The fourth way

Ten years ago, overseas investors entering China were faced with a stark choice between a local joint venture (JV) and a foreign registered representative office. This was followed in due course by the wholly-owned foreign enterprise (WFOE) as Beijing began meeting the WTO’s market access requirements.

Now there is a fourth way. The State Council recently authorized the Ministry of Commerce (MOC) to create regulations allowing foreign individuals or companies to participate in partnerships in China. The first draft of the Foreign Invested Partnership Law (FIPL) is now pending submission to the Standing Committee of the National People’s Congress.

The draft law is significant because it reduces the threshold for foreign investment in China. It could be of great advantage to small and medium-sized enterprises that cannot afford the level of investments required to set up a JV or a WFOE.

The FIPL applies to both general and limited partnerships. These foreign investment partnerships (FIPs) may be formed by any combination of foreign and Chinese individuals, and foreign and Chinese companies or organizations. Partnerships can also comprise of two or more foreign companies. Moreover, the FIPL allows a parent company and a subsidiary in China to form a partnership.

FIP is no JV

While some have tried to argue otherwise, a FIP is in no way a JV, but rather a completely new method for foreign investment. Whereas parties to a Sino-foreign JV in China must be legal person entities (i.e. Chinese or foreign companies), enterprises and individuals can qualify as parties to a FIP.

As a legal person entity, a JV has limited liability but a FIP has unlimited liability that passes to the partners as is the case in partnerships in many other jurisdictions around the world. Furthermore, legal person entities are taxed both on income and on dividends paid out to shareholders; for partnerships, income tax obligations pass through to the partners, thereby eliminating the possibility of “double taxation.” Therefore, in the case of a FIP, the individual income tax law is applicable as opposed to the new Enterprise Income Tax Law.

Although a FIP differs from a WFOE or JV, it must comply with the same government policies relating to foreign investment. For example, where a FIP is to participate in a sector from which WFOEs are legally excluded (i.e. a JV-only sector), there must be one or more Chinese partners.

For FIPs operating in areas in which the law does not simply require a JV but “Chinese majority ownership” or “Chinese relative control,” the Chinese partners will have final say over certain matters as referenced in various articles of the FIPL. Additionally, where “Chinese majority ownership” is required, the Chinese partners must have a stake of at least 51%.

The draft FIPL allows a FIP partner to inject cash, intellectual property, land use rights or make contributions in kind among other things. However, while Chinese partners may contribute labor, foreign partners may not. When a partner wants to make a contribution – be it in-kind, intellectual property rights, or land use or other property rights – the value of the asset or assets must first be assessed and verified by a PRC-authorized valuation entity. This is not the case in a solely Chinese partnership where the value of the assets contributed can be negotiated by the partners.

All capital contributions made by partners, profits derived from the partnership and other property acquired in the name of the partnership are owned by the partnership. In the case of a FIP, the draft law provides that no funds may be transferred outside China prior to the liquidation of the FIP.

While partners in a solely Chinese partnership can adjust their capital contributions per the terms of their agreement or upon the consent of all the partners, the FIPL restricts the partners’ ability to modify capital contributions in a FIP. However, language does exist in the draft law which indicates contributions may be adjusted with appropriate government approvals.

Additionally, research suggests capital contributions could possibly be altered in the event of a major change in a FIP such as a change in the scale of a partnership’s business operations.

Sharing the wealth

One area where the draft FIPL does not offer specific guidance is profit and loss allocations. It is explained – without great detail – that a partnership agreement should clearly describe the methods of sharing profits and losses. If a partnership fails to address this issue, or does so inadequately, the partners will have to negotiate the profit and loss allocations when the issue arises. If such negotiations fail, profits or loss allocations must be proportional to each partner’s actual capital contribution. Should the information on this be unclear, profits or losses must be apportioned among the partners equally.

In a FIP, the ratio of profit and loss distributions can be agreed upon by the partners and need not accord proportionally with each partner’s contribution. However, a FIP agreement may not allocate all profits to one partner and all losses to another.

The creation of a new category of foreign investment in China is not an everyday occurrence. While certain restrictions that apply to foreign investors do not apply to domestic Chinese investors, draft rules such as the FIPL signal a significant change in China’s attitude towards business.

By ALEXANDER MAY of Shuang Cheng, attorneys-at-law. China Axis Limited in association with Shuang Cheng Attorneys-at-Law are experts in matters of market entry and investment in China. They regularly assist companies in structuring investments in China and manage relationships and risks involving local partners. For more information, contact amay(at)shuangch.com or go to http://www.shuangch.com