May 1st 2007, China released a new Franchise Regulation (Regulations on the Administration of Commercial Franchises). It replaces the existing Commercial Franchise Measures that were implemented on February 1st 2004. The New Regulations introduce several significant changes to the legal framework set up under the 2004 measures.

Franchises are proven to be the most successful way of starting a new business in China, even if the term "franchising" is only vaguely understood and its limits as a business model here are ill-defined. Franchising is a system with its own terminology and that may be where some of the confusion arises in China.

Market Development

There is no surprise that in the most rapidly growing economy in the world, the franchise sector will represent 30% of China's total retail sales within the next five years. At the end of 2006, 168,000 franchise stores were operating in China with 2,600 franchisees in over 60 different industries. The market has been growing at a year-on-year rate of 40 to 50%. Franchises are developing in wide range of industries. Currently the top franchise industries in China are convenience stores, car repair and maintenance shops, home decoration stores, real estate companies, education and training companies, health and beauty facilities, food and beverage eateries, laundry shops and clothing stores.

Examples of successful global franchise systems in China include Subway, TNT, 3M, Cambridge English, Century 21, DIO Coffee and Starbucks Coffee. As two of the most famous franchise systems in China and around the world, Kentucky Fried Chicken (KFC) began operating in 1987 and McDonalds in the 1990s. Both waited until 2000 to begin franchising. Today the minimum start-up cost for a McDonald's franchise in China is approximately RMB 3 million (USD 375,211) with restrictions on borrowed finance capital.
KFC requires an estimated USD 1 million in franchising fees from regional franchisees. In addition to a regional franchising fee as high as USD 2 million, Dairy Queen requires to have marketing and operation expertise in the food, retailing or service industries.

Reasons for Franchising

China's consistent market growth corresponds with its franchise growth and with the new regulations there is even greater potential for China market seekers. As the urban and rural per capital disposable income is consistently on the rise, people have the opportunity to purchase more, offering companies the market potential. As a consequence, franchising has become a popular method of investment as less capital is required on the side of the franchisor and there are easier government regulations then when establishing ones own entities all over the country. Chain stores, such as Starbucks, use franchising as an expansion method for national sales because the country is so large and they do not have the resources to expand at such a quick pace. At the same time, many companies looking for physical distribution of their products would require to setup franchises because they themselves are not familiar with the market and possibly cannot obtain distribution licenses by the Chinese government.

Naturally there is always a risk, particularly in China. Without protecting ones own trademarks, copyrights and patents, franchising can become a risk. Foreign franchisors want to ensure brand quality but are concerned that their knowledge, expertise, reputation and management skills may be in threat if they hand it over to the franchisee. However if a secure and risk-proof franchise contract is in place, then these can be diminished. An important point is to not become too dependent on the franchisee.

Considerations before entering into a Franchise

It is a mistake to consider China as one market, particularly as language, culture, development and consumer taste will vary across provinces in China, same as they do globally. The potential for a foreign franchised product or service in any of China's regional markets will depend upon timing, local taste, local economy, and of course, local competition, which should not be underestimated. McDonalds adapted its menu by including a "Bag Breakfast" for Chinese consumers.

Corporate structure considerations are key in China, particularly where fewer sectors are being constrained by foreign investment, and where structure, once chosen, will determine the franchisor's flexibility for control, financing, foreign exchange, import, licensing and repatriation of franchise fees. This is then followed by financing as many foreign franchisors underestimate the investment necessary to establish their brand in one or more of China's regional markets.

The next issues are local influences. Success or failure for the foreign franchisor in China can depend critically upon an initial choice of a franchise partner(s). In order to choose the most beneficial one, due diligence is highly recommended. Careful attention and observation is required in conducting any type of business in China and in order to develop strong ties with the franchisee, a "hands-on" approach is required in China.

Definition of a Franchise in China

The new Franchise Regulations defines clearly a commercial franchise as the following:
"A franchise is involved in business activity in which the franchisor possesses business resources, such as registered trademark, business logo, patent, or know-how, and confers usage of these resources to the franchise through execution of a contract; the franchisee operates under the contract in accordance with a uniform model of business operation; and the franchisee pays franchise fees to the franchisor."

The confusion for local business people is that they do not expect to have to pay for brand rights and do not want to have to pay to enter into a franchise. They understand a franchise as a joint venture type structure, which it is not. It should be clearly understood that a business relationship is a franchise when the following four basic elements exists:

- the franchisor must be an enterprise and possess such business resources as a registered trademark, business logo, patent or know-how;
- the franchisor confers to the franchisee the right to use its business resources through a contract;
- the franchisee does business under a uniform model of operation (for example, system of management, promotion, quality control, design and layout of store, logo, etc); and
- the franchisee pays a required fee or fees to the franchisor.

Regulations for Franchisors

The new regulations do not impose any further requirements for Foreign Invested Enterprises (FIEs), implying that FIEs are subject to the same franchising rules as Chinese franchisors.

In the 2004 Measures, one of the pre-requisites what that before engaging in franchising in China, franchisors had to operate a minimum of two "directly-owned" stores for at least one year in China ("the 2-stores-1-year rule"). The new regulations indicate that cross-border franchise operations are possible, meaning that the two directly operated stores no longer need to be located in China. This may imply that foreign franchisors who meet those requirements but have no operations in China (i.e. have two qualified locations abroad) can also apply.

The new regulations do not specify any other information concerning cross border franchising. Although the new regulation cancels previous additional filing requirements and does not require the franchisor to be incorporated in China, it is still not clear whether cross-border franchising is allowed. This may be subject to discretion by the approval authorities.

Regulations for Franchisees

All qualifications for franchisees contained in the 2004 measures are cancelled by the new regulations. Individuals can also be franchisees. All franchisees are required to keep franchisor's trade secrets confidential, both throughout the duration of the franchise contract and following its termination or expiration. Franchisees may not transfer a franchise to others, or continue to use the franchisor's trademark, trade name, patent and know-how after expiration or termination of the franchise contract, unless agreed upon by the franchisor.

Other Major Items for Consideration

- Franchise contract duration and requirements
The contract period should not be less than three years, unless otherwise agreed to by the franchisee. This does not apply to extensions of a franchise agreement.
During the period of the franchise contract the franchisee can unilaterally withdraw from the contract. This provides the franchisee with more freedom, however there is no indication of any associated liabilities if the franchisee cancels the contract.

- Franchising Fees
The new regulations imply that franchisors and franchisees are allowed to establish their own fees. However, it is recommended to check the implementation rules. For the establishment fees, a written letter must be drafted by the franchisor to explain what the designated fees are for and what the timeframe for payment is. The new regulations forbid franchisors to publish advertisements promising profits to franchisees.

- Information Disclosure requirements
At least 30 days before the franchise contract begins, the franchisor has to provide the franchisee with all essential information for running the business (which must be all included within the contract). Any economic loss incurred by the franchisee caused by retention of information or false information or omission in connection with required disclosures by the franchisor, will result in the franchisor bearing all liabilities and the franchisee has the right to rescind the contract.

- Penalties
Heavier penalties have been implemented. The new law raises the maximum permissible fine from RMB 30,000 (USD 3,800) to RMB 500,000 (USD 64,200).
If a franchisor does not satisfy the criteria of the "2-stores-1-year-rule", the fine will be assessed by RMB 50,000 - RMB 500,000 (USD 6,400 - 64,000).
It is important to note that the new regulations do not stipulate any penalties on franchisees.

Tax Issues for Franchises in China

In order to minimize the overall tax burden, it may be desirable to break a franchise arrangement into different components. For example, one component of the franchise arrangement may involve offshore services to be rendered by the foreign franchisor and fees for these services should not be subject to Chinese taxes. However fees for services rendered within China are clearly taxable in China.

A typical licensing arrangement would require franchisees to make periodic royalty fee payments to franchisors for the use of trade names or trademarks. Currently China tax laws impose a withholding tax of between 10-20% on royalties, subject to whether a double taxation treaty applicable to the franchise arrangement. In addition there is the 5% Business Tax which will be applied to royalty payments remitted abroad. All of these taxes will burden the flow of royalty type fees remitted abroad to a foreign franchisor from China.

If a franchisee requires support in China from the franchisor, such as management or training arrangements, franchisors may be pushed to create permanent establishments in China. If permanent establishments are established, such as Wholly Foreign Owned trading or service companies, the franchisor will be subjected to income tax on the income generated by these services. Starting from January 1st 2008 the income tax will be unified at 25%.

Future Outlook

Thus far the implementation rules have not yet been distributed. There seems to be quite a few inconsistencies between the new regulations and the old measures. It is expected that implementation rules will vary from location to location and possibly even from establishment to establishment, depending on the reputation of the franchisor.

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.