franchise’s brand image, particularly among new customers who may not be able to distinguish the real from the fake. To guard against this, it’s important to file for trademark protection with the local patent offices as soon as possible and protect trade secrets by having franchisees sign nondisclosure agreements.

How to fend off the copycats
To counteract piracy when it does occur, some U.S. companies operating in China and India have increased advertising to reinforce how their product differs from imitators. Emphasizing the higher quality of imported food products also helps, because this is one of the biggest appeals of Western brands in China and India. The Chinese in particular — who have been rocked by food safety scandals, including the discovery of melamine-contaminated infant formula — are often willing to pay more for foreign-made products because they assume they are prepared according to high standards.

Maintaining quality to protect your brand is not always easy. It requires careful monitoring of the supply chain — through video surveillance, surprise audits and close supervision of your partners, among other tactics. Without such measures, you may find yourself in the trouble McDonald’s and KFC did in China, when employees of their meat supplier were caught on video relabeling expired meat packages bound for fast-food companies.1
What you need to know about the Foreign Corrupt Practices Act (FCPA)
The FCPA prohibits bribing of foreign officials for business advantages. Enacted in 1977 in response to revelations of widespread bribery of foreign officials by U.S. businesses, the law also requires companies to maintain accurate records and internal accounting controls. It applies to both publicly and privately held companies, and violations can prompt penalties for violations of civil law as well as criminal prosecutions.

Over the past decade, the U.S. Department of Justice and the SEC, which share enforcement authority, have dramatically stepped up the number of investigations.

Experts caution that compliance programs can’t just be “window dressing” — it’s not enough to hand out documents or do staff presentations. Training should involve your general counsel, compliance officers and financial team, as well as sales and marketing, human resources and managers, and should be done on an annual basis and whenever an employee takes on a position in which he or she will have greater contact with government officials.

U.S. companies will need to assess the particular risk factors of the foreign regions in which they’re operating and develop policies to deter specific types of fraud and corruption that may occur. It’s also important to be aware of whom they’re doing business with by performing due diligence investigations into franchise partners and vendors. In China, there are many partially or wholly owned state enterprises — and it may not be immediately obvious they are government-owned. From the viewpoint of the From the viewpoint of the FCPA, unless you have strong evidence indicating otherwise, assume that any employee of a local company could be considered a foreign official, notes Paul Peterson, director at Grant Thornton China within the Forensic, Investigative and Dispute Services Group.

Finally, companies will need to send auditors with local knowledge to review all accounts to make sure their franchise partners are abiding by compliance policies and procedures.

Additional FCPA resources:
Guide (PDF) to understanding and complying with the FCPA from the U.S. Department of Justice
Short video featuring Grant Thornton’s Paul Peterson and Mark Sullivan, who discuss how to set up meaningful compliance programs

Risk #2: Political and social pitfalls
Corruption also is a staggering problem. China and India ranked 100th and 85th, respectively, among 175 countries in Transparency International’s 2014 Corruption Perceptions Index, which gauges the perception of public-sector corruption.2 And the risk of violating the U.S. Foreign Corrupt Practices Act (see sidebar) and other antibribery laws is high in these countries, as are the civil and criminal penalties, which can run into the hundreds of millions of dollars.

Problems often arise because U.S. franchisors must rely on third parties to act as intermediaries and help them secure real estate, work with contractors or obtain supplies; problems also may arise because of the reliance in some quarters on cash payments. These dealings may lead to the payment of small bribes, or “grease payments,” to get work done. Franchisors are liable even if they are unaware of these dealings: the U.S. Department of Justice has made it clear that it holds companies liable for the actions of their contracted agents and third parties.

How to keep risks under control
The Chinese and Indian governments are starting to crack down on corruption. India’s new prime minster has pledged to make it easier to do business there, and China’s president has led a high-profile campaign to go after both “the tigers and the flies” — the large and small players involved in corrupt business dealings. To avoid getting caught in costly and brand-damaging litigation, businesses must be proactive in establishing a compliance program in these countries. The program should include performing periodic risk assessments to identify opportunities for corruption and put in place rigorous controls to prevent or deter improper transactions. This involves thorough training of all franchise employees, reinforced with regular audits and continuous monitoring. It’s also important to perform due diligence to investigate your potential partners. In China, because there is not much information in the public domain, such investigations may involve field inquiries and on-site observations to confirm potential suppliers’ or contractors’ business.

“Headquarters also needs to set a proper tone at the top that bribery and fraud won’t be tolerated — and get that message out from the leadership to managers and front-line employees in-country,” says Paul Peterson, director at Grant Thornton China within the Forensic, Investigative and Dispute Services Group. This is particularly important in China because so many businesses, including suppliers, are state-owned enterprises, which means even low-level employees are considered “foreign officials” of the government. Thus, an inappropriate payment or gift to a low-level employee may be a violation of the FCPA.

Risk #3: Financial record-keeping
Franchisors will also need to have rigorous oversight of franchisees’ financial accounting to make sure the sales records are accurate and complete. Historically, businesses in China have not been familiar with how to maintain internal controls over financial reports, because finance has not been seen as a key function in an organization. Financial statements have also been historically tax-driven, so management and finance personnel’s familiarity with accounting standards consistent with International Financial Reporting Standards is limited.

How to monitor finances
Such monitoring may be hard to do from your home office thousands of miles away — you’ll need to maintain eyes and ears on the ground. “Even though franchisees have their own say how to run their business, don’t just take a back seat and wait for the fee to come,” says Sandy Chu, principal and national leader of Grant Thornton’s China Business Group. “Continue to stay connected with them, stay close with them, and understand what they are doing.”

Risk #4: Evolving tax structure and incentives
As you develop franchise agreements abroad, you should also consider the tax implications: What will be taxed by the foreign governments, and at what rate? Professional advice is critical. The Chinese government has recently reformed a number of tax laws and regulations, including corporate income tax law. Local tax authorities also retain the right to interpret existing laws and regulations, which can result in a lack of consistency across individual provinces and jurisdictions.

Franchise agreements to provide specific services or license intellectual property or trademarks are also subject to different interpretations in other countries. “An agreement that states a franchisor will provide franchisees with know-how to operate their business may be interpreted by a foreign government as providing intellectual property — which is subject to a withholding tax — when what’s really being provided is training,” says David Sites, partner for International Tax Services at Grant Thornton.

How to stay on top of taxes
It’s important to have a tax professional with knowledge of the local laws help to structure and review agreements. Along with withholding rates, he or she should pay attention to value-added taxes (VAT), which are used in India and are now being piloted in China. “Franchisors may want to structure the agreement so that the VAT becomes the responsibility of the franchisee, because they are typically registered for them,” Sites says. Franchisors may also benefit from the bilateral income tax treaties in place between the U.S. and both India and China. In some cases, U.S. franchisors may be eligible for reduced tax rates for dividends and royalties.

“In China, tax rules are constantly changing, so it is vital to monitor and understand their development, as they may have an impact on franchise fee determination,” says Chu.
Master franchising vs. area representative agreements
Many franchisers looking to move into Asia are attracted to the master franchise model, which allows them to assign responsibility for expansion in a region or the whole country to master franchisees. Typically, both parties will agree to a development schedule under which the master franchisee must open a certain number of franchises each year. By contrast, under the area representative model, a U.S. franchisor hires a representative to recruit franchises within a certain region but enters into agreements with the unit franchisees itself.

U.S. franchisors prefer the master franchising model because it can lead to rapid expansion, and because most of the upfront capital required is contributed by the master franchisee. They can also take advantage of the cultural expertise and language skills of the master franchisors.

Still, there can be pitfalls to this approach: It puts great pressure on the master to expand, risking neglect of their operations, and may result in less profit because of the need to share royalties and licensing fees. It also gives franchisors less control, because the master franchisor is responsible for training employees and ensuring standards.

For large and complex markets like India and China, many experts recommend a targeted approach — with master franchising or area representative licenses granted to a particular region. In either case, your franchising partners need direct knowledge of the local markets and the bandwidth to take on the operational logistics and development activities in their regions.

Risk #5: Regulation uncertainty
Government intervention in the franchising sector also varies significantly by country. Starting in 2005, China began to allow foreign-owned companies to do business there independently (prior to that, foreign companies had to enter into joint ventures with Chinese nationals). Still, there are fairly stringent regulations on foreign franchisors. For example, under what’s known as the 2+1 rule, franchisors must own and operate at least two businesses elsewhere before operating in China, and must run the Chinese franchise for at least one year before subfranchising it to others.

China also has foreign exchange controls, which regulate money going into and out of the country. Franchise agreements will have to be registered with the Chinese government to facilitate payments to the franchisee and franchisor. Under China’s disclosure guidelines, franchisors must also register their contract, marketing plan and business plan with local authorities, with fines levied for failure to comply.

India does not have regulations specific to franchising, which means that franchisors will have to comply with multiple layers of regulations that may vary by region, says Vinamra Shastri, a partner for business advisory services at Grant Thornton India. “The multiple layers of duties are complex, and in some cases archaic laws can act as hurdles to setting up operations here,” Shastri says.

For example, India bans the importation of beef and strictly controls other products, which can cause long delays due to the need for products to be sampled and tested by customs — something that the UK-based Ping Pong chain discovered to its chagrin when it sought to import many of the items needed for its dim sum menu, according to Shastri.

How to navigate unfamiliar regulations
Legal systems in India and China are also not as developed as in the West, and it can be time-consuming and costly to rely on local courts to resolve contract disputes. For this reason, it’s vital to ensure that franchise agreements abide by local regulations and specify what will happen should disagreements between the two parties arise. Many companies ask franchisees to sign an official document acknowledging that the information provided to them by the franchisor is complete and accurate.

Risk #6: Cultural differences
Just as the tastes for salty, spicy or sweet tend to vary from region to region in India and China, so too do the consumer habits and business practices. For this reason, many experts advise U.S. franchisors to grant licenses for certain cities or regions — not countrywide — even though this may create headaches for larger companies juggling multiple licenses.

How to adapt to the local culture
It’s often said that in China nothing is agreed until everything is agreed — and franchisors might be surprised when their Chinese partners continue to negotiate terms after signing a contract. Franchisors can prepare for this eventuality by setting clear parameters for negotiation; by taking part in negotiations with local landlords, suppliers and government officials; and by maintaining ongoing relationships with these parties.

In India, says Shastri, “relationships are the start and end of any business. I would go out of my way to help you with your brand if we have a personal relationship.” As is the case worldwide, Indian and Chinese business people appreciate when their U.S. partners make an effort to understand their cultures and don’t impose Western habits on them. Small gestures also help. “In India, business partners don’t need tangible gifts. Saying ‘thank you,’ ‘you did so well’ or ‘we enjoyed talking to you’ is much better than sending a pen,” Shastri says.

International expansion best practices

1Cendrowski S: “Why McDonald’s supplier failed in China,”
2Transparency International’s 2014 Corruption Perceptions Index