In the old economy, foreign investors came to China to manufacture specific products at a specific location. Investments in the new economy, particularly in the internet industry, are challenging the traditional structures, raising complex issues for foreign investors and regulators alike.
The challenges have arisen largely due to three reasons. First, an internet business typically offers a broad range of products and services, but a foreign-invested enterprise (FIEE) can only conduct business within its permitted scope of business, and each business is normally subject to its own industry approvals.
For example, a portal can create its own content, but there are restrictions on publishing original news content. Portals also often carry advertising in the form of banners or hyperlinks or perform the role of an advertising agency, but these functions are strictly controlled. E-commerce covers online shopping, online auctions and business venues, but FIEs cannot carry on domestic trade. Travel and human resources services require specific licensing requirements. Software sales can include selling specific software linking buyers to specific portals, and entering into arrangements with local manufacturers to pre-install software, but the FIE may not have obtained approval to develop and provide software. FIEs are further prohibited from selling audio and visual products over the internet.
Furthermore, under new regulations on internet content providers (ICP measures) issued by- the State Council on October 1, websites that provide news, publications, education, medical and health care, pharmaceutical and medical equipment, among others, must first obtain approval from the relevant department. The ICP measures additionally require that all websites that provide information to the public, whether commercial or non-commercial, must be licensed and/or registered. This development potentially increases the overall risk level to FIEs that set up their own websites, but which are not in compliance with these specific rules.
Second, a new economy business uses heavily regulated new technologies. There has been a prohibition on foreign investment in the provision of telecoms services. How-ever, it should be noted that with the new telecoms regulations promulgated by the State Council on September 25, which con-template the establishment of FIEs in telecoms services, as well as with China's WTO commitment to open up the value-added telecoms services sector, the investment environment will change significantly.
The major potential prohibition comes from regulations dealing with deregulated telecoms services, which is seen to cover web-based activity. Foreign investment in the internet industry has been greatly restricted, although the new ICP measures have pro-visions concerning foreign investment in ICPs. FIEs seeking access to international connections for computer information networks in China must comply with various requirements and use an authorised internet service provider. A plethora of rules surrounds the internet and the mainstream of social stability and state security, in addition to regulations on encryption.
Third, these new technologies are used as the platform on which to deliver such products and services.
Types of Internet FIEs
Foreign-invested internet activities in China can be split into three categories:
Clicks and mortar operations
These refer to Old economy FIEs that have become web-enabled in order to improve sales by develoninc e-commerce and specific business-to-business sales channels. While FIEs have always been permitted to sell their own products in China, distribution and marketing obstacles have often hampered their efforts. It would follow that an FIE should be entitled to establish a website to post product specifications and list prices and set standard conditions of sale, although this may be subject to possible approval/registration requirements under the ICP measures. However, because of the above restrictions, the position is not totally risk-free.
Such e-commerce activities are unlikely to attract regulatory attention, unless: (i) rules on the maintenance of social stability and protection of state security are breached; (ii) the FIE's internet activity becomes its primary business rather than merely a sup-porting function; or (iii) the FIE becomes a dominant player in China for its particular product, thus affecting the business of its Chinese competitors.
Many foreign investors also import products manufactured by their non-China subsidiaries into China and sell them through their representative offices. Besides boosting sales in China, the use of parallel imports is intended to meet customer demand. FIEs with websites that include significant information on these parallel imports attract regulatory attention, increasing the risk. Indeed, the new regulations divide ICPs into commercial and non-commercial ICPs. However, the status of ICPs and portals that provide information for free, but which are essentially `commercial' in nature, still remains unclear.
This category covers marketing and sales support sites for a China representative office as well as portal businesses that cover the local market. Such portal offices might develop software, explore strategic alliances with Chinese partners or aggregate content.
To minimise government scrutiny, foreign investors may choose to post information on parallel imports on offshore websites. It is unlikely that websites offering this sort of information would be blocked unless there is harmful activity threatening social stability and state security.
In the case of foreign portals that have a global or regional audience and whose servers are located outside China, but whose contents are China-focused, the relevant issues are whether the portal has a China presence, how specific the portal is to China, and the dependence of the portal on the China market. If the portal has no presence in China, then the main risk the foreign portal faces is having access to the site blocked.
Regulatory scrutiny increases if the site is highly specific to China, particularly if the site is primarily directed at a Chinese audience and is in Chinese. Foreign sites that become dependent on the China market for business purposes face a greater business risk as the authorities can choose to block the site at any time.
Portals in China
This category comprises comprehensive China-oriented portals based in China. Risks arise as to whether the FIE is permitted to act as a portal, as well as technology and stock exchange listing issues.
FIEs have long been prohibited from operating telecoms businesses and from providing telecoms services, and only recently have events led to the gradual opening of these sectors. FIEs that have portal-like functions have typically been approved to develop software or to conduct research in new technologies. Their business scopes do not typically allow activities normally associated with portals, including providing intemet content, and they do not have the necessary licences or registrations required under the new ICP measures.
It may be possible to host websites established by Chinese partners, claiming that the portal itself is not acting as an ICP, but this argument is not entirely reliable. FIEs can have their business licence revoked or be compelled to end all unauthorised activities. Presently, internet activity is being allowed to develop with evolving regulatory enforcement. For example, the new ICP measures indicate that foreign investment in ICPs may be allowed under certain restrictions and with a Chinese partner. The ICP measures stipulate that ICPs planning to form Sino-foreign equity joint ventures, co-operative joint ventures, or seeking offshore listings, must observe relevant investment ratio rules and be approved by the Ministry of Information Industry. Specifics, however, have not yet been issued and the lack of clarity regarding the status of foreign investment may act as a deterrent to investors.
Although it is possible to operate a China-focused portal outside of China, servers need to be located in China if the portal provides higher-speed access.
With regard to listing portals, the Chinese government recently made pronouncements requiring China portals to divest their inter-net assets before listing. This is evidence that the government will not necessarily enforce strictly current restrictions on China portals, but that they are taking a gradual approach in regulating internet activities.
In order to maintain some control over internet assets, a China portal can arrange to transfer its internet assets to a duly licensed or registered ICP with which it has an association, for example an ICP controlled by the foreign investor's Chinese partner or by a Chinese employee. The China portal would license the- appropriate intellectual property rights to the ICP for it to operate the website. The ICP would then operate the website in accor dance with its licence. It is likely the China portal would transfer the servers to the ICP. The China portal would receive fees for the intellectual property licences and for upgrading and maintaining the servers and software.
The authorities will look to see whether the internet assets have been sufficiently separated. They are likely to look at four guide-lines: the domain name must have been transferred to the-ICP; the servers must have been transferred to the ICP; the ICP is responsible for paying and leasing the trans-mission line; and the ICP must be the licensee of content. Clearly, the greater the degree to which these criteria are met, the easier it would be to demonstrate that the internet assets of a China portal have been transferred and that the China portal is not acting as an ICP.
In matters over domain name, for listing purposes the authorities may take a pragmatic view and concede that the China portals require ownership of their own domain names. In this case, use of domain names and associated copyrights and trademarks would be licensed to the ICP.
The consequences of restructuring are significant. For example, without its ICP assets, the China portal has to rely on contractual arrangements to deliver its service and this may be difficult to enforce. Where the ICP assets are owned by a Chinese national who also has an interest in the portal, the contractual arrangement between the portal and the ICP may be considered to be a transaction between connected persons and the transaction may need to comply with the requirements of certain stock exchanges. Restructuring also entrenches the position of the Chinese partner or employee that controls the ICP. Furthermore, transactions between the portal and the ICP may be subject to business tax and this will increase the cost of providing the service. Lastly, restructuring may affect investor appeal to the listing.
The implications of establishing a website depend on several factors. First, it must be determined if the portal is intended to be the primary business or a sup-porting function to an underlying business. Second, it has to be 3 decided whether the portal is off a shore or onshore. Third, it must be decided whether the portal will tar-get a Chinese audience. The increased regulatory risk to FIEs due to the mandatory licensing/registration requirements for websites may raise the need to restructure.
Different considerations will apply depending on business need. Because the regulatory regime is still evolving, it is difficult to arrive at enduring structures with a high degree of legal comfort. However, investments continue to be made by investors who appreciate the risks of various approaches and who are nimble enough to respond to regulatory changes.
Written by Seung Chong of the international law firm Freshfields Bruckhaus Deringer in Hong Kong. Seung Chong recently practiced in the firm's Beijing office. For further details, contact Seung Chong in Hong Kong (tel.. +852 2846 3400) or by e-mail (seung. thong@ fr-eshfields.com).
Making wine in the cesert
As the poorest and most arid area in China, Ningxia Hui autonomous region is a good place to judge the prospects of success of the government's strategy for developing the western regions. The strategy envisions attracting profitable companies from the country's advanced coastal provinces into the back-ward western areas.
The shape of things to come in China's west is represented by the efforts of Guangxia Industry Co. Guangxia started out making floppy disks in Shenzhen, Guangdong province and was listed on the Shenzhen stock exchange back in 1994. Seeking radically new areas of investment, Guangxia moved into the cultivation of cash crops in desert areas. It chose Ningxia partly because the company's founder, Chen Chuang was born there. At a total cost of Yn650m, Guangxia has reclaimed 5,400
acres of desert, which at one time was the source of the blanket of dust that used to cover Yinchuan, the region's capital, 12km away. Some 13m cubic metres of sand were removed, and more than 2m trees planted.
Medicinal plants, including ephedra and lycium chinensis, are now grown on 1,500 acres. These herbs are making handsome profits for the company, but the real money spinner, both at home and abroad, is expected to be the wine the company makes from its 2,640 acres of vineyards.
Among the blizzard of statistics manager Yu Wanming has at his fingertips is the fact that the steel wire supporting the grape trellises could circle the earth four times. The reclaimed sandy soil and the lengthy sun-shine make this part of Ningxia ideal for grape growing. Israeli experience was drawn on for the planting of the vineyards, and French and Italian technology for the wine-making plant. Water for irrigation is pumped from the nearby Yellow River.
Such endeavours, which create wealth and employment while `improving' the environment, are core parts of the Chinese government's blueprint for developing the west. President Jiang Zemin and other state leaders have visited Guangxia. Another aspect of the strategy is tourism. For example, Sand Lake, to the north of Yinchuan, used to be part of a state farm. Today, it attracts 500,000 visitors a year, with facilities ranging from boating and fishing to camel riding.
Ningxia's leaders recognise that the fight against the desert has to be won if any economic progress is to be made. This involves phasing out sheep raising and most other types of farming, and afforesting the land on a massive scale. Farmers are paid to plant and look after trees, and huge tree plantations have been set up on state land. This was a tough decision to make, because halal mutton has been one of the region's top exports, taking advantage of Ningxia's close connections with the Muslim world.