12 Jul Do it like a boss: setting up your business in China – the different types of business entities for foreign investors
Whether you are an enthusiastic entrepreneur, or company appointed agent to browse the Chinese foreign investment market, you have a common goal: establish a foreign business entity in China. You may already have sufficient funds, a solid supporting overseas business, an exciting business plan and etc.; in other words: you are ready to roll! However, in order to avoid a cumbersome trial-and-error process, it is important to understand what options foreign investors have to set up a company or extend their business into China. In the following blog, we will introduce the various types of foreign business entities, their characteristics and whether or not they accommodate your needs.
NEW FOREIGN INVESTMENT LAW
According to Practical Law, The National People’s Congress (NPC) adopted a new Foreign Investment Law (FIL) on 15 March 2019 to “improve the openness, transparency and predictability of the investment environment, establish equal treatment for foreign and domestic investors, and address concerns of foreign investors around technology transfers”. The FIL will come into effect on 1 January 2020. It replaces the three foreign capital laws passed between 1979 and 1990, which set the framework for the country’s transition from decades of economic isolation. The concept of ensuring equal treatment of domestic and foreign-funded enterprises is reflected throughout the provisions of the FIL. The FIL sets up a new information reporting system that requires foreign investors and foreign investment enterprises to report their investment in stock markets and any change of investment profiles. The FIL gives an enterprise funded by foreign investment a five-year transition period so that it can adjust its governance structure during the transition period to be aligned with the Company Law. The FIL is opaque, however, leaving many details to be addressed in other regulations and implementation procedures.
FOREIGN INVESTMENT ENTERPRISE (FIE)
An FIE is essentially a Chinese entity with 25% minimum foreign investment. In other words, as opposed to non-legal entities described above, FIEs are legal entities entitled to Chinese company law rights and protection. FIEs can conduct profit generating business activities in compliance with their government approved business scope. In general, FIEs encompass industries such as manufacturing, processing, trading and/or service activities. However, a fundamental legal document for FDIs in China is the “Catalogue for the Guidance of Foreign Investment Industries”, which places FDIs in four separate categories: “permitted”, “encouraged”, “restricted”, and “prohibited”. In accordance with the “Catalogue”, companies have to clarify which types of FIEs apply to their industry-specific sector.
There are three types of FIEs, depending on ownership and shares of profits:
1. Equity Joint Venture (EJV)
An EJV is an independent legal entity with at least one foreign investor and at least one Chinese investor. Ownership and profit division depends on each party’s respective contributions to registered capital. Investors hold equity interests instead of stock shares from public issuing (more information from Joint Stock Company section). Equity can be cash, capital, intellectual property rights, materials and etc with the exception of labour. Directors, who are assigned by the investors, have voting power instead of the shareholders in western country enterprises. In accordance with the “Catalogue”, companies are also required to set up joint ventures in the predefined industry sectors.
The advantages of Chinese partners are domestic financing, sharing financial risks, larger or deeper access to domestic markets, and easier contact with domestic social networks. Since foreign companies are not familiar with the Chinese markets and their characteristics, they often face problems when they enter the market. Hence, a JV partner may also provide China-specific knowledge. Furthermore, as a holding company, an EJV can benefit from economies of scale in operations and management via collective investments under one corporate identity. More specifically, EJVs may implement centralized purchasing, personnel training, project management coordination and product marketing. A Chinese investor to the EJV can greatly assist foreign investors in interacting with government officials, accessing the labour market and material supply sources and, if appropriate, assessing the domestic market.
2. Cooperative Joint Venture or Contractual Joint Venture (CJV)
Besides the EJV, it is also possible to establish a CJV. There are two characteristic differences between an EJV and a CJV. Firstly, while an EJV is always a limited liability company, a CJV can be a legal as well as a non-legal person. The latter option is not very common though because it would mean that the partners of the joint venture would be personally liable for any losses the company might make in the future. Secondly, in an EJV the distribution of profits must be proportionally equivalent to each party’s capital contributions ratio. However, in a CJV the distribution of profits may be decided more flexibly by the parties.
Since CJVs can be more short-term and project-oriented, they can serve as flexible instruments for economic cooperation between foreign and Chinese companies. Moreover, a minimum stake in the company is not required and contributions do not necessarily have to be through financial means. Given its flexibility in capitalisation and profit-sharing, the CJV mode allows the foreign investor to set up a JV with a smaller amount of investment for a quicker return and therefore with a lower risk relative to an EJV. In addition, the contractual terms can be renewed at any time and for any extended period, subject to the approval of the government.
3.Wholly Foreign-owned Enterprise (WFOE)
According to the China law blog. A WFOE, quite self-explanatorily, offers foreign investors exclusive control of the enterprise. It has higher establishment requirements and is able to conduct a full range of business activities including signing contracts, collecting payments, and issuing special tax invoices in RMB. A WFOE has separate liabilities from the parent company. The establishment process typically takes two to four months and the minimum registered capital requirement varies according to the business activities of the company.
Chinese partner involvement is not mandatory or required under investment regulations for WFOEs, thus WFOEs show a faster and more flexible decision-making process in comparison to JVs. Furthermore, WFOEs are sometimes used to protect technology, innovations and intellectual property. Additionally, the approval process is simpler and the limitations on business expense payment and local sales volume are more lenient for WFOEs. One effective use of a WFOE is to replace the foreign enterprise representative office (RO). A wholesale FICE may carry out wholesaling, commission agency, import and export, and other auxiliary activities. FICEs may directly establish and operate new stores, and authorise others to open franchise stores. There are, however, certain restrictions on the products and business activities related to China’s commitments as a member of the World Trade Organisation.
Another Option is Joint Stock Company (JSC).
A JSC is the only form of FIE that is eligible for a public listing on a Chinese stock market. Other types of FIEs can be transformed into JSCs by converting registered capital into a stock of the company. On the downside, in order to set up a JSC, large initial capital investment is required. JSCs can invite shareholders in the company to increase capital and establish connections with other legal entities in China. Furthermore, JSCs do not require prior authorization from other partners to dispose or transfer interests.
REPRESENTATIVE OFFICE (RO)
Representative offices are non-legal entities that are viable foreign investment vehicles. They are “non-legal” in the sense that any direct profit-generating activities are strictly prohibited. Indirect business operations permissible for ROs are marketing, research, publicity and liaison activities. Needless to say, contracts cannot be concluded between ROs and other parties in China. Furthermore, ROs must recruit their staff via local agencies and are treated as permanent establishments in China, which means that they have to pay corporate income tax, business tax and VAT. They can only employ up to three representatives and one chief representative. ROs do not require any registered capital and have a relatively short establishment processing time of between one and three months.
If you are a trade agency or in the service industry and you have little initial investment funds, you may opt for ROs. The setup process and capital requirement for ROs are more easily obtained compared to that of foreign-invested enterprises. You can also learn more about the country to make sure that is the right place for setting up a business.
BRANCH OF A FOREIGN CORPORATION
Branches are also non-legal entities for foreign investment and thus cannot engage in direct profit-making operations. A liable Chinese legal representative must be appointed to the branch. Unfortunately, as an extension of their overseas head offices, branches are not eligible to the legal rights and protection that Chinese business entities are entitled to.
If you are in the financial services sector or the oil exploration industry, you may opt for branches. Theoretically, all foreign enterprises can apply for branches in China, but in practice, only branch applications from companies in the fields mentioned above are processed.
So now that you have an overview of the various types of foreign investment entities in China, you have a head start on choosing which form is most appropriate for your start-up, your extension business from an overseas establishment, your potential collaboration with Chinese business partners and etc. You even have a good idea of what to put in that Chinese market report for your boss who wants to expand your company into China!
For more details on regulations, application process and tax systems, Maxxelli Consulting services can provide you with further information upon request. Send us an email email@example.com to find out more.