Retail and Wholesale Markets Open Slowly to Foreign Investors

Article by Gerry Deyell and Andrew Pollock, ©2005, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on International Trade - November 2005

Until very recently, the ability of foreign companies to engage in wholesale and retail trade in China has been extremely limited. Companies with an established production operation in China have always been able to import raw materials and have been encouraged to export their products, but access to the wholesale and retail markets by foreign investors was limited by geographic barriers, requirements that foreign companies engaging in such activities have large international annual sales volumes and extremely high registered capital requirements. In addition, foreign investors were forced to partner with a Chinese company in order to establish a retail or wholesale operation and the Chinese partner was subject to similarly stringent entry requirements. Generally, the market was closed to all but the largest international players who were able to work with Chinese companies that could fulfill the domestic capital adequacy requirements or who had good political connections. Most foreign enterprises were effectively excluded from engaging in any retail, wholesale or agency activities.

In line with China’s WTO obligations, the Ministry of Commerce enacted the Administration of Foreign Investment in Commercial Sectors Procedures (the Procedures) last summer. At that point, geographical restrictions were lifted and capital adequacy and sales volume requirements were significantly reduced. However, it was not until December 2004 that ownership restrictions were lifted and foreign investors were allowed to establish wholly owned commercial enterprises. Despite an initially slow response by the authorities to granting approvals, a number of approvals have now been given.

Under the Procedures, foreign investors are allowed to establish commercial enterprises in China in the following forms:

One. Commission Agency Sales, which involve the sale of goods of third parties by sales agents, brokers, auctioneers or wholesalers and the provision of related services;

Two. Wholesaling and the provision of related services;

Three. Retailing, either from stores or by way of television, mail order, the Internet or vending machine sales, and the provision of related services; and

Four. Franchising.

As noted, entry to the wholesale and retail sector was limited by extremely high registered capital requirements. Minimum capital requirements under the Procedures are now in line with Company Law requirements and, as a result, it is only necessary to contribute RMB500,000 (approximately USD62,000) to establish a wholesale operation and RMB300,000 (approximately USD37,000) to establish a retail operation. There are, however, a number of requirements that could pose problems for potential investors. Under the Procedures, the foreign investor must enjoy "high prestige", which is a vague concept open to administrative interpretation and discretion. In addition, the Procedures provide that foreign investors with "economic strengths, advanced commercial management experience and marketing technology and an extensive international sales network" will be encouraged to invest in commercial enterprises. Again, this is a vague concept that could be applied to limit market access.

The Ministry of Commerce is in charge of approving commercial ventures in China and the application process, although similar to the application for other types of foreign invested enterprises, is somewhat simplified and streamlined, at least in theory, to the extent that there are fewer than the usual number of agencies to deal with. There are, however, a number of documentary requirements that are not standard for other types of foreign invested enterprises. Chief among these is the requirement that foreign investors submit an audit report for the previous year. In addition, where a commercial venture wishes to establish retail shops, it must obtain confirmation from local authorities that such shops are in compliance with urban development and urban commercial retail requirements.

Foreign invested enterprises that already have a presence in China, that are in good standing and are fully capitalized may apply to increase their business scope to include commercial activities. At present, foreign invested production enterprises established in China are entitled to reduced taxes as incentives to investment. Although the Provisions allow for such production enterprises to expand their business scope to include commercial activities, there is a danger that such expansion could lead to the loss of tax incentives. For example, if a production enterprise increased its scope of business to include wholesaling within China of products produced by a parent or affiliate and the profits of such enterprise shifted from production profits to wholesaling profits, it could lose tax exemptions and reductions otherwise available. Given recent discussions about harmonizing corporate income tax rates to remove the incentives available to production based foreign enterprises, this may not be a principal concern. Nonetheless, some tax planning should be undertaken before deciding whether to convert an existing foreign invested production enterprise into a mixed production/commercial enterprise or whether to establish a brand new entity for commercial purposes.

In general, the Provisions will allow foreign invested enterprises in China an expanded level of control over their import and export functions and management of the supply and distribution chains. However, despite the opening trend evidenced by the Procedures, there are still a number of areas in which foreign participation is limited or prohibited: (a) distribution of books, newspapers and periodicals is still subject to separate state regulation; (b) foreign invested gas stations and distributors of automobiles will continue to be subject to separate regulations; (c) the sale of pharmaceuticals will continue to be subject to state regulations; (d) even though wholly owned enterprises are allowed in the commercial sector, foreign investors will not be allowed to hold more than 49 per cent of the enterprise where (i) the aggregate number of stores opened by the foreign invested company in China exceeds 30; (ii) the enterprise deals in merchandise including books, newspapers, magazines, automobiles, pharmaceutical products, agrochemicals, mulching films, chemical fertilizers, processed oil, cereals, vegetable oils, edible sugars and cotton; and (iii) such merchandise is obtained from different suppliers; (e) neither wholesalers nor retailers may currently sell tobacco, and there is no indication that this limitation will be lifted; and (f) direct selling is still heavily regulated and access is limited while pyramid sales are prohibited.

Although the Procedures, on their face, seem to open up the retail and wholesale markets considerably, we have not yet seen an influx of retailers into China. Foreign companies applying to establish wholesale distribution centers for their own products seem to have comprised the bulk of investors applying to enter the field or at least the bulk of those foreign investors that have received approval to establish commercial enterprises. The Procedures offer such enterprises significantly more flexibility and control over their operations. There is some concern that requirements for local approval and some of the more vague application criteria will lead to retail protectionism and that local retailers will be preferred over foreign companies. Such requirements may violate China’s WTO market access commitments. It is still too early to make a judgment in this regard. Nonetheless, the Provisions provide further evidence of China’s ongoing commitment to taking steps to opening its markets and demonstrate that for all its difficulties, China continues to be one of the world’s more accessible developing markets.

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