Many foreign investment companies have established a presence in the 15 free trade zones (FTZs) located around China's coastal areas. The advantage of being located in one of these zones, which were set up about seven years ago, is the ability to conduct domestic trade and provide general services – activities which seemingly have been denied to foreign investors in all other parts of China.
The 15 zones, from Dalian in the north to Haikou in the south, offer favourable policies which provide an attractive environment to foreign investors. They have also been a useful means of promoting exports, especially since the onset of the Asian crisis.
Two of the most prominent zones are the Waigaoqiao Free Trade Zone in Pudong (Shanghai) and the Tianjin Free Trade Zone. The Tianjin zone is rapidly gaining in popularity among companies operating out of Beijing and other cities north of the Yellow River. The Waigaoqiao zone is the oldest and most established free trade zone in China, attracting US$530m in foreign investment last year and exporting goods worth US$1.05bn. Intel Corporation established a US$198m plant in the zone last year to assemble and test its flash memory products.
Companies in these zones are allowed to engage in foreign trade and entrepot trade, harbour services, bonded warehousing, simple processing and export processing. However permission for domestic trading is not specified – a major drawback for many foreign companies since this is an activity they are particularly keen to perform.
Under current regulations, foreign investment enterprises are not allowed to conduct domestic trade, with the exception of a few specially approved Sino-foreign joint venture trading companies established under a pilot scheme. Despite this restriction, free trade zones are frequently marketed as regions where trading companies are permitted to conduct domestic trade. How is this possible when the business licences issued to these companies do not include domestic trade?
In. the Waigaoqiao FTZ, domestic trade can be conducted by foreign investment enterprises through the use of ‘bonded markets' – local organisations set up under the approval of the local government. These markets can act as the import/export agent and can also help issue VAT invoices to customers on behalf of Waigaoqiao FTZ companies in return for a fee.
Based on this mode of transaction, it would appear that Waigaoqiao FTZ companies are not violating any legislation since it is the bonded market that imports the goods and sells to the customers. However, in practice the VAT invoices are issued in the names of China's 15 free trade zones the Waigaoqiao FTZ companies. There is therefore a technical argument that these companies are conducting domestic trade in violation of their permitted business scope.
The Tianjin FTZ also has a bonded market through which companies in the zone may conduct their domestic trade. However, the Tianjin authorities do not insist that domestic trade must be conducted through the bonded markets. In fact, they facilitate companies in the zone to conduct direct domestic trade by allowing them to purchase VAT invoices that they can then issue directly to their local customers. On this basis, there are even fewer grounds for a Tianjin FTZ company to claim that it is not conducting domestic trade. The opinion of the zone is that, should the company be accused of conducting domestic trade, it can switch to transacting through the bonded market in the same manner as a Waigaoqiao FTZ company.
Although the conducting of domestic trade is an ongoing concern for free trade zone companies, these trading activities have been going on for several years and are supported at least at the local government level. Most of the zone authorities also believe a possible clampdown by the central government is unlikely, especially in view of China's pledge to further open up its trading sector in a bid to enter the World Trade Organisation. This risk for free trade zone companies may therefore be reduced over time.
Companies that set up in free trade zones can invoice in either foreign or local currency. This is an advantage over foreign companies in other parts of China which can only invoice in foreign currency, and domestic companies which have to invoice their Chinese customers in yuan.
Foreign exchange controls
In response to the Asian currency crisis, the State Administration of Exchange Control (SAEC) issued Notice No. 8 which forbids free trade zone companies from converting their yuan income to foreign exchange to pay their foreign suppliers. In response to this notice, the Shanghai branch of the SAEC issued Notice No. 12101, clarifying that ware-housing companies and manufacturing or export processing companies can still purchase foreign exchange, but only after they have exhausted their own foreign currency savings. Although not stated in the notice, a limit is also placed on the amount that can be exchanged, which has to be negotiated with the zone authorities. While the Tianjin branch of the SAEC has not issued a similar notice, it is carrying out the same rules in practice.
As trading companies do not fall within the categories stated in Notice 12101, they are not able to convert yuan to foreign currency to purchase imports as they would in the past. We understand that, in an attempt to combat this, some companies are selling their imported goods to the bonded markets or import/export companies for foreign currency and then purchasing the goods back in yuan, at an exchange cost of 0.2-0.5 percent of the transaction value. Although this is time consuming and costly, it enables companies to circumvent the exchange restrictions for the time being.
The standard corporate income tax rate in China is 30 percent plus three percent local tax. Companies that set up in free trade zones typically enjoy a reduced rate of 15 percent, with the local tax waived.
Manufacturing companies in the zones enjoy normal incentives that are available to similar manufacturing foreign investment enterprises outside the zone. In addition, a trading company in the Waigaoqiao FTZ is given a tax rebate which effectively allows it to enjoy two years of tax exemption from the first profit-making year, followed by tax at a rate of 10 percent up to the year 2000.
' With regard to value-added tax, a Waigaoqiao FTZ company is given a rebate of 25 percent of the net VAT paid for its domestic trading activities provided the company has an operating period of more than 10 years and its international trade level exceeds 15 percent of its total trade.
The finance minister Xiang Huaicheng recently announced that the allocation of tax revenue to local governments would be reduced. This puts into question whether the above tax incentives currently enjoyed by companies in free trade zones can be extended beyond 2000 when local governments have less money at their disposal. Most analysts, however, believe that in the current economic situation existing tax incentives will not be abolished in the short term.
A major drawback for free trade zone companies is that they are not allowed to set up branches or liaison offices outside the zone. Since these zones tend to be close to ports and are not easily accessible to the general work-force, they are inconveniently located for the purposes of setting up an office. Therefore, many companies in the free trade zones have set up shell offices in these zones while actually operating through a pseudo presence in the offices of holding companies and representative offices of foreign companies outside the zones.
The Shanghai and Tianjin branches of the State Administration for Industry and Commerce have taken steps to allow FTZ companies to establish non-operational offices outside the zones, but this is vulnerable to challenge since these measures go against the rulings of the central authorities.
Despite this drawback and others – the expiration of certain tax incentives in 2000 and the possible contravention of the scope of business – a free trade zone company remains the only viable option for foreign investors wanting to conduct domestic trade.
Current regulations do allow joint ventures in Pudong or Shenzhen to engage in domes-tic trade but the conditions laid down for investors are onerous.
Given that the minimum registered capital required for investors in the FTZs is only US$200,000, it is a relatively cheap risk to take compared with the potential returns. Besides, most manufacturers of international brands distributed in China have a presence in the FTZs. Therefore, if there is a clampdown by the central authorities, they will all be affected in the same way.
Written by Dawn Foo, tax partner, and Christine Chan, senior tax manager, PricewaterhouseCoopers in Beijing. The above information is not intended to be comprehensive or final. Professional advice is strongly recommended before entering into any planning arrangements based on the announced regulations.
Filling in the gaps
CF Pan of the international law firm Freshfields assesses the implications of several new developments under China's Contract Law.
After much anticipation, China's Contract Law was promulgated on March 15, 1999 and will be implemented on October 1, 1999 – the 50th anniversary of the founding of the People's Republic.
For the first time, one comprehensive law will consolidate contractual concepts contained in various Chinese laws and regulations, including the Economic Contract Law, the Foreign Economic Contract Law and the Technology Contract Law. The Contract Law also develops some new concepts and rules for contracts. It will be applicable to non-economic as well as economic contracts, and to contracts concluded between Chinese entities and to contracts involving foreign parties.
Forming the contract
Gaps and inconsistencies in China's commercial and legal environments have sometimes subjected foreign investors to hard lessons in the enforceability of contracts. The new Con-tract Law clarifies some ambiguities often encountered in contract formation in China. Contracting authority Identifying whether a Chinese party has the necessary authority to enter into an economic contract with a foreign party has never been straight-forward. Due diligence checks with relevant authorities may be difficult or impossible. The burden of clarification has always been placed on the foreign party, who relies on the government approval process to a large extent. However, many contracts do not require government approval and the consequences of contracting with a party who has not been duly authorised may be an invalid contract. The Contract Law has sought to redress this problem by introducing new rules concerning ‘apparent authority.’
Where a person executes a contract on behalf of a party without appropriate agency authority, the agency is nonetheless deemed effective if the other party reasonably believes that the person has the proper authority to conclude the contract. Similarly, where a legal person, legal representative or person-in-charge executes a contract on behalf of its represented entity (or for itself in the case of a legal person) outside the scope of its authority, the representation is construed as effective unless the other party knew or had reason to know that the representation exceeds the authority.
The language of these provisions is sufficiently broad to cover representatives of commercial businesses and government bodies.
Defining an enforceable contract
The question of whether an agreement is an enforceable contract has been the subject of Chinese litigation. The Contract Law clarifies the formation of the contract by introducing the concepts of offer and acceptance. A contract is deemed formed and effective at the moment the acceptance becomes effective. Where the acceptance makes only non-material changes to the offer, these changes do not affect the effectiveness of the contract and are disregarded. Replies with material changes to the offer are not deemed to be acceptances.
Additionally, the Contract Law provides that contracts may be oral or written. Previously, they could only be in writing.
Binding the parties
Given the rapid pace of social and economic change, it is common for contractual parties to attempt to nullify a contract based on commercial decisions made after the contract has been executed. One rule enacted before the Contract Law which exacerbated this problem provided that contracts executed under fraud or duress are automatically void. This approach in effect gave the party which committed fraud or took advantage of duress the option of choosing when and whether to disclose such information, should it be more advantageous to avoid the contract altogether. The Con-tract Law now only grants the injured party the right to request the people's court or an arbitral tribunal to modify or terminate a con-tract concluded under fraud or duress.
The Contract Law rectifies the lack of rules dealing with the assignment of rights, which is fundamental to commercial transactions. Whether con-sent or only notice is required for assignment will depend on the obligations held under the contract. If the party assigning the contract receives the benefit of contract performance, then he may assign his rights by only notifying the other contract party. Consent is no longer required in such cases, which should simplify assignments, especially where the creation of security is involved.
Dealing with breach
The Contract Law provides some new remedies for breach.
‘No fault' liability
Prior to the Contract Law, a non-performing party could be held liable for breach only if it could be demonstrated that the party had not performed its obligations and had some degree of `fault' in causing such breach. If the party had not per-formed its obligations because some higher authority had so requested, then the party could argue it was not at fault even though its breach was not contestable.
Under the Contract Law, `no fault' breach is the prevailing standard. Now a breaching party, with some exceptions, assumes liability regardless of fault. Further reinforcing this standard, the Contract Law stipulates that a breaching party is liable to the injured party even though the breach may be attributable to a third party. These provisions are important in solving the problem of Chinese contractual parties attempting to escape breach liabilities by shifting the `fault' of breach to third parties.
Previously, the option to petition the people's court to compel performance against a breaching party was limited to contracts involving Chinese entities only. The Contract Law now permits any contractual party to choose this option as a 'remedy against breach, and has explicitly broadened `specific enforcement' to cover non-economic contracts. This development is especially useful to foreign investors whose operations in China are contingent upon their Chinese contractual parties per-forming 'certain non-monetary obligations, such as supplying ancillary facilities. The breach of these obligations may indirectly jeopardise an entire project or would likely result in losses which are difficult to quantify for the purposes of assessing damages.
A new provision in the Con-tract Law could be construed so as to allow a party which has performed its obligations before the contract was avoided, to be restored to its original state prior to such performance, regardless of whether the contract was avoided due to breach or was void to begin with. This rule, similar to the common-law theory of restitution, may afford foreign businesses the opportunity to recover some losses previously unrecoverable under Chinese law.
Previously, where one contractual party's act endangers the objective of the contract or causes loss to the other injured party, and where such act does not amount to a breach, the injured party had only limited options. Now, the Contract Law provides some new protective measures in this area.
If a debtor causes losses to its creditor because the debtor did not pursue diligently a debt due from a third party, the creditor may petition the people's court for subrogation so as to assume the debtor's rights to collect the debt.
Avoidance of obligor's acts
If a debtor causes losses to its creditor as a result of its waiver of debts due from third parties or transfer of assets without compensation, the creditor may petition the people's court to avoid the debtor's act. Likewise, if the debtor causes losses to the creditor due to the debtor's transfer of assets at unreasonably low prices, the creditor may petition the people's court to avoid the debtor's transfer, provided that the transferee was aware of the situation.
The Contract Law provides for the new contractual concept of anticipatory repudiation – the clear indication through words or action by the obligor, before the date fixed for performance, that it will not perform. Although not technically a breach since the deadline for performance has not yet passed, the obligee is allowed to rescind the contract or seek liabilities for breach before the date fixed for performance. The option to immediately seek damages or other breach liabilities creates crucial negotiation leverage for an obligee who wants to persuade the obligor to perform according to the contract. The danger in this approach is that the obligee's right and opportunity to sue may be lost in the future if certain events (such as force majeure) arise which prohibit further performance by the obligor without giving rise to breach liabilities.
The new developments in rules regarding contract formation have also given rise to potential problems.
Oral contract claims
The Contract Law now allows both oral and written contracts, in order to increase the speed and efficiency of commercial transactions (though some specific types of contracts must be in writing). However, the Contract Law does not require that contracts involving a certain monetary amount or duration be in writing. Consequently, oral contracts may open up new possibilities of confusion or fraud.
Burdensome contract formation
The Contract Law does not draw a distinction between the formation of casual agreements and sophisticated business transactions. As a result, while consumers may find the new provisions detailing contract formation helpful, these same provisions may be an impediment to transactions involving sophisticated businesses or merchants. For example, the application of the concept of offer and acceptance to enforceability means that a commercial purchaser would not be able to make non-material amendments to purchase orders based on industry practice or a previous transaction, as these amendments would be unenforceable.
Freshfields 1999. Freshfields in an inter-national law firm. Most of its offices throughout Asia, Europe and North America include China specialists. For further details, contact Lucille Barale in Hong Kong (tel. +852 2846 3400) or by email (email@example.com) or Matthew Cosans in London (tel: +44 171 936 4000) or by email (mcosans@ freshfields.com).