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Foreign Investment in China

Published April 2006

2005: The Year in Review

After a period of significant growth in 2004, when utilized foreign direct investment (FDI) reached $60.63 billion, utilized FDI inflows to China leveled off in 2005. In the first quarter of 2006, however, FDI rebounded with a year-on-year increase of 6.4 percent. Last year, China's utilized FDI fell by 0.5 percent to $60.33 billion (see Table 1). This slight decline was largely due to the high base effect caused by the record inflows registered in 2004, rather than any major policy or economic developments.

To focus on realized FDI values, rather than contracted figures that are often artificially inflated by local governments seeking central-level incentives, the Ministry of Commerce (MOFCOM) stopped reporting contracted FDI in December 2005. Though MOFCOM no longer publishes contracted FDI figures, for the first time it published foreign investment statistics on the financial services sector. MOFCOM reported that in 2005, China approved 18 foreign-invested banks, insurance companies, securities firms, and fund management operations. Although official MOFCOM statistics still do not count these deals toward China's total FDI, they accounted for an additional $12.08 billion in capital inflows and would combine with the official FDI figure to reach a total of $72.41 billion in foreign investment.

Two of the hottest areas for FDI in 2005 were banking (see below) and high-tech industries. Among the highest profile deals, Microsoft Corp. introduced its MSN unit to China through a joint venture with Shanghai Alliance Investment Ltd., and Yahoo Inc. negotiated a deal to pay $1 billion for a 40 percent stake in Alibaba.com Corp., China's largest e-commerce company. In another landmark transaction, E. I. du Pont de Nemours & Co. announced a $1 billion investment plan to build a titanium dioxide factory in Shandong, the company's largest single investment since its founding 200 years ago.

Top foreign investors

In 2005, the primary contributors of FDI in China remained largely unchanged from previous years (see Table 2). Hong Kong continued to be China's greatest source of foreign capital, followed by the Virgin Islands, Japan, South Korea, and the United States. Singapore, Taiwan, the Cayman Islands, Germany, and Western Samoa round out the top 10. Hong Kong and the tax havens are likely the source of much "round-trip" investment--PRC funds funneled out of China that return masked as FDI.

US investment in China

As has been the case for the past several years, the United States retained its position as China's fifth-largest source of FDI in 2005 with a total of $3.06 billion. Though the US rank remains the same, the 2005 figure is down 22 percent from the 2004 total of $3.94 billion.

According to a recent US Government Accountability Office (GAO) report on China trade, in 2004 China ranked twelfth among recipients of FDI originating from the United States. The report also stated that by 2004, cumulative US investments in China totaled $15 billion. When compared with FDI from the United States to other major trading partners such as the European Union ($952 billion), Canada ($217 billion), and Japan ($80 billion), cumulative US investment in China is still relatively low. It is also interesting to note that actual US investment inflows to China grew roughly 6 percent annually from 1995 to 2003, matching the rate of EU investment in China and surpassing that of Japan.

The GAO report also highlighted the fact that US investment in China has generally been concentrated in the manufacturing sector. This no doubt reflects that many service sectors have only just been opened to foreign investment as part of China's phased-in World Trade Organization (WTO) obligations. Although the annual growth rate of manufacturing sector FDI originating in the United States has leveled off significantly during the past 10 years, annual investment levels continue to far surpass that of any other sector. Within the manufacturing sector, the report identifies transportation equipment, chemicals, and computers and electronics as the industry groups attracting the most US investment.

FDI Trends

Banking

China's banking industry has undergone steady liberalization since 2001 in accordance with the country's WTO commitments. By December 11, 2006, Beijing is expected to remove all remaining restrictions on foreign banks. The frenetic pace of foreign investment as foreign investors jockey for position made China's banking industry one of the biggest investment stories of 2005.

Still, foreign banks may not provide renminbi (RMB) banking services to Chinese individuals (scheduled to be permitted by December 2006), and prudential restrictions limit foreign banks' ability to develop extensive branch networks. Thus, many foreign banks have turned to buying stakes in state-owned banks in an attempt to gain greater access to China's market. As China continues to reform its troubled banking system, Beijing has welcomed the capital injections and shared industry expertise that comes with foreign investment. Among the deals that took place in 2005 were Bank of America Corp.'s acquisition of a 9 percent stake in China Construction Bank for $3 billion, the 10 percent stake in Bank of China acquired by the Royal Bank of Scotland Group and Merrill Lynch & Co., Inc. for $3.1 billion, and Standard Chartered Bank's $123 million investment in the newly established joint venture Bohai Bank.

Distribution rights

Overall, the past year has seen considerable progress in the implementation of China's WTO commitment to allow foreign-invested enterprises (FIEs) to exercise trading and distribution rights. Foreign companies now may choose one of two ways to acquire trading and distribution rights. They can set up a new, standalone foreign-invested commercial enterprises (FICE) or apply to expand the business scope of an existing FIE. Existing manufacturing FIEs, free-trade zone trading FIEs, investment companies, and regional headquarters FIEs may all apply to expand their business scopes. While delays in application approvals were reported up through the end of last year, USCBC member companies are reporting that the application and approval process has become clearer and more efficient. In particular, the recent devolution of approval authority to provincial-level authorities for most distribution rights applications, as mandated by a PRC Ministry of Commerce (MOFCOM) notice, is a major step forward in simplifying and shortening the application process. Waiting times should be as short as two months in some areas, down from the previous average of four months. (Distribution rights refer to the ability to sell--either retail or wholesale--products within China.)

About 40 percent of FIEs that have acquired distribution rights are based in Shanghai, which is emerging as the site of choice for companies to set up distribution operations. According to the Shanghai Foreign Investment Commission, by the end of February 2006, 601 FIEs had acquired distribution rights in Shanghai, either by establishing a FICE or expanding their business scopes. Of these, 331 are wholesale FICEs, 92 are retail FICEs, and 110 are expanded-scope FIEs. The remaining 60 are expanded-scope or newly established trading companies in the Waigaoqiao Free-Trade Zone (FTZ).

In conversations with USCBC, companies have reported a variety of remaining challenges. For example, expanded-scope trading companies and FICEs in FTZs may have difficulty obtaining sufficient foreign exchange quotas and acquiring the right to independently issue value-added tax (VAT) invoices. Expanded-scope manufacturing FIEs must keep manufacturing revenue above 50 percent of total revenue or face losing their tax incentives. Though PRC authorities have made some clarifications of how this ceiling will be calculated or enforced, some questions remain, such as how imported items that are "bundled" with manufactured products will be counted.

In addition, expanded-scope manufacturing FIEs may only distribute products in categories similar and relevant to the products they produce. Expanded-scope manufacturing FIEs that produce or trade in hazardous products must apply for a new operation license to exercise their distribution rights, separate from their existing production license for hazardous materials. Companies using FICEs as the distribution and sales channel for products of related-party manufacturing FIEs must carefully manage the pricing of these transactions to avoid transfer pricing issues with tax authorities.

Another area of concern for companies acquiring distribution rights is the approval process for setting up branches. Under MOFCOM regulations, if a FICE (including an expanded-scope FIE) wishes to establish branches outside its home province, the commerce authority of the FICE's home jurisdiction must obtain the consent of the commerce authority of the jurisdiction in which the FICE wishes to establish a branch to approve an application. In evaluating the FICE's application, the commerce authority where the branch is to be established must decide if the FICE's proposed branching scheme conforms with the local development plan. It is unclear how efficiently this process will work and how this process will apply to companies in FTZs and other bonded zones.

Finally, local authorities prefer firms to set up entirely new FICEs rather than expand the scope of existing entities. New FICEs bring in new registered capital and boost the overall level of foreign investment within a locality, a key criterion in the performance evaluations of local officials.

What to Watch in 2006

Labor Contract Law

Preventing labor disputes, protecting workers, and fighting unemployment remain top concerns of the PRC leadership. The 2006 National People's Congress (NPC) legislative calendar includes two laws specifically aimed at labor issues: the Law on the Arbitration of Labor and Personnel Disputes and the Labor Contract Law. NPC released a draft of the Labor Contract Law for comment on March 20, but a draft of the Law on the Arbitration of Labor and Personnel Disputes has yet to be issued.

Though the Labor Contract Law is primarily aimed at domestic enterprises that do not use written labor contracts and that fail to make the required social security payments on behalf of their workers, the proposed legislation will affect the operations of all employers in China, including FIEs and representative offices of foreign companies. In particular, the law will likely make the hiring and dismissal of employees more cumbersome and expensive.

The draft law requires severance pay even when fixed-term contracts expire and companies decide not to renew them; mandates a one-time compensation equivalent to an employee's annual salary to enforce non-compete agreements, which may be valid up to only two years; and places a one-year maximum on any position that is filled by a worker hired through a labor service company. The draft law also limits the lengths of probationary periods at the start of employment during which companies can terminate employees at will. For nontechnical positions, the probationary period may not exceed one month; for technical positions, two months; and for professional technical positions, six months.

The law also significantly increases the leverage of workers' unions. For example, the law requires that enterprises first inform the union of any decision to terminate a labor contract, even if it has cause. A union may raise objections, and the enterprise must respond to such an opinion and convey its decision in writing to the union. An enterprise must also consult and obtain the consent of its union in establishing any company policy that directly affects workers' interests or if it seeks to lay off at least 50 people over the course of major reorganization.

Finally, the law is strongly tilted toward the individual worker in other important respects, no doubt reflecting leadership concerns about the labor practices of local enterprises. For example, the law indicates that if an enterprise and a worker have different interpretations of a labor contract that are both based on "common sense" (changli), the interpretation that is most beneficial to the worker shall prevail.

Discontinuation of FIE representative offices

Citing changes to the recently revised PRC Company Law and Administrative Rules on Company Registration, the PRC State Administration of Industry and Commerce (SAIC) has ordered its local offices to no longer approve the establishment or renewal of representative offices of FIEs as of January 1, 2006. Though foreign-based companies may continue to establish and maintain representative offices, FIEs that qualify as companies under the newly revised Company Law may not establish new representative offices.

Previously, domestic companies could set up representative offices to conduct liaison, public relations and market research activities, in accordance with the Implementation Rules on the Administration of the Registration of Legal Entities, issued by SAIC in 1988. The newly amended Administrative Rules on Company Registration, however, do not contain any provision on representative offices of domestic companies and instead detail requirements for branches of domestic companies. SAIC thus argues that the new company registration rules and other relevant rules no longer provide a legal basis for the establishment and maintenance of representative offices.

According to SAIC, although current FIE representative offices will be deregistered after their terms of operation expire, SAIC will allow FIE representative offices to continue to operate as long as they do not engage in "business activities." The practical effect of this new policy, however, may be to force FIEs to close or convert their representative offices into branches because deregistered representative offices will not have the legal documentation that is generally necessary to maintain their operations. Meanwhile, creating new FIE branches entails significant administrative costs in part because firms must create separate invoicing systems and file annual tax returns with the local tax authorities at each branch's location.

As this report went to press, SAIC had yet to publish a draft of the new policy, so much remains to be clarified in terms of implementation and ramifications for foreign investors. USCBC is currently communicating a number of concerns regarding the new policy to the SAIC, MOFCOM, and the State Administration of Taxation. USCBC is also actively seeking feedback from concerned member companies for a possible written submission of comments. If your company would like more information on this issue or is concerned, please contact USCBC.

The Antimonopoly Law and focus on "National Champions"

In contrast to antitrust laws in the United States and the European Union, the most recent draft of China's antimonopoly law (AML) contains multiple "public interest" exceptions that raise concerns regarding the law's intent to protect domestic companies at the expense of consumers and foreign competitors. Given the government's announced intention to promote "national champions"--Chinese companies that can develop into globally competitive firms--foreign investors are concerned that the government may use the AML to skew the playing field toward domestic competitors.

Though the draft AML has not yet been finalized, USCBC sources have indicated that the Legislative Affairs Office plans to meet NPC's legislative schedule, which calls for the NPC Standing Committee to read the AML for the first time in June. In the fastest scenario, the AML would be reviewed three times before being passed into law in October.

Tax unification

The PRC government's official corporate income tax rate is 33 percent. This rate is often adjusted for both FIEs and domestic firms, with FIEs in particular enjoying numerous and substantial tax breaks. As a result, FIEs currently enjoy an effective income tax rate of 11 percent, while domestic firms face an effective 23 percent rate, according to press reports. The preferential tax policies available to foreign firms have been successful in attracting FDI inflows over the past 20 years, but Chinese firms have complained that the tax incentives enjoyed by FIEs penalize domestic competitors. PRC authorities agree and are planning to "unify" the country's tax rate in legislation expected to take effect in the latter part of 2007.

According to the PRC State Administration of Taxation (SAT), SAT will likely permit contracts signed before the introduction of the new tax regime to maintain current tax rates and will keep existing incentives in place.

Industry experts have indicated that the new corporate income tax regime will likely be set at around 25 percent. Though many current tax incentives, such as the tax holiday enjoyed by newly established FIEs, will be phased out, the new rules are expected to introduce industry-related incentives to replace the current ones, which are largely geographically based.