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Overview of Common Foreign Investment Vehicles and Transaction Structures in China |
DateŁş2006-5-7 |
OVERVIEW OF COMMON FOREIGN INVESTMENT VEHICLES AND TRANSACTION STRUCTURES IN CHINA
1. INVESTMENT IN CHINA
China’s re-entry into the World Trade Organisation (“WTO? in December 2001 represented a fundamental shift in China’s commercial and legal environment. A new wave of foreign investment is now permitted as China begins to open certain industry segments, particularly in the services sector, that previously were closed to foreign participation. Whereas previously only major multi-national corporations were equipped to manage the complexities of investment in China, more and more small- and medium-sized foreign enterprises are entering China as it becomes the workshop for the world, increasingly in high technology areas as well as in more traditional manufactured goods.
Operations of multinational corporations in China are becoming increasingly more localized, and Chinese enterprises are becoming increasingly sophisticated and internationalized. Certain remnants of the old centrally-planned economy have not yet been fully discarded, but the direction of change in China continues to be positive and the pace of change continues to be remarkable. Thus, while conducting business in China is still challenging, the market and regulatory environment continues to improve, keeping pace with the growing importance of China as a manufacturing centre and consumer market.
1.1 WTO
In connection with its re-entry into the WTO, in addition to a schedule of tariff reductions China has agreed to certain market access undertakings in key service sectors, including telecommunications, insurance, banking, trade, distribution and logistics, etc. In the majority of these sectors, foreign investment and participation is to follow a schedule whereby initial investment caps and business scope and geographic scope limitations are gradually liberalized over a period of several years. Implementing regulations may impose additional practical restrictions, but these WTO service sector commitments do represent a major step forward in the overall opening of China to foreign investment.
1.2 Foreign Investment Framework
China's WTO commitments are reflected in the Foreign Investment Guidance Catalogue ("Catalogue"), which lists various types of foreign investment projects under the following category heads: encouraged, restricted and prohibited. All foreign investment projects not included in the Catalogue are considered to be permitted.
Establishment of foreign-invested enterprises ("FIEs") all require approval of the Ministry of Commerce ("MOFCOM") (the successor in powers and authorities of the former Ministry of Foreign Trade and Economic Cooperation), or its local counterpart, the provincial or municipal Commission of Foreign Trade and Economic Cooperation ("COFTEC"). While the process is well established, and the foreign investment vehicles in China are considered stable, MOFCOM and the local COFTEC do have some discretion in certain aspects of the FIE approval process.
Production-oriented FIEs with a minimum 25% foreign investment are currently entitled to certain tax incentives (see Section 3.2 below). FIEs with at least 25% foreign investment also have greater access to foreign loans (including shareholder loans from the foreign parent) with no practical interference by Chinese foreign exchange regulatory authorities. Foreign investors can invest less than 25% of the equity in a Chinese-registered company, but such investment vehicles do not qualify as FIEs or for the favourable tax and foreign exchange treatment described above.
2. COMMON INVESTMENT VEHICLES
2.1 Representative Office
The most basic form of foreign business presence in China is the Representative Office. A China Representative Office provides a permanent base from which its resident personnel may conduct local sales and purchasing activities. As a practical matter, it is desirable, and in most cases necessary, to establish a formal Representative Office for a foreign company to do the following in China:
?Open an office with company signage
?Print company business cards showing local contact information
?Open bank accounts
?Import office equipment and supplies
?Import personal effects of resident company representatives, and
?Hire Chinese employees.
Representative Offices are prohibited from engaging in “direct business operations?and violations may result in fines and the closure of the office. There is no precise definition of “direct business operations? However, it is clear that the Representative Office may not directly enter into contracts with a view to making profits nor may it directly invest in the PRC with a view to making profits.
[For more information on representative offices, please see Outline of Basic Legal and Practical Issues in Respect of the Establishment of a Representative Office]
2.2 Equity Joint Ventures
The Equity Joint Venture (“EJV? is probably the most common of the foreign investment vehicles in China.
(a) Legal Form
EJVs are limited liability legal person entities. The concept of limited liability now appears to be both settled and respected in China and conforms substantially to international custom and practice.
(b) Capital Contributions
Capital contributions to an EJV (which are referred to as the "registered capital") must be made in cash, patented and unpatented technology, materials and equipment and other property rights. However a recent circular released by State Administration of Foreign Exchange ("SAFE") has loosened the restrictions to allow foreign parties to make capital contribution in assets other than those listed above, such as the proceeds of investments (released through liquidation, share transferring, capital reduction etc.) from FIEs it has previously invested in. The investors must share the profits and bear the losses of the EJV in proportion to their respective equity contribution percentages. The ratio of debt to equity and the timing of equity contributions must conform to applicable PRC legal requirements.
(c) Management and Operation
An EJV functions substantially as a corporation in Western jurisdictions, with a board of directors and a general management office operating under the supervision and direction of the board. However, an EJV also shares many characteristics of a partnership in that the directors are appointed by the parties in general proportion to the investors?respective equity shares. There is no concept of a Shareholders meeting in an EJV (or any FIE) with power being concentrated at the board level. Also, equity interests can be transferred only with the consent of the other investors, and certain other fundamental activities require unanimous Board resolutions to be validly executed.
[For more information on joint ventures, please see Outline of Basic Legal Issues in Respect of the Establishment of Sino-Foreign Joint Ventures.]
2.3 Cooperative Joint Ventures
(a) Forms of Cooperative Joint Ventures (“CJVs?
In the past, CJVs took one of two different forms: a “true?CJV which did not involve the creation of a legal person that was separate and distinct from the contracting parties; and a “legal person?CJV in which a separate business entity was established and the parties?liability was generally limited to their capital contributions.
In the case of a “true?CJV, each party was responsible for making its own contributions to the venture, paying its own taxes on profit derived from the venture and bearing its own liability for risks and losses. In contrast, a “legal person?CJV, the more prevalent form today, shares more of the characteristics of an EJV. The "true" CJV is a rare animal in today's market as few investors are willing to entertain the prospect of unlimited liability. For purposes of this overview, we will discuss only the "legal person" CJV structure.
(b) Parties' Investments
The primary difference between a CJV and an EJV is that parties to a CJV, instead of or in addition to contributing to the registered capital, may provide “cooperative conditions?that may consist of access to or use of certain assets and/or rights that cannot be or are not assigned formally to the CJV, such as market access rights or undertakings to supply certain services or cooperation that will promote the business prospects of the CJV. In the most common scenario, the Chinese party provides such non-equity “cooperative conditions?in exchange for an agreed share of the profits, while the foreign party contributes most or all of the true registered capital in the form of cash or other permitted in-kind contributions.
(c) Distribution of Profit
The distribution of profits from a CJV does not have to conform rigidly to the ratio of the parties' capital contributions. Consequently, CJVs are considerably more flexible than EJVs, permitting schemes whereby the profit?sharing of the parties is not necessarily tied to the value of the contributions. Unlike EJVs, CJVs are expressly permitted to distribute dividend in kind as well as cash.
(d) Management and Operation
A CJV must either have a board of directors or a joint management office. In practice “legal person?CJVs typically adopt the board of directors model. The CJV law also permits the management of a CJV to be delegated to a third party with government approval. This arrangement has been the standard mode of operation for the hotel industry but could be utilised in other industries as well, although this is not so common.
(e) Recoupment of Investment
It is permitted in CJV contracts, subject to approval, to provide that the foreign party may recoup its equity investment prior to the expiration of the term provided that if the foreign party has already recovered its investment, all of the fixed assets of the joint venture will revert to the Chinese party upon termination of the CJV. In other cases, liquidation will be handled with reference to the procedures applicable to EJVs.
[For more information on joint ventures, please see Outline of Basic Legal Issues in Respect of the Establishment of Sino-Foreign Joint Ventures.]
2.4 Wholly Foreign-Owned Enterprises
(a) Permitted Industries
In connection with China’s re-entry into the WTO, certain previous requirements that a WFOE be a high-technology or export-oriented (with more than 50% of products exported) production (but not service) enterprise have now been relaxed, and WFOEs are permitted in a broader range of categories. However, where the Catalogue or other PRC laws and regulations specifically refers to a joint venture requirement, WFOEs may not be possible.
(b) Parties Involved
The foreign investor in a WFOE does not need to negotiate with a Chinese enterprise matters such as the scope of operation, number of workers, percentage of exports and changes in control or ownership of the business. A WFOE will therefore be easier to establish and exit from than an EJV or CJV. In fact, in the past few years, the WFOE has become the foreign investment vehicle of choice, accounting now for more than half of all foreign investment in China.
(c) Management and Operation
Responsibility for the daily operations of a WFOE lies solely with its own management, although financial reports must be filed regularly with the PRC tax and financial authorities. However, such filings are for regulatory purposes only, and PRC law prohibits interference in operation and management activities of a WFOE pursuant to its approved articles of association ("AA").
(d) Approval and Capitalization
Outline of Basic Legal Issues in Respect of the Establishment of Sino-Foreign Joint Ventures relating to permitted industry sectors (Section 2.1), government approvals (Section 2.2) preferential treatment for FIEs (Section 2.3), scope of business (Section 2.4), capitalization (Section 3.2) and term of operation and operating licenses (Section 3.5) also apply generally to WFOEs.
2.5 Holding Companies
(a) Scope of Holding Company Operations
For a foreign company with many investments in China, a holding company structure can provide many advantages such as centralised management, employment, marketing and distribution. Upon approval by the relevant authority, a holding company may also balance foreign exchange within the group and hold other group companies?interests in other Chinese investments. In recent years, the scope of permitted holding company activities has been expanded to include R&D, buy-sell distribution and systems integration, technical training, test marketing and holding shares in companies limited by shares, in each case subject to certain consents and approvals.
(b) Qualifications
To establish a holding company the regulations set out high threshold tests. The registered capital of the proposed holding company must be at least US$30 million and must be used for new investments (i.e. you cannot use it to buy-in the interest in FIEs brought under its mantle). For a wholly-foreign owned holding company, the applicant foreign company must have (i) had total assets in the year prior to application of not less than US$400 million, (ii) already established FIEs in China with paid-up capital of more than US$10 million and (iii) secured approval for at least three more projects or, alternatively established more than ten FIEs each with a paid up capital of more than US$10 million.
2.6 Alternative Investment Structures
(a) Acquisition of Equity Share in Existing FIE
As an alternative to establishment of a new FIE or as part of an overall acquisition transaction involving entities in China, it is possible to acquire the registered capital in an existing FIE held by a domestic or foreign investor. The other party(ies) to an EJV or CJV have a pre-emptive right to acquire the equity share of the proposed transferor, and have absolute consent rights to any transfer generally. All transfers of registered capital in any FIE additionally require amendment to the AA of the FIE, unanimous approval of the FIEs board of directors and approval of the local COFTEC (or in some cases, MOFCOM). Consequently, the transfer of registered capital in any FIE, including a WFOE, is more complex than a simple transfer of shares in an off-shore corporate entity generally, and the transfer of registered capital in an EJV or CJV is even more complex as it invites a possible renegotiation of the AA as a condition to the transfer. Tax and other related issues in respect of the sale of an equity interest in an FIE are discussed in Section 5.1 below.
(b) Acquisition of Off-shore Vehicle
Many financial or strategic investors planning to do private placement capital raises in anticipation of an eventual public offering set up an off-shore special purpose vehicle ("SPV") in a tax-efficient jurisdiction to be the named foreign investor in the FIE. Even many multinational strategic investors not planning for a potential exit from the investment may also utilize an off-shore SPV for their China investments for internal management purposes. Instead of selling its interests in the FIEs concerned, the foreign investor may sell its shares in the off-shore SPV which holds the FIE interests in China. Consents and approvals of such sale of off-shore SPV interest are not required, as PRC law is not directly applicable to such transaction.
However, since EJVs and CJVs operate in many respects as a partnership (and good partner relationships are the key to the success of any such EJV or CJV), and since the new investor may wish to negotiate amendments to the AA of the EJV or CJV in any event as a condition to the acquisition of the SPV shares (which will require board and COFTEC approvals), it is as a practical matter necessary and desirable for each new investor in the SPV to cultivate a positive working relationship with, and obtain at least tacit consent of, the other investors before concluding the investment.
Acquisition of the shares in an off-shore SPV holding all of the registered capital of a WFOE, of course, is much simpler. However, given the ease with which a new WFOE can be set up, the circumstances in which acquisition of the SPV's indirect interest in an existing WFOE will, as a practical matter, be simpler may be limited.
(c) Branch Office
To establish a branch office of a foreign company in China, significant prerequisites have to be fulfilled. Among other requirements, the applicant must have had a Representative Office in China for over two (2) years and the minimum working capital of the branch office must exceed US$10 million. A branch office will not have legal person status and as such, as in the West, its parent company will be held liable for its activities. Certain branch office restrictions have recently been lifted in compliance with WTO provisions, which will allow foreign companies to establish liaison offices for a local parent company. However, approval of branch offices for other purposes is, at present, rarely given and then only in certain industries such as banking and insurance.
(d) Foreign Invested Company Limited by Shares ("FICLS")
An FICLS essentially is a blend between an EJV and a Western stock company or public company. An FICLS is governed by a board of directors which is subordinate to the shareholders. For an FICLS, the board of directors must be established in addition to the supervisory board consisting of representatives of the shareholders and employees. Compared to EJVs, some of the advantages of an FICLS include having perpetual existence and no requirement of unanimous consent of “shareholders?as is required in EJVs. The foreign investor is required to hold more than 25% of the total shares of the FICLS to qualify as an FIE. An FICLS can be established by way of promotion with a minimum of US$30 million of paid up capital. However, if the FICLS is set up by way of public share offering the total investment will be substantially higher. Unlike FIEs, FICLS can, with approval, be listed on a recognised PRC stock exchange, or even offer shares overseas. Guidelines issued by MOFCOM indicate that promoters may be jointly and severally liable to pay for the shares of an FICLS in full.
(e) Acquisition of Shares in State-owned Companies (Direct Cross-Border M&A)
Corporate law in China generally did not contemplate direct cross-border merger and acquisition ("M&A") investments until recently (below Section 2.6(f)). In addition, many foreign investors have been reluctant to take on the liabilities of existing state-owned enterprises ("SOEs"). Consequently most FIE deals involving SOEs have taken the form of asset acquisitions, in which selected SOE assets have been contributed to or acquired by a new EJV or CJV.
However, in a landmark deal in 2002, Chinese authorities allowed a foreign investor to acquire a stake in a Chinese state-owned bank and relevant cross-border M&A rules for foreign purchase of equity interest or shares in SOEs were issued shortly afterwards by the State Economic and Trade Commission ("SETC") (now merged into MOFCOM) and other authorities. Foreign investors may acquire a minimum of 10% (10-25% to qualify as an FIE, or more than 25% to be able to enjoy the preferential treatment afforded an FIE) of SOEs that do business in industries that are not prohibited to foreign investors either: (i) by acquiring certain state-owned equity interest or unlisted shareholdings, (ii) by becoming an additional investor in an SOE through a capital increase or issuance of new unlisted shares, (iii) by acquiring claims of SOE creditors by way of debt transfer, or (iv) by purchasing assets of an SOE to establish a new FIE. However the multi-stage approval procedures are cumbersome and lack clarity, and thus take up remains low.
(f) M&A Conversion of Domestic Enterprises
Under tentative rules jointly issued in March 2003 by MOFCOM and other authorities and which became effective in April 2003, a foreign investor may directly acquire an equity interest in an existing domestic enterprise (share deal), and if the resulting foreign ownership share is more than 25% and the investment otherwise complies with the other laws, rules and regulations applicable to FIEs, then the target domestic company can be converted into a new FIE. Alternatively the foreign investor can also acquire assets of a domestic enterprise and inject these into an existing FIE or use such assets to establish a new FIE (asset deal). For the first time, these rules introduce criteria and thresholds under which a merger or acquisition is subject to anti-trust reporting, hearing and review procedures. Such reporting obligations also apply to offshore-only transactions that give rise to competitive effects in China. There remain many ambiguities in these rules which will not be resolved until new regulation is issued in this area.
The form of M&A discussed here, is a direct form of investment, as opposed to the typical quasi-M&A investment in which the domestic company contributes or sells its key assets to the new Sino-foreign joint venture but the joint venture does not assume the liabilities of the Chinese company (although typically the liabilities of the Chinese investor must be addressed, otherwise the Chinese party will not be able to make the investment). This is still a relatively new, untested and procedurally intensive investment structure (formerly only available in Beijing under rules issued in 1999 by the Beijing COFTEC) which requires substantial negotiation among the parties and consultations with the relevant government authorities.
It appears that these rules, which are applicable to all domestic companies that are not FIEs, are complementary to the above-mentioned M&A rules in regard to SOEs (above Section 2.6(e)), although there is some overlap. The merger of SETC into MOFCOM has at least partially consolidated approval jurisdiction in this area. However, it remains to be seen if and how the disparate cluster of M&A related rules will be consolidated in the future.
(g) Qualified Foreign Institutional Investor ("QFII") Scheme
Foreign portfolio investment in domestic PRC A shares is now possible under a set of new rules made effective in December 2002. Since China's currency, the Renminbi (RMB), is not convertible on the capital account (see Section 3.3 below), the equity of PRC listed companies is split between RMB-denominated A shares and B shares (denominated in RMB but tradable in either US dollars or Hong Kong dollars). A shares account for most of the value of the PRC equity market, but were previously off-limits to foreign investors. The new regulations permit foreign institutions from 16 jurisdictions to invest in A shares, subject to some restrictions, and repatriate profits and principal without having to establish a PRC business vehicle.
Four different types of institutions are eligible to apply for a license for QFII status: fund managers with at least a five (5)-year track record and US$10 billion in assets under management; insurance and securities companies with thirty (30) years experience, US$$10 billion in assets under management and paid-in capital of at least US$1 billion; and commercial banks ranked within the top 100 banks globally in terms of assets and not less than US$10 billion in assets under management. In addition to these financial qualifications the applicant must satisfy other requirements such as having had no record of material regulatory sanctions in the last three (3) years.
Under the new regulations, the minimum investment quota is US$50 million and the maximum is US$800 million. Portfolios can be managed by the QFII itself, or by a nominated securities house, but assets must be held via a custodian. A number of foreign invested banks are qualified to provide this service. All trades must be executed by a licensed PRC securities house and all settlements and offshore repatriations must be effected by the QFII custodian.
The regulations outline a somewhat restrictive liquidation mechanism devised to encourage longer term investments.
QFIIs who are closed-end fund managers are subject to a three (3) year lock-in period, whereas the lock-in period for other QFIIs is one (1) year. Repatriations of principal must be made in instalments of not more than 20% of total invested principal and must be separated by a defined period of time.
3. BUSINESS OPERATIONS
3.1 Land & Buildings
Under Chinese law, land is either owned by the state or by collectives (mostly in rural areas), and individuals and enterprises are granted only fixed-term rights to use land. Land use rights traditionally have taken one of two principal forms: allocated land use rights and granted land use rights. As indicated by the names, allocated land use rights are in the form of a personal, non-transferable, non time-limited right to use specified land. On the other hand, granted or transferable land use rights may be freely alienated for the balance of the term of use. In most cases, any land use rights to be acquired by an FIE will either be in the form of granted land use rights initially or be converted into a granted land use rights at the time of contribution, transfer or lease. Allocated land use rights are seen less and less these days due to the restrictions as to what you can do with allocated land and they have the downside of not being realisable asset on liquidation of the FIE. The term for granted land use rights depends on the use. Residential property land use rights have a maximum term of seventy (70) years. Land use rights for industrial purposes have a maximum term of fifty (50) years. Commercial land use rights have a maximum period of use of only forty (40) years. Comprehensive or mixed use land use rights have a maximum term of fifty (50) years. Upon expiration of the land use rights term, the land together with all improvements thereon reverts to state ownership pending payment of a separate land use rights fee for a renewed period. Building ownership in China is however possible and is often a part of the Chinese party's capital contribution to an EJV or CJV.
3.2 Tax
China maintains a bifurcated tax system with separate tax collection on the national and on the local level. The most significant of the taxes applicable to an FIE are enterprise income tax, business tax and value added tax ("VAT").
(a) Enterprise Income Tax
Generally FIEs and other foreign enterprises with a presence in China engaged in production and business operations are subject to enterprise income tax at a rate of 33% on their worldwide income. The enterprise income tax regime is expected to be modified (with overall rates reduced to 24-28%). No timeline or any specifics have been announced, but it is anticipated that such amendments cannot be put in place until 2006 at the earliest.
Certain income streams of foreign enterprises without a China presence such as loan interest, rental income, royalties from trademark or copyright etc. are also subject to enterprise income tax on a withholding basis. The usual withholding tax rate is 20% but was reduced to 10% in January 2000 for income such as interest, rentals, royalties etc.
(b) Income Tax Incentives
A complex system of tax incentives at the national and local levels grant exemptions, reductions and refunds to an FIE on an approval basis depending on the business type, invested industry or locality of investment. Some of the most significant incentives include:
?FIEs engaging in production (manufacturing or software development but not service-oriented FIEs) with a term of more than ten (10) years may avail themselves of a two (2)-year income tax exemption and a further three (3)-year 50% reduction on the income tax payable from the first profit-making year.
?For certified technologically advanced enterprises belonging to state-encouraged production projects etc., a 50% tax reduction is available for a further three (3) years after the above-mentioned five (5)-year tax holiday expires.
?Export-oriented FIEs may receive tax breaks in Special Economic Zones, Economic and Technological Development Zones, Shanghai Pudong New Area, Coastal Open Economic Zones. Also certain FIEs established in the Special Economic Zones engaged in service industries may apply for certain tax breaks.
Further incentives are available for investing in certain localities or zones, such as in so-called old urban areas or in areas of Western China. Also industry-specific incentives are provided, e.g. for certain basic infrastructure or high technology projects.
These tax incentives for production-oriented FIEs are expected to be discontinued when the anticipated overall modifications to the enterprise tax regime (see Section 3.2(a) above) are implemented. In the past, when other major changes were made to the tax regime, FIEs established prior to the effectiveness of the new tax regime were "grandfathered" and continued to receive the benefit of the prior more favourable tax regime. This may also be the case in connection with these anticipated changes, but this still remains to be seen.
(c) VAT
FIEs and foreign enterprises that are engaged in the sale or import of goods and processing, repair and replacement services in the PRC are subject to VAT, a kind of turnover tax. The normal VAT rate is 17%. For the sale or import of certain goods the rate is 13%. A low VAT rate of 6% may be applicable if annual sales do not exceed certain thresholds. Exports of goods, except those goods specially prescribed by the State Council, are exempted from VAT.
(d) Business tax
Business tax is levied on services not covered by the VAT and based on the income from (i) provision of labour services, (ii) sales of immovable property and (iii) assignment of intangible assets. The tax rate normally falls in the range of 3% to 5%, but in certain industries such as entertainment businesses the tax rate is higher (20%). Exemptions from business tax are possible under various laws and regulations.
3.3 Foreign Exchange System and Profit Repatriation
China's two-tier foreign exchange ("forex") system was abolished in 1994 and was consolidated into a unified, controlled, floating rate system. China's WTO accession has catalysed further liberalisation, for example with the recent abolition of the former foreign exchange balancing requirements where FIEs were required to generate the foreign exchange revenues needed by their business for purchasing overseas etc. However, the continuing macro-fiscal trends such as the 1997 Asian financial crisis have brought on an opposite trend of increased control over forex remittance transactions. Both relaxation and tightening of forex rules in accordance with the overall fiscal situation, in an attempt to maintain a stable RMB exchange rate, are expected to continue to be the main policy drivers for further modifications in the forex system going forward.
(a) Forex Current Account and Capital Account
The central concept of control over inbound or outbound forex depends on whether the nature of the transaction involves the transfer of capital or ordinary expenditures. If the transaction has the purpose of creating capital, i.e. equity investments (into FIEs), loans, securities investments, guarantees benefiting a foreign entity etc., the forex will be regarded as a so-called "capital account" item with strict control over its movement in the PRC currency market. Such item has to be placed in a controlled bank account and virtually all such related transactions require the approval of the competent department under the State Administration of Foreign Exchange ("SAFE"), which is routinely obtained without difficulty in many circumstances. If the forex transaction is within the category of cross-border expenditure in the ordinary course of business, e.g. payments and receipts from international trade in goods and services, payment of interest on forex loans (but not repayment of principal) and repatriation of dividends from an FIE, (see subsection (c) below), the item is classified as a "current account" item and is usually only requested to be supported by documentation checked by the relevant bank, although such current account items may still be subject to authentication by SAFE in certain defined cases.
(b) Remittance Control
Chinese banks remitting forex are required to confirm the authenticity of the remittance and, in certain respects, the underlying transaction. For forex capital account remittances requiring SAFE approval, the SAFE approval document must be presented to the bank. Even for forex current account remittances not requiring SAFE approval certain additional guidelines apply. For example, remittances of payments for imported goods may be made only if proper customs clearance documents are presented to the bank and other anti-fraud and anti-money laundering requirements are satisfied. Similarly, remittances of royalties under a cross-border technology license contract are subject to presentation of a technology import registration certificate or an import permit for the license contract.
(c) Profit Repatriation
Foreign investors may repatriate profits from an FIE without restriction subject to compliance with certain procedural requirements, such as prior PRC accounting to determine profits, payment of income tax and obtaining SAFE approval, which is routinely granted.
There is no direct cap on profit repatriation. However, FIEs are required to allocate a certain rate of after-tax profit, determined by the board of directors, to a reserve fund and to an employee bonus and welfare fund. Joint ventures additionally have to make allocations to an enterprise expansion fund. WFOEs are required to allocate 10% of their after-tax profit to the reserve fund and cannot reduce this rate until the fund reaches an amount equivalent to 50% of the registered capital. Furthermore, profit distribution is not permitted until the WFOE has made up for losses of previous years.
There is currently no additional PRC tax levied on distributions of profits to a foreign investor in an FIE.
4. COMMON TRANSACTIONS IN CHINA
4.1 Technology Transfer
(a) Introduction
China's foreign investment policy has traditionally placed a strong emphasis on the transfer of technology to Chinese enterprises. Consequently, technology licensing has played and continues to play a major role in foreign investment projects in China. Applicable laws, regulations and administrative practices have also imposed some significant restrictions on the terms on which such technology can be licensed into China.
(b) Applicable Regulations
Prior technology transfer rules and regulations imposed certain onerous limitations on the contents of technology transfer contracts and required centralised government approvals. This approval/registration regime has been further streamlined post-WTO to the effect that many of the previously more onerous existing provisions and practices have been eliminated or further relaxed.
(c) Prior Technology License Terms
Under the prior technology licensing rules, without approval, a technology transfer contract was void. It was also not permitted to include any of the following restrictions or requirements:
(i) requiring the licensee to purchase related raw materials, parts, components or equipment from the licensor at prices exceeding international market prices;
(ii) restricting the export of products produced by the licensee utilising the imported technology; and
(iii) prohibiting the licensee from continuing to use the technology after expiration of the term of the contract (typically, not more than ten (10) years).
In practice, MOFCOM also imposed a cap on the royalty payable under a technology license contract. The general practice was to limit such royalties to not more than 5% of the licensee’s net sales, although additional royalties could sometimes be obtained for separate famous trademark licenses.
On a more positive note, MOFCOM practice was less intrusive on items (i) and (ii) above, so parties had more flexibility in practice to control inputs and sales territories without interference by MOFCOM. On the other hand, MOFCOM routinely imposed its separate judgment on a myriad of commercial terms in a technology license contract, thereby requiring essentially a separate negotiation with MOFCOM on many matters not clearly restricted by the applicable legislation.
(d) New Technology License Terms
Fortunately, China agreed as part of its WTO market access undertakings to eliminate such intrusive approval practices as well as the license term limitations. Unfortunately, under the new PRC Technology Import-Export Management Regulations issued December 10, 2001 ("New Technology Regulations"), there is still some room for interference by MOFCOM personnel.
The New Technology Regulations provide for classification of technology as prohibited, restricted and permitted for import-export purposes. Prohibited technology cannot be imported or exported; restricted technology can be imported or exported only with approval and the issue of a license; and permitted technology can be imported or exported without approval, but registration is required. Since registration is necessary to support remittance of royalty payments under the license, it is important to determine how local COFTEC officials in the relevant local jurisdiction implement the New Technology Regulations as a practical matter.
The New Technology Regulations do contain an important improvement over the prior technology licensing regime in respect of the term of the license. Under the New Technology Regulations, the term is no longer strictly limited to ten (10) years and at the expiration of the license term the licensee no longer has the automatic right to continue to use the licensed technology on a royalty-free basis. This will permit evergreen license arrangements covering continuously updated technology within the scope of the license and will avoid the need to license only a current "snapshot" of the existing technology with all improvements thereto being licensed under separate contracts subject to separate rolling ten (10)-year license terms.
Under the New Technology Regulations, as under the prior licensing regime, the technology import license contract is required to include basic warranties regarding the rights of the licensee to the subject technology and the completeness and ability of the technology to achieve the stated objectives, as well as relatively standard IP indemnity provisions.
In addition, the technology license import contract is not to include any of the following provisions (which represents some improvement in some, but not all areas):
(i) improper tie-in arrangements, including requiring the purchase by the licensee of "unnecessary" technology, raw materials, products, equipment or services;
(ii) requiring the licensee to pay royalties or assume other obligations in respect of expired or invalid patents;
(iii) limiting the licensee's ability to make improvements or use such improvements (and the intellectual property rights to such improvements made by the licensee are to vest in the licensee);
(iv) restricting the licensee's right to obtain other similar or competing technology;
(v) "unreasonably" restricting the source of the licensee's raw materials, components, products or equipment;
(vi) "unreasonably" restricting the licensee's production volumes, product types or sales prices; or
(vii) "unreasonably" limiting the export sales channels of products manufactured using the licensed technology.
It remains to be seen how the above items will be implemented in practice by the relevant local COFTEC officials. Given the use of the qualifying terms "unnecessary" and "unreasonably" in items (i), (v), (vi) and (vii) above, these elements should be flexible enough that the current standard practice of deferring to the commercial agreement of the parties will be continued. However, the absence of qualifying terms in clauses (ii) and (iii) creates some uncertainty as to the position that will be taken as a practical matter by local COFTEC officials if the parties agree to terms inconsistent with these requirements. It is also possible that local COFTEC will be more intrusive in the approval context and less intrusive in the registration context, but this remains to be seen.
[For an example of a cross-border license agreement incorporating relevant terms addressing the above issues and other local practice matters in China, please see the template Technology Licensing Contract.]
4.2 Distributors and Value-Added Resellers
(a) "Buy Local" Trend
As discussed, the procedures for conversion of RMB, purchase and remittance of foreign exchange can be cumbersome. This is particularly true for cross-border service contracts. Consequently, many China-based customers, including FIEs, prefer to “buy local?whenever possible in order to pay for goods and services in RMB. In addition, with the continuing crack-down on smuggling, some purchasers of imported goods have also opted to “buy local?to avoid direct participation in the import process. Because of the time and expense required to set up an FIE to supply the goods or services on a domestic sale basis, many foreign companies have instead opted to appoint domestic distributors or sub-contractors.
(b) Trading and Distribution Requirements
The selection of a local distributor in China requires a 2-step analysis of import rights and distribution rights. Both import-export trading rights and wholesale and retail distribution rights have been tightly controlled in China.
Under long-standing pre-WTO policy in China, most domestic Chinese companies do not have direct import rights and so must purchase imported goods through a licensed trading company under a 3-party contract. FIEs, on the other hand, have import-export rights but these rights are primarily with respect to the purchase of components for their own use and the sale of their own products.
Controls over trading (import-export) rights have now been gradually relaxed over a post-WTO phase-in period. Instead of a handful of monolithic state corporations there are now several thousand domestic companies to choose from. All FIEs, which currently enjoy import rights, were granted export rights for third-party products sourced in China, commencing at the end of 2003. All domestic enterprises will be granted full direct import and export rights by the end of 2004. So the prior trading restrictions will soon be eliminated completely.
However, trading rights are not the same as distribution rights. A party may import goods for its own use but not be licensed to distribute such imported products in China. Pre-WTO not all domestic companies and only a handful of trial trading FIEs were granted the right to distribute third party products on a buy-sell basis.
Moreover, prior to WTO, foreign investment in distribution enterprises was limited to the handful of trial trading FIEs. This will change as a result of China's WTO market-access commitments, which provided that minority foreign-owned joint ventures were permitted to engage in distribution services starting from the end of 2002, majority foreign-owned distribution joint ventures were so permitted starting at the end of 2003, and distribution WFOEs will be so permitted by the end of 2004.
[For an example of a cross-border distribution agreement for use in China, please see the template Distribution Contract.]
(c) Value-Added Resellers
If a manufacturing FIE does not obtain distribution rights, a separate distribution FIE may be set up. However, as an alternative a manufacturing FIE may be engaged as value-added reseller since the resulting product may be considered to have been “made?by the FIE. The PRC government has yet to establish or enforce clear guidelines as to minimum value-added input criteria. For domestic companies it will still be necessary to confirm that the proposed distribution activity falls within its approved business scope as stated in its business license, although a domestic company with relevant manufacturing rights or a systems integration scope of business can also be engaged as a value-added reseller as described above.
(d) Security of Payment
Another critical aspect in selecting a distributor will be security of payment. The common practice is to require the distributor (or import-export company, as the case may be) to open a letter of credit drawable upon presentation of shipment documents. However, not all qualified distributors will have the financial capability to open a letter of credit. Even when they do, in some cases they may still insist on cross-border payment terms that match the domestic payment terms received from the local purchaser. This is an important issue that should be managed carefully.
5. EXIT STRATEGIES
5.1 Sale of Equity Interest
The most efficient way to exit from an investment in a China FIE is to transfer the equity interest to an existing partner or a third party. As noted above, transfer of the direct equity interest in an FIE requires partner consents and waivers of pre-emptive rights (not applicable in the case of a WFOE), unanimous FIE board approvals and local COFTEC (or MOFCOM) approvals. Sale of an indirect interest in an FIE via sale of shares in an off-shore SPV can be simpler but, as discussed above, will still require tacit approval and collation of remaining partners as a practical matter.
Gains on the sale of equity interests in an FIE are taxable under PRC law at a rate of 20%, or at a rate of 10% pursuant to certain double taxation treaties entered into between China's and foreign governments. If the equity interest of a foreign investor is purchased by a domestic party, including an existing Chinese partner, then the Chinese purchaser will be required to withhold such tax from the purchase price remitted and present other COFTEC and SAFE approval documents to the remitting bank to support the forex remittance.
If the purchase of a foreign investor's equity interest by a domestic party results in the level of foreign equity interests being reduced below 25% of the total equity, then the FIE will no longer be entitled to preferential tax and forex treatment. If, as a result of such transfer, no foreign investment remains, then the FIE will have to be converted into and reregistered as a purely domestic company. In some local jurisdictions in China, the FIE must be liquidated and the assets acquired by the surviving domestic party, but in other localities, the transfer and remittance of the purchase price can be approved and completed as a first step and the conversion can take place post-exit.
5.2 Termination and Liquidation
Events permitting termination of an FIE are generally left to the negotiation of the parties and are set out in the FIE's AA (and, in the case of an EJV and CJV, the joint venture contract). However, termination of an FIE also typically requires an unanimous FIE board resolution (some exceptions apply), so termination of an EJV and CJV still requires consensus action as a practical matter (the parties can be put under obligation to cause their appointed directors to approve such a resolution in agreed circumstances, but parties can instruct their directors to breach such obligations, delaying the process). Typical termination events include: breach of joint venture contract or ancillary contract, insolvency of a party or of the joint venture company, regulatory changes by PRC government authorities or force majeure with adverse effect on the joint venture's business, inability to access forex jeopardizing operations, operating losses exceeding defined ceilings etc.
Termination is followed by liquidation and dissolution of the FIE. Under the FIE Liquidation Procedures liquidation can be standard or special. In the standard liquidation, the board of directors unanimously appoints a liquidation committee which follows the procedures in the FIE Liquidation Procedures and in the FIE's constitutional documents (joint venture contract and/or AA). A creditor's meeting is not required. Special liquidation usually applies in situations where the board members of the FIE, typically a joint venture, disagree on dissolution and thus liquidation can only be triggered by an application to the original approval authority. In case of such a special liquidation, the procedures are taken out of the hands of the joint venture parties. The approval authority will appoint a liquidation committee which exercises the powers of the board of directors and reports directly to the approval authority. Also a creditor's meeting will be required. After liquidation is complete, the FIE is to complete dissolution by filing a liquidation report, approved by the board of directors, with the approval authority. Within ten (10) days of filing the liquidation report the liquidation committee has to complete FIE de-registration procedures with the tax and customs authorities, and within a further ten (10) days, with the Administration for Industry and Commerce. Finally a public announcement of de-registration has to be made in a national and local newspaper.
Termination, liquidation and dissolution can be very time consuming and expensive, and may not realise the best value for investors. Accordingly many FIE investors prefer to negotiate a buy-out by one of the parties in order to avoid having to go down that particular road.
[For sample termination and liquidation procedural clauses, please see the relevant clauses of the template Joint Venture Contract.]
6. CONCLUSION
This overview is intended to provide only a summary of certain aspects of common investment vehicles and transaction structures in the People's Republic of China. The information contained in this publication should not be relied on as legal advice or regarded as a substitute for detailed advice in individual cases.
ADDENDUM OCTOBER 2004
1. INTRODUCTION
The National Development and Reform Commission ("NDRC") promulgated the Interim Foreign Investment Project Ratification Administrative Procedures with effect from 9 October 2004 (the "Project Ratification Procedures"). These provide the detailed implementing rules for the State Council Decision on the Reform of the Investment System issued on 25 July 2004.
2. NEW RATIFICATION THRESHOLDS FOR FOREIGN INVESTMENT PROJECTS
The Project Ratification Procedures provide that based on the Catalogue, foreign investment projects with a total investment (or increases in capital to existing projects) will be dealt with as set out below:
(a) projects with a total investment of US$100 million or more in the "encouraged" or "permitted" categories, or US$50 million or more in the "restricted" category, must be reported to NDRC for ratification: applications for projects in the "encouraged" or "permitted" categories, where the total investment amount is US$500 million or above, or in the "restricted" category where the total investment is US$100 million or above, will, after the NDRC has examined and verified the application, be submitted to the State Council for final verification.
(b) "encouraged" or "permitted" category projects, where the total investment is below US$100 million and "restricted" category projects, where the total investment is below US$50 million must be ratified by the local NDRC; of these, "restricted" category projects must be ratified by provincial-level NDRC, and this ratification right cannot be delegated down to lower level bodies.
The Project Ratification Procedures also set out the contents of the project application to be submitted to NDRC. This resembles the information typically contained in a Memorandum of Understanding ("MOU"), such as scale of project, place and main types of construction, requirements in terms of land, water and energy, total investment amount, registered capital, respective equity interests of the parties and types of contributions, financing methods, need to import equipment, an environmental impact assessment, number of people employed, products produced and main technology deployed.
3. DOCUMENTARY REQUIREMENTS FOR NDRC RATIFICATION
The Project Ratification Procedures also list the documents to be attached to the application for project ratification, namely:
?Business licences / registration certificates and audited accounts for both parties;
?LOI / MOU, resolution of Board of Directors for approving increases in capital or merger or acquisition;
?Bank finance letter of intent;
?Provincial or national level Environmental Protection Authorities opinion on the environmental impact;
?Provincial level planning departments site selection opinion;
?Provincial level or national level Land Resources Authorities project land use pre-approval opinion; and
?Where State owned assets or land use rights are being contributed as capital contributions, the confirmation letter from the relevant departments.
4. TIMING
Perhaps the most significant aspect of the Project Ratification Procedures is that they pin NDRC down to a specific timetable in terms of ratification, in line with the principles elaborated in the PRC Administrative Licensing Law:
(a) Where a foreign investment project is required to be verified by national level NDRC or the State Council, the application is submitted to local NDRC for initial verification and examination before being forwarded to the national level NDRC.
(b) Where national level NDRC needs to seek opinions from industry regulators from departments under the State Council, these departments must provide a written opinion to NDRC within 7 working days.
(c) NDRC must instruct consultants within 5 working days of accepting an application to carry out assessment and proof of key issues, and to report back to NDRC within the stipulated time frame.
(d) NDRC must either complete its ratification of the project application within 20 working days of acceptance of such application, or hand over its verification opinion to the State Council within the same period, but if the verification cannot be completed within that period, a 10 working day extension may be granted with the approval of the responsible person at NDRC and the applicant must be told of the reason for the extension. This time limit does not include the time taken by the consultants.
(e) If the application is rejected, the NDRC must issue a written decision and notify the applicant giving the reasons and notifying the applicant of its rights to apply for an administrative review or bring administrative proceedings.
This establishes a basic 30 day window for NDRC to ratify or reject a foreign investment project, which is a great improvement on the previous open-ended timing for approval, and means foreign investors can now plan their business establishment in China based on a pre-determined statutory timetable.
5. CRITERIA FOR APPROVAL
In a move towards greater transparency, the Project Ratification Procedures set out the criteria on which NDRC is to judge whether to grant ratification. These range from the very concrete (conformity with the Catalogue, Chinese laws and regulations) to the very broad-brush and abstract (conformity with public interest and the national people's livelihood and medium to long term social development). Interestingly, conformity with State anti-monopoly regulations is a specific ratification criterion, presumably a reference to the forthcoming PRC Anti-Monopoly Law.
6. STATUS OF THE VERIFICATION
The NDRC verification document forms the basis for the applicant to carry out procedures to obtain land use rights, establish (or change the particulars of) the FIE, import equipment and for the application of tax policies (amongst others). The verification document will have a validity period, during which all the relevant procedures should be completed. If not, an extension must be obtained. Departments such as the State Administration of Industry and Commerce, Customs, Tax Bureau, and State Administration of Foreign Exchange are instructed not to carry out "relevant procedures" for projects where verification has not been obtained.
The verification can be rescinded where the project applicant provides fake documents or breaks up the project into smaller pieces to get below an approval threshold.
7. Changes to Projects Requiring Re-ratification
Certain major changes to projects require a project to be re-ratified under the Project Ratification Procedures, including:
?change of construction location
?change of shareholder/equity interests proportions
?change of 20% or more in total investment amount as compared to that previously ratified
The procedure for re-ratification follows the main application procedures.
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