Today, China has a policy of encouraging the import of foreign capital and technology. However, foreign companies are only able to establish certain kinds of business entity within China, and such entities are only able to engage in a limited range of business activities.
The question of what kinds of business entity may be established in China is basically a legal one, which can be addressed in the first instance by reference to China's published laws and regulations. The question of what kinds of activity may be engaged in is, however, basically a matter of policy (which may be reflected in published laws and regulations, but which can only be fully understood in the context of Chinese business practice).
Approvals are essential to doing business in China. Generally the Ministry of Foreign Trade and Economic Cooperation (Moftec) or its provincial or municipal counterparts will be responsible for examining and approving proposals to establish foreign investment enterprises in China. The State Planning Commission or ministries/authorities related to the industry in which the investment is proposed may also be involved (either at the central government level or, where the investment is comparatively small and non-controversial, at the provincial or municipal levels).
Foreign investors may set up any of three forms of enterprise (commonly known collectively as foreign invested enterprises or FIEs); these are equity joint ventures, cooperative (or contractual) joint ventures and wholly foreign-owned subsidiaries. They may now also invest in shareholding companies.
Equity joint ventures
An equity joint venture (EJV) is an independent Chinese legal entity with limited liability established pursuant to the EJV Law of 1979 and its detailed Implementing Rules of 1983. EJVs are subject to the most comprehensive legal regime of any of the FIEs and have file following important features:
* profits must be divided in proportion to each party's share of registered capital.
* statutory debt/equity ratios must be complied with and the foreign investor can not withdraw its contribution to registered capital (which may be in the form of equipment, technology and cash) during the term of the EJV.
* at least 25 per cent of the equity capital must be held by the foreign party(s). * at the end of the term of an EJV (usually 15 -30 years but there is now no legal limit for EJVs established in certain fields), the EJV is liquidated and the proceeds distributed between the parties.
Cooperative or contractual joint ventures
A cooperative joint venture (CJV) may or may not constitute an independent Chinese legal entity with limited liability, depending on the election of the investors. If a separate limited liability legal entity is created, a CJV will often appear the same as, and be treated in a regulatory sense in the same way as, an EJV. If, however, the CJV is a mere contractual arrangement between two independent investors, they will not enjoy limited liability and, in the absence of statutory provisions to the contrary, their rights and obligations will be basically as set out in the CJV contract (this allows a significant degree of flexibility to investors in CJVs).
The establishment of CJVs is now governed by the CJV Law of 1988. Prior to 1986, CJVs were the most popular form of foreign invested business entity in China. Largely due to the preference of Chinese joint venture partners for EJVs and the trend towards treating CJVs in the same way as EJVs as a matter of law and practice, the popularity of CJVs decreased. CJVs are now, however, undergoing something of a revival. In particular, their flexibility offers foreign investors a solution to some of the foreign exchange related problems of capital contributions encountered with EJVs. Features of CJVs likely to be of particular interest to foreign investors are:
* profits need not be divided in proportion to each party's share of registered capital (it is not uncommon for the foreign investor to take 80 per cent — 90 per cent of profits until it has recovered its investment and for the profit share to be adjusted thereafter).
* the same debt /equity ratios apply now to CJVs as apply to EJVs, but the foreign investor in a CJV may recover his contribution to registered capital during the term of the CJV.
* at the end of the term of a CJV, the assets are normally given without compensation to the Chinese investor (the foreign investor having recovered its investment and profits during the term of the CJV).
Wholly foreign-owned enterprises
A wholly foreign-owned enterprise (WFOE) is a wholly-owned subsidiary of a foreign parent established as a Chinese legal entity under the Chinese WFOE Law of 1986 and its detailed Implementing Rules of 1990. It will normally enjoy limited liability. Important features to note are that:
* some investors avoid WFOEs because of the practical difficulties of operating in China without a local partner while, conversely, many favour WFOEs because, in a joint venture, they would be dependent to a large extent on the cooperation of the Chinese party.
* WFOEs are subject to the same debt/ equity ratios applicable to EJVs and CJVs.
* because of the absence of a Chinese party to a WFOE, the types of business in which WFOEs may engage are narrower than those permissible in the case of EJVs and CJVs. However, the perception of WFOEs as being purely for manufacturing purposes is being gradually eroded (they may, for example, be used as holding companies).
Local legislation relating to companies with a share capital exists in certain areas, including Shenzhen, Shanghai and Beijing; these shareholding companies are governed by a separate legal regime to that which applies to FIEs. The only companies so far to be approved as companies limited by shares have been approved for the purposes of listing on the Shenzhen and Shanghai stock exchanges, each of which are sino-foreign _ joint ventures which have been converted into shareholding companies. Some requirements applicable on a national basis (although not in Shenzhen) to shareholding companies are set out in a document called Views on the Standardisation of Companies Limited by Shares, dated May 1992. These include the requirement that the promoters (shareholders) must be PRC legal persons. This includes joint ventures, although it is stated that sino-foreign joint ventures may not constitute more than one-third of the total number of promoters.
Many foreign companies with multiple investments in China in the form of joint ventures and/or WFOEs and are looking at ways to consolidate their presence there by forming a PRC holding company. Although holding companies do not constitute an alternative to the investment vehicles referred to above, they are mentioned here because this is currently an area of considerable interest.
Common objectives in establishing a holding company include increasingg corporate perception in China, the pooling of management resources in China, coordination of training, sales and servicing capability between the various ventures and the pooling of foreign exchange and RMB resources between subsidiaries. Most holding companies are set up as WFOEs (although there are some joint venture holding companies) and the fact that, strictly speaking, the holding company is a PRC entity, does not appear to affect the status of the subsidiary companies as foreign-invested enterprises.
A small number of such companies has already been set up but, in the absence of any specific regulation in this area, the authorities remain fairly cautious and impose quite strict requirements which must be satisfied before approval will be forthcoming. Some new regulations on holding companies are expected, but are not likely to be issued for some time.
FIEs business scope
The scope of business activities in which an FIE established by a foreign corporation in China engages will be limited to that approved in its business licence and articles of association (and joint venture contract, if applicable). It is not possible to simply incorporate a company, commence trading and then at a later stage seek the relevant regulatory approvals. A coherent plan with a feasibility study (including means of balancing foreign exchange income and expenditure) must be presented before approval will be given to establish a Chinese business entity. The subsequent business activities of that entity must then comply strictly with the approved business scope. Foreign business activity in China is based on the premise that nothing is possible unless specifically authorised, unlike most Western economies where the opposite is the case.
Foreign exchange balancing
The inconvertibility of the RMB is a constant headache for investors in China, because of the constant concern that there will not be sufficient hard currency available to pay to the foreign investor his share of the profits of the enterprise. There are a number of ways to deal with this problem, some of which areas follows:
* the export of products is the method most favoured by the Chinese and, indeed, it can be difficult to obtain approval for a project that does not involve substantial exports.
* swaps of locally earned RMB for surplus foreign currency held by other FIEs and Chinese enterprises are possible within certain parameters. They may be arranged through so-called swap centres or directly with a counterparty, although the swap must always be conducted with the approval of and through a swap centre. Swap centre rates vary across China and the ability to swap always depends upon the availability of the relevant currency.
* import substitution is another commonly used method, whereby (with approval) the enterprise's products may be sold in China for hard currency if the products are of a type urgently needed in China and manufactured with advanced technology and are products that would otherwise have to be imported.
Taxation of FIEs
Following an income tax law for FIEs and foreign enterprises effective from 1 July 1991, EJVs, CJVs and WFOEs are all taxed on an identical basis (with the exception of certain CJVs which are not separate legal entities).
Investment other than by establishing an FIE
There are certain other forms of business activity which, although they do not involve the incorporation of a separate Chinese legal entity, they can involve committing a substantial amount of capital and/or technology in China. Brief details of some of the more common types are as follows:
Technology transfer/ licensing
The licensing of technology (particularly on the basis of royalty payments, which can be in foreign currency) has become the favoured means of acquiring advanced western technology. All "technology import contracts" (as they are styled in China) must be approved by MOFTEC in accordance with the 198 Regulations for the Administration of Technology Import Contracts and their 1988 Implementing Rules. This legislation (supplemented by local regulations and internal documents, the ratter not being publicly available) sets out the basic conditions for technology import contracts (which include contracts for the acquisition or licensing of proprietary technology, patents and technical
services, but not trade marks).
In a standard compensation trade transaction, the foreign investor provides equipment and technology to a Chinese factory, and takes the products of the factory in payment for the equipment and technology provided.
Processing and assembly
Under this type of arrangement, the foreign investor will lease a factory or conclude a production contract with a factory, whereby it provides equipment, technology, parts or raw materials and production training to the factory, which then manufactures the products on behalf of the foreign investor for a fee. This type of arrangement is normally encouraged for export-orientated production, and as the foreign investor will require a return in hard currency, it will normally take some or all of the production in kind for sale in overseas markets.
* Officially, representative offices may only conduct liaison work for their overseas parents and are not allowed to engage in business activities (such as marketing and sales). The Chinese authorities have, however, recognised the fact that many representative offices do in fact conduct business activities on behalf of their parents or provide services for a fee for other companies or group affiliates and have consequently extended the income tax rules applicable to foreign enterprises to cover representative offices.
* Despite the recognition and tolerance of such activities by the Chinese authorities, the scope of operations of representative offices still remains limited. They cannot, for example, establish joint ventures or engage in trading or distribution activities.
Whether a potential investor in China decides to set up an FIE or to use one of the alternative methods mentioned above as a means of doing business in China often depends upon his experience in China. It is not uncommon for foreign companies with a long-term aim of setting up an FIE first to try one of the alternatives and find that one of the alternatives actually serves their purposes very well. If the intention, however, is to build up a substantial presence in China, the authorities will often look more favourably on a foreign investor setting up an FIE as a sign of its commitment. *
Clifford Chance, Suite 898, Shanghai Centre, 1376 Nanjing Xi Lu, Shanghai 200040. Tel: +8621 2798461, Fax: +8621 279 8462