June 2003

Foreign business establishments in China can take four main forms:

1) Representative Offices
2) Branches of foreign companies
3) Joint Ventures and
4) Wholly Foreign Owned Enterprises.

Many factors influence a foreign investor's choice: The industry, the scope of activities in China, and the necessity to have a Chinese partner, either due to legal requirements or in order to gain access to the market and benefit from the partner's experience.

Establishing a Representative Office is the most popular approach. However, the range of permitted activities is very limited. Representative Offices may not be involved in direct business activities. In practice, there are Representative Offices that do not comply with these limitations and thus may face legal consequences.

For foreign investors planning to legitimately engage in profit making business activities, the only options are either a Joint Venture with a Chinese partner or a Wholly Foreign Owned Enterprise.

Branches of foreign enterprises exist only in theory and there are no rules and regulations for implementation.

Very often, investors prefer Wholly Foreign Owned Enterprises to Joint Ventures, because they have full control over their business. However, in certain industries a Wholly Foreign Owned Enterprise cannot be established - although the number is steadily decreasing. And there are investors who choose to form a joint venture with a Chinese partner for strategic reasons. Generally speaking, however, the popularity of WFOEs is increasing, mainly because establishing a WFOE has become much easier than in the past.

Representative offices

Representative Offices, under Chinese law, may not carry out direct business activities. This means that they should not directly generate profits. Representative Offices may establish and arrange contacts, liaise with authorities and business partners, render advice, prepare market studies, and collect general information. Billing clients or signing contracts are not permitted activities. Representative Offices may promote, but selling is not allowed.

Since these activities do not directly generate income, investors argue that Representative Offices should not be taxed. The tax bureau, however, does not agree. Representative Offices must pay business tax and foreign enterprise income tax. Income tax for Representative Offices is calculated in various different ways. Usually based on the office's turnover, income tax is paid at a rate of a little less than ten percent of the office's overhead. There are exceptions however. If it can be proved that the parent company is a manufacturer and the Representative Office is used for purchases in China, it can obtain an exemption.

The transparency of China's legal system is improving and authorities are increasingly enforcing the law. It definitely pays to do things correctly. The closure of a Representative Office can be a lengthy and complicated process if it is not done the right way. This is especially the case if establishing the office was not originally done entirely in accordance with the law, but rather through "back-door" connections.

Joint Ventures

Equity Joint Ventures

There are two types of joint ventures - Equity Joint Ventures and Cooperative Joint Ventures. The Equity Joint Venture is the older type, which provides less flexibility. An Equity Joint Venture always takes the form of a limited liability company. This shields the personal property and wealth of the responsible individuals from corporate loss.

The allocation of profits is the most significant difference between Equity Joint Ventures and Cooperative Joint Ventures. In Equity Joint Ventures, the ratio of capital contributions made by the partners determines how profits are allocated. If one party contributes 40% of the total capital investment, they will receive 40% of total profits.

Most manufacturers prefer Equity Joint Ventures as an investment vehicle. Before making a decision which type of joint venture to choose, the purpose of the investment must be clear.

Cooperative joint ventures

Cooperative Joint Ventures offer more flexibility. They can be organized either as a limited liability company or as a non-legal person, in which the partners are subject to unlimited liability and thus entirely liable for any losses the joint venture may incur. Most Cooperative Joint Ventures are established as limited liability companies.

Unlike Equity Joint Ventures, Cooperative Joint Ventures allow for profits to be allocated according to the partners' discretion. One party may recover its investment through an accelerated repayment structure, and the other party may become the owner of the joint venture's assets after termination of the joint venture.

The legal system in China and the business climate are changing in favor of Wholly Foreign Owned Enterprises and the restructuring of joint ventures. Joint ventures can be restructured into WFOEs. In another scenario, the Chinese side may be transformed into a "silent partner" without significant decision-making powers by reducing their equity stake. To change the equity structure, the foreign investor may contribute additional capital without the Chinese partner increasing their original investment.

The Ministry of Foreign Trade and Economic Cooperation must approve any type of equity change. There are a few sensitive industries, in which 100% foreign ownership is not permitted and the Chinese partner must be the majority holder.

Wholly Foreign Owned Enterprises

International investors wishing to manufacture, process, or assemble in China generally chose a Wholly Foreign Owned Enterprises (WFOE's) as their investment vehicle. In the past, foreign investors in industries that were not high technology or export oriented had to establish joint ventures with Chinese partners instead of Wholly Foreign Owned Enterprises. The changing legal framework, however, opens the possibility of setting up a WFOE to businesses in other sectors, specifically the service sector.

Wholly Foreign Owned Enterprises are limited liability companies established under Chinese Company Law. WFOE shareholders are 100% foreign - typically an international business. The total value of registered capital injected into the business, which may be cash and equipment, determines the extent of the WFOE's liability. Registered Capital Requirements vary from industry to industry and from region to region. The basic investment criteria, however, do not change: The Foreign Investment Bureau assesses the general viability and reasonable cash requirements of the project.

Using an offshore company for investments in China

There are many good reasons for foreign investors to use offshore companies for their China investment activities. One important advantage is the limited liability provided by offshore companies. This removes the risk from the valuable parent company. The flexibility of offshore corporate law gives the investor the option to sell the China investment by transferring the offshore entity, rather than the stake in the Chinese entity, which is a much more complicated process due to Chinese bureaucracy.

Most importantly, investors may use offshore entities for tax planning purposes. Significant tax savings can be achieved by carefully arranging financial affairs. However, some schemes may constitute illegal tax evasion and investors must take great care when setting up in these jurisdictions. Examples of offshore jurisdictions include the Cayman Islands, British Virgin Islands, Samoa and Mauritius. Due to its special status and proximity to the mainland, Hong Kong is also very popular among investors.

Major investment zones in China

There are several types of investment zones in China. The so-called "Special Economic Zones", encompassing individual cities in Southern China, namely, Shenzhen, Xiamen, Hainan, Shantou and Zhuhai are the largest ones. Their legislation is different and the corporate income tax rate is reduced from 33% (the rate in other regions) to 15%. Various eastern seaboard cities, provincial capitals and selected cities in border regions are so-called "Open Cities". This is another type of investment zone with many sub-zones offering tax incentives comparable to those of Special Economic Zones. "Economic and Technological Development Zones" are tailored to technology intensive industries. The power of local authorities to approve projects is greater and tax incentives reduce corporate income tax to between 15 - 24 percent, depending on the timeframe of an enterprise. Other very similar zones are the "High Tech Development Zones", for which the Ministry of Science administers tax incentives. "Free Trade Zones" are mainly used for warehousing and processing. Imports and exports enjoy duty free status and foreign exchange regulations are relaxed.

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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.