China: 2008 Perspective – China Trends

Copyright 2008, Blake, Cassels & Graydon LLP

Identifying trends in the dynamic legal and business environment that characterizes China is a challenge. Nonetheless, the following six significant trends will have an impact on how foreign investors conduct their business in China.

1. Shift from a Manufacturing Base

China's economy and its impressive growth rate since its opening up in the late 1970s has been based upon manufacturing and export and processing trade, a system built on an abundance of inexpensive labour and tax breaks and other incentives made available to foreign investors. Now China is actively working towards transitioning from a manufacturing-based economy to one that is positioned higher on the global value chain. China's new tax laws, which entered into force in early 2008, phased out traditional tax incentives for manufacturers and exporters. The incentive structure was repositioned to allow tax breaks to companies engaged in specific industry sectors, primarily companies engaged in the development of high technology, environmental protection and energy-saving processes. Prior to the implementation of the new tax laws, a revised foreign investment catalogue was issued, the contents of which indicate the government's desire to shift the economy away from a manufacturing base and towards sustainable economic development and higher-value industries. Investors who still view China as simply a manufacturing or finishing hub may discover their investments are no longer greeted with the open arms they once were. Investors who are willing to establish research and development facilities, on the other hand, should expect a warmer welcome from the Chinese authorities.

2. Investing in Central China

The focus of foreign investment in China has traditionally been on the eastern provinces and the Pearl River Delta. With rising costs in the more developed parts of the country, investing in inland China is becoming a more attractive alternative. The Chinese government has been working hard to attract investors into the central provinces by offering tax incentives and by pouring resources into the development of information and transportation infrastructure. These policies are driven by concerns that the central region of China has not kept pace with the economic development of the east, as well as a desire to re-tool the eastern provinces as centres of innovation and value-added industry. Investors who are familiar with the lack of certainty and the need for flexibility that has often defined doing business in China should be prepared to encounter those issues in the central provinces, as those provinces work to catch up with the eastern part of the country. However, given the rising costs of doing business in those areas of China that have traditionally attracted foreign investment and the efforts being made to integrate the central part of the country into the overall economy, for investors who are willing to adapt to changing conditions there are likely to be benefits to investing in the emerging central cities and provinces.

3. Merger Regulation

On August 3, 2008, China's State Council issued implementing rules under the new Anti-Monopoly Law (AML) specifying the monetary thresholds for transactions that would require mandatory pre-merger notifications to the relevant Chinese AML enforcement authorities. The new AML that came into effect on August 1, 2008 after more than 10 years of drafting and discussion introduces a modern competition regime to China. The AML covers three main areas: (i) merger control; (ii) prohibition of abuse of dominant positions; and (iii) prohibition of monopoly agreements that restrict or eliminate competition.

In relation to merger control, which is generally of greatest concern to foreign investors, transactions that meet either of two thresholds are subject to pre-merger notification: (i) if the total worldwide turnover in the previous fiscal year of all parties to the transaction exceeded 10-billion yuan renminbi (RMB) (approximately US$1.5-billion) and the turnover of at least two parties exceeded RMB 400-million (approximately US$60-million) within China; or (ii) if the total turnover within China in the previous fiscal year of all parties to the transaction exceeded RMB 2-billion (approximately US$300-million) and the turnover of at least two parties exceeded RMB 400-million within China. In addition, even if a transaction falls below those thresholds, if there is evidence it may result in restricting or eliminating competition, the relevant AML enforcement authority may conduct an investigation.

The effect of the new AML and the associated implementing rules regarding mergers is that foreign and domestic entities seeking to enter into transactions involving Chinese entities, and indeed even transactions outside of China that have the effect of restricting competition in China, must determine whether pre-merger approval is required from the relevant Chinese enforcement agency and obtain such approval before the transaction is completed. Closing a transaction without obtaining the requisite approval could result in significant sanctions, including fines and an unwinding of the transaction.

Ultimately, the real test of the merger control provisions and the pre-merger notification requirements will be in the implementation and application of these provisions. It won't be long before this happens – Coca-Cola's US$2.3-billion acquisition of Chinese fruit-juice maker Huiyuan announced in September 2008 is expected to require pre-merger notification and is anticipated to be a major test of the merger control provisions of the AML.

4. Employment Laws

Since the dismantling of the "iron rice bowl" under which Chinese citizens were effectively cared for from cradle to grave by the state-owned enterprises that employed them, it has been a challenge for the Chinese government to implement a broad-based social safety network. Employers have been forced to shoulder a significant portion of the social benefit cost by way of contributions to various social benefit programs. In China's largest cities, the employer cost of social benefit contributions for an employee making an average salary can equal as much as 50 per cent of the employee's monthly salary. In addition, the ability of employers to terminate employees is much more limited than in many other jurisdictions. In many cases, employer obligations have been ignored, either intentionally or through a lack of understanding of what is involved, and employees have been hesitant to take action to enforce their rights under employment law. This is changing. China recently promulgated an employment contract law that levies penalties against employers who fail to enter into written employment contracts with their employees. In addition, as the individual rights movement in China gains momentum, more and more employees are taking action against employers that fail to comply with Chinese employment laws. These actions, as well as being supported by the courts and labour tribunals, have developed a tendency to become very public in nature, causing public relations problems for the companies involved. The cost of labour in China is still relatively inexpensive and one of the key benefits of doing business in China, a highly motivated work force, still exists. Nonetheless, employers in China will need to pay closer attention than ever before to ensure their relationships with employees are conducted in accordance with law. Failure to do so could lead to costly termination settlements and unwelcome publicity.

5. Foreign Currency

China continues to struggle to find a balance between allowing the free flow of foreign investment capital into the country, trying to protect against unwelcome and potentially harmful hot-money inflows and attempting to achieve a balance of payments. Although there is still a general perception that getting money out of China can be a challenge, in reality, current foreign currency policies are much more concerned with the inflow of foreign currency and its conversion into RMB.

A number of recent regulations and circulars have been promulgated in China setting forth details as to how the supervision of foreign exchange is to be implemented by the State Administration of Foreign Exchange and its local branches (SAFE). These recent changes appear to consolidate what has been developing on an ad hoc basis over the past few years.

Typically when a foreign investor establishes an entity in China it capitalizes that entity with foreign currency. The foreign currency is held in a segregated capital account. When the foreign invested enterprise applies to a bank for the conversion of funds from its registered capital account into RMB, it must first obtain a "capital verification" report from a licensed Chinese accounting firm. A capital verification report can take up to two weeks to be issued by an accounting firm and, under the current rules, foreign currency cannot be converted from the registered capital account until a capital verification report has been issued.

Generally, RMB funds that have been converted from capital contributions may not be held by a foreign-invested enterprise in its RMB bank account, except where the funds are to be used for payment of wages and salaries and other obligations that are payable within a limited period of time. Where a conversion of foreign currency above a predetermined amount is requested, it is necessary to provide fairly voluminous documentation to prove why the funds are needed by the company. Typically a contract confirming that a payment must be made, a related invoice evidencing the required payment and a commitment letter from the company confirming how the funds are to be used are required before funds will be converted into RMB.

What is clear is that investors need to remain abreast of foreign currency policies in China in order to avoid the unpleasant (but all too common) situation of needing to quickly fund an operation only to discover that funds will not be available for weeks due to the formalities involved in converting capital contributions into local currency.

6. Intellectual Property

Effective protection and enforcement of intellectual property (IP) rights in China has always been a concern to foreign investors and enterprises. Recent developments suggest that there is a growing awareness of the need to protect IP rights and the availability of enforcement mechanisms to do so among Chinese companies. The level of intellectual property activity in China is high. For the past few years, the total number of new patent applications filed by Chinese entities has increased at an annual rate of approximately 20 per cent. There is also significant IP litigation in China, mostly between and among Chinese parties. Between 2001 and 2007, over 77,000 IP court cases were filed, of which 18,521 involved patent litigation. This is comparable to the number of patent cases filed in the United States, even though the total number of issued patents in China is still far fewer than in the United States.

These statistics point to a greater awareness of the value of IP and a more aggressive IP protection strategy being adopted by Chinese companies. Of note to foreign investors is the fact that foreign companies are more and more often the ones being sued by Chinese owners of IP. In a recent court case, a Chinese company based in Wuhan successfully sued a Japanese company and its customer (a wholly owned subsidiary of a foreign company) in China for patent infringement. The Japanese company was found liable for patent infringement and ordered to pay damages of about RMB 50-million (about C$8.7-million) while its customer was ordered to pay an annual royalty of RMB 480,000 (about C$83,000) for the remainder of the patent term. Although the trial court's decision has been appealed, IP infringement actions against foreign companies and their Chinese subsidiaries are no longer isolated cases. When formulating an IP strategy, it is no longer enough to only consider protection and enforcement; it is becoming equally important for foreign investors to ensure they and their Chinese affiliates are not breaching the intellectual property rights of others.

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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