China offers a set of business models quite similar to those of more developed nations. Differences apply not to the business models themselves, but to the specific regulatory and contextual environment for each business model. Basically speaking, there are two groupings of business models: Cross Border Business Models : these business models involve no direct or relevant investment in China, and involve either exporting to China or importing from China. Direct Investment Business Models : these business models involve the establishment of a company in China. The investment vehicles available to foreign investors in China are mostly limited liability companies, and as they are separate legal persons distinct from their investors, the liability of the investors is limited to the contributions made to the Registered Capital. This is similar to the position of limited companies in other parts of the world and is therefore familiar to foreign investors. The following Figure describes the main business models to enter the Chinese Market. Each business model can be dimensioned according to three basic parameters: investor commitment, risk assumption and operational control. 1
Figure 1: China Business Models High Commitment, Risk and Control Wholly Foreign Owned Enterprise Joint Venture (WFOE) (JV) Foreign Investor Branch Office Representative Agency or Office (RO) Distribution Foreign Invested Commercial Enterprise (FICE) Technology Transfer Low Commitment, Risk and Control Source: InterChina Consulting Technology Transfer Under the Chinese legal framework, technology transfer is a very broad concept, that includes assignment of the patent right or assignment of the patent application right, licensing for patent exploitation, assignment of technical secrets, technical services and transfer of technology by other means. The New PRC Technology Import-Export Regulations issued December 10, 2001 ( New Technology Regulations") supersede several older sets of regulations and provide a classification of technology into three categories: (i) (ii) (iii) that for which transfer is banned (import and export not allowed). that for which restrictions apply (import and export only with approval and the issue of a license). that which is freely transferable (import and export without approval, but registration is required). The New Technology Regulations contain an important improvement in respect of the term of the license, which means the term is no longer strictly limited to ten 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. 2
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. Agency or Distribution Agreements Key PRC laws applicable to distribution and agency contracts are Contract Law of the People s Republic of China (effective as of 1st October 1999) and General Principles of the Civil Law of the People's Republic of China (effective as of 1st January, 1987). As in most other countries, distribution involves the sale of goods by the foreign company to the local PRC entity which will then resell such goods on its own account, not as agent for the foreign company, to PRC consumers directly or indirectly via retailers or other middlemen. The local PRC entity sells the goods at a higher price than that which it pays to the foreign company and thus generates gross profit. By contrast, agency involves the appointment by the foreign company of the local PRC entity as its agent to sell the goods, not on its own account, but as agent for and on behalf of its principal, the foreign company. Any contract of sale to a PRC consumer, retailer or other middleman thus binds the foreign company directly. The local PRC entity earns commissions from the foreign company instead of generating gross profit on re-sales. Distribution contracts are probably more common than agency contracts and are certainly more appropriate when a foreign company does not wish to establish an agency relationship with a local PRC entity, i.e. give such entity express authority to enter into contracts on its behalf. Such agency relationships often require detailed and specific instructions from principal to agent. If such instructions need to be modified, PRC law provides that the agent must first obtain the principal s consent, except in the case of an emergency when it is difficult to establish contact with the principal. A foreign company unwilling to entrust this level of responsibility to a local PRC agent may instead prefer to appoint the local PRC entity as its distributor. Representative Office (RO) A Representative Office (RO) is the simplest and fastest way for a foreign company to establish a direct and legal presence in China. It is a relatively low risk initiative in comparison to alternative market entry vehicles, allows a certain level of control over China business activities through the employment of staff, and is often taken by foreign companies as the first step in developing full commercial operations in China. A RO has certain advantages as it allows the foreign companies to get familiar with the China market, to promote their brands, and to develop key relationships. However, it is not recognised as a legal person, so the RO cannot be involved in such business activities as signing sales contracts and issuing invoices, conducting trading, warehousing and distribution on their own account, and providing after sales services against charge. 3
Branch Office To establish a branch office of a foreign company in China, significant prerequisites must be fulfilled. Among other requirements, the applicant must have had a Representative Office in China for over two years and the minimum working capital of the branch office must exceed US$ 10 million. A branch office should not be confused with a representative office. A representative office does not have the power to engage in manufacturing operations or in the sale of products on its own behalf. In this respect, a branch office is much more powerful than a representative office because under the PRC Company Law they have the power to sign sales contracts, invoice and sell samples. At the same time, however, the branch is not considered a Chinese legal person and as such, its parent company will be held liable for its activities. Because of the inherent liability prone to this corporate structure, this type of entity has not been widely used by foreign companies that conduct business in China. 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. Joint Venture (JV) A Joint Venture (JV) is a business arrangement in which the Joint Venture partners create a new business entity or official contractual relationship, and share the investment & operational costs, management responsibilities, and profits & losses. During the roll out of China s Open Door policy over two decades ago, JVs were the initial investment vehicle used by foreign investors, not by choice but by obligation. At this time, the Central Government used JVs as a vehicle to transfer advanced technology and management techniques from foreign companies to state owned enterprises. In return, foreign investors benefited from access to markets and suppliers, as well as lower investment and operational costs. Although liberalization of foreign investment has led to alternative investment vehicles, such as WFOEs, some projects still require the involvement of Chinese partners, thus forbidding WFOEs and limiting foreign investors to establishing JVs. There are two types of Joint Venture, the Equity Joint Venture (EJV) and Contractual Joint Venture (CJV). Both investment vehicles require the drafting and agreement of a joint venture contract between the foreign partner and the Chinese partner, specifying the responsibilities, rights and interests of each partner in detail. Whereas the EJV has this division in accordance with the ratio of equity interests, the division in a CJV is up to the partners to decide. 4
Wholly Foreign Owned Enterprise (WFOE) By definition, WFOEs are enterprises wholly owned by foreign investors. In China, WFOEs were originally conceived for and limited to manufacturing activities that were either export orientated or introduced advanced technology. Whilst WFOEs are still encouraged in these areas, with China's entry into the WTO these conditions have been gradually abolished, and WFOEs as a whole have gained in legal acceptance and support from the Chinese government. WFOEs have become more popular with foreign investors, in part due to the increasing range of business activities in which WFOEs are allowed to participate, including the service sector, as China proceeds with its WTO commitments, and in part due to the full level of control that foreign investors have over WFOEs and the widely experienced problems that foreign investors have had with JVs. However, it should be noted that there are still certain regulations that may impact on whether a foreign investor can establish a WFOE or not. The Catalogue on Guiding Foreign Investment details certain prohibited projects in which foreign investment is banned altogether, and certain restricted projects that have to be in the form of a JV rather than a WFOE. Foreign Invested Commercial Enterprise (FICE) In December 2004, Measures for the Administration on Foreign Investment in Commercial Sector allowed FICEs to be incorporated in the form of WFOEs. Thus, trading & distribution rights apply, within specified limits, to both foreign invested production companies and foreign invested 3 rd party trading & distribution service companies. Distribution rights extend to commercial distribution, warehousing, after-sales service, maintenance operations and related logistics. Licenses are issued automatically on the basis of routine applications and modest threshold requirements. Compared to the Non-FTZ Trade & Distribution JVs, the investor asset value and historical average sales volume thresholds have been removed, and the project Registered Capital threshold is greatly reduced. Table 1: Parameters for FICEs Parameter Requirements Investment JV As of 1st June 2004 Vehicle WFOE As of 11th December 2004 Generally Commission agency, wholesale, retail or franchising (subject to the 1997 Franchise Regulation, a very simple set of rules originally intended for domestic enterprises). Commission agency, wholesale. Business Scope Wholesale Import and export rights allowed. No geographic restrictions as of 1st June 2004. Retail, franchising. Retail Export rights allowed. Import rights restricted to imports for self use. No geographic restrictions as of 11th December 2004. Registered Capital Wholesale RMB500,000 (US$60,000). Requirements Retail RMB300,000 (US$36,000) Term of Operation 30 years (in Western China this is extended to 40 years). 5
Operational Restrictions Application Procedure Parameter Chain Stores (companies with more than 30 stores) Wholesale Retail Documents Approval authority Timeframe Existing Foreign Invested Enterprises (FIEs) Requirements Will not be permitted to own more than 49% of an FICE if the products it sells includes certain restricted products: books, automobiles (until 11th December 2006), medicines, agricultural chemicals etc. Shall be restricted from dealing in salt or tobacco (additional restrictions on goods remain in place as part of China s WTO commitments). Shall be restricted from dealing in tobacco (additional restrictions on goods remain in place as part of China s WTO commitments). Application, audit & valuation reports, bank credit certificate, registration certificate, JV contract and feasibility study, among others. Filed with the provincial-level equivalent of the MOFCOM, which then forwards the entire application to MOFCOM for final approval. However, the MOFCOM may, at its discretion, authorize provincial-level authorities to examine and issue approvals. The MOFCOM should approve each application within 3 months of receipt. Existing FIEs will be permitted to apply for expansion to their business scopes to include trading & distribution activities, thus enabling them to significantly expand their product portfolio and operational capacity. Summary Representative Office, Joint Venture and Wholly Foreign Owned Enterprise are still the most popular investment models for foreign investors by far. Table 2: Comparison of Different Investment Modules Parameter RO JV WFOE Restricted industries: Establishme nt procedure: Upfront investment: Mostly unrestricted, exceptions apply Fast, simple. No registered capital requirement, should be regarded as a cost rather than an investment. Mostly only prohibited industries. Long, complex. Need to do due diligence on, then negotiate the JV contract with, a Chinese partner in China. Shared with JV partner, and lower upfront investment risk if transferable customers or sales contracts. Prohibited industries plus some restricted industries. Increasing liberalization. Quite fast, quite simple. Shouldered by foreign investor, relatively high exposure to upfront investment risks. 6
Parameter RO JV WFOE Assistance from JV Support: partner in obtaining Dependent of support government Little support from newly recruited approvals, labour required. staff or external recruitment, acquiring consultants. land & production facilities etc. Time to market: Control: Market: Supply: Intellectual property: Termination: Up and running quickly. Full control, but limited business activities. No sales, but can do market research and marketing. No procurement, but can do sourcing and quality control. Not applicable. In theory straightforward, but in practice tax issues often arise. Up and running quickly, but risk of JV partner shifting excess workers to the JV. Control compromised by JV partner, risk of partner disputes, depends on structuring. JV partner can provide access to market, especially distribution channels. Can provide access to tried and tested suppliers. High risk exposure to IPR infringement, many bad experiences. CJV easier than EJV. Could be first step to acquiring the JV partner. Likely time lag, plus taxation on existing resources before initiation of operations. Full control over major decisions, operations and corporate culture. Stronger position with customers who value a purely foreign supplier. Relatively simple, except for a few relatively closed sectors. Lower risk exposure to IPR infringement than JVs. Still requires monitoring of staff. Easier to terminate than an EJV, but not as easy as a CJV. 7