Doing Business in China
Part 1 – Overview
China has become a global economic powerhouse over the past 30 years.
Such immense change does not happen by chance – policy and new laws have paved the way. As a result, China’s legal framework is a work in progress. There are gaps and ambiguities in the law, policy can sometimes change quite quickly and without warning and the changes are not always ones that everyone would prefer. Therefore, although economic opportunities are real and the legal framework backing up those opportunities quite solid, the legal environment remains challenging.
This guide provides basic information on the legal framework for foreign investment and operations in China, in three parts:
Legal system in China
The legal system of the People’s Republic of China (PRC) is based on the PRC Constitution, which was last amended in 2004. It is made up on a hierarchy of written laws, regulations and administrative directives. The Constitution formally stipulates that political power is exercised by the people, from the bottom up, through representative people’s congresses from the local up to the provincial and national levels.
In practice, policymaking and administration can at times be highly centralised and uniform in nature, and at others highly decentralised and diverse.
Legislative function: the National People’s Congress (NPC) and its Standing Committee have the power to pass laws on behalf of the state. The NPC can amend the Constitution and enact and amend basic laws governing state departments and public, civil and criminal matters. The Standing Committee of the NPC has the power to interpret, enact and amend laws other than those which must be enacted by the NPC.
The Party: although it is not granted any formal legal status or powers in the Constitution and is technically separate from the government, the Chinese Communist Party (Party) parallels, overlaps with and controls the government at all levels. This system helps the Party to ensure a high degree of national uniformity and cohesion, but it also sets the Party above the government which can make it difficult in practice to subject the Party itself and its individual members to the rule of law.
Executive/administrative function: the State Council of the PRC (State Council) is the highest level of state executive administration and has the power to enact administrative rules and regulations consistent with law. Ministries and commissions under the State Council are also vested with the power to issue orders, directives and regulations within their respective areas of competence. The State Council also submits legislative proposals to the NPC or its Standing Committee for enactment into law.
Foreign investment is approved by the Ministry of Commerce (MOFCOM) and the National Development and Reform Commission (NDRC). The State Administration for Market Regulation (SAMR or local AMR) is also important, as it is responsible for business registration and also a number of business oversight functions.
Judicial function: the judicial power to apply the law in civil and criminal matters is vested in the people’s courts at various levels – from the central Supreme People’s Court (SPC), provincial High People’s Court, municipal Intermediate People’s Courts and local Basic People’s Courts. People’s courts at different levels are not independent, but carry out the judicial function in fairly close coordination with the courts, government and Party at the same and higher levels.
In the PRC’s civil law system, court cases do not act as binding precedents. However, many court opinions are published annually and may provide useful guidance for outcomes in similar cases. SPC decisions also provide non-binding judicial guidance for lower courts, and the SPC’s detailed interpretations on the application of national laws are considered to have the force of law.
Localities: the Party-controlled central legislative/executive/judicial structure is repeated at lower levels. The people’s congresses of provinces and their municipalities may enact local rules and regulations. Administrative bodies at those sub national levels, such as local offices of the central state ministries and administrations, enforce local and central enactments and may make administrative rules and directives applicable to their respective administrative areas. People’s courts at lower levels look to courts at higher levels and to government and Party at the same and higher levels for guidance.
Laws and regulations made at lower levels must not conflict with those made at higher levels, and generally only serve to implement central-level enactments. However regulations, rules or directives are occasionally enacted or issued at the provincial level in the first instance on a trial basis, and later enacted on a national basis after sufficient experience has been gained.
Despite the uniformity attributable to centralisation, there can be a great deal of variation in local practice and interpretation where central policy is silent or unclear.
Sectors open to foreign investment
Direct foreign investment is not permitted across the board in China. When planning to make an investment, the first step is to ascertain whether and under what conditions the contemplated activity is open to foreign investment. Those conditions may also include more favourable policy treatment for activities in which the government is eager to encourage foreign investment.
Companies registered in Hong Kong, Taiwan and Macao are treated as ‘foreign’ for the purposes of most PRC regulations governing foreign investment.
Business licensing: All companies, including foreign invested enterprises (FIEs), receive a business licence permitting them to operate only within a specific, narrow area of business. Permissible business lines are limited to those set out in the National Economic Industry Category Definitions. It is not usually possible to combine unrelated activities in the same licence, such as property management and manufacturing.
The ‘negative list’ and national treatment: Previously, China maintained a ‘foreign investment guidance catalogue’ under which all business activities were classified as one of “encouraged”, “restricted”, “prohibited” or “permitted” to foreign investment.
A more liberal ‘negative list’ approach, first used in China’s free trade zones (FTZs), has now been extended nationwide and is set out in the PRC Foreign Investment Law, passed on 15 March 2019 and effective from 1 January 2020.
The negative list, or “Special Administrative Measures for Foreign Investment Access”, is a document jointly issued by the NDRC and MOFCOM and will be updated periodically. Activities on the list may be prohibited to foreign investment outright (e.g. TV or film production), or may be restricted. Where an activity is restricted, approval is at the discretion of the authorities and a joint venture (JV) with a Chinese party will be required. Any activity that is not included on the negative list is supposed to receive “national treatment”, and to be subject to the same criteria and requirements as domestic investment in the same area.
The most recent version of the negative list should always be consulted as a first step when planning any investment. However, local approval authorities have significant discretion in interpreting the list and implementing related policy. Even though an activity is not included on the negative list and is technically ‘permitted’, it still may not be approved in fact by the approval authorities. The permissibility of the planned FIE scope of business should always be confirmed in advance on a case-by-case basis through consultation with the competent local authorities.
There is also a FTZ-specific negative list which operates alongside the national negative list. This provides somewhat improved terms of access for certain activities in the FTZs, although as the national negative list is itself already a distillation of the areas that China considers most sensitive for foreign investment it does not significantly increase access. The FTZs continue to offer preferential access policies for certain trading functions, like customs clearance and foreign exchange cash pooling. They may also continue to enable foreign investment in certain areas first liberalised there but not generally open elsewhere – for example, training schools, hospitals and internet data centre businesses in the Shanghai FTZ.
Encouraged catalogue: Following the introduction of the negative list, MOFCOM and the NDRC now maintain a separate list of projects in which foreign investment is encouraged. This is called the Catalogue of Industries Encouraged for Foreign Investment (encouraged catalogue).
Central-western catalogue: The negative list is supplemented by the Catalogue of Priority Industries for Foreign Investment in the Central-Western Region (central-western catalogue). This lists activities and sectors in which foreign investment is encouraged in China’s less-developed central and western regions, as well as in the north east region and on Hainan Island. Activities included in the encouraged catalogue are also eligible for preferential treatment under a range of policies when undertaken in these regions. The central-western catalogue is revised on a regular basis.
Preferences for Hong Kong companies – the Closer Economic Partnership Arrangement: the PRC and Hong Kong entered into the first phase of the Closer Economic Partnership Arrangement (CEPA) in June 2003. Macao also has a similar arrangement in place. Among other things, CEPA provides eligible Hong Kong resident companies with more liberal investment access to the mainland than is available to companies from other jurisdictions. This means that eligible Hong Kong companies can enter into certain activities before companies from elsewhere.
Any location search should also take into account the possibility of gaining benefits offered by a variety of different development and trade zones.
The CEPA eligibility requirements for Hong Kong Service Supplier (HKSS) status are designed to ensure that companies with an active presence in Hong Kong are the main beneficiaries. However, there are exceptions to the HKSS requirements, and newly-established Hong Kong entities may be able to benefit from CEPA in these cases.
Because of this complexity, and because the details of the liberalised sectors are open to interpretation in certain respects, the availability of CEPA preferences for any particular investment must be confirmed in detail through consultation with the relevant PRC approval authorities.
Foreign NGO activities in China: The standard foreign investment regime for commercial entities does not apply to foreign NGOs. A more restrictive regime, the Law on the Management of Foreign Non-governmental Organisation Activities in China (the foreign NGO law) applies to the activities of foreign NGOs in China.
Geography and location
The choice of location is a fundamental step in establishment planning. Since different geographic areas are developing at different rates, some of the most fundamental geographic distinctions are economic. Probably the most basic division in the country is that between the eastern coastal regions and the less developed western and central regions, but there are similar distinctions between heavy industry in the north and the newer, more dynamic light industrial, services and tech-focused economies of the south.
Special zones: Apart from these broad geographical variables, any location search should also take into account the possibility of gaining benefits offered by a variety of different development and trade zones. The range of zones includes:
- national level high-tech industrial development zones
- regular economic and technology development zones
- free trade zones
- export processing zones
Most foreign manufacturing businesses are located within a zone of some type because of the range of benefits offered by these areas.
For simple economic and industrial development zones, the principal benefits can include access to land and infrastructure, proximity to suppliers, customers and talent and certain tax and fiscal incentives. For intensely managed export processing zones, the benefits also include duty-free import and re-export of processing components and products.
However, the zones’ ability to offer tax and financial incentives to new investors is gradually being curtailed. Before planning to locate to any area, the permissibility and sustainability of any specific preferential terms or conditions should be confirmed in detail.
Pilot Free Trade Zones
Following the establishment of the Shanghai Pilot FTZ in 2013, the central government began experimenting with wide-ranging, but limited, liberalisation and rationalisation in the foreign investment regulation, company registration and foreign exchange control regimes on a limited geographical basis. Three new Pilot FTZs in Fujian, Guangdong and Tianjin were announced in 2015, and the Hainan pilot FTZ was announced in October 2018.
The intention is that the reforms trialled in the pilot FTZs will eventually be extended to the country as a whole. But the FTZ reforms represent incremental rather than fundamental change, and firms operating in the pilot FTZs face broadly similar challenges to those operating elsewhere.
Although the pilot FTZs are not a panacea, foreigners should consider them as a location for any new establishment.
Shanghai pilot FTZ: The Shanghai FTZ launched on 29 September 2013. It consolidated four existing free trade zones in Shanghai, with an area of 120.72 square kilometres.
The Shanghai FTZ was billed as a crucial step towards China’s next wave of reform and opening up. But not all of the reforms are primarily intended to benefit foreign companies – many are directed at domestic companies. Some of the main reforms include:
- somewhat increased opening to foreign investment in certain activities
- streamlined company establishment requirements and procedures for a range of activities
- liberalised access to foreign exchange
- bonded zones and streamlined customs procedures.
Tianjin pilot FTZ: The Tianjin FTZ is located in the central area of the Bohai Economic Rim, giving it a regional advantage as a transportation hub for North China.
There are three parts of the Tianjin FTZ: the Tianjin Port district, the Tianjin Airport district and the Binhai New Area Central Business District. The total area is about 119.9 square kilometers.
Elements of the Tianjin FTZ include:
- Financial innovation focusing on a trial run of free RMB conversion with quotas under capital items, voluntary settlement of foreign currency capital, innovation on usage of cross-border RMB and financial leasing;
- Further opening-up of several areas of investment to foreigners including international shipping management, international shipping agency service, financial services, ship financing, shipping, operating lease business, financial leasing, e-commerce, professional services, culture services, advanced manufacturing and high-end equipment repairs;
- Application of ‘one window’ procedure and foreign investment special entry administration to all enterprises incorporated in the Tianjin FTZ.
Guangdong pilot FTZ: the Guangdong FTZ covers an area of 116.2 square kilometres and consists of three zones: the Guangzhou Nansha New Area, the Shenzhen Qianhai Development Zone and the Zhuhai Hengqin New Area.
Measures which distinguish the Guangdong FTZ from other FTZs are:
- Further promotion of the liberalisation of trade in services between Guangdong and Hong Kong and Macao;
- Deepening of the liberalisation of the financial sector in these three locations;
- Allowing the set up of bonded exhibition and trading platforms in the special customs supervision area.
Fujian pilot FTZ: the Fujian FTZ covers 118.04 square kilometres made up of three independent areas: Pingtan Area, Xiamen Area and Fuzhou Area. The Fujian FTZ sets out specific functions for each of the three areas.
- The Pingtan Area focuses on the development of a cross-strait tourism, investment and commerce.
- The Xiamen Area will develop as a demonstration zone for cross-strait emerging industries and modern service industries, a southeast international shipping centre, as well as a cross-strait regional financial service centre and trading centre.
- The Fuzhou Area focuses on establishing an advanced manufacturing base, serving as a platform for communication and collaboration among countries and regions in SE Asia, as well as a demonstration zone for cross-strait cooperation in trade in services and financial services.
Hainan pilot FTZ: The Hainan FTZ was announced in October 2018. Unlike the other zones, the Hainan FTZ covers the full Hainan province – a relatively massive area of some 35,000 square kilometres. The focus of the zone will be technology, tourism and ecology, and the opening of a gateway to SE Asia.
Part 2 – Establishing a Business in China
The Foreign Investment Law, which takes effect on 1 January 2020, will eliminate some of the traditional forms of foreign-invested enterprise (FIE) in China and, with that, much of the formal distinction between foreign-invested and domestic companies. However, it is not yet clear what will replace the well-established, if onerous, old framework.
Until 2020, foreign investors wishing to establish a presence to do business within the People’s Republic of China (PRC) must establish one of the several different statutory forms of FIE. Some limited business may be done in the country without a formal establishment – for example, through an agent – but an establishment will be required for any significant operations such as leasing premises, opening bank accounts, buying and selling in local currency or hiring more than a few employees.
- Wholly foreign-owned enterprise (WFOE): a limited liability company 100% owned by one or more individual or corporate foreign investors. The liability of the investors is limited to their subscribed registered capital. WFOEs are the most popular form of FIE;
- Equity joint venture (EJV): the most common of the two types of statutory joint venture. An EJV is a legal person company invested in together by both foreign and domestic corporate investors. The equity interests of the investors, and the division of profits, is strictly proportional to their shares of contributed registered capital;
- Cooperative joint venture (CJV): CJVs are normally established as legal person limited companies, but may also be established as a non-incorporated contractual cooperation. The liability of the partners in an unincorporated CJV is unlimited, and investors tend to have greater flexibility. Non-incorporated CJVs are typically only established for specific limited purposes and activities such as collaboration in natural resources exploration;
- Foreign invested company limited by shares (FICLS): a joint Chinese and foreign-invested company, hence a form of joint venture (JV), limited by shares. An investor’s liability is limited to its individual subscription. Companies seeking listing on the Chinese stock market must be in the form of a FICLS. A WFOE, EJV or CJV may convert to an FICLS in accordance with PRC law;
- Foreign invested partnership enterprise (FIPE): available since 2010. Except for market access and related differences, FIPEs function under the same rules as domestic partnerships and generally much the same as partnerships in the west. Given the still fairly limited experience with this form of entity, partnerships still face many more legal, tax and administrative uncertainties relative to other, more mature forms of enterprise.
Significant changes in the Foreign Investment Law: as discussed in part 1, the Foreign Investment Law aims to complete the unification of law governing domestic and foreign enterprises. Part of the way it does this is by expressly terminating the original standalone enabling laws governing WFOEs, EJVs and CJVs and stipulating that the Company Law and Partnership Law will instead apply to all FIEs. From 2020, foreign investors will presumably be required to set up a standard LLC or FIPE under the Company Law or Partnership Law.
Like their domestic counterparts, FIEs should then only require registration with the State Administration for Market Regulation (SAMR) in the vast majority of cases where the negative list or other standard pre-approval requirement does not apply. However, there is already a vast bureaucracy dedicated to approving and registering FIEs, so it seems more likely that a whole new set of much more limited procedures will be required.
The change in the law could also create significant confusion for existing entities. This is not likely to be much of an issue for WFOEs, which are similar to standard LLCs under the Company Law. However, the tens of thousands of existing JVs simply do not fit within the Company Law framework. JVs could therefore face significant complexity while these issues are worked out.
Special types of FIEs: in addition to the different basic forms of FIE, special types of FIE also exist to carry out certain specific business activities. Some notable examples include:
- Foreign Invested Commercial Enterprise (FICE) – a CJV, EJV or WFOE approved to carry out domestic agency, wholesale, import-export and perhaps retail activities;
- Foreign Invested Venture Capital Investment Enterprise (FIVCIE) – a CJV, EJV or WFOE specifically approved to undertake VC-type RMB equity investments in non-listed PRC high-tech companies, but only such companies. The limitation to high tech portfolio companies means that the FIVCIE is not a general-purpose RMB foreign-invested onshore PE/VC fund vehicle. It is however possible to establish general-purpose wholly foreign owned fund management companies;
- Joint universities. There are generally two types of higher education JV – JV Programmes and JV Institutions. Neither of these falls under the standard rules for EJVs or CJVs. A JV Programme is a short term collaboration by contract, normally for three years. A JV Institution can be established for long term cooperation, up to 50 years, and must have a least three programmes. JV Institutions are generally set up as dependent colleges of the Chinese partner institution, and not as independent legal persons, except in the case of a limited number of large-scale Sino-foreign joint venture universities;
- Holding company and regional headquarters. Investors which already have major operations in the country may wish to consider applying for holding company or a regional headquarters status, to help consolidate certain group treasury, support services and trading functions. There are significant minimum investment thresholds, and operations are limited to holding company functions.
Representative offices and branches: Where more limited activities are contemplated or limited liability is not required or permitted, foreign investors may establish a representative office or branch in China:
- Representative office (RO) – an entity that may conduct some restricted activities on behalf of a foreign parent company, but generally cannot engage in direct profit-making activities itself;
- Foreign company branch – a branch of a foreign company is permitted to engage in direct business activities, however this is only available for certain businesses such as commercial banking and oil exploration;
- Domestic company branch – a company already established in China may set up branches to operate its business at places different from its registered address. Such a branch does not have independent legal personality or limited liability, and its parent therefore has unlimited liability for its debts. The scope of business of a branch may not exceed that of its parent.
The Foreign Investment Law, which takes effect on 1 January 2020, will eliminate some of the traditional forms of foreign-invested enterprise (FIE) in China and, with that, much of the formal distinction between foreign-invested and domestic companies. However, it is not yet clear what will replace the well-established, if onerous, old framework.
VIE structures: China’s restrictions on foreign investment in different sectors have not entirely prevented foreign investment in those sectors.
The most common way around the restrictions has been the so-called variable interest entity (VIE) structure. This is a US accounting term for a subsidiary entity that is not controlled by voting rights but is subject to contractual controls functionally equivalent to voting rights that allow the subsidiary’s accounts to be consolidated with the parent.
Under a typical VIE structure the domestic business restricted to foreign investment will be carried out by a purely domestic operating company, with only PRC shareholders; the foreign investors will set up a WFOE in a permitted sector, typically technical or management consulting; there will be a series of contracts between the WFOE, the operating company, and the operating company’s shareholders, basically giving the WFOE and foreign investor the right to control and take the profits of the operating company. The structure will typically include management contracts, IP licenses, share pledges, share purchase options, nominee shareholder agreements and loan agreements. Typically the Chinese parties owning the domestic operating company will also own equity in the offshore group parent, and will also own equity in the offshore group parent, and will look to be compensated at that level.
Because the purpose and effect of the structure is to permit foreign investment in areas prohibited to foreign investment, VIE structures inhabit a grey area of PRC law. There are a number of risks to the VIE structure, and the risks are probably greater for companies that are ultimately owned by foreign investors.
Those risks include:
- complex contractual structure makes contingency planning difficult, and future outcomes unpredictable.
- the VIE contracts could be deemed invalid and unenforceable, as against public policy.
- multiplication of entities is tax inefficient under transfer pricing requirements.
- regulators could expressly deem the structure illegal in general in future, or could crack down on any particular VIE structure.
Because of these risks you should not enter in to a VIE lightly, and should consider whether there any viable alternatives; and if the structure is adopted, plan and document it carefully.
The introduction of the Foreign Investment Law does not appear to materially increase the risks around VIEs, and may even decrease them. It does provide additional legal grounds for acting against VIEs, by providing a general definition of “foreign investment” that could include VIE contractual controls. However, it omits an important distinction between ultimate foreign and Chinese control, which appeared in earlier drafts. This would have allowed a selective crackdown on foreign-controlled VIEs, while sparing the many prominent foreign-listed VIEs under ultimate Chinese control.
Equity ownership in WFIEs and JVs is expressed as a percentage of ‘registered capital’. Registered capital has the following features:
- registered capital is defined as subscribed capital, rather than paid-in capital;
- there is no general requirement to pay in registered capital, although there are consequences for failure to do so, such as limits on the company’s ability to take foreign exchange loans;
- there are no general minimum registered capital requirements, although specific limits are prescribed in national law or State Council regulations for certain activities;
- there are no fixed time limits for paying in registered capital, although a company’s articles of association should require that it be paid in before the end of the term of the company;
- there are no minimum ratios of cash to other forms of registered capital, although there are limits on the types of permissible non-cash contributions.
An FIE’s registered capital can be stated in either foreign currency or Chinese currency (RMB).
It is generally quite easy to increase registered capital but this can be a time consuming process. The recommended approach to capital planning is that investors should fix initial total investment at an amount required to fund capital expenditures and working capital until the enterprise reaches operating break even.
However, it may be less easy to reduce registered capital, so any excess could become trapped in the company. The use of some amount of debt financing to satisfy total funding requirements helps avoid a cash trap for excess registered capital.
Forms of capital contribution: registered capital can be contributed in the form of cash, capital equipment, land use rights, debt and share rights and intellectual property rights.
In general, title to contributed non-cash assets should pass to the enterprise. Accordingly, revocable licenses, future services and other such contingent interests are generally not permissible as contributions to registered capital. There is however an exception in the case of CJVs, where it is permitted to contribute “cooperative conditions” that may include contractual performance. Mortgaged assets may not be contributed to registered capital in any event.
Cash and in-kind contributions to registered capital should be verified by certified PRC accountant. The valuation of non-cash contributions must be confirmed by a licensed PRC appraiser.
Debt ceilings: in order to help ensure corporate financial strength, FIEs and domestic enterprises alike are limited in the amount of foreign exchange borrowing that they can undertake.
Traditionally, FIE borrowing was limited by certain statutory ratios of paid in capital to total investment. First in May 2016, and then with new regulations in January 2017, a new system was put in place nationally, whereby FIEs could opt to calculate debt ceilings based on a more flexible multi-factor test. The multi-factor test had previously been trialled in the FTZs.
The ability to choose between the old or new system was made available only for a limited transitional period of one year, to January 2018. If an FIE made an election during that time, it must use the same method going forward. If not, it may elect to use either method.
Under the traditional debt ceiling regime, the debt-to-equity ratios of FIEs are limited by specifying minimum ratios of registered capital relative to “total investment”, defined to include registered capital plus long-term borrowing by the enterprise over one year. In practice, only foreign exchange borrowing is counted. However, there are lifetime limits for the enterprise, so no more can be borrowed once the thresholds are exceeded even if earlier loans are paid down. The ratios of total investment to registered capital, and therefore the levels of permissible borrowing, increase with the scale of the enterprise, subject to additional rules governing special industries.
Under the new regime introduced from 2016, non-bank FIEs can borrow foreign debt up to a risk-weighted balance.
Timing of capital contributions: there is no specific time limit for completion of the full capital contribution. However, in practice, the AMRs in many areas may still require that a fixed contribution deadline be included in the company’s articles of association. In practice, there is no longer any clear mechanism to require compliance with the articles of association payment deadlines. But because certain consequences can result from non-payment, such as inability to make forex loans, it is prudent to pay in the registered capital in accordance with the articles of association.
Complex China Securities Regulatory Commission and MOFCOM approval requirements apply to major acquisitions and changes of control of listed companies.
Transfers of and changes in registered capital: any change in the amount or ownership of LLC registered capital must be filed or approved, and re-registered with the competent authorities. Co-investor consents are also required for different transactions.
- Transfers of interest in registered capital – co-investors have a statutory right of first refusal to purchase registered capital in the event of transfer to a new investor. Their consent for such transfers is required in advance. MOFCOM filing is sufficient for most activities, but its approval is required for companies involved in activities on the negative list. Resulting changes in the company’s articles of association and registration details must be registered with the AMR.
- Pledge of interest in registered capital – investors may pledge their interests in registered capital only with the approval of the original co-investors and provided it is not otherwise prohibited by the company’s articles of association. Pledges should be filed with or approved by MOFCOM and registered at the AMR with jurisdiction over the company.
- Increase in registered capital: investors have a statutory right to subscribe to new capital in the same proportion as their original equity shares, although this may be waived or varied in the articles of association. MOFCOM approval or filing is required for capital increases, but approval, if required, is normally granted as a matter of course. However, where the original registered capital has not already been contributed in full, MOFCOM may require that this be done before approving a capital increase.
- Decrease in registered capital: this may only be done under fairly limited circumstances, generally related to a decrease in the scale of the business. Previously, MOFCOM approval was required in all cases. For companies not involved in activities on the negative list, capital reduction is now subject to MOFCOM filing rather than approval. However, MOFCOM still has wide discretion in administering filings, and it may use heightened scrutiny in reviewing applications to reduce capital.
The law governing transfers of and changes to registered capital may be subject to fundamental change once the Foreign Investment Law comes into force in 2020.
Rather than establishing a new wholly-owned or joint venture (JV) company in China, foreign investors may wish to acquire the equity or assets of an existing company. As in other jurisdictions, acquiring the equity of a company will normally mean acquiring it with all of its liabilities, whereas in an assets acquisition there is generally a choice whether or not to acquire any of the target company’s liabilities.
Acquisitions and joint ventures: any acquisition of less than 100% of the equity of a domestic limited liability company (LLC) will result in the target being converted into a JV which will be subject to the more conservative legal regime governing JVs.
Particular care is required in structuring JVs with individual shareholders continuing post-acquisition. The JV regulations assume that a JV will have only a few corporate entities as investors. For instance, each party normally has the right to terminate the JV under certain circumstances, and to appoint board members. This will not be appropriate in situations where there are multiple individual shareholders. Special care is required to balance the investors’ rights and interests in these circumstances.
Basic acquisition methods: subject to the broad rules applicable to all foreign investments, foreign investors may acquire an existing domestic business through either asset or equity acquisition.
Under these broad rules acquisitions are subject to approval, are only possible in sectors open to foreign investment, and should result in at least 25% foreign equity in order for the target to be classified and treated as an FIE after the transaction is complete.
Equity acquisitions can be accomplished either by purchasing existing equity or subscribing to a capital increase.
Asset acquisitions can be accomplished by injecting the assets into an onshore vehicle, which will then operate them. In the latter case, the assets can either be purchased by the new company itself after establishment, or may be purchased by the investor of the newco and then contributed to the new registered capital of the newco.
Asset acquisitions are less common than equity acquisitions. This is in part because it is often difficult to transfer key assets free of encumbrances, and impossible to transfer key licences in heavily regulated industries. Also, from the perspective of the sellers, asset transfers may leave cash assets trapped in a predecessor company, rather than in the pockets of the controlling shareholders.
Approvals: as with greenfield investments, the approval procedures for acquisitions have been simplified and streamlined in recent years. Filing or approval with the PRC National Development and Reform Commission (NDRC) applies in the same way as for greenfield ventures, as set out above. Also, as with greenfield sites, only filing for the record with MOFCOM is required for business activity not on the negative list.
Additional or higher-level approvals may be required where the target is a state-owned enterprise or a listed company.
Central MOFCOM approval is required where the target company has traditional brands or a well known trademark or is doing business in an industry key to national security and national economic security; or where shares are used as consideration. Use of shares is only permitted if the consideration shares are already listed on a stock market, or are those of an overseas special purpose vehicle to be used as a listing vehicle for the PRC target company’s business.
M&A anti-monopoly review: under the PCR Anti-Monopoly Law (AML), the parties must report and notify any acquisition or merger to the Anti-Monopoly Office of MOFCOM for merger review if the transaction meets certain thresholds relating to global and PRC revenue and presence.
A transaction that does not meet the thresholds may still be subject to review should the Anti-Monopoly Office consider that the transaction is likely to result in the, ‘elimination or restriction of competition’, though use of this approach has not been reported.
The Anti-Monopoly Office can stop the transaction or require divestitures, undertakings or other measures to address anti-competitive effects. It also imposes rules prohibiting a range of anti-competitive practices along lines similar to European competition law.
National security review: in addition to the standard approval regime, China also has in place a national security prior review requirement for foreign acquisitions of domestic companies’ equity or assets. The requirement applies to any transaction targeting domestic military industrial enterprises and tertiary enterprises, enterprises located near major and sensitive military facilities, other entities related to national defence or security, or in other sectors related to national security such as major agricultural products, major energy and resources, infrastructure, transportation services, key technologies and key equipment manufacture. Proposed transactions may be ordered to be modified or prohibited as a result of the review.
The rules do not expressly apply to JVs, although an analogous informal review may take place in those cases.
State-owned enterprises and state-owned assets: foreign investors can acquire the equity or assets of State-owned Enterprises (SOEs) or their subsidiaries. However, the process is designed to ensure that state assets are not undervalued and to minimise the impact on employees. Therefore, the process is quite cumbersome and burdensome. It is administered primarily by the state-owned Assets Supervision and Administration Commission (SASAC) at central and lower levels.
In any transaction involving SOEs or state assets, it is critical to confirm that the seller has complied with the mandatory procedures for state asset transfers. These include use of a local state asset clearinghouse, internal approval and approval by the relevant SASAC, auditing, evaluation, publication of and invitation to bid, and undertaking a bidding process if two or more interested parties respond.
Acquisition of companies listed on PRC domestic stock markets: only companies limited by shares established in China (not LLCs, and not foreign companies) can be listed on the Shanghai and Shenzhen Stock Exchanges. Foreign investors may purchase the shares of domestic listed companies in three principal ways:
- acquire B shares – foreign investors may trade ‘B shares’ denominated in US$ listed on the Shanghai Stock Exchange or in HK$ listed on the Shenzhen Stock Exchange.
- acquire A shares through a Qualified Foreign Institutional Investor – the shares of most companies listed in China are ‘A shares’, meaning Chinese currency (RMB) ordinary shares. Foreign investors may trade A shares through a Qualified Foreign Institutional Investor, large foreign asset managers who are specifically approved for this purpose, and highly regulated by the State Administration of Foreign Exchange (SAFE).
- acquire A shares as a strategic investor – a foreign investor may qualify as a strategic investor if it has net assets of more than US$100 million or manages overseas assets of more than US$500 million. Once approved by MOFCOM a strategic investor can, either directly or through a wholly-owned subsidiary, invest in A shares with a lock-up period of three years by acquiring existing A shares by written agreement from an existing shareholder, or subscribing to newly issued A shares directly from a listed company.
Complex China Securities Regulatory Commission and MOFCOM approval requirements apply to major acquisitions and changes of control of listed companies. Particular care may be required to avoid the need to make a general tender offer when acquiring more than 30% of the shares of a listed company.
It is also possible for an onshore foreign invested enterprise(FIE) to undertake limited purchases of A shares for its own account provided that this does not constitute a significant component of its income and therefore causes it to exceed its approved scope of business.
Existing FIEs – onward onshore acquisitions: existing FIEs may engage in acquisitions of domestic companies operating in areas of business open to foreign investment, subject to conditions established at law and in the companies’ articles of association.
For such onward investments, only registration with the AMR is required to record the change in shareholding of the target. MOFCOM approval in advance is required only if the target company is operating in a restricted sector. Any subsidiaries of the target company should not be engaged in activities prohibited to foreign investment.
Again, a domestic subsidiary of an existing FIE generally does not enjoy FIE treatment for foreign exchange and other purposes, except in the Central-Western region or for holding company investments.
There are certain restrictions on the permitted sources of funds for onward investments. For existing companies, the reinvestment of RMB retained profits requires SAFE prior approval. For newly established and funded enterprises, it is prohibited to use foreign exchange registered capital to acquire equity interests in a domestic company.
Part 3 – Practical Considerations
Organisation and governance
Over the years, China has steadily unified its regulatory regimes for domestic enterprises and FIEs. The Company Law, first published in 1993 and last amended in 2014, is applicable to both domestic enterprises and FIEs. However, various special rules governing EJVs, CJVs and WFOEs continue to subsist alongside the Company Law. As a result, FIEs are still treated differently than domestic companies in certain ways, although the areas of common treatment are steadily increasing between the two.
Structuring – offshore special purpose vehicles (SPVs): Foreign investors should considering structuring their investment through an offshore SPV. The basic advantage of this is that, if the offshore SPV owns the equity of a PRC investee, transfers of ownership in the PRC investee can be cleanly completed by a transfer of shares in the offshore SPV, thus generally avoiding the need for the onshore PRC transfer procedures set out above.
If PRC-domiciled parties invest in such an SPV, the PRC investors should first obtain relevant offshore investment approvals and foreign exchange registrations for this ’round trip’ investment.
Shareholder meetings: WFOEs and FICLSs must hold shareholder meetings at least once a year, and these constitute the company’s highest authority.
Board of directors or executive director: the board of directors is the highest authority of EJVs and incorporated CJVs. Non-incorporated CJVs have a management committee, which is constituted and operates similarly to a board of directors. Board powers are specified partly by statute and partly by articles of association and, for JVs, in the JV contract.
LLCs with relatively few shareholders may appoint a single executive director in lieu of a full board. Given the control dynamics, this is most likely to be feasible for single-owner WFOEs.
In EJVs and CJVs, board representation should reflect the equity ratio between the parties.
Board meetings must be held at least once a year for JVs, and 2/3 of the directors are required for a quorum. WFOE board meeting requirements and powers will be as provided for in the articles of association. FICLS board meetings must be held every six months, or on petition of 10% of the shareholders or 1/3 of directors. For a FICLS, 1/2 of the directors constitutes a quorum.
Chairman: in EJVs the chairman is generally appointed by the majority equity holder. The other party generally appoints the vice chairman. The chairman’s position is one of prestige rather than of formal statutory powers. The chairman’s real powers are as set out in the articles of association.
Legal representative: the legal representative of an LLC or company limited by shares is an individual who is legally accountable for the company and its acts, and who generally has the power to contractually bind the company. The role therefore raises sensitive issues of both internal control and personal liability.
Supervisors: responsible for general oversight of company finances and compliance. A board of three supervisors is in principle generally required, but smaller LLCs may appoint a single supervisor. Senior managers and directors of a company may not also serve as supervisors of the same company.
Management: companies are largely free to specify their management structures. This is typically done in the articles of association and, for JVs, the JV contract.
JVs must have a general manager, generally appointed by the majority party; and a financial manager. In LLCs, the general manager, executive director and legal representative may all be the same individual. This may be attractive in terms of efficiency and cost, but can raise conflict of interest concerns.
Company chops: each enterprise, subsequent to registration, will be issued with a company ‘chop’ – a stamp or seal that are generally presumed to be definitive proof of the company’s approval of documents to which the chop is attached. Managing the chop will be a critical aspect of an enterprise’s internal controls.
Organisation and governance requirements may be subject to fundamental change once the Foreign Investment Law comes into force, particularly in terms of the requirements for CJVs and EJVs.
Establishing a business in China is more complex and time-consuming than in many western jurisdictions. The process is even more burdensome for foreign than for domestic investors. Procedures will vary depending on the type and characteristics of the project so should be confirmed on a case-by-case basis, in relation to the specific target locality.
The timing for approvals depends in large part on the nature of the investment, and whether pre-approvals are required. In the simplest scenario, the basic approval and registration process will normally take about a month or two, assuming there is no problem with the documents. More time will be required depending on the number of documents which must be prepared.
Company name reservation: done with the AMR business registration authorities in the target locality. An FIE will need to adopt a Chinese company name according to a standard form, normally consisting of four elements:
- name of the administrative region where the FIE will be located;
- trade name consisting of at least two Chinese characters;
- business or industry;
- organisational form.
Only Chinese character names can be registered as company names. Trademark searches and registrations should be carried out at the time of company name selection. Trademark registration will be critical in order to prevent passing off by competitors, and to guard against squatters maliciously registering one’s company or brand name as a trademark.
Project approval: the National Development and Reform Commission (NDRC) manages economic planning and industrial policy. Part of this is a regime of pre-establishment review and approval for new foreign-invested companies.
The extent of the review depends on the scale and sensitivity of the project. Smaller, less sensitive projects are subject to a simple ‘filing for the record’ process requiring only basic information on the project and its investors.
Larger and more sensitive projects are subject to verification and approval. This intensive review process involves the submission of large amounts of information by investors and official review of a range of project parameters. The extent of verification and approval required increases with the scale and sensitivity of the project, from local to provincial to a central level in Beijing.
The NDRC publishes and regularly updates the list of activities that need to go through this process, called the ‘Verification and Approval Catalogue’. If a project is not covered by the catalogue it should only be subject to filing for the record with the NDRC.
MOFCOM filing or approval: MOFCOM also has a role approving projects. If a project is not included in the negative list it need only be filed for the record with MOFCOM. If it is included in the negative list then prior review and approval is required. This will entail pre-approval from the administration in charge of the industry and verification and approval by the NDRC.
Business license issuance: the SAMR issues business licences as proof of the company’s due legal establishment. It is the equivalent of the certificate of incorporation in other countries.
The SAMR and its local branches are responsible for registering and issuing business licences for investments approved by or filed with MOFCOM. Filing for AMR registration should be carried out within 30 days of the conclusion of MOFCOM filing/approval. The date of issuance of the business licence is the date of establishment of the company.
Establishing a business in China is more complex and time-consuming than in many western jurisdictions. The process is even more burdensome for foreign than for domestic investors.
In theory, AMR registration may be applied for and issued on a conditional basis prior to MOFCOM filing or approval. However, in practice, the AMRs usually require MOFCOM filing or approval to be done first.
Ancillary registrations: Newly-registered businesses should file for registration with various government departments for a number of additional registration certificates within 30 days after the business license is issued.
Establishment procedures will be subject to fundamental changes once the Foreign Investment Law comes into force.
Foreign exchange controls
Foreign exchange controls are a critical factor in the planning of both investments and operations in China, and proposed cross-border fund flow of any type should be evaluated from this perspective early in the planning process.
Foreign exchange controls are principally administered by the State Administration of Foreign Exchange (SAFE).
Liberalisation of foreign exchange controls was a significant element of the reforms introduced in the Pilot FTZs, and has for the most part been extended to the rest of the country. However, the freedom of cross-border fund flows for FIEs and domestic companies alike is still limited in many fundamental respects, especially in regard to capital account transactions.
Foreign exchange bank accounts: for FIEs, all foreign exchange transactions must be conducted through foreign exchange bank accounts opened at a designated foreign exchange bank. SAFE foreign exchange registration must generally be obtained before a bank will open a foreign exchange bank account for an FIE.
Capital account and current account: all foreign exchange payments and receipts must be based on a bona fide underlying transaction, so it is important to document cross-border transactions fully and accurately.
Foreign exchange transactions are categorised as either current account or capital account transactions and each is subject to different controls.
Current account items relate to day to day business operations such as interest payments, or payments received or made for goods and services. Higher scrutiny generally applies to transactions of over $50,000, and withholding tax obligations must be settled in advance.
Capital account items are transactions that increase or decrease the debt or equity of an enterprise through the inflow or outflow of capital. They are subject to SAFE registration or approval in advance.
Foreign borrowing: FIEs, unlike domestic enterprises, are generally free to undertake foreign currency loans from offshore lenders. However, these loans must be registered with SAFE.
Profit remittances: FIEs may declare profits on an annual basis after all taxes have been paid and previous years’ losses have been made up. They must allocate 10% of after-tax profits to a statutory reserve up to the point where the reserve balance equals 50% of registered capital.
FIEs are in general allowed to remit dividends to offshore investors without case-by-case approval from SAFE. But the approval function lies with banks, which will review board resolutions; tax clearance certificates; audited accounts, and other documents as a condition to approving dividend payments. Also, foreign exchange policy continues to fluctuate with China’s macro foreign exchange flows. For example in 2016, after a period of record currency outflows, SAFE introduced a new policy requiring case-by-case review for all fund outflows over $5 million, resulting in significant difficulties for many large multinational corporations in remitting dividends abroad.
Acquiring real property
The People’s Republic of China (PRC) legal regime does not recognize private ownership of land. All land is owned by the state or by collectives. Collectively owned land is generally for agricultural purposes and can only be used for construction after undergoing a complex conversion process.
Because of animosity to private property ownership during Mao’s time, China’s land registration and transfer infrastructure are still fairly imperfectly and irregularly developed. As a result, the process of obtaining land and buildings is often complex and costly. The situation is usually better on the developed east coast, in urban areas and in segregated economic development or industrial zones.
Because of this, new facility builds by FIEs are almost always located in development zones.
FIEs can own buildings and structures on land by purchasing or being granted a ‘land use right’, which is a right to use land for a specific purpose and period of time. Land use rights do not include the right to use natural resources, minerals or treasure under the land. In general, buildings on land must be owned by the same party that holds the land use right.
There are three types of land use right in China.
Granted land use right: This is the most common type of land use right, and is initially obtained directly from local authorities by paying a fixed fee. The maximum use period varies depending on the use of the land:
- 40 years for commercial, tourism and entertainment use;
- 50 years for industrial, education, science, technology, culture, health or sports use (although in several cities such as Shanghai, the term for new grants of industrial land use rights was shortened from 50 to 20 years from 1 April 2014);
- 70 years for residential use.
Granted land use rights can generally be freely transferred, let or mortgaged without having to obtain formal approval from the authorities. However, all such changes should be registered with the land management authorities.
An application to extend a granted land use right must be made no later than one year before its expiry.
Allocated land use right: This is a land use right allocated by the state free of payment for an indefinite period, normally for restricted uses such as governmental use, military use, infrastructure projects and public facilities.
The law does not expressly prohibit foreign companies or individuals from obtaining allocated land use rights. However, because of the restrictions on use and transfer, these rights are not normally held by foreign companies or individuals. Utility or infrastructure projects are the most common exceptions.
Generally, allocated land use rights should first be converted to granted rights in order to be transferred. The process is cumbersome and difficult.
The People’s Republic of China legal regime does not recognize private ownership of land. As a result, the process of obtaining land and buildings is often complex and costly.
Leasing of buildings and land use rights: It is quite common for FIEs to lease premises such as offices and factories, rather than buying the right for a one-off payment. The maximum term of leases is 20 years, and they may be renewed upon expiry.
Various legal requirements apply to company registered offices including: that the registered address match the property ownership certificate; that the premises should be zoned for the contemplated activity; and, in some areas including Beijing, that the premises should not be owned by a foreign national. Therefore, when considering office premises, investors should confirm with the landlord in detail that the office is suitable for use as a registered office, and incorporate a condition into the lease.
China has increasingly emphasised environmental protection in recent years, and continues to legislate actively in this area. The importance that China now places on environmental issues is reflected in the upgrade in March 2008 of the original State Environmental Protection Administration to full ministerial status, becoming the Ministry of Environmental Protection.
Major amendments to the Environmental Protection Law came into effect on 1 January 2015 that significantly strengthened the enforcement regime. These included potentially unlimited fines for polluters, strengthened private rights of action, and strengthened punishments for local environmental authorities failing to enforce the law.
Although PRC law currently lays the burden of environmental remediation on the polluter, liability is gradually being extended to non-culpable successor occupants. Environmental due diligence is therefore of critical importance in any greenfield project or acquisition of existing facilities.
Environmental impact assessments (EIAs): an EIA is required before a construction project and related investment can be approved.
The EIA, either in the form of a full report or simpler registration form, must be prepared by a qualified environmental engineering firm and approved by the competent environmental protection authority.
A re-assessment report is required where major changes are made to a project’s nature, scale, location, production process or waste treatment measures; or where construction of the project has not commenced within five years after approval.
Environmental protection facilities: these are required for projects where pollutants are handled on site. They must be designed, engineered and operated simultaneously with the main body of the construction project.
Local environmental protection authorities will carry out examination of environmental protection facilities upon completion of construction. Projects can be put into formal operation only after issuance of an Inspection and Acceptance Letter confirming that the project has passed examination. This typically follows a period of trial operation lasting about six months.
Waste discharge control: a system of waste discharge control permits is in effect for air, water and noise.
A project may not discharge waste without a discharge permit or exceed the permitted discharge volumes. To obtain a discharge permit, an enterprise must have passed examination by the environmental protection authority by demonstrating that suitable waste treatment facilities have been installed and that the waste to be discharged after treatment complies with both national and local standards.
Ongoing supervision: local environmental protection authorities exercise ongoing supervision on all operating projects through waste discharge sampling.
Protecting intellectual property rights (IPR)
Foreign businesses operating in China must take care to protect their valuable IPR, ranging from trade names and brands, to copyrights, patentable inventions, trade secrets and know-how. IPR strategy should be considered early in the investment planning process, and monitored, updated and implemented on a continuing basis.
Registrations: China has established registration regimes to recognise exclusive rights to use various forms of IPR. These include trademarks, trade names, patents, designs and integrated circuit layouts, new varieties of plant, copyright and software and domain names.
Practical measures: Unregistered trade secrets are protected under the Anti-Unfair Competition Law, on terms similar to other jurisdictions – information must be commercially valuable non-public information, and efforts must be made to protect its confidentiality.
Companies must take steps to protect their trade secrets, including: segregating know-how, with important elements being retained offshore; access controls on IT systems and paper files; physical security at sites; monitoring of compliance, detailed IT policies, handbooks, and training.
Treaties: China is a signatory to a range of key international treaties on IPR, including the Paris Convention (patents and trademarks); Patent Cooperation Treaty (patents); Berne Convention (copyrights); WIPO Copyright Treaty (copyrights); the Madrid Treaty and Protocol (trademarks); and TRIPS under WTO.
Enforcement: several avenues are available for enforcing intellectual property rights against violators, with administrative rather than judicial action being most common.
The State Administration for Market Regulation (SAMR) and its local branches can take administrative actions including: investigation, seizure, confiscation, administrative injunctions, fines and even closing down infringing businesses.
The State Intellectual Property Office may investigate and issue administrative injunctions against patent infringement.
The Administration for Quality Supervision, Inspection and Quarantine may investigate and prosecute ‘passing off’ involving shoddy goods or violations of state standards.
The National Copyright Administration is empowered to issue administrative injunctions, confiscate goods and impose fines for copyright infringement.
The General Administration of Customs may confiscate products for export that infringe registered IP rights. Since customs officers are generally more free from local political and economic pressures than other agencies, customs enforcement can be very effective.
Litigation for IPR owners and criminal prosecution are other possibilities. Although damages awards have been low by western standards they have been increasing to more realistic levels over the past several years. Preliminary injunctive orders and orders for preservation of evidence may be available. Trade secret related enforcement requires litigation under the Anto-Unfair Competition Law.
Chinese law is very protective of employee rights. The Employment Contract Law governs the rights of employees in China but there is a great deal of variability in many details of labour policy between different parts of China.
Important elements of the law include:
- a written contract, which generally must be signed within one month after starting a new job;
- termination by an employer is not freely permissible – it must be by notice, can only be based on one of a number of limited statutory grounds and is subject to compliance with mandatory procedures. Severance compensation is required for dismissal by the employer for reasons outside of the permitted grounds, or where the employer refuses to renew a fixed-term contract on expiry;
- an open term contract must be offered to an employee after the completion of two fixed-term contracts and to an employee who has been working for the employer for a consecutive period of 10 years;
- company rules on issues directly involving the personal interests of employees should be discussed with all employees and the labour union – this includes rules on working hours, breaks and vacation and health and safety;
- non-competition covenants may be agreed with senior managerial staff, senior technical staff and other staff with confidential responsibilities for a maximum period of two years. Monthly compensation must be paid during the non-compete period for it to be enforceable.
Representative Office Local Employees: there is a fundamental distinction between representative offices (ROs) and foreign-invested enterprises in respect of employment relations. While JVs, WFOEs and others can directly hire local employees, ROs must hire local employees through a government sanctioned labour outsource services company such as the Beijing Foreign Enterprises Human Resources Service Co., Ltd. (FESCO) or China International Intellectech Co. (CIIC).
Employee handbooks and company policies: a unique feature of the Employment Contract Law is that it makes it permissible to unilaterally terminate an employee for a serious violation of company policies, but not for breach of the employment contract itself.
It is therefore critical that a company put in place comprehensive employee handbooks and policies spelling out in detail the company’s rules and regulations, and the conditions under which employees’ violation of the policies can constitute grounds for unilateral termination.
It is also important to note that company policies will not be binding on employees unless the policies are properly circulated to the employees for comment. So circulation for comment is an important procedural step. Also, the employees must be in a position to understand the policies, so Chinese-language versions of the policies should be put in place unless all employees are fluent in English.
Social insurance: employers and employees are both required to make payments into various social insurance schemes including for unemployment, medical, work-related injury, maternity, pension and housing funds. Although the rates vary in different parts of the country, total contributions average around 35% to 40% of the wage bill within the range of average salary levels. However, contributions are subject to caps based on average local wages, resulting in proportionately lower contributions for high salary employees.
Under the Social Insurance Law, foreign national expatriates are included in China’s social insurance system in principle, although they are not included in the housing fund system. However, in practice, contributions by foreigners are still not uniformly required in all jurisdictions. Therefore, the situation should be confirmed dependent on the target location.
Hiring PRC employees from offshore: there are two basic options by which foreign companies new to the market may hire just one or a few Chinese nationals onshore without setting up a Chinese entity: hiring the individual directly from offshore, and hiring the individual through a local labour outsourcer.
There are advantages and disadvantages to each approach. In addition, both approaches could be considered to violate rules prohibiting foreign entities from operating an unregistered representative office in China. If the arrangement is deemed to constitute an unregistered representative office, the authorities could impose a fine and order cessation of the activity. Both approaches also carry a significant risk of being deemed to constitute a permanent establishment if discovered by the tax authorities.
Trade unions: employees in China have the right to set up a workplace labour union. If employees request to set up a union, the employer must offer assistance and allocate 2% of the monthly payroll to the union. All unions are subordinate to the All-China Federation of Trade Unions, which is currently actively advocating the unionisation of FIEs.
Current PRC regulations allow unions a role in major decisions by FIEs including the right to review dismissals, participate in board meetings and review company rules involving salaries or work conditions.
Expatriates and visas: the hiring of foreign nationals is permitted, but only subject to approval, and only for qualifying employees. In particular, the regulations stipulate that foreigners can only be hired to fill posts with special needs, and which cannot be satisfied by domestic candidates. Foreign employees must be above the age of 18 and be healthy, and must possess relevant professional skills.
All foreign nationals must have a valid visa in order to enter and stay in China. Different types of visas are available depending on the intended purpose and duration of the stay, and subject to satisfaction of relevant approval requirements.
Forms of visa most commonly relevant to foreign nationals working in or visiting China include:
- L Visa – a tourist visa, for those visiting China for a short period of time for tourism;
- M Visa – a short-term business visa issued to an individual invited to China for commercial and trade activities. This is the typical visa for individuals visiting their group companies or trading contacts in China;
- Z Visa – a formal work visa for individuals hired by companies established in China;
- Short-term Z Visa – a formal work visa required for a limited set of defined activities including film production, sports training, fashion shows and “completing tasks such as those involving technology, scientific research, management and guidance at the place of the China partner”.
The requirements for obtaining work visas are complex. For new work applications, the submission requirements include notarised and legalised copies of diplomas and home country criminal record checks, which can be very burdensome to obtain. Some steps must be carried out in advance by the employer in China, while others can only be carried out with PRC embassies or consulates overseas.
China’s tax system is growing in sophistication and detail along with the rest of its institutional infrastructure. The laws are complex, fast changing and subject to varying interpretation.
Enterprise Income Tax Law: China’s Enterprise Income Tax Law (EITL) came into force on 1 January 2008. Unlike previous corporate income tax laws, the EITL applies equally to both FIEs and domestic enterprises.
Features of the law include:
- a unified tax rate, with all domestic enterprises and FIEs subject to tax on income at a flat rate of 25%;
- tax incentives for qualified hi-tech enterprises, advanced services enterprises and enterprises active in encouraged sectors in the central and western regions. Previous tax holidays for manufacturing FIEs have now been eliminated;
- several categories of tax-free income, including that received by recognised charities and dividends paid from domestic subsidiaries to their domestic parents;
- broad anti-avoidance, thin capitalisation, transfer pricing and controlled foreign corporation rules. Among others, the PRC tax authorities scrutinise and may apply anti-avoidance rules to assess tax in cases where equity of a Chinese company is indirectly transferred via selling its foreign offshore holding company, where this is considered an abuse of organisational structure to evade PRC tax liability without a bona fide business purpose;
- special treatment for restructuring. However, the availability of preferential tax treatment usually cannot be finally confirmed until after the transaction is complete, potentially resulting in significant uncertainty and risk for participants.
Taxation of representative offices: although they are not permitted to earn income, ROs are nevertheless required to pay income tax on the basis that they ultimately generate economic value. The taxation of ROs is generally based on a deemed profit method, with tax calculated as a percentage of RO operating costs. Under this method, the minimum deemed profit rate is 15% of operating costs. The standard 25% corporate income tax is payable on the amount of deemed profit, and no deductions are allowed.
Income tax withholding and double taxation arrangements (DTAs): a foreign enterprise without an establishment in China, or with an establishment but with China source income not related to such establishment, is generally subject to withholding tax at a rate of 10% on such China source income. The domestic payer is the withholding agent for these taxes.
Deductions to reduce taxable income are generally not allowed in the withholding context.
China has bilateral treaties for the avoidance of double taxation in place with many foreign jurisdictions, including arrangements with Hong Kong and Macao. These may reduce withholding rates even further. Access to DTA tax benefits is now restricted to offshore companies that qualify as beneficial owner under PRC tax rules, meaning entities which have control over the profits or rights or assets generating the profits, and which have a bona fide business purpose and presence in the foreign jurisdiction. This means that it is no longer possible to enjoy favourable PRC tax treaty treatment merely by setting up a shell company in a foreign jurisdiction for that purpose. In addition, favourable tax treatment under DTAs is not granted automatically, but can only be enjoyed on application to the Chinese tax authorities.
Hong Kong’s tax arrangements with China were in the past particularly favourable, and may still be relevant given Hong Kong’s strategic position as a hub for business in Asia and a gateway for Chinese investment. However, under the DTA between the UK and China effective from 2014, UK businesses enjoy tax treatment just as favourable, in most respects, as that enjoyed by Hong Kong companies.
Permanent establishment: foreign companies that do not have a subsidiary company or RO in China may nevertheless be deemed to have a permanent establishment (PE) in China, and subject to PRC tax on income attributable to the PE. The factors triggering a PE are generally spelled out in the DTA between China and the investor’s home country. In general, under the DTAs, PE can be deemed to have been established by a foreign company where:
- foreign company employees are working in China for over half of the year;
- the foreign company has a dependent agent in China; or
- the foreign company uses or has available to it a dedicated physical premises in China, even if not formally leased by it or used on a full-time basis.
If PE is deemed to be established, the foreign party must register the PE with the local tax authorities and file to pay taxes. Tax will generally be assessed on a deemed profit basis, calculated based on the expenses attributable to the PE. The deemed profit rate varies from 15% to 50% of expenses, depending on the activity involved.
Turnover taxes: sale of goods within China are generally subject to VAT at rates of either 13% or 17%. Provision of repair and replacement services may also be subject to VAT at 17%. Certain services, such as design services, are now subject to VAT at either 6% or 3%, depending on the status of the VAT taxpayer. In addition, local governments often levy surcharges that are collected along with VAT, typically less than 1% of the transaction value.
Certain luxury and “unhealthy” goods are subject to a consumption tax ranging from 3% to 45%, paid by the VAT payer at the same time as payment of VAT.
Other taxes: these include customs duty, land appreciation tax, resource tax, stamp duty, land use tax, deed tax, and vehicle and vessel tax.
Enterprise termination and bankruptcy
The PRC’s first generally applicable company bankruptcy law came into effect in 2007. The slow pace of development in this area reflects the PRC’s early reluctance to sanction the failure of state-owned enterprises. The Enterprise Bankruptcy Law is broadly similar to the laws in western economies on the surface. However, it contains numerous loopholes which give courts significant discretion in accepting and settling bankruptcies.