By Richard N.Frasch and Charlotte Zhanghaixia Westfall ( Source :www.forbes.com )
This article islast in a three-part series on doing business in China, with a focus on howU.S. and foreign companies can establish a physical presence (e.g., salesoffice or factory) when doing business in China. The first article addressedeight basic considerations U.S. companies should consider when sourcing goodsin China, and the second article addressed eight common mistakes U.S. companiesshould avoid when sourcing goods in China.
Although thefirst two articles focus more on how smaller U.S. companies can do business inChina, this article focuses on what larger U.S. and other foreign companiesmust consider when establishing a physical presence in China. These variousfactors include an entity structure (e.g., a wholly foreign-owned enterprise ora Chinese joint venture), intellectual property protection, tax and importissues, foreign exchange regulation, labor law compliance, and more. Thisarticle discusses some of the bigger issues:
1. Are There Any Restrictions on Foreign Investment tothe Target Sector?
The initialfactor for U.S. and foreign companies (hereafter referred to simply as“companies”) to consider is whether they are going to enter an industry sectorin which foreign investment is restricted or prohibited. The Chinese governmentregulates all foreign investment in China. Companies should review the 2015Catalogue of Sectors for Guidance of Foreign Investment (“2015 Catalogue”) tosee what category of sector their operations fall under: encouraged,restricted, or prohibited. The sectors not listed in the 2015 Catalogue areputatively permitted. The classification of sectors decides the level ofapproval required for foreign investment.
Companies mayhave limited options when establishing a physical presence in China for therestricted category of sectors. They may not set up a wholly foreign-ownedenterprise (see section 4 below for further discussion of “WFOEs”) for certainsectors that are restricted to foreign investment or ownership in China (e.g.,construction and operation of cinemas). However, companies may have the optionsof setting up a representative office or forming a joint venture with a Chineselocal partner if they want to establish a physical presence in China.
2. Location, Location, Location!
The geographicallocation in China of a sales office or factory can often be very important.China is a big country. Different geographic regions within China offer adifferent consumer market for a certain industry. Similarly, whole cities havebeen “built up” to support certain industries such as Wuxi (outside ofShanghai) with respect to the pharmaceutical industry. Such cities usually haveuniversities and other important infrastructure (such as international airportsand modern highways) that can significantly reduce operating costs. Moreover,local governments may have incentive measures to encourage certain areas ofgrowth and foreign investment in particular industries. To take full advantageof these local incentives, companies need to do their due diligence and marketresearch.
A basicunderstanding of the China city tier system is necessary. China’s first-tiercities are Beijing, Shanghai, Guangzhou, and Shenzhen. Second-tier citiesinclude capital cities of provinces or coastal cities like Tianjin, Chengdu,and Xiamen. Third-tier cities are usually medium-sized cities (often withpopulations of over 5 million people) of each province. Each type of city hasits own advantages and disadvantages for doing business. Several factorsdetermine the tier of a city in China, including population size, economicgrowth, GDP, transportation systems, and historical and cultural significance.
Companies needto perform sufficient preliminary market analysis to decide which city bestfits their business strategy and development. They should know whichgeographical market has the most potential for their business growth and wheretheir competitors are located in China. For example, in recent yearssecond-tier cities have become increasingly attractive because of their lowercost of real estate and labor expenses and high potential consumer marketgrowth.
3. Intellectual Property Protection Strategy
Companies shouldhave a carefully structured intellectual property (“IP”) protection strategy inplace before establishing a physical presence in China. Although IP protectionin China has been improved over the years, significant risks still remain forforeign companies, particularly as a result of the rampant IP piracy and theincreasing antitrust law enforcement in the past few years. Because of theseand related concerns, companies should strongly consider consulting with alocal Chinese IP attorney and devise an effective IP protection plan beforeestablishing operations in China.
As part of suchan IP protection plan, companies should seriously consider registration oftheir trademarks and patents in China so that they have legal protectionagainst IP infringement. On a more practical level, they should also implementstrict internal policies and protocols for accessing and disclosing sensitiveinformation, both within their organization and with their Chinese businesspartners.
4. Form of Business Entity for Operations in China
Generallyspeaking, there are three forms of business entities for companies to use whenestablishing physical operations in China:
RepresentativeOffice. Companies can set up a representative office in China to help withtheir business activities. A representative office can be set up relativelyquickly with lower cost than other types of business entities. However, arepresentative office has a very limited business scope in China. It is limitedto engaging in only certain specified activities such as locating suppliers,monitoring quality control at Chinese factories, and other liaison activities.Also, companies must have existing operations for at least two years beforeapplying to set up a representative office.
A representativeoffice is a good option for companies that are not yet ready to investsignificant time and money in the Chinese market. Establishing such offices canoften serve as the first step for companies to enter the market because itallows the companies to do market research, build local connections, learnlocal market practices, and better understand the market and people. It is alsoan option for companies whose businesses are in the restricted or prohibitedindustry sectors, but want to have a China presence; for example, a U.S.medical institute.
Joint Venture. Ajoint venture is a Chinese company with at least one foreign and one Chineseshareholder, with the Chinese shareholder being a company rather than anindividual. A joint venture enables companies to gain access to their Chineselocal partner’s existing business connections, distribution channels, salesnetwork, and local market knowledge. Although a joint venture offers theadvantage of providing access to a local partner’s many resources and businessplatform, it is not a favorable option for many companies. First, manycompanies find it challenging to find a suitable local Chinese partner.Secondly, conflicts often arise among parties in a joint venture with regard tomanagement styles, business cultures, IP, and local standards and practices.
A joint ventureis a good option for companies that already know a local Chinese partner verywell and want access to the local partner’s strong Chinese market position andother business resources. As discussed above, a joint venture is also analternative for companies that enter into a regulated sector that the 2015Catalogue (see section 1 above) prohibits them from setting up a WFOE (see nextsection for a discussion of WFOEs).
A WhollyForeign-Owned Enterprise (“WFOE,” pronounced “wolf-ee”). A WFOE is a privatelyheld limited liability company in China in which all of the equity is held bynon-Chinese shareholders. A WFOE is a popular option for companies looking toestablish a physical presence in China. It is attractive because the parentcompany has full control of the WFOE, leading to efficient decision makingwithout the challenges of potential clashes in management style or businessculture incompatibility as can often be the case with a joint venture. A WFOEalso often allows better protection of IP rights in China in contrast to ajoint venture.
When consideringwhether to form a WFOE, a company should first check whether it is entering arestricted sector in China. If the industry is restricted, then a WFOE may notbe allowed (see section 1 above). Second, the company then needs to determineif it can afford the capital requirements that are sometimes imposed on a WFOE.Currently, minimum capital requirement for setting up a WFOE depends on thenature of its business. A WFOE with a scope of business in consulting, trading,retailing, or information has no minimum registered capital requirement. Someother industries, however, still need to meet a minimum registered capitalrequirement (e.g., banking). Regardless, companies often find it necessary orexpedient to register some minimum registered capital for a WFOE in order tominimize the application of China’s foreign currency control policies.
5. Consider Locating Your Business in a ChineseFree-Trade Zone
What and WhereAre FTZs? U.S. and foreign companies have recently been granted the option toset up a physical presence in free-trade zones (“FTZs”). Today, mainland Chinahas four FTZs: Shanghai Free-Trade Zone (“Shanghai FTZ”), Tianjin Free-TradeZone (“Tianjin FTZ”), Guangzhou Free-Trade Zone (“Guangzhou FTZ”) and FujianFree-Trade Zone (“Fujian FTZ”).
Shanghai FTZ isthe first free-trade zone in mainland China, which was officially launched inSeptember 2013. It covers an area of 120.72 square kilometers that initiallyincluded Waigaoqiao Free Trade Zone, Waigaoqiao Free Trade Logistics Park,Yangshan Free Trade Port Area, and Pudong Airport Free Trade Zone. In April2015, the Shanghai FTZ was further expanded to include three new areasincluding Lujiazui Financial Area, Shanghai Jinqiao Economic and TechnologicalDevelopment Zone, and Zhangjiang High-tech Park.
Following theestablishment of the Shanghai Pilot FTZ, China launched another three new FTZsin early 2015. The three new FTZS are Tianjin FTZ, Guangzhou FTZ, and FujianFTZ.
The Tianjin FTZis the only free trade zone in northern China, which includes Tianjin Port,Tianjin Airport, and the Binhai New Area industrial park. It covers an area of119.9 square kilometers. The Guangzhou FTZ includes the Nansha New Area inGuangzhou, Shenzhen Qianhai and Zhuhai Hengqin New Area, with an area of total116.2 square kilometers. The Fujian FTZ is a FTZ near Taiwan, which includesindustrial areas in the provincial capital of Fuzhou, the whole of Xiamen, andPingtan, with an area of total 118.04 square kilometers.
When Should FTZsBe Used? The Shanghai pilot FTZ is a testing ground for economic andgovernmental reform, including loosening foreign exchange control, liberalizingRMB interest rates, and simplifying administrative approval procedures. TheShanghai FTZ introduced many reforms to attract foreign investment bypublishing a list of 18 service industries to receive more flexible policies inthe zone, including medical services, banking, and value-added telecommunications.It adopts a “negative investment list” approach to foreigninvestment, which specifies restrictions or bans on certain given sectors. Thisapproach has been well received as it loosens the previously strict regulationof the Chinese government and offers more options for business operators.
Although theShanghai FTZ introduces many appealing reforms to attract foreign investment,it has been a slow process for it to implement these reforms. Many companieswith a physical presence in the Shanghai FTZ have not found the businessbenefits to be as great as they had hoped. Many do not know exactly how theShanghai FTZ works as no detailed regulations have been publicly issued.According to a recent Wall Street Journal article, “an annual survey releasedrecently of more than 370 members of the American Chamber of Commerce inShanghai found that almost three-quarters of respondents” believed the ShanghaiFTZ offered few business benefits for their business, Still, some companiesbelieve that it is wise to set up a small physical presence in the Shanghai FTZtoday so that they will be better positioned for that day when the plannedreforms are finally implemented.
The three newlylaunched FTZs have the same goal as the Shanghai FTZ—to carry out Chineseeconomic reform and create a more attractive foreign investment environment.They have many of the same negatives as the Shanghai FTZ. Whether these newFTZs will implement the planned reforms more efficiently and effectively thanthe Shanghai FTZ has yet to be seen. Companies should keep a close eye on howthese FTZs evolve, but it will take time for China to implement its plannedreforms.
Entry into theChinese market is a challenging yet rewarding process, no matter what route youchoose. There are administrative formalities to go through once you decide toset up a physical presence in China, including application submission, registration,and certification. While it is becoming increasing costly to do business inChina, it is still a good destination for those companies that wish to accessthe ever-growing Chinese consumer market.