Alternative business structures

Introduction, FIEs and alternative structures

The principal business vehicles for FDI in the PRC include cooperative joint ventures (CJV), equity joint ventures (EJV), wholly foreign-owned enterprises (WFOE), and limited stock enterprises. Collectively known as foreign invested enterprises (FIEs), these business vehicles are discussed in detail in the next chapter.

Foreign companies may also use other structures to conduct business in the PRC. These include representative offices, compensation trade, processing and assembly operations, management contracts, and agency, distribution, franchising and technology transfer arrangements.

Representative offices

Representative offices are a popular, low cost, alternative to FIEs. Representative offices allow foreign entities to explore the PRC market, search for investment opportunities and introduce their products and services to the PRC. Representative offices also offer certain advantages over FIEs. First, approvals are generally easier to obtain. Second, capital outlays are generally low. Finally, multiple offices may be established throughout China.

Legislation
The laws governing representative offices are found in the:

• PRC Interim Regulations Concerning the Control of Resident Representative Offices of Foreign Enterprises (October 1980);

• Circular Concerning the Registration of Resident Representative Offices of Foreign Enterprises (May 1981);

• Procedures of the PRC State Administration for Industry and Commerce (SAIC) for the Registration and Administration of Resident Representative Offices of Foreign Enterprises (March 1983); and

• Detailed Rules of the Ministry of Foreign Trade and Economic Cooperation (MOFTEC) for the Implementation of the Provisional Regulations Governing the Examination, Approval and Administration of Resident Representative Offices of Foreign Enterprises (February 1995).

The application process

In order to establish a PRC representative office, an applicant must apply (via an officially-sanctioned sponsoring agency) for formal approval to establish at MOFTEC or a delegate in specialized industries (the Approval Authority), and complete registration formalities with the SAIC. The Approval Authority will determine whether a ' genuine need' for a representative office exists and, if so, issue an approval certificate which the applicant must file with the SAIC within 30 days of receipt.

Scope of permitted activities

Although not allowed to engage in direct business operations, representative offices may:

• execute office and residential leases;

• obtain residence permits and multiple-entry visas for foreign staff;

• open foreign and local currency bank accounts in the company's name ;

• display office signs and distribute business materials;

• employ local staff via government-sanctioned employment agencies;

• liase with contacts in the PRC on the parent company's behalf ;

• coordinate the parent company's PRC business activities; and

• conduct market surveys and research.

Although there is no clear guidance on what constitutes 'direct business activities', the following activities are generally considered outside the scope of a representative office's lawful operations:

• directly engaging in revenue-generating activity;

• entering into commercial contracts in the parent company's name;

• buying property or importing production equipment;

• collecting or making payment in connection with sales and purchases; and

• providing services to entities other than the parent company.

Compensation trade (buchang maoyi)

Compensation trade is a barter transaction whereby a Chinese party obtains foreign machinery, equipment or technology from a foreign party who receives the product the Chinese party produces with the imported machinery, equipment or technology as its compensation.

Legislation
No single, comprehensive law governs this form of trade although it is actively encouraged. Rather, the applicable laws are found in the unified Contract Law of the PRC (the 'Contract Law'), licensing regulations, including the PRC Measures for the Administration of Registration of Technology Import and Export Contracts and the PRC Administration of Technology Import & Export Regulations , and various tax and customs laws.

Other considerations
Compensation trade, popular between Hong Kong companies and Chinese enterprises in Guangdong and Fujian provinces , has rapidly developed in the PRC in recent years . These arrangements usually involve fishery, agriculture, animal husbandry, natural resources, chemicals, light textiles and electronics.

Although product quality disputes are common, this form of trade is still frequently used. Incentives for using compensation trade include tax advantages, flexibility in structuring the agreement and no foreign party concern with labour issues.

Where possible, exporters will often obtain performance guarantees whereby a reliable financial institution will pay the purchase price if the importer fails to fulfil its obligations to deliver the products under the sales agreement. The Chinese party must be an enterprise or other economic organization with foreign trade authority (discussed in detail in the Agency Relationships section below) and cannot be an individual. This type of transaction does not produce a new or merged Chinese- foreign legal entity.

Processing and assembly agreements

Processing and assembly agreements exist where a Chinese party processes materials or assembles parts supplied by a foreign party. The foreign party usually also provides the manufacturing equipment. The Chinese party either earns a fee for services or retains a portion of the finished goods for on-sale as its compensation. Whether the Chinese party retains the equipment at the end of the term is negotiable.

Legislation
There are regulations governing processing and assembly at national and local levels. The early regulations governed the activities of domestic and foreign entities separately. This approach has been gradually abandoned and most laws now apply uniformly to domestic and foreign entities, such as the Contract Law. Some of the other major laws in this area include the:

• Regulations of the General Administration of PRC Customs on Administration of Importation of Materials and Parts for Fulfilling Product Export Contracts by FIEs (promulgated 24 November 1986);

• Administrative Measures of the PRC Customs Governing Import and Export Commodities Involved in Import Processing (promulgated 6 May 1999);

• PRC Foreign Trade Law , (adopted 12 May 1994); and

• Provisional Measures on Administration of Examination and Approval of Processing Trade (effective 1 June 1999).

Processing and assembly trade products are classified as prohibited, restricted, or permitted. The PRC Foreign Trade Law details the categorization of products, including those that are prohibited .

Restrictions
The relevant department in charge of foreign economics and trade at the local level has the right to approve all processing and assembly trade contracts. MOFTEC is responsible for nationwide examination and approval.

After completing processing or assembly, the end products must be exported within a specified time limit. This is specified in the Approval Certificate for Processing Trade Business and is, in principle, the same term as the export contract, which is generally not more than one year. Further permission must be obtained to make domestic sales of imported parts and materials and the completed end products.

Incentives
Various regulations provide incentives to encourage Chinese enterprises to undertake processing and assembly arrangements. Normally, imported goods are subject to customs duties , product tax or value-added tax. Imported parts and materials, which are used to produce end products and are then exported under a processing and assembly contract, however, are specifically exempt from these levies. Other incentives include waiver of import licence requirements, retention of a high proportion of the foreign exchange earned, other tax reductions and priority access to financing.

Management contracts

Foreign investors may cooperate with PRC enterprises through management contracts in certain locations and industries. Under such agreements the foreign party generally provides day-to-day management and training for a PRC enterprise in return for a share of revenues . As the PRC enterprise is generally responsible for providing the business facilities, equipment and staff, this type of business arrangement allows the foreign party to invest in a PRC without making a substantial capital contribution.

Legislation
MOFTEC promulgated the Contract Management Regulations for Sino-foreign Joint Equity Enterprises on 15 October 1990, to govern foreign management contracts.

Joint ventures
JVs may be contractually managed under certain conditions, such as when a JV is in financial trouble. The management contractor assumes all or part of the JV's operational and administrative rights and shares responsibility for the JV 's risks and liabilities. The board of directors must unanimously consent to be administered and the JV must submit proof of this to its original approval authorities, together with other documentation such as the management contractor's legal and financial status. The term may not exceed five years. In order to provide management under such an agreement, the contractor must demonstrate that it conducts business in the same industry as the JV and has at least three years of relevant management experience.

Agency relationships

A major point of discontent for foreign entities seeking to sell to PRC consumers has been market barriers put in place by the PRC government, which has generally restricted or prohibited the importation and distribution of foreign manufactured goods. As a result, foreign entities unwilling to establish FIEs have been forced to enter the PRC market via other avenues, the most common of which are agency and distribution agreements.

Foreign entities often appoint Chinese enterprises as agents or distributors . The local enterprises handle issues related to domestic sales on the foreign principal's behalf and assist with procuring export goods or materials. One positive aspect of the principal agent relationship is that, by utilizing an agent's knowledge of PRC markets, business contacts and distribution channels, foreign enterprises may achieve a certain degree of market penetration. However, market penetration often comes at a cost.

One important aspect of the principal/agent relationship is the concept of foreign trade authority (FTA). FTA is basically a government-sanctioned oligopoly. Under the PRC Foreign Trade Law only PRC enterprises with FTA may directly contract with foreign parties. This means that, unless the proposed agent has FTA (which is often not the case), the foreign entity must establish a contractual relationship with a third party, licensed PRC importer. This additional barrier to business relationships was a major obstacle in China's WTO negotiations and, as a result, all PRC entities should have FTA by 2005.

Franchising

A number of foreign entities have considered franchising as an alternate way to access the PRC market. However, the lack of a comprehensive and developed regulatory framework has limited the number of international franchise arrangements.

Legislation
The PRC laws governing franchising generally include:

• The Rules for the Administration of Commercial Franchise Operations (the Franchise Rules), promulgated on 17 November 1997 by the Ministry of Internal Trade;

• The Circular Regarding the Response by the State Council To Questions Related to Foreign Investment in Domestic Trade, issued by the State Council in 1992;

• The Catalogue for the Guiding of Foreign Investment in Industry in the PRC (the Foreign Investment Guidelines); and

• The Measures for Pilot Projects for Commercial Enterprises with Foreign Investment, issued by the SETC and MOFTEC in June 1999.

Practical considerations
China has yet to publish a definitive set of franchising regulations, although, at the time of this Chapter's publishing, new draft regulations have been circulated in the international community, and the MOFTEC is rumoured to be reviewing the draft language with an eye towards promulgation in late 2002 or early 2003. Today, however, most foreign enterprises franchise in the PRC through FIEs or licensing agreements.

Franchising through FIEs
The main issues under this type of arrangement are that FIEs are limited in their business scope so that franchising is normally not included and that investment in China is restricted by industry type by the Foreign Investment Guidelines. Nevertheless, certain foreign entities have established FIEs that execute franchise/ licensing agreements with PRC domestic enterprises.

Franchising through licensing agreements
Considering the lack of legal clarity, foreign investors sometimes break down their franchise arrangements into a series of contracts that are more familiar within the PRC legal context. For example, instead of having a single franchise agreement, it may be desirable to conclude a trademark licensing agreement, a know-how transfer agreement and agreements for management consulting services. This increases transaction costs, but phrases the transaction terms in concepts more familiar to MOFTEC and other approval authorities. It also avoids some of the pitfalls associated with painting the arrangement as something entirely new.