Hong Kong: Structuring a Franchise in the PRC

Last Updated: 26 September 1995
This article is intended to provide a general guide to the subject matter. Specific advice should be sought about individual circumstances. Further information or advice may be obtained from Linklaters & Paines, Hong Kong office, 14th Floor, Alexandra House, Chater Road, Hong Kong; telephone: (852) 2842 4888; fax: (852) 2810 8133; contact David Mullarkey or Jeremy Parr.

The following article examines the manner in which a franchise operation may be structured in the PRC.

The manner in which a franchise is structured largely is dictated by various factors such as the degree of control which the franchisor wishes to exercise over the franchisee, the capability of the franchisee, the available resources and the degree of market penetration which the franchisor or franchisee may have in the PRC market. The following are just a few ways in which a franchise arrangement may be structured:-

(a) a simple trade mark licence. By this, the franchise arrangement is simply a licence by the franchisor granted to the franchisee allowing the use of trade marks, trade names, service marks and get up subject to certain quality control standards being complied with. The franchisor may also provide some marketing material and a supply of products. In return, the franchisor earns certain royalities from the license and payment for the products supplied to the franchisee.

The advantage here is that with franchise arrangements that comprise no more than a simple trade mark licence, approval of such licence probably will not be required. Although the PRC Regulations on the Administration of Technology Import Contracts ("Technology Import Regulations) stipulate that a licence in respect of industrial property rights must be approved by the Ministry of Foreign Trade and Economic Cooperation ("MOFTEC"), MOFTEC has maintained that a simple trade mark licence will not require to be approved in order to be valid. However, the licence will still be required to be registered with the PRC Trade Mark Office and the local Bureau of Administration of Industry and Commerce.

The main disadvantage of a simple licence arrangement is that the franchisor has little control over how the franchise is run and quality control.

(b) a franchising agreement allowing the franchisor greater control over the franchisee. This arrangement would comprise a licence granted by the franchisor to the franchisee to utilise the franchisor's marks, names etc.. In addition, the franchisor may provide patents and manufacturing knowhow, marketing materials, tied products, management training, shop fitting and decoration design, marketing and service schemes and consultancy services. The franchisee may be required to permit the franchisor to inspect the premises and products and provide the franchisor with reports and updates. The franchisor may also have some control over the selection of raw material sources, employees and pricing.

The advantage to such a fuller franchise arrangement is that the franchisor has a greater degree of control over the way the franchise is operated and the quality and consistency of the product.

The disadvantage is that the provision of industrial property such as patents, and knowhow and technical services such as management, service and marketing strategies, may bring the agreement under the regulation of the Technology Import Regulations. Such regulation may be disadvantagous to the franchisor in certain respects discussed in further detail under the heading "Relevant Legislation" below.

(c) The establishment of the franchisee by the franchisor. This can take two forms. The first is where the franchisor may already have an existing manufacturing venture (either wholly owned by the franchisor or a joint venture with a PRC party). Under PRC law, this PRC foreign investment enterprise will be a PRC legal entity and it may in turn enter into a domestic joint venture with another PRC party to run the franchise. Theoretically, if the articles of association of the foreign investment enterprise allows it to invest in related businesses, it may invest in other PRC enterprises without further approval and to use its retained earnings or registered capital to do so. However, this method is not usual and in the light of the Interim Provisions on the Guidance of the Direction of Foreign Investment which re-asserts central government control over certain types of foreign investment activities in the PRC including retailing and wholesale, the views of PRC counsel should be sought as to the continued viability of this method.

A variation on this structure is where the franchisor establishes a joint venture with the sole purpose that it be the franchisee. This will allow the franchisor a greater degree of control over the franchisee than if the franchisee was an independent third party. At the same time, the franchisor will involve in the franchise arrangement a PRC partner who will be helpful in areas of obtaining the relevant approvals, the sourcing of materials and financing. The joint venture may also avail itself of favourable tax treatment given to foreign investment enterprises. However, the disadvantage is that such joint venture may be regarded as a retail joint venture under the Retail Provisions if its sole purpose is to retail to the PRC market. Therefore, in addition to MOFTEC approval, it may require approval from the State Council and the Ministry of Internal Trade, which may be difficult to obtain. The joint venture will also be subject to regulation under the Retail Provisions with regard to the 30% limit on its sales of imports.

(d) Sub-franchisement. This refers to the situation where the franchisor is itself a franchisee under a master franchise. For instance, a foreign franchisor may itself be a franchisee of the master franchisor with rights to the PRC market and may sub-franchise to PRC parties or to its PRC joint venture. This is the method used, for example, in the Yoshinoya franchise (a Japanese restaurant chain) in the PRC. One disadvantage is that the franchisee must sub-license the necessary marks to the sub-franchisee. However, sub-licences of marks may not be recognised under PRC law and it may be necessary for the master franchisor and the sub-franchisee to separtely enter into a licence agreement which should be registered with the PRC Trade Mark Office.

Further information or advice may be obtained from Linklaters & Paines, Hong Kong office, 14th Floor, Alexandra House, Chater Road, Hong Kong; telephone: (852) 2842 4888; fax: (852) 2810 8133; contact David Mullarkey or Jeremy Parr.

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