Lehman, Lee & Xu Gordiano Casas Herrera

Macau University of Science and Technology 澳门科技大学 November 2006 2006年11月雷曼律师事务所 Lehman, Lee & XuGordiano Casas Herrera Lehman, Lee & Xu - www.lehmanlaw.com

Foreign Direct Investment Investment Vehicles

Market Statistics • In 2003, China surpassed US as leading destination for FDI • In 2006, China and India were main destinations for FDI in the world • first time for developing countries • FDI will exceed USD 60 billion in 2006 • Between 1978 and 2006, average GDP growth rate over 9.5%

Market Entry Essentials • Have a clear entry strategy • what • where • how • Have a clear exit strategy • Have full knowledge of the risks: • market research/due diligence • local and foreign competition • regulatory/legal issues (national, provincial and municipal) • Long-term commitment is key.

Taxation • Foreign Enterprise Income Tax • Flat rate of 30% • Plus 3% local tax on the taxable profit. • Manufacturing: special treatment • First 2 years : no tax • Next 2 years: 50% • Can enjoy 50% reduction for further 3 years if export more than 70% of production • In some SEZs can enjoy even further tax reduction if export 100%

Preferential Taxation • Open Economic Zones • Taxed at a rate of 24% • Eligible for tax holiday & 3 year reduced rate. • Special Economic Zones • Taxed at a rate of 15% • Shenzhen, Zhuhai, Xiamen, Shantou and Hainan Island. • Eligible for tax holiday & 3 year reduced rate. • Soon will be eliminated and general rate 27%

FDI Legal Framework • The legal framework guiding foreign investment in China is contained in two sets of regulations: • State Council, Guidance of Direction of Foreign Investment Provisions (the "Guidance Provisions") • Foreign Investment Industrial Guidance Catalogue (the "Catalogue") • Since China's World Trade Organization (WTO) entry, government has relaxed investment regulations

FDI Divisions Encouraged (262) Agriculture New/high technology Industries which develop Western/Central regions Restricted (92) Resource-intensive/wasteful enterprises Approval according to the amount of Investment Prohibited (33) Industries which cause pollution and ruin natural resources Projects which utilize processes/technologies which are unique to China Permitted All other industries not listed in the Catalogue.

Investment in PRC • Business enterprises must: • obtain state approval on a project-by-project basis • comply with numerous regulations • Each particular business scope requires a minimum amount of Registered Capital, which must be contributed in formation of the company. • Depending on the proposed investment vehicle and industry, the requirements for approval will vary

Foreign Investment Operating Structures • Representative Office • Equity Joint Venture • Cooperative Joint Venture • Wholly Foreign Owned Enterprise • Holding Company

Representative Office • Straightforward and inexpensive way to establish a commercial presence in China • Over 35,000 foreign companies have established Rep Offices in China • RO allow foreign companies to: • further understand the Chinese market, • promote their products and services, • develop new contacts, • examine the feasibility of an investment project • For certain industries (insurance and banking), a RO is a legal prerequisite to establish an operating entity in China

Representative Office • A RO is an "extension" of foreign company (not a separate legal entity) • Restrictions on business activities • Once established, RO may: • lease premises, • employ local and expatriate staff (approval) • conduct business liaison activities on behalf of its overseas parent company.

Legal Framework • People's Republic of China State Council Interim Provisions on the Administration of Resident Representative Offices of Foreign Enterprises (中華人民共和國國務院關於管理外國企業常駐代表機構的暫行規定) • Measures for the Administration of Registration of Resident Representative Offices of Foreign Enterprises (外國企業常駐代表機構登記管理辦法) • Detailed Rules for the Implementation of the Examination, Approval and Administration of the Resident Representative Offices of Foreign Enterprises in China (關於審批和管理外國企業在華常駐代表機構的實施細則)

Establishment Criteria • Applicant must comply with stipulated establishment criteria: • be lawfully registered in the country in which it is located, • enjoy a "good business reputation" • supply true and reliable information to approval and registration authorities • handle establishment procedures in accordance with Chinese law. • applicant has been in business for a specified period of time • evidence of prior business with China

Permitted Scope of Business • A RO may only engage in "non-direct business activities“ • business liaison, • product presentation, • market surveying, • technical exchange • "..... under no circumstances may a Rep Office sign contracts, receive income or in any way engage in direct profit-making activities ...." • Serious consequences: • warning, • hefty fines, • confiscation of any illegally-generated income • cancellation of its business registration!

Taxation • Although permitted activities do not generate income, ROs must pay: • foreign enterprise income tax • RO tax is based on turnover at a rate around 10% over expenses

How to Establish a Rep Office • Two separate stages: • applying for approval • applying for registration • Upon registration, Registration Certificate (登記証) will be issued(fully established) • Post-registration formalities within 30 days. • Parent company is responsible for all activities conducted by the RO in China. • RO under a newly incorporated subsidiary company • in existence for at least one year • minimum capital US$10,000

Approval Process • Approval Authority: • MOFCOM or its local bureau (provincial or municipal level) • In specialised industries, the relevant Chinese government authority (Ministry of Justice…) • Designated Sponsor: • application submitted to MOFCOM through a government-authorised "sponsor" organisation • role of the sponsor is to submit application documents on behalf of the Applicant for approval. • renewal or change in Business Registration Certificate must be effected through the original sponsor

Application Documents • Documents to be submitted: • application form and application letter (Chinese) • copy of Applicant's constitutional documents (also Chinese translation) • reference letter from bank • lease agreement of the premises • letter of appointment of the Chief Representative • passport copies • any other documents which may be required. • Approval authorities will grant approval within 20 working days(Certificate of Approval (批準証書))

Registration • With the State Administration for Industry and Commerce (SAIC) or its local bureau (AIC) • Within 30 days from date of issuance of the Certificate of Approval • Documents to be submitted: • original Certificate of Approval, • copies of all documents submitted at the approval stage, • registration form and a prescribed fee (RMB2,000). • SAIC (or local AIC) issues Business Registration Certificate, within 20 days. • Registration Certificate valid for one year (renewed annually)

Post-Establishment Registrations • Once Registration Certificate has been issued • Registration with various official departments: • public security bureau, • local and state tax authorities, • customs authorities • local bank • Also apply for work permits, employment visas and residence permits for expatriate staff

Employment of Local Chinese Employees • RO may not directly employ local Chinese employees (not independent legal entities) • Must use “local service agencies" (FESCO…) • Impose: • service charge on RO • administration fee on employee • Takes care of labour and social insurance contributions on behalf of the employee.

RO Summary • Advantages • Quick and simple. • Inexpensive • No minimum registered capital. • Allows for collection of market information and preparation for direct market entry. • Easy to dismantle • Disadvantages • Cannot engage in revenue generation. • Taxation regardless of prohibition on profit making activities.

Joint Ventures • First structure established by PRC to facilitate foreign investment in the country. • Two JV structures available: • equity joint venture (“EJV”) • cooperative or contractual joint venture (“CJV”). • In some sectors JVs are the only means for foreign firms to get a foothold into the market (aviation, telecoms..) • The larger the project, the more likely the Chinese government will require a EJV structure to be used

Reasons for entering into JV • Lack of viable options • JV is often the only investment vehicle permitted • Real estate acquisition • JV partner can provide land in crowded or expensive development areas • Investors must make sure that land-use rights have been converted into granted rights and have been legally transferred to the JV • Guanxi or brand • Network of connections, sales and distribution clientele, or its strength as a brand name

…also for Chinese partner • Chinese partner looks to a foreign investor for the following: • Capital • Management expertise and techniques • Training opportunities for Chinese staff • Financial engineering and rescue skills

Disadvantages of JV • Inflexibility • JV operations are governed by the initial JV contract • Changes in the contract require: • unanimous vote of the board of directors (includes representatives of local and foreign partners) • government approval • creates difficulties in adapting to market changes • Difficulties in expanding investment • chinese party unable to contribute additional capital • increase equity stake in the venture (requires unanimous vote by the board) • Conflict of interest between partners • management philosophies of Chinese and foreign JV partners may differ

Setup Process • Divided into 4 stages: • Project approval • Feasibility study approval • JV contract/AOA approval • Enterprise registration

Equity Joint Ventures • Most common type of foreign business structure in China • Method of transferring cash and expertise to domestic enterprises • Independent chinese legal person with limited-liability • EJVs are associations of one or more companies jointly undertaking a commercial enterprise with a Chinese partner • Established for a fixed term (usually 10 – 50 years)

Equity Joint Ventures • Profits, risks and looses shared in proportion to the partners’ equity stakes • determined by capital contributions • Foreign participation must be at least 25% for the JV to enjoy preferential tax treatment afforded to FIEs. • Equity can be contributed in the form of: • foreign currency, • equipment, • buildings • intangible assets (industrial property)

Capitalization • Parties must make their contributions in proportion to their equity stakes in the venture • Parties may pay: • in a single lump sum within six months after license issued • by installments • 15% within three months • 85% within one to three years • If registered capital over US$10m can negotiate a longer schedule • Failure to meet the capital payment schedule: • revocation of business license • payment of damages

EJV Management Structure • Two tier structure: • Board of Directors • appointed by investors • Management organization • responsible for day to day operation

Summary EJV Advantages • Chinese partner will bring connections and an established sales and distribution network; • Local partner will bring local and particularized knowledge of both market and bureaucracy. • Chinese partner will usually have or can easily obtain an operational site, which aides in efficient start-up Disadvantages • JV contract often difficult to negotiate • Differing objectives and management styles often result in conflict. • Lack of control by foreign party • Difficulty in selling shares in venture.

Cooperative Joint Venture • Offer more flexibility • Organized in a very similar manner to an EJV • Profits, risk and looses distributed according to the JV contract • can specify an accelerated return on investment for the foreign investor • Mainly used in ventures: • involving large fixed assets (real estate and infrastructure projects) • Where desired Chinese partner does not have sufficient cash/assets to contribute to an EJV

Kinds of CJVs • Purely contractual arrangement: • each party agrees to: • undertake certain obligations • provide certain capital (cooperative conditions) • agreement sets out the objectives of the venture • rights and obligations flow strictly from the contract • no separate legal entity and therefore unlimited liability • Independent Chinese legal person • liability limited to the amount of capital of the JV • sharing of profits and risks governed by agreement between the parties

CJV Agreement • Parties should provide in the CJV contract: • investment or cooperation conditions, • distribution of earnings or products, • sharing of risks and losses, • form of operation and management • title to property upon termination of the CJV • Since CJV is based on a contractual relationship, it leaves much room for negotiating profit sharing, management etc…

Contributions • Investment or cooperation conditions provided by parties may be in the form of: • cash, • material objects, • land-use rights, • industrial property rights, • non-patented technology • other property rights.

Summary on CJV • Similar to Equity Joint Venture in structure but with more flexibility because of the following: • Sharing profits is governed entirely by contract • Foreign partner can obtain return of investment in priority to Chinese partner. • Setup requirements similar to that of Equity Joint Venture.

EJV vs. CJV

Wholly Foreign Owned Enterprise • Enterprises established by foreign investors in accordance with relevant Chinese law, exclusively with their own capital (Law of PRC on WFOEs) • WFOE structure can only be used in certain business sectors (restrictions) • Not authorized in PRC until 1986 • In 1997, WFOEs largest number of approved FIEs, eclipsing EJV • WFOEs can better achieve business goals • WTO accession made it easier to establish WFOE

Advantages of WFOE • Complete management control (no chinese partner) • avoid disputes and conflicts (common in JV) • business decisions more flexibly and quickly to adjust operations to the demands of markets • Simpler establishment procedures • quicker negotiation and approval process (no JV contract) • Easier to terminate • JV can only be liquidated on agreement of both parties or through a court order • Dissolution of a WFOE requires government approval

Advantages of WFOEs • Foreign investors are entitled to all the profits • reinvest or repatriate • Greater control over: • confidentiality of technology • IPRs • Flexibility of location • JVs located where local partner has an existing plant • WFOEs are free to build on green field land

Potential Drawbacks • Foreign investors may need more time and energy to develop their businesses (no Chinese partner) • More legal restrictions on the establishment and operation of WFOEs (restricted in sensible areas) • Foreign investor cannot rely on a Chinese partner to provide a site for operations. • will have to make its own arrangements for land use

WFOE Registration Procedures • WFOEs are established in three stages: • preparation, • examination and approval, • registration.

Preparation • Prior to application for establishment, submit a report to the local government where enterprise is to be established • Report shall include: • aim of the establishment • scope and scale of business operation • products to be produced • technology and equipment to be used • area of land to be used • quantities of water, electricity, coal, gas and other forms of energy resources required • requirement of public facilities.

Application • WFOE application must be submitted to MOFCOM (local) • Include following documents: • written application form (in chinese) • feasibility study report • articles of association of the WFOE (in chinese) • name list of the legal representative • legal and credit certifying documents • inventory of goods and materials to be imported • any other documents required • Business License: 90 days • Registration (SAIC): within 30 days • Secondary filings (tax, customs and SAFE): 30 days

Articles of Association • Most important document • Must include: • name and location of the enterprise; • aim and scope of business operations; • total amount of investment, registered capital, and time limit for contributing investment; • form of organization; • internal organizational structures and functions, duties and limits of powers of legal representative, general manager, chief accountant and other staff members; • system of financial affairs, accounting and auditing; • labor administration; • term of business operations, termination, and provisions for liquidation; • procedures for the amendment of the articles of association.

Capitalization • Capital contributions can be made in: • currency • machinery • equipment • technology • Capital paid according to schedule set forth in AOA • Payment can be made in installments: • 15% or more within 90 days • remaining within three years of establishment • If not met, business license may be revoked • FIEs may not reduce registered capital • Increases or reassignment must be: • approved by original approval authorities • registered with SAIC

Total Investment and Capitalization • Ratio between registered capital and total capital investment: • Total investments up to $3,000,000, registered capital must be a minimum of 70% of this amount; • Total investments over $3,000,000 to $10,000,000, registered capital must be a minimum of 50% of this amount; • Total investments over $10,000,000 to $30,000,000, registered capital must be a minimum of 40% of this amount; • Total investments over $30,000,000, registered capital must be a minimum of one third of this amount.

Summary on WFOE Advantages • Quicker setup as there is no Chinese partner • Simpler management structure and objectives which are simply those of the parent organization. Disadvantages • Independence is often, in itself, a shortcoming because of lack of connections, established markets, and local knowledge. • WFOEs cannot operate in some sensitive areas such as securities.

Lehman, Lee & Xu Gordiano Casas Herrera