OUTLINE OF BASIC LEGAL ISSUES IN RESPECT OF

THE ESTABLISHMENT OF A SINO-FOREIGN JOINT VENTURE 

 

1. INTRODUCTION

This outline contains only a brief summary of certain aspects of Chinese law and practice that may be pertinent to establishing a Sino-foreign joint venture in the People's Republic of China ("PRC"). This outline is not intended to address all possible issues that may arise in connection with the structuring of your proposed joint venture project.

 

2. GENERAL ISSUES

 

2.1 Guidance Catalogue

The initial starting point for analysis of foreign investment projects in China is the Foreign Investment Industrial Guidance Catalogue (“Catalogue”), which is updated from time to time. The most recent edition of the Catalogue took effect on 1 April 2002. The Catalogue groups foreign investment projects in specific industries and sectors in the following categories: encouraged, restricted and prohibited. Any foreign investment project not included in the Catalogue is deemed to be permitted. Different approval requirements apply depending on the classification of the project.

The Catalogue also indicates whether there are limitations on the foreign ownership percentage in a project, e.g. projects in which 100% or majority foreign ownership are not permitted.

 

2.2 Government Approvals

Approval levels for foreign investment projects also depend on the total investment amount. (The total investment amount is the sum of the registered capital (equity) and any anticipated additional debt. The ratio of registered capital to total investment is prescribed by law. Please see paragraph 3.2 (b) below for more detailed information.)

The State Council Decision on the Reform of the Investment System issued on 25 July 2004 (the "State Council Decision") was directed at both the Chinese domestic and foreign investment projects. It generally abolishes the system for approval of investment projects (as opposed to the approval of the establishment of foreign investment enterprises ("FIEs")) but requires major and restricted projects to be subject to the system of ratification or filing.

Whilst not explicit on the point, it appears that the State Council Decision does de facto impose a cap of a total investment of US$100 million on local approval for projects in the "encouraged" category. Accordingly, following the State Council Decision, the local investment "approval" threshold for foreign investment projects classified as "encouraged" or "permitted" in the Catalogue is now for a total investment of up to (but not including) US$100 million. That is to say, in accordance with relevant regulations, only the local People's Government is required to ratify investment projects of below US$100 million in the "encouraged" or "permitted" categories. At US$100 million or above, the State Development and Reform Commission has to ratify ("核准") the project application, not the project proposal (as was the case previously). This ratification involves a broad macroeconomic and policy-based review of the project. The Articles of Association and Joint Venture Contract for such a project (or if it is subject to investment restrictions or is a project falling into a special category e.g. involving quotas etc.) will also have to be approved by MOFCOM. As regards investments in the "restricted category", the local investment "approval" threshold is US$50 million.

Previous MOFTEC circulars and notices such as the MOFTEC (and various others) Opinion on Further Encouraging Foreign Investment dated 3 August 1999 and the MOFTEC Relevant Questions Concerning the Record Filing with MOFTEC of the Examination and Approval by Local Authorities Themselves of FIEs in the Encouraged Category issued on 15 October 1999, appeared (subject to a few exceptions) to give local authorities almost unlimited powers of approval in this regard.

 

2.3 Preferential Treatment for FIEs

PRC regulations contemplate that an enterprise will have FIE status so long as the foreign ownership percentage is not less than 25% of the total registered capital, and the project otherwise complies with all of the relevant laws, rules and regulations applicable to FIEs. Manufacturing FIEs currently are granted preferential treatment, and all FIEs are free from certain other restrictions currently imposed on purely domestic enterprises under various PRC laws. These preferences are as follows:

(a) Currently, manufacturing FIEs are entitled to a two (2) year tax holiday followed by three (3) years of 50% reduction in applicable tax rates starting from the first profit-making year. Service FIEs are not entitled to similar tax breaks and are subject to the full effective PRC corporate income tax rate of 33%. Other tax incentives are available for foreign investments in specific zones and in the western region of China generally. It has been long rumoured that with China’s re-entry into the WTO, these standard two (2) year plus three (3) year tax preferences for manufacturing FIEs will be eliminated, and recently there was a semi-official announcement to align the more favourable income tax treatment of FIEs with the income tax treatment of Chinese domestic companies by 2006. It is anticipated that the preferential tax treatment in its current form will soon no longer be enjoyed by FIEs, and that a new uniform tax rate for FIEs and domestic companies between 24% to 28% will apply. However, while details of this standardization initiative are yet unclear, it seems that certain incentives for FIEs will remain. In the past changes in tax laws did not affect, or only marginally, affected FIEs that had already successfully obtained tax incentives. Whether such "grandfathering" of status will also be granted for the upcoming round of tax changes remains to be seen.

(b) FIEs also may borrow foreign exchange loans without approval of the State Administration of Foreign Exchange (“SAFE”). FIEs are merely required to register such foreign exchange debts with the SAFE, which is a perfunctory matter. In contrast, domestic enterprises are required to obtain SAFE approval for foreign exchange debts, and such SAFE approval is often very difficult to obtain.

 

2.4 Scope of Business

FIEs, like all other legal entities in China, have a limited scope of approved operation as set out in the business license to be issued by the State Administration of Industry and Commerce or one of its competent lower-level department ("SAIC"). It generally is not possible to obtain a general scope of business for a company in China. (Recently some local authorities have issued business licenses on a case-by-case basis with a broader scope of business, typically (i) prohibiting business activities that are prohibited by PRC laws, regulations and state policies regarding foreign investment industries, (ii) prohibiting business activities that require special approval prior to obtaining the special approval and (iii) permitting any and all business activities that are not subject to special approval as provided by PRC laws and regulations and are not classified as "restricted" according to PRC foreign investment industry regulations. However, whether such broadening of the approved scope of business will develop into a more widely adopted practice remains to be seen.) The approved scope of business typically is restricted to a specific category of manufacturing or service based on the contents of the feasibility study report (“FSR”). In many cases, the approved capitalisation of an FIE will be evaluated to determine whether it matches the capital investment, working capital and business operation requirements described in the FSR. If the scope of operation is to be expanded in the future, then a separate FSR will typically be prepared and commitments for additional capital funding may be required.

 

3. KEY ISSUES REGARDING A JOINT VENTURE

 

3.1 Nature of JV Project

(a) The principal differences between an EJV and a CJV can be simply summarised as follows:

(i) For an EJV:

· each party must make cash or permitted in–kind contributions in proportion to its subscribed percentage of the EJV’s registered capital.

· profit must be distributed strictly in accordance with the parties’ respective percentage shareholding of the registered capital of the EJV.

· upon dissolution of the EJV at the expiry of the term of operation, the EJV’s net assets are to be distributed to each party in accordance with its respective shareholding of the EJV’s registered capital.

(ii) For a CJV:

· a party (typically, but not always, the Chinese party) may contribute non-cash intangibles in the form of “cooperative conditions”. Such “cooperative conditions” may consist of market access rights, rights to use buildings or office space owned or leased by the party that are not subject to clear valuation. In exchange for such “cooperative conditions”, the party is entitled to participate in the distributable earnings of the CJV.

· profit sharing in a CJV need not be made strictly in accordance with the parties’ respective percentage shareholding of the registered capital of the CJV but can be made in accordance with the agreement of the parties (e.g. the Chinese party may be entitled to a fixed profit share with the balance to be distributed to the foreign party, or the parties may agree on a multi-tiered profit-sharing arrangement that permits the foreign party to recover an amount equal to its capital investment on a priority basis, following which the profit split will be changed, etc.).

· upon dissolution of the CJV at the expiry of the term of operation, the CJV’s net assets may be transferred to the Chinese party without compensation (thus operating in many respects as a BOT project) so long as the foreign party has been able to recoup its capital contribution during the term of the CJV. Such recoupment typically is funded by excess cash flow generated by accelerated depreciation of the CJV’s assets. Such arrangement requires approval of relevant finance and tax authorities in China. Note that this capital recoupment is separate and distinct from possible priority rights to receive after-tax net profit distributions as outlined in the bullet point above.

 

3.2 Capitalisation of JV

(a) The concepts of authorised and issued capital are not used in connection with Sino-foreign joint ventures. Instead, the concepts of “registered capital” and “total investment” are employed. Under applicable PRC law, registered capital is defined as the total amount of capital contributions subscribed to by the parties and registered with the Chinese authorities. Thus, the term “registered capital” refers to the parties’ equity in the venture. The concept of “total investment”, on the other hand, includes both registered capital and external borrowings.

(b) Pursuant to regulations promulgated by the SAIC, certain minimum equity requirements are imposed on joint ventures. These are:

Minimum Equity

Total Investment (% of Total Investment)

￡ US$3 Million 70%

>US$3 but ￡ US$10 Million 50% or US$2.1 Million

(whichever is higher)

>US$10?30 Million 40% or US$5 Million

(whichever is higher)

>US$30 Million 33.3% or US$12 Million

(whichever is higher)

PRC laws governing joint ventures require that the foreign party contribute no less than 25% of the registered capital.

(c) The capital to be injected by the parties constituting their capital contribution may take a variety of forms including cash, machinery, equipment and intangible property, such as proprietary technology, trademarks and other industrial property rights. Pursuant to a circular promulgated by SAFE and effective as of 1 April 2003, subject to SAFE's approval, a foreign party may also use the assets obtained by way of early recoupment of investment, liquidation, share transferring, capital reduction etc. from FIEs it has previously invested in. In addition, the Chinese side may contribute the right to use a site and count this as part of its contribution.

There are, however, certain restrictions on in?kind contribution by a party. For example, the technology contributed as registered capital by a party generally should not exceed 20% of the total registered capital (but this can be increased with approval for certain encouraged projects) or 50% of an individual investor’s capital contribution. The issue of the appropriate valuation of in?kind contribution can often be a major stumbling block in joint venture negotiations.

Once the joint venture contract is approved, the parties must inject their subscribed registered capital amounts within the time limits set out in the contract. If paid in one lump sum, the registered capital contributions must be made within six (6) months of the issuance of the business license for the joint venture. If the subscribed registered capital is to be injected in instalments, the first instalments, which must not be less than 15% of the total subscribed registered capital, must be made within three (3) months following issuance of the business license. The balance is to be contributed in accordance with a schedule agreed by the parties, provided that the parties must complete all such contributions within the following time limits (calculated from date of issuance of the business license) depending on the total amount of registered capital of the joint venture company:

Registered Capital (US$M) Contribution Time Limit

≤ 0.5 1 year

> 0.5 but ≤1.0 1.5 years

> 1.0 but ≤3.0 2 years

> 3.0 but ≤10.0 3 years

> 10.0 subject to approval with

reference to actual condition

(d) Chinese law permits joint ventures to borrow funds from either Chinese or foreign banks in excess of the parties' capital contributions. Shareholder loans from the foreign party are also permitted. (Chinese partners likely will not have a sufficiently broad scope of business to permit them to provide shareholders loans.) All such loans should be registered with SAFE and should not exceed the difference between the registered capital amount and the total investment amount.

 

3.3 Transfers of Equity Interests in Joint Ventures

If a party proposes to transfer all or part of its interest in the registered capital of the joint venture company to a third party, then each other party has a pre-emptive right to purchase the equity interest proposed to be transferred. As an equity transfer also requires amendment of the joint venture contract and articles of association, which in turns requires the signature of each party, each party in effect holds absolute consent rights to any transfer generally. All transfers of registered capital additionally require a unanimous approval of the joint venture company board of directors and approval by the original government authority which approved the joint venture contract and articles of association.

 

3.4 Off-shore Structures

(a) Offshore Structures

The entity to be used by the foreign investor as the offshore investment holding company ("OHC") for its investment in the EJV will be determined by a number of factors. One of the main considerations driving choice of OHC is tax-efficiency. In this respect the foreign party needs to ascertain whether there is a double tax treaty ("DTT") covering the types of revenue streams that are likely to be coming out of the EJV as between the PRC and the jurisdiction where the OHC is established. DTTs generally cover loan interest, dividends and distributions, income taxes, royalties and capital gains. The tax treatment of dividends tend to be less important in terms of determining the location of the OHC because, at present, China exempts dividends by FIEs to their foreign shareholders from withholding and other taxes (although this could change as the post-WTO levelling of the playing field progresses, as Chinese parties do not benefit from such an exemption). There are proprietary software programs for determining the most tax-efficient jurisdiction under the applicable DTTs, based on a specific set of input parameters which you provide.

Based on past experience, popular DTTs for investment in China are the PRC-Mauritius DTT (but note the provisions on capital gains do not apply to FIEs whose principal assets comprise real estate assets), PRC-Netherlands and PRC-Malaysia. If you are using a Labuan company, note that certain countries have objected to Labuan companies getting Malaysian DTT benefits in the country of investment because it is a tax haven within Malaysia, although China does not appear to have done so to date.

A number of industries in China, notably the telecommunications, fund management, banking, venture capital and many others require foreign investors to meet certain qualification requirements which may preclude using a special purpose vehicle ("SPV") as the OHC. This needs to be considered on an industry-by-industry, case by case basis. It may be possible, in some cases, such as under the Foreign Invested Venture Investment Enterprise Administrative Regulations to use an affiliated entity to satisfy the qualification requirements where there is an express legal basis for doing so, whilst investing through an SPV located in a tax-efficient jurisdiction.

Another possibility to consider, when establishing an EJV in "special industries" with foreign investor qualification requirements, is whether the industry regulator would accept the use of an SPV backed up by a parent company guarantee of the SPV's obligations in relation to the EJV or similar arrangement, based on an agreement negotiated with the regulator. Again there are no hard and fast rules as to what may or may not be possible as it depends on the position taken by the regulator. You should make telephone enquires to confirm.

Tax structuring of the foreign party's investment in an FIE does not, however, stop at the OHC level, as you also need to consider (where applicable) the tax implications of repatriating funds from the OHC to the foreign party's home jurisdiction, and the DTTs (if any) between OHC jurisdiction and the foreign investor's home jurisdiction.

(b) Tax Havens as OHCs

Many foreign investors tend to favour the use of tax haven jurisdictions, typically the British Virgin Islands ("BVI"), the Cayman Islands and so forth as OHCs for China investments.

From the foreign investor perspective the main advantage is low or zero rates of tax on funds once they reach the tax haven or on disposals of shares in OHCs located in the tax haven. On the other hand, tax havens do not have any DTTs to reduce the tax withheld at the China end, so the tax required to be withheld in China before a remittance of funds out by EJV (other than for dividends) by way of payment of loan interest, royalties etc. will be the maximum applicable rate under Chinese law and policy at the time, thus giving a substantially reduced amount on arrival at the tax haven.

The location of OHCs, as can be seen from the above, is not always straightforward and is a decision that will be determined by a large number of variables on a case-by-case basis. Often foreign investors will make the decision based on internal policies or on the basis of advice from their own in-house or external tax advisers.

 

3.5 Miscellaneous

(a) Under PRC law, joint venture companies have a fixed term of operation. Currently, the most common term of operation approved is fifty (50) years. This term can be extended with the consent of all parties and approval of the relevant government authorities. In some instances, particularly in BOT-like CJVs, the term of operation agreed by the Chinese party and approved by the relevant government authorities will be much shorter.

(b) Depending on the nature of the operations of the proposed joint venture company, certain additional government approvals, permits or licenses may be required, e.g., sanitation certificates, environmental permits, production approvals, export licenses, value-added telecom services operating licenses, etc.

Certain other legal and practical considerations relating to the establishment of a Sino-foreign joint venture company are set out in the notes at the end of the template Joint Venture Contract.