Choosing a China Investment Vehicle

Foreign companies that want to expand their business in China have more investment options than ever before—though they still face PRC government restrictions.by Lester RossThe time when foreign investors were restricted to entering China through representative offices and joint ventures (JVs) has long passed. Foreign companies in most industries now have a range of options for investing in China, including wholly foreign-owned enterprises (WFOEs), companies limited by shares, foreign-invested partnerships (FIPs), and other investment vehicles. Each investment type offers certain advantages and drawbacks, and companies can choose the option that best suits their development goals and capabilities.

Wholly foreign-owned enterprises

In recent years, the WFOE has been the most popular vehicle for foreign investors to operate in China, accounting for 80 percent of China’s approved foreign-investment projects in 2009 (see Table). The rise in popularity of WFOEs is largely due to relaxed foreign-investment restrictions after China’s 2001 accession to the World Trade Organization (WTO), which dismantled some barriers to foreign investment in the retail, trading, wholesale, and other sectors. The WFOE structure gives the foreign investor full business control and profit rights—but the investor also bears all the risks within the context of limited liability.

One of the main attractions of this investment structure is that it takes less time to establish than a JV, because the foreign company does not need to select a suitable local partner or negotiate JV contract arrangements. In addition, the WFOE structure gives foreign companies greater control over their operations, as no local partner is involved in management and human resources decisions. Most foreign investors—particularly after they have become familiar with China’s business environment—find it much easier to recruit, train, and retain employees when the foreign investor is in full control of the employer side of the relationship. Having the autonomy to manage employees also reduces the likelihood of intellectual property erosion.

The growing popularity of WFOEs does not eliminate the need to work with non-equity Chinese partners, however. Hiring local managers is essential to a foreign company’s success in China because their compensation requirements tend to be lower than their foreign counterparts and they are more familiar with local market conditions, business etiquette, rules and regulations, and government affairs. WFOEs must also interact with local companies to establish distribution channels, customer relationships, and in many cases a government affairs function, given the PRC government’s extensive role in the economy and society.

Not all sectors are open to WFOEs, however. Foreign investors in industries subject to foreign investment constraints, such as telecom and publishing, may consider investing through WFOEs established as consulting companies. These types of companies contractually control most business aspects of the licensed business, which is formally owned by Chinese investors or, where allowed, a JV.

Joint ventures

An equity or cooperative JV (see Two Options for Joint Ventures) is still the preferred investment structure for many companies. Primarily, JVs are preferred when companies want to enter industries in which the PRC government restricts foreign investment. The PRC Catalogue Guiding Foreign Investment in Industry lists various industries in which foreign companies can invest only through Sino-foreign JVs and sets caps on the percentage of foreign ownership in the JV, but these limits may be relaxed for qualified investors from Hong Kong and other regions in China that have separate legal systems. Some of these caps are listed in China’s WTO-entry commitments and tend to linger even if there is no longer a demonstrated need to protect infant industries. For example, though foreign life insurance companies have more extensive experience in the life insurance industry than their Chinese competitors, PRC caps and regulatory restrictions keep domestic companies dominant: Foreign-invested enterprises (FIEs) hold only a 5 percent market share in China’s life insurance industry. Obtaining PRC government approval for foreign investment in these industries also tends to be more difficult, and local partners may help to navigate the process. In some cases, particularly in industries where FIEs are normally prohibited, foreign investors may agree to limit their investment to less than the 25 percent threshold to qualify as a foreign-invested JV.

A JV may also be preferred when the foreign company needs a partner to share the capital investment burden. China’s economic boom and rising prosperity has created a widening pool of potential Chinese partners. Foreign investors in capital-intensive industries in particular may need a Chinese partner to share the investment load, but cash-short investors in technology and other industries may also appreciate the JV option for this reason.

In addition, Chinese companies may have certain technology, distribution capability, or other attributes that make them attractive JV partners. This may be particularly true in industries where the state or state-owned enterprises (SOEs) are the principal customers.

Though many JVs have proved to be effective vehicles for entering China, the structure has certain statutory features that diminish its attractiveness to foreign investors. Under PRC law, a JV requires unanimous approval from its board of directors on major issues—including capital changes, mergers and demergers, and amendments to the articles of association—as well as on other issues contractually agreed by the partners.

Moreover, JVs can be challenging to form or operate successfully anywhere in the world because they require an integration of corporate cultures. Sino-foreign JVs can be particularly difficult to operate because of statutory restrictions and, in many cases, foreign-investment caps and tighter regulation of JVs’ business activities relative to their Chinese-owned counterparts. Employees on both sides of a Sino-foreign JV are also more likely to regard themselves as delegates of their parent companies rather than as representatives of the JV—consigning fiduciary duty to their parent company rather than to the JV. In addition, because structural changes to a Sino-foreign JV require unanimous approval from the board of directors and approval from the PRC government, the JV is less likely than its counterparts elsewhere in the world to be spun off into an independent company by its investors.

Foreign-invested company limited by shares

An alternative investment option to WFOEs and JVs is a foreign-invested company limited by shares (FICLS)—a joint-stock company with its capital divided into shares of equal value and voting rights. Like WFOEs and JVs, FICLS are established on the basis of limited liability; shareholders bear no liability beyond the price of their acquired shares. The FICLS structure has many advantages, including that it allows Chinese partners to invest through companies or as individuals (whereas only Chinese companies can invest in JVs). This structure also facilitates capital formation by allowing the issuance of additional shares to existing or new shareholders, which can promote employee retention by creating an employee stock-ownership arrangement. Perhaps the most attractive feature of a FICLS is the dispensation of the unanimity voting rule. All decisions made by the board of directors or by the shareholders require only a two-thirds majority. A single shareholder can thus exercise full control of the company if he or she holds at least two-thirds of the shares or by virtue of a shareholders’ agreement.

In the absence of regulatory restrictions, the FICLS structure would likely eclipse JVs and even narrow the gap with WFOEs in terms of popularity. But PRC law subjects FICLS to higher capital requirements and restricts FICLS founders to a three-year lock-up period during which they cannot dispose of their shares. A FICLS may be newly established or converted from an existing FIE. In the case of a conversion, the company must satisfy several requirements, including demonstrating that the existing Chinese company has been profitable for at least three consecutive years. In practice, a FICLS is better suited as a vehicle to acquire less than 100 percent interest in a profitable existing business rather than as a greenfield investment.

Foreign-invested partnerships

The FIP is a new vehicle that was established this year by the 2007 PRC Partnership Enterprise Law and its implementing regulations, the State Council’s Administrative Measures on the Establishment of Partnership Enterprises in China by Foreign Enterprises or Individuals, and the PRC State Administration for Industry and Commerce’s Administrative Provisions on the Registration of Foreign-Invested Partnership Enterprises. The FIP structure is particularly attractive to the private equity and venture capital industries for establishing renminbi-denominated funds. Though PRC foreign-investment restrictions still apply, FIPs may be easier to set up because they do not require examination and approval by the PRC Ministry of Commerce. (For more information on FIPs, see Introducing the Foreign-Invested Partnership.)

Holding companies

Foreign investors with multiple projects and large capital investment needs (at least $30 million) should also consider establishing a foreign-invested holding company. A holding company is one way to establish internal programs to train and promote local managers and employees, as employees can be rotated through the holding company’s subsidiaries. Setting up a holding company also allows for consolidation of sales, research and development, and back office functions (but not the filing of consolidated tax returns). Such functions are performed pursuant to a contract between the holding company and its subsidiary and can be more difficult to negotiate if the subsidiary is a JV. This structure can also raise the investor’s profile because it allows the words “holding company” (touzixing gongsi ) and “China” (zhongguo) to be included in the company’s name, whereas PRC law generally restricts other structures from using these terms in their names. In addition, holding companies readily qualify as regional headquarters, which may offer additional benefits.

Further considerations

The increased flexibility in investment structure does not negate other impediments to business success in China, such as government caps on foreign investment and restricted access to government procurement contracts and subsidies. When planning to invest in China, foreign companies should consider other aspects beyond structural and regulatory factors.

China’s tax and investment preferences are factors that can significantly affect FIE operations. Though the PRC government no longer provides a preferential enterprise income tax rate previously enjoyed by foreign investors in production enterprises (and preferential rates for grandfathered companies are being phased out), many localities, industrial or science and technology parks, and other special administrative zones offer tax rates below the 25 percent base set in the PRC Enterprise Income Tax Law.

In addition, the PRC Catalogue Guiding Foreign Investment in Industry is a key document for foreign companies to consult when considering investing in China (see China’s Foreign Investment Catalogue Offers Critical Guidance for Company Investment Structures). The catalogue provides insight on foreign-investment structures that the PRC government permits or restricts in particular industries, and it may dictate the type of investment a company can make in China, depending on how the company’s sector is classified.

[box]

Two Options for Joint Ventures

PRC law provides for two different types of joint ventures: equity (EJV) and cooperative (CJV). Like wholly foreign-owned enterprises, EJVs are independent legal persons with limited liability under PRC law, and CJVs in China also generally operate under this format. There is a statutory exception from limited liability for some CJVs, but in practice this type of investment structure is rarely if ever approved and is unlikely to be attractive to foreign investors because of its potential exposure to unlimited liability.

EJVs are established on the principle of strict proportionality—dividends and shares in the residual assets of the JV after dissolution are distributed strictly in proportion to the parties’ contributions to the JV’s registered capital. Representation on the JV’s board of directors and board of supervisors also tends to be allocated in proportion to the registered capital contributions. In contrast, CJVs are more flexible, allowing one or more parties to contribute terms of cooperation instead of—or in addition to—cash or readily appraisable in-kind assets. The distribution of dividends, residual asset shares, and participation in governance in a CJV reflect the terms of cooperation rather than the proportion of registered capital contributions. Recently, however, PRC commerce bureaus, which have approval authority over JVs, have imposed stricter reviews of the proposed terms of CJV contracts, reducing some of the flexibility associated with the CJV structure.

—Lester Ross
[/box]

[box]

China’s Foreign Investment Catalogue Offers Critical Guidance for Company Investment Structures

The Catalogue Guiding Foreign Investment in Industry is a long-standing tool used by PRC policymakers to manage and direct foreign investment into China. First issued in 1995, the catalogue has been revised numerous times over the years, most recently in 2007. China is expected to release new revisions to the catalogue this year that may shake up certain sectors.

The catalogue divides industries into three basic categories: encouraged, restricted, and prohibited. Foreign-invested enterprises (FIEs) in encouraged industries are often permitted to establish wholly foreign-owned enterprises (WFOEs) and are generally eligible for investment incentives. Foreign investment in industries in the restricted category may be limited to equity or cooperative joint ventures (EJVs or CJVs)—in some cases with the Chinese partner as the majority shareholder—and are subject to higher-level government approvals. Prohibited industries are closed to foreign investment. Industries not listed in the catalogue are generally open to foreign investment unless specifically barred in other PRC regulations and are generally ineligible for investment preferences.

Review: Breaking down the 2007 revisions

The 2007 revisions to the catalogue present a mixed bag for investors—providing more support and openness to some industry sectors while imposing ownership or other restrictions on others. Though the revised catalogue does not open major areas to foreign investment beyond those laid out in China’s World Trade Organization commitments, it includes a more detailed breakdown of industries in the encouraged section and adds some smaller sectors to that list. For example, the revisions add high-tech services sectors and more environmental and energy-saving technologies to the encouraged category.

Despite revisions, certain sectors that the PRC government considers sensitive or strategically important remain closed off to foreign investment. For example, the catalogue forbids foreign investment in print and publishing, film and TV production, Internet content, and certain real estate markets. Other sectors with significant foreign investment also face new restrictions:

• Agriculture  Investment in edible lipids processing, such as soybean and rapeseed oil processing, and biofuel production is limited to JVs with Chinese majority ownership.
• Autos  Foreign investment in auto manufacturing and auto research and development centers is capped at 50 percent.
• Chemicals  Investment in large-scale coal and chemical product manufacturing is limited to JVs with Chinese majority ownership.
• Energy  Foreign investment in the manufacture of new-energy power generation equipment and parts or finished components for power generation in renewable energy is limited to JVs.
• Financial services  The catalogue caps foreign ownership of financial firms at 50 percent for life insurers, 49 percent for fund management and futures companies, and 33 percent for securities companies.
• Logistics and transportation  Wholesaling of certain products (such as vegetable oils, autos, and chemical fertilizers) and the establishment of passenger transport companies are restricted to majority Chinese-controlled JVs.
• Resources  The survey, development, and extraction of oil and natural gas deposits, as well as several categories of renewable energy, are limited to EJVs and CJVs. Investment in the construction and operation of electricity networks is restricted to JVs with Chinese majority control.
• Telecom  Foreign investment in value-added and basic telecom services may not exceed 50 percent.

What’s next for the catalogue?

An April 2010 PRC State Council notice on improving the use of foreign investment stated that China aims to improve its market environment for foreign investors. According to the notice, the updated catalogue planned for release this year will encourage foreign direct investment in high-end manufacturing, new and high technologies, modern services, new energy, energy-saving sectors, and environmental protection. FIEs in these industries could benefit from preferential policies and more flexible investment options.

On the other hand, ongoing PRC government efforts to curb overcapacity may negatively affect FIEs in certain industries (see China Accelerates Efforts to Combat Overcapacity). The government has highlighted industries such as coal, coal-to-chemical, construction materials, ferrous alloys, nonferrous metal, steel, and thermal power as key targets for reducing overcapacity. The new revisions will likely further limit foreign investment in these sectors, as well as in low-end, highly polluting, and energy-intensive industries.

Foreign companies should be on the lookout for upcoming revisions to the catalogue that may expand or limit their options for investing in China. FIEs operating in restricted industries should also be aware of provisions in the catalogue that limit the format and level of foreign investment, and should work with central- and local-PRC government officials that supervise and approve foreign-investment projects.

—Julia Zhao
[/box]

[author] Lester Ross ([email protected]) is co-partner-in-charge at Wilmer Cutler Pickering Hale and Dorr LLP’s Beijing office. [/author]