By Charlotte Zhanghaixia Westfall and Richard N. Frasch
This article is last in a three-part series on doing business in China, with a focus on how U.S. and foreign companies can establish a physical presence (e.g., sales office or factory) when doing business in China. The first article addressed eight basic considerations U.S. companies should consider when sourcing goods in China, and the second article addressed eight common mistakes U.S. companies should avoid when sourcing goods in China.
Although the first two articles focus more on how smaller U.S. companies can do business in China, this article focuses on what larger U.S. and other foreign companies must consider when establishing a physical presence in China. These various factors include an entity structure (e.g., a wholly foreign-owned enterprise or a Chinese joint venture), intellectual property protection, tax and import issues, foreign exchange regulation, labor law compliance, and more. This article discusses some of the bigger issues:
1. Are There Any Restrictions on Foreign Investment to the Target Sector?
The initial factor for U.S. and foreign companies (hereafter referred to simply as “companies”) to consider is whether they are going to enter an industry sector in which foreign investment is restricted or prohibited. The Chinese government regulates all foreign investment in China. Companies should review the 2015 Catalogue of Sectors for Guidance of Foreign Investment (“2015 Catalogue”) to see what category of sector their operations fall under: encouraged, restricted, or prohibited. The sectors not listed in the 2015 Catalogue are putatively permitted. The classification of sectors decides the level of approval required for foreign investment.
Companies may have limited options when establishing a physical presence in China for the restricted category of sectors. They may not set up a wholly foreign-owned enterprise (see section 4 below for further discussion of “WFOEs”) for certain sectors that are restricted to foreign investment or ownership in China (e.g., construction and operation of cinemas). However, companies may have the options of setting up a representative office or forming a joint venture with a Chinese local partner if they want to establish a physical presence in China.
2. Location, Location, Location!
The geographical location in China of a sales office or factory can often be very important. China is a big country. Different geographic regions within China offer a different consumer market for a certain industry. Similarly, whole cities have been “built up” to support certain industries such as Wuxi (outside of Shanghai) with respect to the pharmaceutical industry. Such cities usually have universities and other important infrastructure (such as international airports and modern highways) that can significantly reduce operating costs. Moreover, local governments may have incentive measures to encourage certain areas of growth and foreign investment in particular industries. To take full advantage of these local incentives, companies need to do their due diligence and market research.
A basic understanding of the China city tier system is necessary. China’s first-tier cities are Beijing, Shanghai, Guangzhou, and Shenzhen. Second-tier cities include capital cities of provinces or coastal cities like Tianjin, Chengdu, and Xiamen. Third-tier cities are usually medium-sized cities (often with populations of over 5 million people) of each province. Each type of city has its own advantages and disadvantages for doing business. Several factors determine the tier of a city in China, including population size, economic growth, GDP, transportation systems, and historical and cultural significance.
Companies need to perform sufficient preliminary market analysis to decide which city best fits their business strategy and development. They should know which geographical market has the most potential for their business growth and where their competitors are located in China. For example, in recent years second-tier cities have become increasingly attractive because of their lower cost of real estate and labor expenses and high potential consumer market growth.
3. Intellectual Property Protection Strategy
Companies should have a carefully structured intellectual property (“IP”) protection strategy in place before establishing a physical presence in China. Although IP protection in China has been improved over the years, significant risks still remain for foreign companies, particularly as a result of the rampant IP piracy and the increasing antitrust law enforcement in the past few years. Because of these and related concerns, companies should strongly consider consulting with a local Chinese IP attorney and devise an effective IP protection plan before establishing operations in China.
As part of such an IP protection plan, companies should seriously consider registration of their trademarks and patents in China so that they have legal protection against IP infringement. On a more practical level, they should also implement strict internal policies and protocols for accessing and disclosing sensitive information, both within their organization and with their Chinese business partners.
4. Form of Business Entity for Operations in China
Generally speaking, there are three forms of business entities for companies to use when establishing physical operations in China:
Representative Office. Companies can set up a representative office in China to help with their business activities. A representative office can be set up relatively quickly with lower cost than other types of business entities. However, a representative office has a very limited business scope in China. It is limited to engaging in only certain specified activities such as locating suppliers, monitoring quality control at Chinese factories, and other liaison activities. Also, companies must have existing operations for at least two years before applying to set up a representative office.
A representative office is a good option for companies that are not yet ready to invest significant time and money in the Chinese market. Establishing such offices can often serve as the first step for companies to enter the market because it allows the companies to do market research, build local connections, learn local market practices, and better understand the market and people. It is also an option for companies whose businesses are in the restricted or prohibited industry sectors, but want to have a China presence; for example, a U.S. medical institute.
Joint Venture. A joint venture is a Chinese company with at least one foreign and one Chinese shareholder, with the Chinese shareholder being a company rather than an individual. A joint venture enables companies to gain access to their Chinese local partner’s existing business connections, distribution channels, sales network, and local market knowledge. Although a joint venture offers the advantage of providing access to a local partner’s many resources and business platform, it is not a favorable option for many companies. First, many companies find it challenging to find a suitable local Chinese partner. Secondly, conflicts often arise among parties in a joint venture with regard to management styles, business cultures, IP, and local standards and practices.
A joint venture is a good option for companies that already know a local Chinese partner very well and want access to the local partner’s strong Chinese market position and other business resources. As discussed above, a joint venture is also an alternative for companies that enter into a regulated sector that the 2015 Catalogue (see section 1 above) prohibits them from setting up a WFOE (see next section for a discussion of WFOEs).
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A Wholly Foreign-Owned Enterprise (“WFOE,” pronounced “wolf-ee”). A WFOE is a privately held limited liability company in China in which all of the equity is held by non-Chinese shareholders. A WFOE is a popular option for companies looking to establish a physical presence in China. It is attractive because the parent company has full control of the WFOE, leading to efficient decision making without the challenges of potential clashes in management style or business culture incompatibility as can often be the case with a joint venture. A WFOE also often allows better protection of IP rights in China in contrast to a joint venture.
When considering whether to form a WFOE, a company should first check whether it is entering a restricted sector in China. If the industry is restricted, then a WFOE may not be allowed (see section 1 above). Second, the company then needs to determine if it can afford the capital requirements that are sometimes imposed on a WFOE. Currently, minimum capital requirement for setting up a WFOE depends on the nature of its business. A WFOE with a scope of business in consulting, trading, retailing, or information has no minimum registered capital requirement. Some other industries, however, still need to meet a minimum registered capital requirement (e.g., banking). Regardless, companies often find it necessary or expedient to register some minimum registered capital for a WFOE in order to minimize the application of China’s foreign currency control policies.
5. Consider Locating Your Business in a Chinese Free-Trade Zone
What and Where Are FTZs? U.S. and foreign companies have recently been granted the option to set up a physical presence in free-trade zones (“FTZs”). Today, mainland China has four FTZs: Shanghai Free-Trade Zone (“Shanghai FTZ”), Tianjin Free-Trade Zone (“Tianjin FTZ”), Guangzhou Free-Trade Zone (“Guangzhou FTZ”) and Fujian Free-Trade Zone (“Fujian FTZ”).
Shanghai FTZ is the first free-trade zone in mainland China, which was officially launched in September 2013. It covers an area of 120.72 square kilometers that initially included Waigaoqiao Free Trade Zone, Waigaoqiao Free Trade Logistics Park, Yangshan Free Trade Port Area, and Pudong Airport Free Trade Zone. In April 2015, the Shanghai FTZ was further expanded to include three new areas including Lujiazui Financial Area, Shanghai Jinqiao Economic and Technological Development Zone, and Zhangjiang High-tech Park.
Following the establishment of the Shanghai Pilot FTZ, China launched another three new FTZs in early 2015. The three new FTZS are Tianjin FTZ, Guangzhou FTZ, and Fujian FTZ.
The Tianjin FTZ is the only free trade zone in northern China, which includes Tianjin Port, Tianjin Airport, and the Binhai New Area industrial park. It covers an area of 119.9 square kilometers. The Guangzhou FTZ includes the Nansha New Area in Guangzhou, Shenzhen Qianhai and Zhuhai Hengqin New Area, with an area of total 116.2 square kilometers. The Fujian FTZ is a FTZ near Taiwan, which includes industrial areas in the provincial capital of Fuzhou, the whole of Xiamen, and Pingtan, with an area of total 118.04 square kilometers.
When Should FTZs Be Used? The Shanghai pilot FTZ is a testing ground for economic and governmental reform, including loosening foreign exchange control, liberalizing RMB interest rates, and simplifying administrative approval procedures. The Shanghai FTZ introduced many reforms to attract foreign investment by publishing a list of 18 service industries to receive more flexible policies in the zone, including medical services, banking, and value-added telecommunications. It adopts a “negative investment list” approach to foreign investment, which specifies restrictions or bans on certain given sectors. This approach has been well received as it loosens the previously strict regulation of the Chinese government and offers more options for business operators.
Although the Shanghai FTZ introduces many appealing reforms to attract foreign investment, it has been a slow process for it to implement these reforms. Many companies with a physical presence in the Shanghai FTZ have not found the business benefits to be as great as they had hoped. Many do not know exactly how the Shanghai FTZ works as no detailed regulations have been publicly issued. According to a recent Wall Street Journal article, “an annual survey released recently of more than 370 members of the American Chamber of Commerce in Shanghai found that almost three-quarters of respondents” believed the Shanghai FTZ offered few business benefits for their business (http://www.wsj.com/articles/shanghais-free-trade-zone-fails-to-impress-u-s-companies-1425449664). Still, some companies believe that it is wise to set up a small physical presence in the Shanghai FTZ today so that they will be better positioned for that day when the planned reforms are finally implemented.
The three newly launched FTZs have the same goal as the Shanghai FTZ—to carry out Chinese economic reform and create a more attractive foreign investment environment. They have many of the same negatives as the Shanghai FTZ. Whether these new FTZs will implement the planned reforms more efficiently and effectively than the Shanghai FTZ has yet to be seen. Companies should keep a close eye on how these FTZs evolve, but it will take time for China to implement its planned reforms.
Entry into the Chinese market is a challenging yet rewarding process, no matter what route you choose. There are administrative formalities to go through once you decide to set up a physical presence in China, including application submission, registration, and certification. While it is becoming increasing costly to do business in China, it is still a good destination for those companies that wish to access the ever-growing Chinese consumer market.
Be sure to read the two other articles in this series:
About Charlotte Zhanghaixia Westfall and Rick Frasch
Charlotte is a corporate law partner at CKR Law LLP based in San Francisco. She represents companies in corporate formation, venture capital financings, and mergers and acquisitions. Charlotte currently serves as general counsel of a software company and is on the board of advisors of several Silicon Valley startups. She advises on market entry strategy, marketing strategy, corporate development, and branding for U.S. companies seeking access to the Chinese market and Chinese companies seeking investment opportunities in the United States.
Rick has significant legal and business experience in contracts, financings, institutional lending, international business transactions (with an emphasis on China), venture capital and mergers and acquisitions. Most recently, he was the VP of Business Development and Legal Affairs for Globitech, Inc., a semiconductor manufacturer, and prior to that, a partner in venture fund KLM Capital Group. Previously, he served as the general counsel of Talegen Holdings, Inc. (1993–1998), the former holding company for the insurance operations of Xerox. Rick has also served as the Chair of the Executive Committee of the Business Law Section of the California State Bar (1991–1992) and was a corporate and banking partner at the law firm of Pettit & Martin (1981–1993).