Shanghai, in its push to develop its retail and wholesale industry, has discretely started to approve the establishment by Chinese holding companies of dedicated sales subsidiaries. Such subsidiaries are permitted to trade on the domestic market in group products, made in China. Until now, the limitation on Chinese holding companies of merely being able to assist subsidiaries in sales and purchases of goods as agent, has been a disincentive to many multinationals.
The approval of sales companies represents a significant loosening of current restrictions on local distribution.
Sales companies were the result of an initiative of the Shanghai Foreign Investment Commission (SFIC), which was originally asked by the Ministry of Foreign Trade and Economic Co-operation (Moftec) for its opinion on the establishment of sales subsidiaries by Chinese holding companies. Moftec showed reluctance to express an opinion on the issue.
SFIC ,has since decided to proceed to approve such applications on an experimental basis. Already it has approved Unilever's application and it is currently processing applications lodged by five other Chinese holding companies. Moftec has so far raised no objection to the approval by SFIC of sales companies of manufacturing groups, but has blocked the establishment of sales companies by trading company groups. It is uncertain how relevant central ministries will react to applications by holding companies engaged in industries subject to government monopoly in sales, such as the auto industry.
In. line with Chinese company law, it appears two shareholders are required. Hitherto, all applicants have proposed the Chinese holding company hold at least a 25 per cent interest, to ensure the granting of foreign-invested enterprise (FIE) status. The other shareholder was a joint venture or a wholly foreign-owned enterprise (WFOE) of the same corporate group in China.
SFIC has, however, indicated that it will consider different forms of investment structure on a case-by-case basis. The requirement is not onerous. For example, the sales company which has already won approvalhas a registered capital of just US$lm.
Although the sales company has HE status by virtue of the 25 per cent interest held by the holding company, it does not receive any corporate income tax benefits. Corporate income tax is levied at a rate of 33 per cent on profits from the first profit-making year or, if located in Pudong, at a rate of 15 per cent for as long as such preferential tax rates continue to be applied by the Pudong authorities.
The sales company has no foreign trading rights. It can neither sell products overseas nor source raw materials or parts offshore for sale to its affiliates in China.
Sales are permitted within China of finished products legally made by FIEs within the holding company's group in China. We understand the sales company can also source domestic parts and raw materials for sale to such group affiliated companies.
It would appear that to qualify as a member of the group for the purpose of using the sales company, an affiliated company will need to have some of its shareholding held by the Chinese holding company or an off-shore affiliate.
SFIC has, however, yet to consider this question in detail. Sanctions may be imposed on sales companies found to be selling goods that are manufactured by companies that are not part of the group.
The headquarters of the sales company must be in Shanghai. There is no prohibition on the establishment of branches or liaison offices in other locations in China. However, the establishment of such sales offices would be subject to approval of the relevant local foreign economic relations and trade commission branch of Moftec and the State Administration for Industry and Commerce, as well as the original approval authority in Shanghai. A degree of lobbying may be required with the relevant locality to acquire such approval.
No formal approval criteria exist. SFIC will not approve every application, although it will look favourably upon applicants which have made a significant commitment to investing in Shanghai. Holding companies registered in cities other than Shanghai will have to demonstrate significant investment commitment to Shanghai in order tohave a chance of winning approval for their application to set up a sales company.
Sales companies help to overcome one of the main restrictions placed on holding companies in China: in respect of sales of products and procurement of parts and raw materials, Chinese holding companies are limited to assisting or acting as agent for investee companies. Sales companies, by contrast, can trade as principal in selling investee company products and purchasing raw materials and parts.
As well as the ability to enter into legally binding domestic trading contracts, tangible benefits can be anticipated through consolidation of group sourcing and sales activities ?this should reduce duplication of sales entities and personnel and result in associated cost savings for the group. Consolidation of orders may result in cost reductions for parts and raw materials.
Additionally, sales companies have the ability, with relevant local government approval, to set up branches in other locations around China. This compares favourably with free trade zone (FTZ) trading companies based in, for example, Tianjin FTZ or Waigaoqiao, which are prohibited from setting up branches elsewhere except in other free trade zones.
There may be further advantages. The setting up of a sales company subsidiary may serve as a hedge against changes in the current policy which allows FTZ trading companies unofficially to engage in domes-tic trading activities in yuan through the FTZ commodities exchange market. Such companies, to undertake domestic trading in yuan, rely on the FTZ commodities trading market for the issue of VAT invoices for sales. As the status of such invoices is unclear, some tax offices in China are reported to have not accepted these invoices for the purposes of VAT set-off. As tax policy in this regard becomes more stringent, the domestic trading advantages over FTZ trading companies should become increasingly apparent.
One can therefore envisage many foreign-invested holding companies setting up sales companies to engage in domestic trade, while retaining FTZ trading companies for foreign trade purposes until such time as the activities of both enterprises can be consolidated into a single entity.
Peter Come is Senior Associate of Simmons & Simmons in Shanghai: 3rd Floor, Shanghai Dynasty Business Centre, 457 Wu Lu Mu Qi Bei Lu, Shanghai 200040 Tel: 86 (21) 6249 0700 Fax: 86 (21) 6249 0706 e-mail: peter come@simmons_simmons.com