China: The Dragon Comes Calling!

Last Updated: 25 May 2006
Article by Andrew Lui

It seems everyone wants a piece of China. China was the world's number two destination for foreign investment in 2004 drawing a record US$61 billion for two years running in 2004 and 2005. With a population of 1.3 billion and GDP growth of 8.1%, China is set to be the second largest economy in the World by 2020, behind only the USA.

Having said that, the nature and extent of foreign investment allowed in China is still heavily regulated by the Chinese government. China is an enormous market abounding with opportunities, offering foreign investors in all trades a vast horizon for development. However, the business environment of China is different from other countries in many aspects such as trade laws, investment approval procedures, import-export administration and taxation. Moreover, in the process of market opening, China has been constantly amending its trade-related laws and regulations, often leaving foreign investors interested in developing the mainland market at a loss. The following sets out in broad terms the considerations for starting up in China but any foreign company hoping to get a piece of the action in China should seek specific advice if contemplating a move into the China market.

Industry sectors in which foreign companies may participate are divided into categories of "permitted", "encouraged" and "restricted". No foreign investment is allowed in "prohibited" categories such as media and mass communication. The last 4 years of liberalisation have seen many "restricted" industries re-categorised as "permitted". These include financial, insurance and foreign exchange consultancies, manufacture of consumer products. Previously "prohibited" sectors such as banking, telecommunications, retail publication, gas, heat and water supplies are now in the "restricted" category.

Investors in "encouraged" sectors (for example, oil and gas exploration, automobiles, wholesale and retail of ordinary commodities) are given incentives such as exemptions from importation VAT and from customs duties on the importation of equipment.

Foreigners carry on business in China through investment vehicles called "Foreign Invested Enterprises" or "FIEs". These may take the form of a representative office ("RO"), a Wholly foreign-owned enterprises ("WFOE") or a joint venture.

The RO is the quickest and cheapest way to set up in China. It is typically used for testing the market. An investor who wishes to do more than just marketing or coordination would have to set up a WFOE or a joint venture. WFOEs are popular for a number of reasons - the investor has more control over the running of the company and over the protection of its intellectual property, plus the WFOE structure obviates the need for a Chinese co-investor, although a foreign investor could also jointly establish a WFOE with another foreign investor (WFOEs are not required to be wholly-owned by one foreign investor). In "restricted" industries where WFOEs are not usually allowed, the foreign investor might have to set up in joint venture with a Chinese co-investor. Disadvantages of the joint venture include capping of the foreign investor's share in some industries which means the foreign investor cannot hold a controlling interest in the company. Approval for sino-foreign joint ventures is easier to obtain if the Chinese party is a large state-owned company or one with a good relationship with local authorities. FIEs may in certain circumstances acquire interests in domestic Chinese companies.

FIE's are generally established as limited liability companies, with liability restricted to the amount of capital contributed by each investor. Chinese law (both nationally and locally) may regulate a number of aspects of an FIE, including its capitalisation and its gearing. Capital contributions need not be made in full up front (although they can be), but depending on capitalisation can be made anywhere between six months and three years from the issuance of the business licence.

It is expected that the foreign party will contribute cash, although other assets such as machinery and intangible assets like patents can be contributed subject to limitations (for example, intellectual property may not comprise more than a certain percentage by value of the foreign investor's share of the capital). The application process for an FIE can take anywhere from two to six months, the timescale varying from city to city within China. The rules also change if an FIE is located in a Free Trade Zone (of which there are a number throughout China).

FIEs generally pay 33% tax (30% on national level and 3% on local level) on net income on both domestic and foreign income sources but FIEs established in special zones pay less tax. For example, FIEs in a Special Economic Zone or Economic and Technology Development Zone only pay 15% tax. Hi-tech enterprises setting up in the Beijing Hi-tech Experimental Zone are exempt from tax for 3 years and allowed a 50% reduction in tax for the following 3 years. Production-oriented FIEs only pay 24% tax, are generally exempt from paying tax in the 1st and 2nd profit-making years and are entitled to 50% reduction in tax in the 3rd to 5th profit-making years.

A key factor to bear in mind is that the Renminbi, the Chinese currency, is not freely convertible and all foreign exchange activities are subject to approval by the State Administration of Foreign Exchange. A foreign investor can repatriate profits (usually by way of dividend) back to its domicile upon audit of the FIE and payment of all due salaries and taxes (such as enterprise income tax). In light of China's exchange control provisions, repatriation must go through a government agency.

Since China's accession to the World Trade Organisation in December 2001, it has clearly become easier for foreigners to do business in China due to the gradual market access liberalisation for foreign investors over the past four years. Investor confidence should also be boosted by the introduction of China's new Company Law which came into force on 1 January 2006. This brings significant modernisation to Chinese Company Law by improving corporate governance, enhancing shareholders' rights and recognising the common law principle of "piercing the corporate veil".

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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