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Doing business in China part 2 - establishing a business in China

This guide was last updated in December 2017

Forms of business establishment

This guide provides basic information on the legal framework for foreign investment and operations in China, in three parts:

For more detail request a full version of the Pinsent Masons guide to doing business in China.

Foreign invested enterprises (FIEs): foreign investors wishing to establish a presence to do business within the People's Republic of China (PRC) must establish one of the several different statutory forms of FIE. These are regulated under stricter laws than domestic companies, but the gap between domestic and foreign enterprise regulation has been diminishing for years. FIEs are subject to the same generally-applicable laws and regulations. In general, only companies with 25% foreign equity or more can be considered as FIEs.

The choice of FIE form depends on the category of the intended activity in the Guidance Catalogue, as well as on the particular operational needs or objectives of the foreign investor. Under China's strict sectoral approach to regulating business activities, FIEs will receive a business license permitting operations only within a relatively narrow scope of business, rather than for any lawful purpose. Forms of FIE include:

  • Wholly foreign-owned enterprise (WFOE): a limited liability company 100% owned by one or more individual or corporate foreign investors. The liability of the investors is limited to their subscribed registered capital. WFOEs are the most popular form of FIE;
  • Equity joint venture (EJV): the most common of the two types of statutory joint venture. An EJV is a legal person company invested in together by both foreign and domestic corporate investors. The equity interests of the investors, and the division of profits, is strictly proportional to their shares of contributed registered capital;
  • Cooperative joint venture (CJV): CJVs are normally established as legal person limited companies, but may also be established as a non-incorporated contractual cooperation. The liability of the partners in an unincorporated CJV is unlimited, and investors tend to have greater flexibility. Non-incorporated CJVs are typically only established for specific limited purposes and activities such as collaboration in natural resources exploration and venture capital investments;
  • Foreign invested company limited by shares (FICLS): a joint Chinese and foreign-invested company, hence a form of joint venture (JV), limited by shares. An investor's liability is limited to its individual subscription. Companies seeking listing on the Chinese stock market must be in the form of a FICLS. A WFOE, EJV or CJV may convert to an FICLS in accordance with PRC law;
  • Holding company and regional headquarters: investors with major operations already in the country may wish to consider establishing a holding company or a regional headquarters to help consolidate certain group treasury, support services and trading functions. There are significant minimum investment thresholds, and operations are limited to holding company functions;
  • Foreign invested partnership enterprise (FIPE): available since 2010. Except for market access and other key differences, FIPEs function under the same rules as domestic partnerships and generally much the same as partnerships in the west. Given the still fairly limited experience with this form of entity, partnerships still face many more legal, tax and administrative uncertainties relative to other, more mature forms of enterprise.

In addition to the different basic forms of FIE, special types of FIE also exist to carry out certain specific business activities.

Foreign Invested Commercial Enterprise (FICE): this is a CJV, EJV or WFOE approved to carry out domestic agency, wholesale, import-export and perhaps retail activities.

Foreign Invested Venture Capital Investment Enterprise (FIVCIE): this is a CJV, EJV or WFOE, specifically approved to undertake VC-type RMB equity investments in non-listed PRC high-tech companies, but only such companies. The limitation to high tech portfolio companies means that the FIVCIE is not a general-purpose RMB foreign-invested onshore PE/VC fund vehicle. It is however possible to establish general-purpose wholly foreign owned fund management companies.

Joint Universities: there are generally two types of higher education JV: JV Programmes and JV Institutions. Neither of these falls under the standard rules for EJVs or CJVs. A JV Programme is a short term collaboration by contract, normally for three years. A JV Institution can be established for long term cooperation, up to 50 years, and must have a least three programmes.  JV Institutions are generally set up as dependent colleges of the Chinese partner institution, and not as independent legal persons, except in the case of a limited number of large-scale Sino-foreign joint venture universities.  

Representative offices and branches: Where more limited activities are contemplated or limited liability is not required or permitted, foreign investors may establish a representative office or branch in China:

  • Representative office (RO): an entity that may conduct some restricted activities on behalf of a foreign parent company, but cannot engage in direct profit-making activities itself;
  • Foreign company branch: a branch of a foreign company is permitted to engage in direct business activities, however this is only available for certain businesses such as commercial banking and oil exploration;
  • Domestic company branch: a company already established in China may set up branches to operate its business at places different from its registered address. Such a branch does not have independent legal personality or limited liability, and its parent therefore has unlimited liability for its debts.

VIE structures: China's restrictions on foreign investment in different sectors have not entirely prevented foreign investment in those sectors.  

The most common way around the restrictions has been the so-called variable interest entity (VIE) structure. This is a US accounting term for a subsidiary entity that is not controlled by voting rights but is subject to contractual controls functionally equivalent to voting rights that  allow the subsidiary's accounts to be consolidated with the parent.  

Under a typical VIE structure the domestic business restricted to foreign investment will be carried out by a purely domestic operating company, with only PRC shareholders;  the foreign investors will set up a  WFOE in a permitted sector, typically technical or management consulting, there will be a series of contracts between the WFOE, the operating company, and the operating company's shareholders, basically giving the WFOE and foreign investor the right to control and take the profits of the operating company. 

Typically the Chinese parties owning the domestic operating company will also own equity in the offshore group parent, and will also own equity in the offshore group parent, and will look to be compensated at that level. 

Because the purpose and effect of the structure is to permit foreign investment in areas prohibited to foreign investment, VIE structures inhabit a grey area of PRC law. There are a number of risks to the VIE structure, and the risks are probably greater for companies that are ultimately owned by foreign investors.

Those risks include:  

  • complex contractual structure makes contingency planning difficult, and future outcomes unpredictable.
  • the VIE contracts could be deemed invalid and unenforceable, as against public policy.
  • multiplication of entities is tax inefficient under transfer pricing requirements.
  • regulators could expressly deem the structure illegal in general in future, or could crack down on any particular VIE structure.

Because of these risks you should not enter in to a VIE lightly, and should consider whether there any viable alternatives; and if the structure is adopted, plan and document it carefully. 

Funding

Equity ownership in WFIEs and JVs is expressed as a percentage of registered capital. Registered capital has the following features:

  • registered capital is defined as subscribed capital, rather than paid-in capital;
  • there is no general requirement to pay in registered capital, although there are consequences for failure to do so, such as limits on the company's ability to take foreign exchange loans;
  • there are no general minimum registered capital requirements, although specific limits are prescribed in national law or State Council regulations for certain activities;
  • there are no fixed time limits for paying in registered capital, although a company's articles of association should require that it be paid in before the end of the term of the company;
  • there are no minimum rations of cash to other forms of registered capital, although there are limits on the types of permissible non-cash contributions. 

An FIE's registered capital can be stated in either foreign currency or Chinese currency (RMB).

It is generally quite easy to increase registered capital but this can be a time consuming process. The recommended approach to capital planning is that investors should fix initial total investment at an amount required to fund capital expenditures and working capital until the enterprise reaches operating break even.

However, it may be less easy to reduce registered capital, so any excess could become trapped in the company. The use of some amount of debt financing to satisfy total funding requirements helps avoid a cash trap for excess registered capital.

Forms of capital contribution: registered capital can be contributed in the form of cash, capital equipment, land use rights, debt and share rights  and intellectual property rights.

In general, title to contributed non-cash asset should pass to the enterprise. Accordingly, revocable licenses, future services and other such contingent interests are generally not permissible as contributions to registered capital. There is however an exception in the case of CJVs, where it is permitted to contribute "cooperative conditions" that may include contractual performance.  Mortgaged assets also may not be contributed to registered capital in any event.

Debt ceilings: in order to help ensure corporate financial strength, FIEs and domestic enterprises alike are limited in the amount of foreign exchange borrowing that they can undertake.

Traditionally, FIE borrowing was limited by certain statutory ratios of paid in capital to total investment. First in May 2016, and then with new regulations in January 2017, a new system was put in place nationally, whereby FIEs could opt to calculate debt ceilings based on a more flexible multi-factor test. The multi-factor test had been trialled in the FTZs, previously.

The ability to choose between the old or new system was made available only for a limited transitional period of 1 year, to January 2018. After that time, SAFE and the NDRC will reassess the situation. It is widely assumed that the multi-factor test will become mandatory.

For now, FIEs will need to determine which method is most attractive.

Timing of capital contributions: there is no specific requirement on the time limit for completion of the full capital contribution. However, in practice, the AICs in many areas may still require that a fixed contribution deadline be included in the company's articles of association.  In practice, there is no longer any clear mechanism to require compliance with the articles of association payment deadlines. But because the consequences of non-payment cannot be fully predicted, it would be most prudent to pay in the registered capital in accordance with the articles of association.

Transfers of interest in registered capital: co-investors have a statutory right of first refusal to purchase registered capital in the event of transfer to a new investor. Their consent for such transfers is required. MOFCOM filing is sufficient for most activities, but its approval is required for companies involved in activities on the negative list. 

Pledge of interest in registered capital: investors may pledge their interests in registered capital only with the approval of the original co-investors and provided it is not otherwise prohibited by the company's articles of association. Pledges should be filed with or approved by MOFCOM and registered at the AIC with jurisdiction over the company. 

Increase in registered capital: this must be approved by the original approval authorities and investors have a statutory pre-emptive right to subscribe to new capital in the same proportion as their original equity shares. MOFCOM approval or filing is required for capital increases, but approval, if required, is normally granted as a matter of course. However, where the original registered capital has not already been contributed in full, MOFCOM may require that this be done before approving a capital increase.

Decrease in registered capital: this may only be done under fairly limited circumstances, generally related to a decrease in the scale of the business. Previously, MOFCOM approval was required in all cases. For companies not involved in activities on the negative list, capital reduction is now subject to MOFCOM filing rather than approval. However, MOFCOM still has wide discretion in administering filings, and it may use heightened scrutiny in reviewing applications to reduce capital. .

Organisation and governance

In the wake of its accession to the World Trade Organisation, China has steadily unified the regulatory regimes for domestic and foreign-invested enterprises. However, original regulations and various special rules subsist. As a result, FIEs are still treated differently than domestic companies in certain key respects, although the areas of common treatment are steadily increasing between the two.

Structuring – offshore special purpose vehicle (SPV): the basic advantage of an SPV is that, if the offshore SPV owns the equity of a PRC investee, transfers of ownership in the PRC investee can be cleanly completed by a transfer of shares in the offshore SPV, thus generally avoiding the need for the onshore PRC transfer approvals mentioned earlier.

If PRC-domiciled parties invest in such an SPV, the PRC investors should first obtain relevant offshore investment approvals and foreign exchange registrations for this 'round trip' investment.

Shareholder meetings: WFOEs and FICLSs must hold shareholder meetings at least once a year, and these constitute the highest authority of the companies. 

Board of directors or executive director: the board of directors is the highest authority of EJVs and incorporated CJVs. Non-incorporated CJVs have a management committee, which is constituted and operates similarly to a board of directors. Board powers are specified partly by statute and partly by articles of association and, for JVs, in the JV contract.

In EJVs board representation should reflect the equity ratio between the shareholders.

Chairman: in EJVs the chairman is generally appointed by the majority equity holder.

Legal representative: the legal representative of an LLC or company limited by shares is an individual who is legally accountable for the company and its acts, and who has the power to contractually bind the company. This is therefore a sensitive position.

Supervisors: being on the board of supervisors involves general oversight of company finances and compliance. Senior managers and directors of a company may not also serve as supervisors of the same company.

Management: companies are largely free to specify their management structures. JVs must have a general manager and a financial manager.

Company chops: each enterprise, subsequent to registration, will be issued with certain chops (a stamp or seal) that are generally presumed to be definitive proof of the company's approval of documents to which the chop is attached.

Establishment procedures

Establishing a business in China is more complex and time-consuming than in many western jurisdictions. The process is even more burdensome for foreign than for domestic investors. Procedures will vary depending on the type and characteristics of the project, so should be confirmed on a case-by-case basis.

Company name reservation: done with State Administration of Industry and Commerce (SAIC or local AIC) business registration authorities in the target locality. Company names in foreign languages cannot be registered in China, although foreign trade names may be registered as trademarks on a first-to-file basis. An FIE investor will need to choose a Chinese business name according to the standard form, normally consisting of four elements:

  • name of the administrative region where the FIE will be located;
  • trade name consisting of at least two Chinese characters;
  • business or industry;
  • organisational form.

Project approval: the National Development and Reform Commission (NDRC) manages economic planning and industrial policy. Part of this is a regime of pre-establishment review and approval for new foreign-invested companies. 

The extent of the review depends on the scale and sensitivity of the project. Smaller, less sensitive projects are subject to a simple 'filing for the record' process requiring only basic information on the project and its investors. 

Larger and more sensitive projects are subject to verification and approval. This intensive review process involves the submission of large amounts of information and it increases with the scale and sensitivity of the project, from local to provincial to a central level in Beijing.

The NDRC publishes a list of activities that need to go through this process, called the 'Verification and Approval Catalogue'. If a project is not covered by the catalogue it should only be subject to filing for the record with the NDRC.

MOFCOM also has a role approving projects. If a project is not included in the negative list it need only be filed for the record with MOFCOM. If it is included in the negative list then prior review and approval is required. This will entail pre-approval from the administration in charge of the industry and verification and approval by the NDRC.

Business license issuance: the SAIC issues business licences as proof of the company's due legal establishment. It is like the certificate of incorporation in other countries. It is issued by the SAIC as a matter of course, based on the MOFCOM approval certificate.

Ancillary registrations: Newly-registered businesses should file for registration with various government departments for a number of additional registration certificates within 30 days after the business license is issued.

Foreign exchange controls

Foreign exchange controls are a critical factor in the planning of both investments and operations in China, and proposed cross-border fund flow of any type should be evaluated from this perspective early in the planning process.

Liberalisation of foreign exchange controls was a significant element of the reforms introduced in the Pilot FTZs, and has for the most part been extended to the rest of the country. 

Foreign exchange controls are principally administered by the State Administration of Foreign Exchange (SAFE). 

Foreign exchange bank accounts: for all FIEs, foreign exchange transactions must be opened at a designated foreign exchange bank.

Capital account and current account: all foreign exchange payments and receipts must be based on an underlying transaction, so it is important to document cross-border transactions fully and accurately. 

Foreign exchange transactions are categorised as either current account or capital account transactions and each is subject to different controls. 

Current account items relate to day to day business operations such as interest payments of payments received or made for goods and services. Higher scrutiny generally begins for transactions of over $50,000.

Capital account items are transactions that increase or decrease the debt or equity of an enterprise through the inflow or outflow of capital. They are subject to SAFE registration or approval in advance. 

Foreign borrowing: FIEs, unlike domestic enterprises, are generally free to undertake foreign currency loans from offshore lenders. However, these loans must be registered with SAFE.

Profit remittances: FIEs may declare profits on an annual basis after all taxes have been paid and previous years' losses have been made up. They must allocate 10% of after-tax profits to a statutory reserve up to the point where the reserve balance equals 50% of registered capital. 

FIEs are in general allowed to remit dividends to offshore investors without case-by-case approval from SAFE. But the approval function lies with banks, which will review board resolutions; tax clearance certificates; audited accounts, and other documents as a condition to approving dividend payments. Also, foreign exchange policy continues to fluctuate with China's macro foreign exchange flows. For example in 2016 after a period of record currency outflows, SAFE introduced a new policy requiring case-by-case review for all fund outflows over $5 million, resulting in significant difficulties for many large multinational corporations in remitting dividends abroad.