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It
has become routine to talk about China and its impact on the global
economy. While the opportunities are many and varied, U.S.
businesses looking at China generally focus on either gaining access
to the vast Chinese market or tapping into its huge and inexpensive
labor pool. Whatever the focus, everyone doing business in China
needs to consider what type of platform to use in entering the
Chinese market. This article describes the different ways an
investor can do business in China and provides examples of investors
that have used these different methods.
Representative Office
(RO)
An RO is a very common form of foreign presence in China, especially
when an investor is exploring opportunities. Significantly, an RO
can only indirectly engage in business in China. This means that an
RO can only do certain limited functions such as serving as a
business liaison, engaging in product promotions or market research
and other specific activities permitted by Chinese law. An RO cannot
receive any fees for its services or engage in any profit making
activities (e.g., no direct sales, production or manufacturing
activities) nor can it hire Chinese employees directly (employees
must be hired through a local Chinese labor agency). The primary
benefit of an RO is that it gives an investor a local presence in
China without undue cost and time to establish.
An RO can be very useful in gaining a foothold in China at a
reasonable cost. In addition, certain businesses can only operate in
China as ROs. Examples of where we have used ROs include a U.S.
company exploring manufacturing opportunities for its core product,
a manufacturer conducting market assessments and monitoring
governmental rules regarding its product and a U.S. law firm wishing
to establish a presence in China (foreign law firms can only operate
as ROs).
Wholly Foreign Owned
Entity (WFOE)
The manufacturer has completed its studies and is now looking to set
up a Wholly Foreign Owned Entity (WFOE) to both exploit the markets
and to open a plant in China.
The WFOE (commonly pronounced "Wuffee") is more of a traditional
company in that it can directly engage in business in China and has
limited liability. Unlike an RO, investors establishing a WFOE are
required to make a minimum capital investment. The level of
investment varies by industry and geographical location and is
subject to governmental approval on a case-by-case basis. In major
cities in China, a minimum investment in a WFOE is probably around
$100,000. Local officials are heavily involved in the approval
process (as well as setting the capital requirements) so it is
imperative to have local contacts to help a business establish a
WFOE.
The WFOE is many times preferred over a joint venture because (i) it
allows the investor to control the company and not deal with a
foreign partner; (ii) the overall time and cost commitment to
establish a WFOE tends to be less than that of a joint venture; and
(iii) it can provide increased security for intellectual property
that may be brought to China. For a number of reasons, shares of
WFOEs are generally held by a holding company formed outside of
China.
The major disadvantage for a WFOE is that it takes time, cost and
effort to get the operation off the ground. An attractive
alternative for someone seeking to enter the market may be to
acquire the shares of an existing WFOE or a holding company owning a
WFOE. We were recently involved in the acquisition of a British
Virgin Island company owning shares in a WFOE that was involved in
selling food products in China. The established presence of the WFOE
allowed the company to obtain an entry into the market at a
reasonable cost. By purchasing shares in the British Virgin Island
company, the client was able to avoid having to obtain the approval
of Chinese authorities, a complex and costly process.
Joint
Venture (JV)
Many foreign investors have found that a successful market entry
strategy requires the involvement of an established Chinese partner.
If a foreign investor is looking at a restricted industry vs. an
encouraged industry, the joint venture may be its only route to
entering the Chinese market. There are two types of JVs under
Chinese law, the contractual joint venture (CJV) and the equity
joint venture (EJV). The fundamental difference between the two
types of JVs is how the JV is established and the allocation of
profits and liabilities of the entity.
An EJV is formed between one or more foreign investors and at least
one Chinese company or individual by the creation of a limited
liability company in which each party holds an equity share.
Control, voting rights, profit distribution and liability are
generally determined by the percentage of equity of the EJV held by
each party.
In contrast, a CJV is created by agreement between the parties and
issues such as control, voting rights, profit distribution and
liability are governed by the agreement establishing the entity.
Compared with an EJV, a CJV allows for greater flexibility in the
arrangement between the parties. A common practice with CJVs is for
foreign parties to put in more of the capital and to receive a
higher percentage of profits during the early years of the CJV while
the Chinese partner(s) receive ownership of the fixed assets of the
CJV at no cost upon termination of the JV.
The advantages and disadvantages of either form of JV are inherent
in having a foreign partner. There are obvious advantages to having
a local Chinese partner (e.g., shared responsibilities, a local
understanding of the Chinese market and consumer, local political
and business connections and the ability to operate in a restricted
industry) but there are also significant disadvantages (e.g., lack
of control, difficulty in liquidity, cultural and legal differences
and the risk of the partner using the other partner’s intellectual
property). If a Chinese partner is required under Chinese law or by
necessity, a foreign investor must select their Chinese partner very
carefully.
In the JV context, we assisted an automobile parts supplier in
partnering with an existing WFOE owned by a Malaysian entity. While
the negotiations were difficult, the established presence allowed
the supplier to hit the ground running. In another case, we were
involved in a failed attempt of an investor to enter the local
energy market. Given that this was a restricted industry, a partner
was the only way to potentially gain entry to the market.
Summary
There are definite advantages and disadvantages to the various forms
of doing business in China. Different businesses require different
approaches and one form is not necessarily good for all ventures.
Moreover, although beyond the scope of this article, the tax
consequences of a structure must be considered. To start their
venture, many businesses use a RO to study the market and gain an
understanding of the market and culture. If they see opportunities,
they may later establish a WFOE or enter into a JV. If they see
limited opportunities, they may look to a distributor or supplier
agreement instead of establishing an actual presence. In any case,
one very important point is that whatever the form of business, it
is critical to recognize that all ventures rely on the cooperation
with Chinese businesses and governmental authorities. In particular,
local Chinese officials are influential and active players in just
about all Chinese ventures. Investors entering the market must have
a high level of deference for the local official’s power and
influence on the success of any venture.
Robert W. Irish, J.D.
is a corporate attorney who heads Godfrey & Kahn’s Shanghai, China
office. He can be reached at 8621-6270-2222 ext. 1236 or by e-mail
at Rirish@gklaw.com.
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