Foreign Direct Investment Vehicles in China
Legislation
There are alternative investment formats available to foreign investors in China: equity joint ventures (EJV), cooperative joint ventures (CJV), Sino-foreign-invested joint stock companies (SFJSC), wholly foreign-owned enterprises (WFOE), and holding companies (also referred to as investment companies) (HC) and technology transfer. The doors to foreign direct investment via the EJV and CJV formats were opened first in 1979 with the enactment of the People’s Republic of China Law on Chinese—Foreign Equity Joint Ventures.
WFOE investment became possible after the promulgation of the Law of the People’s Republic of
China on Wholly Foreign-Owned Enterprises in 1986, and the Detailed Implementation Regulations for the Law of the People’s Republic of China on Wholly Foreign-Owned Enterprises, which became effective in 1986. FJSC investment became possible in 1985 with the Provisional Regulations on the Establishment of Foreign Invested Joint Stock Companies. HC investment was opened with the 1995 Tentative Provisions for Establishment of Companies with an Investment Nature by Foreign Investors.
In addition to the above, the 1999 Contract Law of the People’s Republic of China and the 1993
People’s Republic of China Company Law are also important pieces of legislation. The Company Law as well as the EJV law also apply to WFOEs where the WFOE laws do not cover a particular matter. For several years China has been enacting, repealing and amending its legislation to facilitate its entry into WTO. China has adopted the civil law system rather than the common law. As such its current practice is to adopt statutes and supplement them with implementing regulations and
interpretations. While court precedent is somewhat influential, it is not binding law per se.
The goal of the WTO is to promote free and open trade among its member states. This does not
directly include investment; however, WTO membership mandates the principle of national treatment and this affects foreign investments. As China is reshaping its laws to unify its bifurcated treatment of domestic and foreign interests, notably in regard to taxation and most
contracts, it still treats FIEs separately from domestic investment in the areas of governance.
Regulation of FDI
The two primary governmental agencies involved in regulating, permitting and governing FIEs
are the Ministry of Commerce and its local arms and the State Administration for Industry and
Commerce and its local arm. MOC is the gatekeeper and all FDI and technology transfers are
channeled through its processes and regulated by it. The SAIC is charged with licensing, corporate governance, trademark administration and fair trade. There are numerous other state,
provincial, local and industrial agencies having their own local regulations that also impact on
FDI.
Cooperative or contractual joint ventures
CJVs provide a flexible joint venture format. This is often preferred for shorter-term projects. The venture may be, but does not have to be, an incorporated legal person. If the company does
register as a legal person, then a minimum of 25% of the registered capital has to be contributed
by the foreign investor. The parties are free to distribute profit and recover investment capital as negotiated. For example, the parties may agree on an equal equity split but provide for a different profit allocation ratio. CJVs have been popular in projects involving large start-up development costs such as hotels and oil and gas projects. A CJV must have either a Board of Directors with a Chairman and Deputy Chairman, or a Management Committee, with a Director and Deputy Director, as well as a managerial structure and these functions are similar to those of an EJV described below.
Equity joint ventures
EJVs represent a compromise of China’s initial preference for technology licensing rather than
investment and they have been allowed and regulated since 1979. An EJV is a limited liability
company created pursuant to the EJV Law in which the investor parties share investment, control, risk and profit in accordance with the equity split. The Board of Directors plays the role of shareholder and board because, since no shares are issued, there are no shareholders. Equity
interests are certified by qualified accountants.
The industrial sectors open to EJVs are more numerous than those open to WFOEs. The Guideline Catalogue of Foreign Investment Industries classifies sectors as encouraged, permitted, restricted and prohibited. With WTO accession the first three categories have all increased, at the expense of the prohibited category. There are many sectors where EJVs are, but WFOEs are not, allowed. In some sectors the foreign equity is limited to a certain percentage.
EJVs are established via the following process:
- The parties negotiate and sign a Letter of Intent which, although not necessarily legally
binding, is very important and should be treated seriously. The LOI should cover all
important issues related to the project and be broad enough to allow a party to alter its
position if necessary. It is wise to include exclusivity and confidentiality provisions in the
LOI and to state that they are intended to be legally binding - The Chinese party prepares a project proposal report to be submitted to MOC or other
approving authority - The LOI is then submitted to the approval authorities for preliminary approval, which
includes permission to negotiate the project; following preliminary approval, a joint
feasibility study is undertaken. As the feasibility study is the basis for formal project
approval, it effectively defines the permitted project in the eyes of the Government.
Again, while the feasibility study is not necessarily legally binding it is extremely critical
and should be treated as such. Although the Chinese investor may be willing to take
charge of the feasibility study work, the foreign investor should participate and be sure
that it represents its views as well. Both parties must sign - While the feasibility study is under way the parties negotiate the joint venture contract and
its annexes which typically include the articles of association, technology license, export
agency agreements and other important contracts or documents - The feasibility study, joint venture contract and articles of association are then submitted
to the approval authority. The contracts take effect upon approval - The joint venture company registers with the Administration of Industry and Commerce
and receives its business license - Within 30 days of the issuance of the business license, the company must process
registrations with customs, tax, the State Administration for Foreign Exchange and other
government agencies
Throughout the approval process it is deemed to be better for the foreign party to establish and maintain good relationships with government officials and departments rather than leave the matter to the Chinese partner. In general, approval levels for productive projects are: $ 100 million of registered capital and greater – The State Council; US$30 million to US$100 million – MOFCOM; less than US$30 million – state authorities. The local approvals are seen as easier to obtain than MOFCOM approvals even though the approving authority might be a branch of the latter. Because of this the local partner might suggest the project be broken into parts within the limits allotted to local authority. This might work to the disadvantage of the foreign investor and should be avoided. While EJVs are the FDI format most acceptable to MOFCOM, they are not allowed in every sector and, where allowed there may be limitations on the equity interest held by the foreign investor.
Checklist for a joint venture contract:
- name and location of the JVC
- business scope of the JVC
- capital structure and contribution schedule
- Board of Directors provisions: Chairman, members, powers, limitations and meetings
- general management provisions: managerial structure, powers and limitations
- land and facilities — offices, plant and factory
- project schedule – construction and start-up
- sales
- financial provisions – tax, audit, accounting, finance management, bank accounts, profit
allocation and distribution - investment incentives
- labour – sourcing, hiring, probation, firing and unions
- procurement of technology
- procurement of raw materials for production
- joint venture term, expiration and termination provisions
- duties, powers and rights of the investors
- liability of the investors
- dispute resolution
Wholly foreign-owned enterprises
WFOEs, companies owned by one or more foreign investors, are authorized under the Wholly Foreign-owned Enterprise Law in 1986, and the Wholly Foreign-owned Enterprise Law Implementing Rules of 1990, are seen as having fewer management and profitability problems and are now more popular among the foreign investment community than joint ventures because they do away with conflicting partner interests, corporate cultural differences and other control problems inherent in any joint venture.
WFOE project proposals are submitted to MOC or local authorities, depending on the registered capital of the project, and if approved, a formal application is made with the company’s proposed articles of association and a feasibility study. Documents relevant to the investors are also required. If approved it takes the form of a limited liability company for a specified term, although a perpetual existence is theoretically possible. After approval the WFOE must go through the same AIC registrations as any other company. Laws, regulations and policies, which are passed for other FIEs often apply to WFOEs.
Where an investment project has begun as a joint venture limited liability company, it is often converted into a wholly foreign-owned company with the buyout of the PRC party’s equity. This is accomplished by assignment of equity after approval of the Chinese partner and the original approval authority pursuant to the 1997 Several Regulations Of The Ministry Of Foreign Trade And Economic Cooperation And The State Administration For Industry And Commerce Concerning Changes In The Equity Interest Of Investors In Foreign Invested Enterprises. Considerable discretion is given to the local authorities in the actual conversion process.
Holding (investment) companies
HCs are governed by The Provisional Regulations for the Investment and Operation of Investment Companies by Foreign Investors and by the 1996—2001 Explanations of and Supplements to the Provisional Regulations. The impetus for this vehicle came from the foreign investment community which wanted a format that would allow certain facilities that were not present under the other formats. This investment format is a FIE limited liability company, either wholly-owned or joint ventured, without the right to manufacture. It allows integration and rationalization of a parent’s China investment structure, direct hiring of PRC staff, centralization of PRC project shareholdings, human resources, sales, marketing and technical services and procurement. It does not allow direct intra-group lending or consolidated accounting.
Athough having an HC raises the profile and prestige of the parent company within China, an HC has not been allowed to be engaged in trading services, production, or buying A shares (reserved for PRC legal persons) of listed PRC companies. With WTO accession, HCs are expected to be utilized in trading and financing investments (without participation of the People’s Bank of China) as it opens up to FIEs. Because of the trading restrictions, therefore, an HC is not a replacement for a representative office in locales employing a strict interpretation of the HC laws and regulations.
The requirements for establishing an HC are stringent: the foreign investor’s asset value must be at least US$400 million; the parent must have established at least one FIE with at least US$ 10 million of the foreign investor’s investment; and have at least three FIE projects which have received project approval or have set up at least 10 manufacturing or construction FIEs in which it has invested at least US$30 million. Like many PRC regulations, the HC Regulations are selectively applied by MOC, which is given the discretion to ignore certain requirements for establishing an HC.
Additional matters
There are other matters that are relevant to FDI such as arbitration, tax, customs and termination. Moreover, there are local regulations, policies and practices which apply to many issues discussed above and attention must also be paid to those when meeting with local officials. MOC is the approving authority for projects valued at over US$ 30 million. For projects below that limit, the agencies in charge of approval include the state ministries, provided a project does not require overall balancing in terms of production, construction or operations. This rule applies to investment projects in the ‘permitted’ and ‘restricted’ categories. For the ‘encouraged’ category, provincial authorities are the approving authorities for investments exceeding US$ 30 million, and local authorities for investment below that level. In light industries, regardless of size, provincial level authorities are allowed to approve foreign investment. The investment limit is lower for projects in the relatively backward western region of China.
Articles source: Gems & Jewellery Industry in China, Embassy of India, Beijing
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