China: New Regulations Make It Easier For Foreign Multinationals To Establish Regional Headquarters In Shanghai

On July 20, 2002, the Shanghai municipal government signaled its intent to establish Shanghai as the preferred city for regional headquarters ("Regional Headquarters") of multinational companies by issuing Tentative Provisions on Encouraging the Establishment of Regional Headquarters by Foreign Multinational Corporations (the "Tentative Provisions"). The Tentative Provisions, as further clarified by implementing rules issued in March 2003 (together, the "RHQ Rules"), lower the threshold for establishing a Regional Headquarters in Shanghai and make it a more attractive base for the "mind and management" of foreign multinational companies managing projects in Asia.

Under the RHQ Rules, a Regional Headquarters is defined as the sole regional head office of a foreign multinational company that conducts overall management and service functions for other existing enterprises in a multi-country region. The RHQ Rules require that a Shanghai-based Regional Headquarters be the only one in China or the region, thus placing Shanghai in direct competition with Beijing, Guangzhou and other cities in Asia.

Under the RHQ Rules, a Regional Headquarters in Shanghai must meet the following conditions:

1. it must have "independent legal person" status;
2. its parent company's total assets must be at least U.S. $400 million;
3. its parent company must have a minimum of U.S. $30 million invested in China; and
4. it should invest in, or be authorized to manage, no less than three enterprises in China or abroad and should have management and service authority over such managed enterprises.

The RHQ Rules imply that at least one of the managed enterprises must be a non-China entity. However, it appears that such a requirement is not currently enforced by the Shanghai Commission of Foreign Trade and Economic Cooperation (the "Shanghai COFTEC").

The RHQ Rules further provide that foreign multinational companies that do not satisfy all of the conditions listed in (a) through (d) above, but have made "extraordinary contributions" to the region's economy, may also be approved to set up Regional Headquarters in Shanghai. Our informal discussions with officials of the Shanghai COFTEC reveal that it has discretion in evaluating what constitutes extraordinary contributions. It is clear, however, that such contributions must go beyond simply providing advanced technology, management expertise or new products. Shanghai COFTEC sees these three areas as normal contributions of any foreign-invested enterprises.

A Regional Headquarters may be in the form of a wholly foreign-owned investment company (a holding company) or a wholly foreign-owned management company (a management company or another enterprise form approved by the Shanghai government). In addition, the RHQ Rules require that:

• Existing holding companies established under the Provisional Regulations on Establishment of Holding Companies by Foreign Investors promulgated by the Ministry of foreign Trade and Economic Cooperation (MOFTEC) must apply for recognition as an RHQ; or
• If a holding company has not been established, an application may be made to form a foreign-owned management company, which must have minimum registered capital of U.S. $2.0 million.

The primary benefit of a management company is that it provides an opportunity for multinational companies to establish a Regional Headquarters in Shanghai with a relatively small investment. Multinational companies that have not previously established holding companies in China, or have established holding companies in cities other than Shanghai, should consider setting up management companies.

Establishing a Management Company

The RHQ Rules set out the procedures for establishing a management company. In particular, they require a foreign investor to submit the following documents to the Shanghai COFTEC for approval:

1. an application report, a feasibility study report and articles of association for the establishment of the management company executed by the foreign investor;
2. documents authorizing the basic functions of the management company executed by the foreign investor;
3. documents concerning the creditworthiness of the foreign investor, the registration document of the foreign investor and the legal representative's identification documents;
4. balance sheets of the foreign investor for the latest three years;
5. approval certificates, business licenses and capital verification reports of the enterprises in China in which the foreign investor has investments;
6. authorization documents for the proposed legal representative of the management company executed by the foreign investor, and the resume and relevant identification documents of the proposed legal representative;
7. the relevant proofs and tax payment receipts, if the foreign investor intends to contribute its profits in renminbi to the registered capital of the management company; and
8. any other documents required by the Shanghai COFTEC.

A Regional Headquarters, whether in the form of a holding company or a management company, may engage in the following operations, management and services:

1. investment and operational decision making;
2. marketing and sales services;
3. capital (i.e., treasury functions) and financial management (i.e., accounting functions);
4. technical support, research and development;
5. information support and services;
6. employee training and management; and
7. other operational, management and service activities as permitted by law.

The capital and financial management functions of a Regional Headquarters are limited to operating a centralized internal capital management system, managing or allocating funds, or coordinating funds utilization among managed enterprises. A Regional Headquarters may enter into a three-party agreement with a commercial bank and the managed enterprises to achieve such purposes. However, a Regional Headquarters may not engage in manufacturing activities and a management company may not engage in investment activities.

Our discussions with officials of Shanghai COFTEC reveal that the Shanghai government is aware that current legal requirements (for example, the rules governing foreign exchange control) may make it difficult for a Regional Headquarters to manage entities in other countries. Therefore, we believe it is likely that what is required in practice for Regional Headquarters to manage an overseas entity may not be as strict as what is contained in the RHQ Rules.

In addition to the permitted activities, Regional Headquarters enjoy the following benefits:

1. Regional Headquarters with research and development functions enjoy the same preferential benefits as hi-tech enterprises;
2. Regional Headquarters whose incorporation and tax registration are in Pudong New Area will enjoy preferential tax treatments applicable in Pudong. Pudong has issued a set of preferential policies applicable to Regional Headquarters. (We understand that these policies are in the process of being streamlined and revised to reflect Pudong's intention of granting Regional Headquarters more preferential tax treatments than those provided to other enterprises in Pudong, and to refund Regional Headquarters all or substantial portions of income tax, business tax and VAT that Pudong will have received in the first few (probably three) years after the recognition or establishment of the Regional Headquarters, for supporting Regional Headquarters' development. Notably, the new policies would probably make an innovative step in providing for refunds of individual income taxes that Pudong will have collected for supporting employee training expenses);
3. when calculating operating profit, Regional Headquarters will be able to deduct their actual payroll as operating costs, without any restriction on the amount of such deduction;
4. Regional Headquarters that establish multinational purchase and logistics centres in Shanghai will be able to obtain import and export rights, and will enjoy VAT rebates for exported goods.
5. Foreign employees and visitors sent to the Regional Headquarters will be able to obtain employment visas or visitor visas valid from between one and five years;
6. Regional Headquarters that provide employees with training in key job skills may qualify for government subsidies; and
7. a Regional Headquarters may centralise the management of its internal finance system for the regional enterprises under its control.

In addition to the benefits described above, Shanghai-established Regional Headquarters that are holding companies are, in theory, able to manage overseas affiliates and affiliates in which the holding company has not invested, which may not be the case for holding companies not registered in Shanghai.

The RHQ Rules demonstrate the Shanghai government's commitment to compete with other cities in Asia and strengthen Shanghai's image as a regional management, service and financial centre for multinational companies. Whether the new legislation will be effective in helping Shanghai attract more multinational companies to set up headquarters there will depend on how well Shanghai's new legislation works with national laws and regulations, and whether the various central government departments in charge of taxation, customs, foreign exchange and banking, among others, share the same commitment as the Shanghai government.

About DWT
Being the first U.S. law firm to obtain approval from the Ministry of Justice to set up a representative office in Shanghai, China, we have extensive experience in assisting U.S. companies in their investment projects in China. Depending on your business needs and applicable legal and investment environment in China, we can provide:

• Legal analysis for investment and management structure
• Legal due diligence
• Document preparation in English and Chinese
• Contract negotiation
• Licensing agreements and other agreements for intellectual properties such as trademarks, brand names, technology and software
• Advice on approval procedures and related matters
• Advice and documentation of employment related matters for your operation in China, including employment contracts, non-compete, non-solicitation and confidentiality agreements
• Legal compliance matters for your operation in China, such as taxation, social benefits and insurance and other statutory requirements
• Legal training for Foreign Corrupt Practices Act regarding its impact on China operations of U.S. companies

This China Practice Advisory is a publication of the China Practice/Shanghai Office of Davis Wright Tremaine LLP. It is not intended, nor should it be used, as a substitute for specific legal advice as legal counsel may only be given in response to inquiries regarding particular situations.

Copyright © 2003, Davis Wright Tremaine LLP.