OREANDA-NEWS. China's new regulations on internet advertising will place additional costs and burdens on some Chinese internet businesses, Fitch Ratings says. However, we believe the new regulations will foster healthier development of China's internet industry over the longer term. The credit profiles of the Chinese internet majors - Alibaba Group Holding Limited (Alibaba; A+/Stable), Baidu, Inc. (A/Stable) and Tencent Holdings Limited (Tencent; A+/Stable) - should remain intact.

On 8 July 2016 the State Administration for Industry and Commerce promulgated long-awaited regulations to protect consumers against false claims and to prevent misleading practices in internet advertising. The regulations will take effect 1 September 2016; currently, there are no national laws or regulations that specifically regulate the Chinese internet advertising business.

Alibaba's and Baidu's pay-for-performance (P4P) services may be reclassified as internet advertising under the new regulations. Currently, P4P services are not subject to China's advertising laws and regulations. The new regulations explicitly categorise paid search results as internet advertising for the first time and all paid advertising in search results will need to be clearly identified as advertisements.

Alibaba believes that its P4P service is different from traditional advertising service and search advertising as buyers come to Alibaba's platforms to find products and services, and the company's platform provides data and technology service to these buyers to enhance their shopping experience. However, the new regulations include any internet services with the purpose of promoting goods and services in its definition of internet advertising.

We believe the reclassification of P4P services as internet advertising may not require Alibaba and Baidu to transfer their P4P businesses to their variable interest entities (VIEs). Currently, their P4P businesses are mainly conducted through their wholly foreign-owned enterprises (WFOEs), which do not hold internet content provision (ICP) licences but are qualified to conduct advertising businesses. Instead, their VIEs hold ICP and other licences, which are qualified to publish internet advertisements through websites. We understand that Alibaba and Baidu are studying any potential requirement for structural change and aim to minimise potential impact on businesses, if any.

VIE arrangements are usually used in China's internet sector to get around restrictions on foreign direct ownership, and are a credit weakness for Chinese internet companies as they may not be as effective in providing control as direct ownership or may face legal challenges in the future. Therefore, if P4P revenue were to be required by law to be transferred from WFOEs to VIEs, credit risks to offshore issuers would increase. However, given the rating headroom, we do not currently expect the additional risks to affect ratings.

However, Alibaba and Baidu may need to pay a 3% surcharge on certain P4P services on top of the existing 6% value-added tax (VAT) because advertising services are subject to a cultural business construction fee under China's law. The impact on profitability should be manageable, given that P4P services have high margins. Reported operating margin of Baidu's search services before unallocated expenses was 51% in 2015, though its overall operating EBIT margin was 18%. For Alibaba, its operating EBIT margin was 31% for the financial year ended 31 March 2016.

We believe the impact from the new regulations on Tencent should be limited. Online advertising only accounted for 17% of Tencent's revenue in 2015. In addition, unlike Alibaba and Baidu, Tencent has been paying the 3% cultural business construction fee on its online advertising services, including brand and performance-based advertising, in addition to the VAT. Unlike P4P, Tencent's performance-based service is not a paid search service, which is categorised as internet advertising for the first time under the new regulations.

The issues with false claims in internet advertisements and advertisers' misrepresentation of qualifications may continue to expose Chinese internet companies to legal and regulatory intervention risk. The new regulations require internet advertising operators and distributors to verify advertisers' qualifications. In addition, China's advertising laws and regulations require advertisers, advertising operators and advertising distributors to ensure the content they prepare or distribute is fair and accurate and is in full compliance with applicable laws.

That said, Chinese internet majors have been taking steps to protect consumers. For instance, Alibaba has revamped procedures to weed out fake goods and rendered help to sellers to establish their own brands. Baidu has over the years established programmes for customer verification, customer feedback and user protection, and implemented vetting of advertising content through algorithmic detection. In addition, since May 2016, Baidu has modified paid search practices, established and enhanced user-protection mechanisms and set up a CNY1bn fund to compensate users who have been harmed by fraudulent advertising.