By Klaus Koehler, Managing Director, Klako Group

When entering the China Market, foreign Investors have the possibility of establishing a Joint Venture or their Wholly Foreign Owned Enterprise in China. Both entities are considered as Foreign Investment Enterprises (FIE's). Due to changes in laws and regulations throughout 2004, more and more foreign companies have decided to establish their wholly foreign owned enterprise in China.

A Wholly Foreign Owned Enterprise (WFOE) is a limited liability company fully owned by the foreign investor. WFOEs allow foreign investors to manufacture, process, assemble, trade, distribute or deliver services in China, without joining together with a Chinese partner.

Setting up a Limited Company does not necessarily mean that you can pursue any sort of activities, as may be the case in the West and certainly in Hong Kong. WFOE's can only be operated within the scope of business as approved by the authorities. If any other activities should be added, these are subject to further approval by the relevant government authorities. It is therefore very important from the onset of your establishment to determine what the functions of your WFOE should be and to detail each of the functions.The company's liability is limited to the amount of registered capital that is invested. Registered capital requirements vary from industry to industry and also on a regional basis. The Company Law states that the capital requirements for WFOE's are:

Trading WFOE: USD 62,000
Retail WFOE: USD 36,000
Manufacturing WFOE: USD 140,000 - USD 200,000
Service WFOE: Varies between USD 12,000 to USD 140,000

These amounts are only the minimum requirements. The registered capital is in proportion to the total investment of the company, which is based on the scale of the business plan in China.

Foreign Trade Rights

The foreign trade law was revised by the Ministry of Commerce on July 1st 2004 in a document known as Circular 8. The new law allows trading and manufacturing companies to apply for Import and Export Rights. This includes local trading and manufacturing companies. Foreign Trade Rights (otherwise known as Import / Export Rights) means that companies have the authority to import and export across borders. For companies that already have the import and export rights prior to July 1st 2004, there is no requirement for them to go through the recordal / application procedure. However, it is recommended that entities established before July 1st 2004 still go through the recordal / application procedure, even though it is officially not necessary, due to problems they might encounter with the customs and other authorities.

New Rules Effective from June 1st 2004 for Commercial Enterprises for FIEs
(Otherwise known as FICE - Foreign Investment in the Commercial Enterprise)

Equity Holding

Generally there is no restriction on foreign equity holding in FICE's after 11th December 2004. A maximum equity holding of 49% is imposed for any single foreign investor who has opened a total of more than 30 shops in China dealing in goods such as books, newspapers, automobiles, medicine, agricultural chemicals, chemical fertilizers, refined oil, sugar, cotton and such goods of different brands which are sourced from different suppliers.

Import and Export Rights

FICEs in the retail business are allowed to import products on its own account and export products procured from within China. FICEs in the wholesale business are allowed to import and export goods regardless of the producer of the goods. The import and export rights are subject to the restrictions on goods stated above.

Domestic Distribution Rights

The measures do not impose any restriction on the trading of products on the basis of whether the FICE manufactured the products or not. FICEs are subject to restrictions on goods stated above.

Foreign investors are allowed to conduct domestic trading by setting up foreign invested commercial enterprises. This includes being able to conduct import and export and have distribution rights. It should be clarified that if a company has distribution rights, they automatically have I/E rights meaning they do not have to go through an I/E agent. If a company has I/E rights, it does not mean they have distribution rights. The company must apply for this either by adding to the business scope or establishing a new entity. This leads to the second rule whereby existing non-commercial FIEs (e.g. a manufacturing FIE) are allowed to engage in the commercial field by expanding their business scope.

Type of Business Available (Able to apply for a combination in the business scope)
1. Wholesale: Sale of goods to retailers, industrial customers, other wholesalers (i.e. not to the final consumer) - Otherwise known as a General Trading Company
A trading business scope is able to include technical services and engineering as long as it is related to the products that they trade in.
2. Retail: Sales of goods for consumption and use of individuals
- At fixed locations (=stores/shops)
- Through television, telephone, mail order, internet, vending machines
3. Franchising
4. Agency Business: Sale of third parties' goods on their behalf

Structural Issues with the New Law

FIE manufacturing companies are now able to include "trade" into their business scope. This entails them to be able to trade products that they do not produce in China. Companies in WaiGaoQiao Free Trade Zone (FTZ) are able to distribute without having to be located in a FTZ and are able to combine international trade with domestic trade Since the implementation rules have not been published thus far the domestic trade is still a grey issue.

Companies that have an existing structure in China
Option 1: Use a single structure
If a company decides to use a single structure, then the company will be using only one entity to conduct all business functions including distribution. The company would have to establish a new FICE and close the existing trade or production structure and any other distribution entities. Another possibility would be to convert the business scope of the existing entity to include the allowable business scope of FICE.

Problems with this option are that they would not enjoy the customs duty deferral permitted in the FTZ. Another point, which will need to be clarified in the implementation regulations is whether the company would lose their preferential tax rates. It is assumed that it depends on the ratio between the manufacturing and distribution divisions of the FICE. If a company's revenue exceeds 50% from the manufacturing division then they will be able to keep the preferential treatment of "After the first profit-making year, 0% tax for the first 2 years, and then half the tax rate for the following 3 years." If trade exceeds manufacturing in terms of revenue then the company may lose out on this treatment.

Option 2: Parallel Structure
If a company decides to have a parallel structure, ie. keep the existing entity or entities and open a new FICE, which handles the exclusive distribution for the company then there is the benefit of the lower income tax rate and the deferral of customs and import VAT in the FTZ, however the management costs increase as well as the expenses due to the second entity. It is still not clear whether a FICE can obtain the VAT refund if they export outside of China. It is hoped that the implementation rules will verify this point.

If a manufacturing company already exists in China, it is difficult to include the distribution function. It is advised that if the company has only 1 entity in China, then they add to the business scope and also increase the registered capital. If the company has several entities in China, it would be advisable to establish a new FICE to be in charge of the distribution for the entire company. Several factors have to be planned such as tax efficiency and expenses.

Advantages of the new laws for Foreign Investors
Foreign investors will be able to access the market in the commercial sector. The new law impacts the internal structure of MNC's China operation by:

- Improving the control over the supply chain
- Establishing their own distribution network
- Exercising better credit control
- Consolidating procurement and sales
- Gaining experience, competent people and business connection to operate in
China

Approval Competence at Present

Wholesale commercial enterprises are firstly approved on the provincial and municipal level and then passed onto the Ministry of Commerce (MOC) in Beijing. This process is estimated to take 4 to 5 months rather than 2 to 3 months. Approval is only necessary on the provincial level if the company falls into one of the following categories:

- Retail enterprises to open stores within one province or municipal city and business scope not involving sales via television, telephone, post, internet or vending machine.
- Not more than 3 stores, each with less than 3,000sqm business area and a total number of similar stores in China must be less than 30
- Not more than 30 stores, each with less than 3,000sqm business area and a total number of similar stores in China should be less than 300
- Sino-foreign equity or cooperative joint venture commercial enterprise (Majority Chinese interests; Chinese owned trademark/trade name; business scope not involving refined oil, pharmaceutical products, automobiles, tobacco, etc.)

It is recommended to obtain professional advice on the new structures available to companies.

If you require assistance with the above subject, please contact us at info@klako.com with your detailed questions.

All information in this report is verified to the best of our ability and is assumed to be correct at time of release; however, Klako Group does not accept responsibility for any losses arising from reliance on the information provided within.