This article focuses on what larger U.S. and other foreign companies must consider when establishing a physical presence in China. These various factors include an entity structure, intellectual property protection, tax and import issues, foreign exchange regulation, labor law compliance, and more. This article discusses some of the bigger issues:
1. Are There Any Restrictions on Foreign Investment to the Target Sector?
The initial factor for U.S. and foreign companies to consider is whether they are going to enter an industry sector in which foreign investment is restricted or prohibited. The Chinese government regulates all foreign investment in China. Companies should review the 2015 Catalogue of Sectors for Guidance of Foreign Investment to see what category of sector their operations fall under: encouraged, restricted, or prohibited. The sectors not listed in the 2015 Catalogue are putatively permitted. The classification of sectors decides the level of approval required for foreign investment.
Companies may have limited options when establishing a physical presence in China for the restricted category of sectors. They may not set up a wholly foreign-owned enterprise for certain sectors that are restricted to foreign investment or ownership in China. However, companies may have the options of setting up a representative office or forming a joint venture with a Chinese local partner if they want to establish a physical presence in China.
2. Location, Location, Location!
The geographical location in China of a sales office or factory can often be very important. China is a big country. Different geographic regions within China offer a different consumer market for a certain industry. Similarly, whole cities have been “built up” to support certain industries such as Wuxi with respect to the pharmaceutical industry. Such cities usually have universities and other important infrastructure that can significantly reduce operating costs. Moreover, local governments may have incentive measures to encourage certain areas of growth and foreign investment in particular industries. To take full advantage of these local incentives, companies need to do their due diligence and market research.
A basic understanding of the China city tier system is necessary. China’s first-tier cities are Beijing, Shanghai, Guangzhou, and Shenzhen. Second-tier cities include capital cities of provinces or coastal cities like Tianjin, Chengdu, and Xiamen. Third-tier cities are usually medium-sized cities of each province. Each type of city has its own advantages and disadvantages for doing business.
Companies need to perform sufficient preliminary market analysis to decide which city best fits their business strategy and development. They should know which geographical market has the most potential for their business growth and where their competitors are located in China.
3. Intellectual Property Protection Strategy
Companies should have a carefully structured intellectual property protection strategy in place before establishing a physical presence in China. Although IP protection in China has been improved over the years, significant risks still remain for foreign companies, particularly as a result of the rampant IP piracy and the increasing antitrust law enforcement in the past few years. Because of these and related concerns, companies should strongly consider consulting with a local Chinese IP attorney and devise an effective IP protection plan before establishing operations in China.
4. Form of Business Entity for Operations in China
Generally speaking, there are three forms of business entities for companies to use when establishing physical operations in China:
Representative Office. Companies can set up a representative office in China to help with their business activities. A representative office can be set up relatively quickly with lower cost than other types of business entities. However, a representative office has a very limited business scope in China. It is limited to 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 before applying to set up a representative office.
A representative office is a good option for companies that are not yet ready to invest significant time and money in the Chinese market. Establishing such offices can often serve as the first step for companies to enter the market because it allows the companies to do market research, build local connections, learn local market practices, and better understand the market and people. It is also an option for companies whose businesses are in the restricted or prohibited industry sectors, but want to have a China presence; for example, a U.S. medical institute.
Joint Venture. A joint venture is a Chinese company with at least one foreign and one Chinese shareholder, with the Chinese shareholder being a company rather than an individual. A joint venture enables companies to gain access to their Chinese local partner’s existing business connections, distribution channels, sales network, and local market knowledge. Although a joint venture offers the advantage of providing access to a local partner’s many resources and business platform, it is not a favorable option for many companies. First, many companies find it challenging to find a suitable local Chinese partner. Secondly, conflicts often arise among parties in a joint venture with regard to management styles, business cultures, IP, and local standards and practices.
A joint venture is a good option for companies that already know a local Chinese partner very well and want access to the local partner’s strong Chinese market position and other business resources.
A Wholly Foreign-Owned Enterprise. A WFOE is a privately held limited liability company in China in which all of the equity is held by non-Chinese shareholders. A WFOE is a popular option for companies looking to establish a physical presence in China. It is attractive because the parent company has full control of the WFOE, leading to efficient decision making without the challenges of potential clashes in management style or business culture incompatibility as can often be the case with a joint venture.
When considering whether to form a WFOE, a company should first check whether it is entering a restricted sector in China. If the industry is restricted, then a WFOE may not be allowed. Second, the company then needs to determine if it can afford the capital requirements that are sometimes imposed on a WFOE. Currently, minimum capital requirement for setting up a WFOE depends on the nature of its business.
5. Consider Locating Your Business in a Chinese Free-Trade Zone
What and Where Are FTZs? U.S. and foreign companies have recently been granted the option to set up a physical presence in free-trade zones (“FTZs”). Today, mainland China has four FTZs: Shanghai Free-Trade Zone, Tianjin Free-Trade Zone, Guangzhou Free-Trade Zone and Fujian Free-Trade Zone.
Although the Shanghai FTZ introduces many appealing reforms to attract foreign investment, it has been a slow process for it to implement these reforms. Many companies with a physical presence in the Shanghai FTZ have not found the business benefits to be as great as they had hoped. Many do not know exactly how the Shanghai FTZ works as no detailed regulations have been publicly issued. According to a recent Wall Street Journal article, “an annual survey released recently of more than 370 members of the American Chamber of Commerce in Shanghai found that almost three-quarters of respondents” believed the Shanghai FTZ offered few business benefits for their business.
The three newly launched FTZs have the same goal as the Shanghai FTZ—to carry out Chinese economic reform and create a more attractive foreign investment environment. They have many of the same negatives as the Shanghai FTZ. Whether these new FTZs will implement the planned reforms more efficiently and effectively than the Shanghai FTZ has yet to be seen. Companies should keep a close eye on how these FTZs evolve, but it will take time for China to implement its planned reforms.