Which legal form we chose for entering the Chinese market depends on a number of factors.
The first step is usually to engage a commercial agent or to set up a representative office. If a production company is being founded, a Joint Venture has been proven to be the most popular form in the past, as a well-networked Chinese partner can be of great advantage. Often there were difficulties with the two partners, particularly due to both having different objectives from the Joint Venture. Currently the most popular form is the WFOE - three quarters of all start-ups are performed as a WFOE.
Even the number of Mergers & Acquisitions (M&A) - the market entry through purchase of shares or assets of an existing Chinese company - are steadily increasing.
A. Commercial Agent
There is no Commercial Agent law for foreign trade. For this reason the parties have a wide scope of action and the contract does not need authorization.
Although some important factors must be considered:
- In addition to your own trade mark, the Chinese Version of the trade mark should also be registered. Otherwise the Chinese Commercial Agent could register the rights for the Character Version
- A non-competition clause for a fixed amount of time after termination of the contractual relations and financial compensation clause in case of premature termination of the contract shall also be included in the contract
- Generally Chinese Agents are more interested in a higher base amount than a sales oriented provision - this shall not be the case here
- Legal Persons who do not have a fixed place of business only have limited power of representation
B. Representative Office
The most common legal construction for a market entry is the establishment of a representative office in China, which usually only takes a few weeks. A representative office is a legally dependent representation of your own company in China. Raising nominal capital or drafting corporate by-laws is not necessary in this legal form.
The business purpose of a representation is: product presentation and advertisement, market research for business activities and liaison activities in relations with the sale of products and provision of services. Also included are activities within the scope of international agreements.
In order to open a representative office in China, a company must have been on the market for at least two years, which additionally has to be proofed. The period of validity for the registration of a representative office is one year. In case you want to extend the operating license, an extract from the commercial register of the parent company has to be notarized, additionally attested, legalized by the Chinese Embassy and then presented. The parent company must have existed for more than two years before the application. The establishment of a company for the purpose of creating a representative office is prohibited. The number of representatives is limited to four people, including the chief representative.
The representative office shall be subject to taxation from the establishment. All representative offices are subject to income tax, as well as value added tax and business tax. Representative offices can only be freed from taxation due to a double taxation agreement. This may also apply to representative offices of German corporations.
Representative offices are unlike foreign companies not relieved from paying tax. A representative is obligated to pay Chinese business tax, which is usually calculated by the basis of the office expenses and control field. Because Chinese authorities assume, that a certain percentage of the profits of the parent company are attributable to the representative office, they therefore demand payment of corporation tax. Approximately 10% of the costs should therefore be calculated for the tax.
Accounting must be conducted in China and the annual financial statement of the representative must be conducted by an auditor. The representative has to immediately notify the authorities if any changes happen to the corporate or capital structure, as well as other changes of importance. In the future the financing has to be provided by the foreign company and not by the local office in China, as it is often in practice.
The chief representative and the representative are allowed to sign contracts for the foreign company if they have been authorized to do so. Local employees have to be employed by the FESCO or a recognized personnel agency.
Special rules are applied to investments from the SAR Hong Kong, because of the special relationship between SAR Hong Kong and VR China.
The establishment of a representative office has to be registered at the Administration of Industry and Commerce (AIC).
C. Joint Venture
A Joint Venture is the oldest form of direct foreign investment in China and , according to Chinese law, a legal person in the form of a limited liability company. It corresponds approximately to the Anglo American Limited Liability Company.
Joint Ventures in PR China are an association of one or more people or companies who operate economically together with a Chinese Partner.
Although because of internal conflicts and disappointed expectations in the past, German investors are slowly moving away from this form of investment. Selecting the right Chinese Partner is very important, which is why the legal structure of the Partner has to be examined and his obligations have to be defined in the Joint Venture.
There are two types of Joint Ventures, which are used by foreign companies. On the one hand we have the Equity Joint Ventures (“EJV”) and on the other hand there is the Contractual Joint Ventures (“CJV”).
An EJV is a, from the founding members different, legal entity with its own asset and its own rights and duties. Each shareholder has the right to distribution of profits at the ratio of his investment. The foreign investor must own at least a 25% share of the registered capital.
A CJV can be established in two different ways: in the first case it is a purely contractual agreement where the parties commit to specific tasks and to adopt a specific capital. The Joint Venture contract also sets out the objectives of the Joint Venture. The rights and obligations arise solely from the contract. The second option of the CJV is only possible if the conditions for the establishment of a legal person are met. The CJV shall be treated as a limited liability company, with the liability limited to the total capital of the CJV. The profit distribution can be regulated in the contract and does not need to be in proportion to the investment of the parties. Both options of the CJV require an approval of the authorities.
Joint Venture contracts can be concluded for a limited or unlimited period of time. The duration of fixed-terms contracts is 10-30 years in most cases, in special cases it can also be for 50 years or longer, if agreed upon. After the termination of the contractual relations, the liquidation will take place in proportion to the capital participation.
Some important factors have to be considered:
- Company names must be written in Chinese characters and must not have any foreign language words, words in Pinyin or Arabic numbers. The use of the words “China” “national” or “international” is only possible to a limited extent.
- The Chinese Party will often submit sample texts from MOFCOM. However these texts are designed too generally, are not up to date and more in favor of the Chinese party. It is therefore recommended that the foreign investor provide a contract draft and negotiate the terms with the Chinese Party.
- The contracts should be drafted in Chinese and English, but in case of doubt, the English Version shall have priority - although getting approval for this regulation may cause some problems.
- In order to benefit from various tax reliefs, the foreign partner must own at least 25% of the shares of an EJV. Although in certain commercial sectors the foreign partner is not entitled to the absolute majority.
- The competence of the general manager should be clearly defined in the JV contract and the Articles of Association. In particular the transactions which need his approval should be listed.
- It should also be regulated, who chooses the employees by which criteria and to what extent other personnel decisions are to be made by the General Manager
- It is recommended to regulate in the contract, whether the financial statement should be examined by an auditor and if accounting reports are to be submitted.
- Because an EJV for an unlimited period is difficult to enforce in practice, a limited term with a renewal clause can be agreed upon instead. In the event of a termination of the EJV, special rules have to be agreed upon. Rules of the liquidation law for foreign invested enterprises from the year 1996 and local regulations have to be considered.
D. Wholly Foreign Owned Enterprise (WFOE)
Since China joined the WTO, there has been a clear trend toward the establishment of wholly-owned subsidiaries. Normally the establishment of a WFOE is faster than a JV because no lengthy negotiations with Chinese partners are required.
In certain economic sectors the establishment of a WFOE is not possible. This includes for example the car production sector and to some extent the service sector. The WFOE must also promote Chinese economic growth and be able to achieve sustained economic success.
The WFOE is usually founded as a limited liability company. It is a legal person of the Chinese law. In some exceptions a different legal form can be approved. Just like for the EJV, a specific ratio of equity to total investment is required for the WFOE. The legal basis are “Law on wholly foreign-owned enterprises”, which was implemented in 2001, as well as the Chinese company law.
The bureaucratic procedures and the necessary documents for the establishment of a company with foreign participation are largely the same for Joint Ventures and WFOE's.
Some important factors have to be considered:
- Documents have to be delivered in Chinese
- Before the actual application, the application letter should be addressed to the district office in charge, with the content: Short description of the company and the resulting benefits for the PRC is
- The capital contribution must be approved by an auditor who is registered in China, who will issue a “Certificate of Verification” (yanzi baogao). For cash deposits the receipts will suffice. If the capital payment is not made within the prescribed period, the business license can be revoked.
- Before receiving the business license and the Certificate of Verification, the company must not take out a loan or distribute the dividend.
E. Mergers and Acquisitions
The “Regulations for Mergers and Division of Foreign-Invested Enterprises”, which were implemented in 2001, regulate M&A activities which foreign companies are a part of. In 2008 the “Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors” took effect. These regulations regulate the acquisition of Chinese companies by foreign investors, who buy either shares or assets of a foreign invested company, a domestic company without foreign participation, a joint stock company or a state company.
The foreign investor can act faster in the Chinese market if he acquires a company that already has its own organization. Additionally acquiring an already existing company is less risky than a start-up company - provided the investor has conducted a thorough examination of the Chinese company.
Generally M&A Deals can be divided into two categories: the acquisition of assets of a company (asset deal) and the acquisition of shares of a company (share deal). If you conduct a share deal, you have to pay a stamp duty. If you have an asset deal, the tax burden is calculated by the assets that are being transferred.
Both Chinese state and private companies prefer conducting acquisitions as an asset deal in order to avoid hidden risks. Mergers within the Chinese market are now also possible. Although an approval of the Chinese authorities will be required, if it is a purely foreign acquisition, in which the shares of a Chinese FIE are bought indirectly through the purchase of shares of a foreign company. Generally the new regulations still have some unresolved questions regarding the authorization and competence of M&A transactions.
Depending on the nature and extent of the participation it will be either a sales and purchase agreement or a Joint Venture agreement if not the whole capital is acquired. For the approval you need to acquire a valuation from an approved evaluation firm. In 2008 an additional cartel law took effect which also regulates the merger control.
In many cases of M&A deals the Ministry of Commerce MOFCOM has to be informed.
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