Since the reform and opening-up policy was introduced in 1978, especially in the past ten (10) years, the People's Republic of China (the "PRC" or "China") has undergone significant changes. China is a growth engine for the worldwide economy, fueling global expansion via higher output and trading relationships with other nations as well as greater contributions from domestic consumption. Over last nine (9) months of 2011, China has already attracted contractual inbound foreign direct investment of USD177.8 billion. Notwithstanding China's status as one of the world's largest economies, and the massive amounts of foreign money invested in China, the basic laws and rules in China governing foreign investment seems mysterious for those who want to invest in China or are accustomed to laws of their countries.
1 Governmental Structure
1.1 China's Political System
Political System of China refers to the political structure, fundamental laws, rules and regulation and practices that are implemented in China, and which control the state power, government, and the relationships between the state and society. Being a socialist country, based on the worker-peasant union and practicing people's democratic centralism, the primary system in the country is the socialist system.
The main political structure of the PRC is comprised of two vertically integrated, but interlocking institutions: the Chinese Communist Party (the "CCP" or "Party"), headed by the Party Politburo and its Standing Committee; and the state government (the "state" or "government") apparatus, headed by the premier, who presides over the State Council, a de-facto cabinet. Throughout China, Party and government structures closely parallel one another, with Party committees and representatives present not only in government agencies, but also in most organizations and institutions, including universities and foreign owned enterprises.
Two other major institutions play roles in Chinese politics. One is the National People's Congress (the "NPC"). According to the PRC Constitution, the NPC of China is the highest organ of state power. Its highest officers are the president and vice president of the NPC, who are directly elected by the members of the NPC. Articles 85 and 92 of the Constitution state that the State Council is the executive arm of the government and reports to the NPC.
The other is the Chinese People's Political Consultative Conference ("CPPCC"). The CPPCC is an organization of the patriotic united front of the Chinese people. It is also an important organ of multi-party cooperation and political consultation under the leadership of the CPC, and an important instrument of democracy in the nation's political life. The CPPCC exercises the functions of political consultation, democratic supervision, and participating in the administration and discussion of state affairs. This is a key link for the CPC and the governments at all levels to ensure that decision-making is scientific and democratic.
Another key institution in Chinese politics is the People's Liberation Army ("PLA"). The distinction between civilian and military leadership in the PRC is tenuous. There are, for instance, two authoritative bodies ostensibly tasked with authority over military policy and decisions: the Central Military Commission of the PRC, a state entity; and the Central Military Commission of the Communist Party, a party organ. Although the former is nominally considered to be in supreme command of military and defense affairs, including the formulation of military strategy, in reality it is the Party-controlled Central Military Commission ("CMC") that exercises command and control over the PLA. Since the membership of the two 11-member commissions is usually identical, it has become customary to refer to the CMC alone without distinguishing between the two. The CMC is chaired by the Party general secretary, emphasizing that leadership of the military is a Party prerogative.
The PRC is governed under the leadership of the CCP. The PRC government is organized in two tiers. The central government, State Council is the highest administration authority of PRC and leads various departments, bureaus and public service units, while local governments have authority over the provinces, autonomous regions, centrally governed municipalities (Beijing, Shanghai, Tianjin and Chongqing), and special administrative regions (Hong Kong and Macau).
The PRC's legal system, administrative apparatus, policy-making and government organizations are broadly divided into three levels, namely, the central government level, provincial or municipal government level, and local municipal or county government level. Foreign investors need to understand which authorities are relevant to their particular activities and it is important to appreciate that the role of government is very significant in PRC business matters.
1.3 Foreign Investment Approval Authorities
There are several authorities responsible for overseeing different aspects of foreign investment through their central and local branches.
- Project Approval involves the National Development and Reform
Commission (the "NDRC")
The NDRC co-ordinates development policy and also takes a major role in approving foreign investment projects. Along with the project approving procedure, opinions from other relevant authorities (such as the opinion from the Ministry of Environment regarding the environmental protection for a plant project) are often involved in this process.
- Approval of establishment of foreign invested enterprises (the
"FIE") by the Ministry of Commerce (the
MOFCOM is responsible for examining and approving the establishment of FIEs, including the form of their constitutional documents and the approved areas in which they will be permitted to conduct business.
- Special Industry Approvals
Although the main approving authorities are the NDRC and MOFCOM, other authorities may also be involved in approving procedures particularly where there is some limitation on the entrance by foreign investors into a special industry. For example, the pre-approval from the State Food and Drug Administration ("SFDA") or its branches is needed if the investment involves the pharmaceutical production.
- Registration with the State Administration for Industry and
Commerce (the "SAIC")
All business entities need to maintain records of corporate documents with local branches of SAIC including basic information regarding registered capital, directors, shareholders and the constitutional documents. SAIC also oversees initial approvals for special industries such as advertising.
- Other business administrations relevant to foreign investors
The tax bureau, the administration of foreign exchange, the finance bureau, the customs and the administration of quality supervision, among others, are all involved in the routine management of FIEs.
1.4 Constitutional Protection
A number of constitutional changes have occurred in recent years. Businessmen have been allowed to join the CCP since November 2002 which is indicative of the importance now placed on the private sector in modern China. The amendment to the state constitution in March 2004 and enactment of the PRC Property Law in 2007 both demonstrated the PRC government's commitment to the protection of property rights and investors' interests. Measures such as these have also helped to strengthen foreign investors' long term confidence in China.
2 Legal System
Shortly after its founding in 1949, the PRC government dismantled the former legal system and created a socialist legal system. The modern Chinese legal system mainly consists of seven (7) branches and four (4) levels of law. The seven (7) branches of law are: the Constitution and laws related to the Constitution; civil and commercial laws; administrative laws; economic laws; social laws; criminal laws; and litigation and non-litigation procedural laws. The four (4) levels of law are: the Constitution; laws; administrative regulations; local regulations, and autonomous regulations, specific rules and rules.
Amendments to the Constitution are rectified by a two-thirds majority vote from all deputies of the NPC.
Laws on the following matters are enacted exclusively by the NPC and its Standing Committee: state sovereignty; the formation, organization, functions and powers of state organs; the system of regional autonomy by ethnic minorities, the system of special administrative regions and the system of autonomy at the grass-root level; criminal offences and punishment; the deprivation of citizens' political rights and mandatory measures and penalties involving the restriction of personal freedom; the expropriation of non State-owned property; the basic civil system; the basic economic system and basic systems of finance, taxation, customs, banking and foreign trade; the litigation and arbitration systems and other matters for which laws must be enacted by the NPC or its Standing Committee. The Standing Committee of the NPC follows the "system of three deliberations" in the enactment of laws, which means that a bill should be deliberated at three (3) meetings of the Standing Committee of the NPC before it is voted on. An important or controversial bill may undergo more than three (3) deliberations.
The State Council enacts administrative regulations in accordance with the Constitution and the laws.
The people's congresses of the provinces, autonomous regions and municipalities directly under the central government, or their standing committees, have the power to enact local regulations. The people's congresses of the ethnic autonomous regions have the power to enact autonomous region regulations and also other specific regulations based on local political, economic and cultural conditions.
Ministries and commissions of the State Council and other organs endowed with administrative functions directly under the State Council, such as MOFCOM, SAIC and the China Securities Regulatory Commission (the "CSRC") may, in accordance with the laws and administrative regulations, enact departmental rules within the limits of their power. The people's governments of the provinces, autonomous regions, municipalities directly under the central government and larger cities may, in accordance with the laws, administrative regulations and local regulations of their respective province, autonomous region or municipality, enact local rules.
Bills are usually deliberated on a non-public basis. The process is not published in government publications, nor are the bills announced to the public. However, in recent years, laws, regulations and rules that are controversial or will have a significant social and economic impact on Chinese society, such as the PRC Property Law, the PRC Labor Contract Law, the PRC Food Safety Law and the Administrative Regulations on the Registration of Resident Representative Offices of Foreign Enterprises, have been released on the Internet to solicit public opinion. Public seminars and public hearings have also been held, for example, in respect of revisions proposed for the PRC Individual Income Tax Law and the PRC Intangible Cultural Heritage Law, as well as the formulation of the Regulations on the Expropriation of Houses on State-owned Land and Compensation. These signify a major change in the PRC legislative system.
In general, legislative bodies are entitled to construe and interpret the laws and regulations that they have enacted, although such laws and regulations are also subject to the construction and interpretation by other legislative bodies of a higher level. The PRC body of laws has undergone a comprehensive overhaul since 1979 with the passage and revision of many major pieces of legislation, including laws and regulations applicable to foreign investment.
3 Establishing a Business Vehicle in China
3.1 General Policy
Provisions on Guiding the Orientation of Foreign Investment promulgated by the State of Council came effective on 11 February 2002, which classifies foreign investment areas into four (4) different sectors, the encouraged, permitted, restricted and prohibited. In the Catalogue of Industries for Guiding Foreign Investment (the "Catalogue") jointly published by the MOFCOM and NDRC further specifies which areas are prohibited, restricted and encouraged for foreign investors, and those areas which are not provided in the Catalogue should be permitted for foreign investors. According to the Catalogue, we understand the prohibited are areas which cannot be invested by foreign investors, the restricted may have some investment requirements or limitations such as only permitting cooperation jointly by Chinese and foreign investors, or only permitting foreign investor to hold minority interests of the proposed company (or other kinds of organizations) up to 49% etc., and the permitted and encouraged are areas which permit the structure wholly invested by foreign investors.
3.2 Types of Foreign Investment Vehicles
Companies that desire a permanent presence have to set up operations as an appropriate legal entity, depending on the intended business scope, and be compliant with Chinese legal and tax requirements. The most common legal structures used for establishing a presence in the PRC are:
- A Representative Office (the "RO")
- A Wholly Foreign-owned Enterprise (the "WFOE")
- An Equity Joint Venture (the "EJV")
- A Contractual Joint Venture (the "CJV")
- A Foreign-invested Partnership Enterprise (the "FIPE")
Each of these structures has unique advantages, restrictions and drawbacks, and it is essential to choose the option best suited to your business aims. Among of the above forms, the WFOE, EJV, CJV and FIPE are collectively referred to as FIEs.
ROs are often the first step taken by foreign companies when establishing a permanent presence in China. ROs can undertake market investigation, display, publicity activities in connection with the products or services of foreign companies, and liaison activities in connection with the products sales, services provision, domestic procurement and domestic investment of foreign companies. However, ROs are not permitted to engage in any profit activity which means that they cannot sign contracts, receive income, or issue invoices and business tax receipts. Under PRC law, an RO is considered to be an extension of its establishing company, and does not have the status of a legal person.
To establish an RO in China is relatively easy. Generally, a foreign company only needs to register with the SAIC to establish an RO. Law firms, financial and insurance companies and other certain industries may require substantive approvals, but for most industries no substantive government approval is required. In addition, ROs are not subject to the capital contribution requirement imposed on companies and their investors.
A WFOE refers to a company incorporated in China with limited liability that is owned by one or more foreign investors. Where permitted, a WFOE is now a popular option for foreign business, as the investor may completely control over their business entity as well as enjoy the full profit from its operation. Moreover, WFOEs also provide a better protection to the investor's intellectual property rights in comparison to other types of entities.
The WFOE is an appropriate structure for companies whose main activities in China are to manufacture and sell products, or provide services such as research and development or business consultancy. A WFOE allows the foreign investor to issue invoices and receive revenues in Renminbi (the "RMB") that can then be converted and repatriated out of China.
Compared to an RO, to establish a WFOE is a little more complex and time consuming, since generally the WFOE has to get the approval from MOFCOM prior to registration with SAIC. In addition, besides the approval from MOFCOM, the WFOE usually should obtain approvals from other governmental authorities such as NDRC and SFDA etc., depending on the WFOE's business scope.
An EJV is typically used for long-term projects and is formed by foreign companies, enterprises, other economic organizations or individuals and Chinese companies, enterprises or other economic organizations. An EJV is typically a limited liability company. The proportion of an EJV's registered capital contributed by the foreign investors shall not be less than 25%.
The board of directors is the highest authority of an EJV, which should decide all major issues concerning the EJV. An EJV must have at least three (3) directors, including a chairman and a vice chairman.
For foreign investors who are not familiar with Chinese market, an EJV may be beneficial for such foreign investors. A good local partner may contribute market knowledge and strong marketing and distribution channels, and they may help reduce the costs and risk of market entry. In certain restricted sectors, such as automotive and insurance, forming an EJV with a Chinese company is still the only permitted route for establishing a permanent presence in China.
The challenge of establishing and running a successful EJV is finding and nurturing the right partnership. Partners have to overcome issues such as mismatched expectations and differences in business culture and practices. The ability to maintain effective communication, and control where necessary, is also crucial.
A CJV is often adopted for shorter-term projects or built-operate-transfer projects, and are formed with join capital or terms of cooperation between foreign enterprises, other economic organizations or individuals and Chinese enterprises or other economic organizations. CJV can be registered as a limited liability company which owns the status of legal person, but it is not mandatory. A CJV should set up a board of directors (a CJV which has the status of legal person) or a joint management committee (a CJV which has no status of legal person) which is the authority of CJV.
CJVs are similar in many ways to EJVs but have the potential to be more flexible in certain aspects. Unlike EJVs, the profits, risks and losses of CJVs may be allocated between the parties in a proportion that differs from the equity contributions by the parties. It may also be possible for the foreign investor to recover its investment before the end of cooperation term of the CJV.
On 1 March 2010, Administrative Measures on the Establishment of Partnership Enterprises in China by Foreign Enterprises or Individuals came into effect, allowing foreign individuals or organizations to participate in partnership enterprises, offering a further alternative to the RO, WFOE, EJV and CJV. FIPEs allow for partnerships between two or more foreign enterprises or individuals, or a combination of foreign enterprises or individuals and Chinese individuals, legal persons or other organizations.
FIPEs do not need to obtain the approval from MOFCOM. They only require registration through the local branches of SAIC. However, businesses in certain sectors will need to comply with other specific regulations and the FIPE should submit approvals from relevant authorities when applying for its registration.
The types of FIPEs include foreign-invested general partnership and foreign-invested limited partnership. Solely State-owned companies, State-owned enterprises, listed companies and public welfare institutions and social organizations shall not be general partners of FIPEs. Limited partners cannot be the executive partner of a FIPE.
The FIPE provides a good channel to enter into Chinese market for foreign investors, especially for those private equity firms.
- Branch Office
Besides the above forms, a foreign company can set up a branch office in China if certain prerequisites, which may vary for different industries, can be met. Such branch office does not have independent legal person status and its parent company will be held liable for all of its business activities in China. Generally, in practice not all industries are permitted to establish a branch office by the foreign company in China.
The approval authority for the establishment of branch offices is generally MOFCOM or its local counterparts, while for certain regulated industries, it is the industry administration authority, such as China Insurance Regulatory Commission ("CIRC") or China Banking Regulatory Commission ("CBRC") that is charged with the approval responsibility. Following the obtaining of approval of establishment, a branch office must apply to the local branch of SAIC for a business license.
3.3 Investment Process
- Establish a New Company
As analysis in Item 3.2, there are several different choices for foreign investors if they want to establish a new company in China. Foreign investors may select a proper vehicle in accordance with their business considerations.
- Merger and Acquisition (the
"M&A") of Domestic Chinese
- General rules
Instead of setting up a brand new company, a foreign investor may acquire the equity interest in or the assets of a domestic Chinese company, assuming that such domestic company is engaged in an industry which is open to foreign investment under the Catalogue, and the shareholding ratio of foreign investors is compliant with the relevant rules and regulations.
There are two ways of achieving this, namely: ? by establishing a FIE with the purpose of using such FIE to purchase assets from a PRC domestic company, or by directly acquiring assets from a PRC domestic company and then using those assets to establish a FIE; and ? by acquiring the equity interest in, or by subscribing for new equity in a PRC domestic company, resulting in the conversion of such PRC domestic company to a FIE.
- Special provisions on State-owned Enterprises
If the subject matter of the M&A involves the equity interest or assets of a State-owned enterprise (the "SOE"), a qualified asset valuation company must be appointed to carry out a valuation of the State-owned equity interest or assets in question. The valuation result must be approved by or filed with the appropriate level of the State-owned Assets Supervision and Administration Commission of the State Council (the "SASAC"), and will be used as a reference for the determination of the transfer price of the State-owned equity interest or assets. Where the agreed transfer price falls below 90% of the valuation, approval from the relevant property rights transfer government authorities must be obtained before the transaction may continue. Moreover, the sale of State-owned equity interest or assets to foreign investors must be conducted publicly through holding public tender, or by listing or being auctioned on a recognized property rights exchange.
- M&A procedures
When acquiring the equity interest in or assets of an existing domestic company, it is necessary to conduct a thorough due diligence investigation on the Chinese target company or the assets to be acquired. It is important to confirm that the target company was duly organized and are validly existing, and to investigate any loans borrowed or extended, and the title of any assets (including but not limited to land use rights, intellectual property rights etc.) owned by the target company. The results of such thorough due diligence can provide guidance to the foreign investor when negotiating the contractual terms of the acquisition.
As the completed M&A will result in the conversion of the domestic company into an FIE, it is essential to obtain approval from the government authorities at the correct level.
If the proposed M&A by foreign investors of a domestic company satisfies the reporting standards as stipulated in the Rules on Standards of Reporting Business Operator Concentration promulgated by the State Council, the foreign investors shall report to the MOFCOM beforehand, and no transaction shall be conducted without reporting.
In 2011, the State Council released certain rules on the national security review. Where the target domestic enterprise is involved in a business that concerns national defense security issues or national economic security issues, the national security review process will be conducted by the Joint Committee led by NDRC and MOFCOM. If the proposed transaction is determined by the Joint Committee that it has or is likely to have a major impact on national security, the merging parties will be required to terminate the transaction or to undertake certain remedies such as the transfer of relevant shares, assets to eliminate any impact on national security. It's worth noting that the variable interest entities mode (the "VIE") which was common used in foreign investments will face restrictions for certain industries in the future.
Following the obtaining of governmental approvals, registration with the local branches of SAIC and other relevant governmental authorities, such as tax administration authority, customs administration authority and foreign exchange administration authority, will have to be conducted within specified time periods.
- General rules
- M&A of FIEs
Alternatively, a foreign investor may acquire the equity interests of a FIE held by another foreign investor. Acquiring the equity interests in an already established FIE requires the consent of all other original shareholders, approval by the government authorities which initially approved the establishment of the FIE, and re-registration with SAIC. In the case of an EJV, unanimous approval of the EJV's board, or in the case of some CJVs, the "joint management committee", is also required.
- Merger and Division of FIEs
Merger and division of FIEs are allowed in the PRC. The merger of two or more FIEs requires approval from the relevant PRC government authorities that originally approved the establishment of each of those FIEs. Similarly, the division of a FIE requires approval from its original examination and approval authority.
- Purchasing Shares in PRC Public Companies
Shares in PRC companies listed on the Shenzhen or Shanghai stock exchanges are classified into "A" shares, which can only be sold to Chinese citizens and organizations, Qualified Foreign Institutional Investors (the "QFII") and strategic foreign investors, and B shares, which can be sold to foreign citizens and organizations, including persons from Hong Kong, Macau and Taiwan, and (since February 2001) also to Chinese nationals residing inside the PRC.
3.4 Government Approval
- Approval Level
According to PRC law, the foreign invested projects should be submitted to NDRC or its local branches for the project review (if necessary) and the contract and articles of association (the "AOA") should be submitted to MOFCOM or its local branches prior to registration with SAIC. The following chart shows which level of government approvals should be obtained.
Sector Investment Amount MOFCOM NDRC Encouraged or Permitted Less than USD300 million Provisional or local MOFCOM Provisional or local NDRC USD300 million and above Central MOFCOM Central NDRC Restricted Less than USD50 million Provisional or local MOFCOM Provisional or local NDRC USD50 million and above Central MOFCOM Central NDRC
Moreover, for the approval of an investment company by MOFCOM, if its registered capital is less than USD300 million, the approval level should be provisional or local MOFCOM, and only if its registered capital is or exceeds USD300 million it should obtain the approval from central MOFCOM.
- The Basic Approval Process
An FIE may be established only with the approval of the Chinese government. The approval process for forming new entities or for acquiring existing companies (thereby converting them into FIEs) is largely the same. The approval process begins with a name reservation application to the SAIC to check on the proposed name for the FIE.
After the company name has been reserved, the applicant must obtain substantive examination and approval of the investment by MOFCOM. Examination and approval by MOFCOM is the key stage in the approval process. It requires submission of the full definitive documents for the proposed FIE to MOFCOM, and may also require a feasibility study report describing background on the project, along with other supporting documents. MOFCOM has the flexibility to request documents not expressly set forth in the statutes if they believe such documents would be helpful to its decision.
Project Verification from NDRC is technically required for any foreign investment project, but in practice, the NDRC's approval is critical only in certain industries, such as automotive industry, oil exploitation industry, etc.
After approvals from MOFCOM and NDRC (if necessary), the FIE may be registered with SAIC for issuance of a business license. Under PRC law, the date of issuance of the business license is the date of incorporation of a company. After obtaining the business license, the FIE should complete remaining registrations with relevant authorities including branches of State Administration of Foreign Exchange (the "SAFE"), General Administration of Customs of the People's Republic of China (the "Customs") and State Administration of Taxation ("SAT"), etc.
- Special Approvals
For some certain industries, the FIE should obtain special approvals.
Environmental approval from State Environmental Protection Agency (the "SEPA") may be required prior to applying to MOFCOM for manufacturing enterprises, or for any investment project that entails a construction project. Before registration with SAIC, for companies involving food or pharmaceutical production, they have to get the approval from SFDA.
The approval from SASAC will be required for investments involving Stated-owned assets.
Some typically regulated industries (including, for example, securities, banking and insurance) involve special approval regimes in addition to, or in place of, MOFCOM examination and approval. CSRC reviews applications to set up or acquire securities companies, CBRC covers banks, and CIRC reviews insurance company applications.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.