FOREIGN INVESTMENT AND OPERATION IN CHINA: OPTIMIZE YOUR DISTRIBUTION MODELS AND STRUCTURES. DLA Piper China Investment Services September 2014

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1 FOREIGN INVESTMENT AND OPERATION IN CHINA: OPTIMIZE YOUR DISTRIBUTION MODELS AND STRUCTURES DLA Piper China Investment Services September 2014

2 Agenda Introduction Selling into China Through E-commerce Selling into China: Business Models and Issues Selling into China Through E-commerce: Legal Entity Structuring 2

3 Selling into China Through E-commerce DLA Piper China Investment Services Daniel Chan, Partner, Hong Kong September 2014

4 1. E-commerce in China Possible Business Models

5 Selling into China through e-commerce Why e-commerce? Why China? Rise of Chinese consumers' purchasing power increasing China's GDP Geographic spread / diversity of Chinese population Anti-bribery campaign wealth spread out more evenly Buying habits / patterns of young generations of Chinese consumers Rising costs of real estate / lease in major Chinese cities 5

6 Selling into China through e-commerce What is possible? 1. Possible business models for selling products and services into China through e-commerce A) Sale of products Model I: Selling through non-chinese website without registering Chinese company a) domestic sourced goods b) imported goods Model II: Non-Chinese company selling through 3 rd -party Chinese e-commerce platform Model III: Establishing a Chinese wholesale / online retail company Model IV: Selling through Free Trade Zone e-commerce platform B) Sale of services, apps, software, etc. Other online information services" for which a value added telecom (VAT) license would be required 2.Consumer protection in China 3.Evolution of wholesale/ retail structure in China 6

7 Possible business models for products model I A) Sale of products Model I: non-chinese website / no Chinese subsidiaries a) Domestically sourced goods - drop shipment from manufacturer (OEM) Foreign Seller Title Transfer Physical Delivery Online Payment Provider (e.g. Alipay, Unionpay, or FX: Visa, Master, Paypal) $? OEM Drop shipment problematic OEM will have problems receiving foreign exchange (forex or FX) from foreign seller (no export document) Consumer will be issued invoices from OEM 7

8 Possible business models for products model I Model I: non-chinese website / no Chinese subsidiaries a) Domestically sourced goods - use of Chinese trading company Foreign Seller Title Transfer Physical Delivery Online Payment Provider (Alipay, Unionpay, or FX: Visa, Master, Paypal) $? Trading Agent OEM Use of PRC trading agent equally problematic Forex remittance of costs of goods to trading agent problematic (no export documents) Invoices to consumer by trading agent, not foreign seller 8

9 Possible business models for products model I Model I: non-chinese website / no Chinese subsidiaries b) Import sales Title Transfer Foreign Seller OEM Physical Delivery Bonded Zone / HK Logistic Company (FedEx, DHL, Zhongtong ( 中 通 ), Shentong ( 申 通 )) OEM Implementation costs: Logistic cost / delay Administrative cost / customs clearance Duty cost (retail price as dutiable value) Return / refund policies complicated with overseas sales Consolidation / u-turn in bonded zone / HK improves delivery time (and customer satisfaction) 9

10 Possible business models for products model I Model I: non-chinese website / no Chinese subsidiaries b) Import sales Foreign Seller OEM Title Transfer Physical Delivery Online Payment Provider (Alipay, Unionpay, or FX: Visa, Master, Paypal) Bonded Zone/HK Logistic Company (FedEx, DHL, Zhongtong ( 中 通 ), Shentong ( 申 通 )) OEM Use of online payment provider e.g. Alipay, Unionpay are the Chinese versions of PayPal Approved Sep 2013 to conduct cross border online payment service (RMB FX and vice versa) Settlements remitted directly to international bank accounts e.g. Alipay transaction caps: US$10,000 for trade of goods; US$50,000 for overseas study, hotel, airplane tickets 10

11 Possible business models for products model I Model I: Non-Chinese website / no Chinese subsidiaries Consumer setting up an Alipay account: procedures General process: 1) Connect bank account to Alipay account using bank number 2) For every transaction, enter name and delivery address 3) Enter Alipay account number (bank account number not necessary) Alipay popular services: 1) 快 捷 支 付 Quick payment Pay with accepted debit or credit card linked to Alipay account 2) 余 额 宝 Yu E Bao Pay with money previously deposited into Alipay account Settlement banks: 11

12 Possible business models for products model II Model II: Non-Chinese company selling through 3 rd -party Chinese e-commerce platforms Market Share of Chinese B2C E-commerce Platforms 天 猫 京 东 QQ 网 购 苏 宁 亚 马 逊 唯 品 会 国 美 在 线 当 当 网 一 号 店 凡 客 诚 品 12

13 Possible business models for products model II Model II: non-chinese company selling through 3 rd -party Chinese e-commerce platforms 13

14 Possible business models for products model II Model II: non-chinese company selling through 3 rd -party Chinese e-commerce platforms Top 10 by Market Share and their Key Product Category 1. Clothes 2. Electronics 3. Electronics 4. Electronic Appliances 5. Books 6. Books 7. Clothes 8. Electronic Appliances 9. Groceries 10. Clothes Source:enfodesk 14

15 Possible business models for products model II Model II: non-chinese company selling through 3 rd -party Chinese e-commerce platforms Jd.com "We currently do not cooperate with foreign suppliers" Tmall.com "There must be a business entity located in Mainland China holding a Chinese retail business license" Currently, for a non-chinese company to engage a 3 rd party Chinese e-commerce platform, the non-chinese company must set up a Chinese company (but please see the next slide) 15

16 Possible business models for products model II Model II: Non-Chinese Company selling through 3 rd Party Chinese E-commerce Platforms Tmall Global (tmall.hk ( 天 猫 )) Non-Chinese companies can engage Tmall Global to conduct sales in China without setting up a Chinese company Orders can be fulfilled and shipped from outside China, and payments settled in preferred native currency All products need to have relevant trademark registrations in Hong Kong Companies are required to provide a Chinabased product return arrangement Import and remittance procedures similar to import sales (slides 7-8) Import sales still suffer from logistics costs / delays 16

17 Possible business models for products model III Model III: establishing a wholesale / online retail company in China Setting up a Foreign Invested Commercial Enterprise (FICE) in the form of a Wholly Foreign Owned Enterprise (WFOE, i.e. 100% owned subsidiary of a non-chinese parent) Foreign Seller OEM Title Transfer Physical Delivery 100% Own Retail Website or Wholesale / Online Retail WFOE OEM contract 3 rd Party E-commerce Platform RMB 17

18 Possible business models for products model III Model III: establishing a wholesale / online retail company in China a) Business scope NOTE: Under relevant Chinese laws, a FICE with a business scope of "wholesale" should be sufficient to operate online retail business, but some cities like Shenzhen disagree Business Scope Pre-packaged food (microwave, refrigerated) and food products, drinks, flavor additives (excluding salt and sugar), uniforms, kitchen tools, plastic products, metal products, paper products, display shelves and counters, daily goods, internet retail (excluding food), imports exports, commission agents (excluding auction), providing relevant consulting services (does not involve goods leaving country, involves quotas, licensed products, relevant application by country) b) Equity investment No legal requirement according to new Company Law; however, the establishment of all foreign invested enterprises (FIE, like WFOEs) requires approvals, and the local approval authorities normally would impose certain minimum equity requirement 18

19 Possible business models for products model III Model III: establishing a wholesale / online retail company in China I. Setting up own website a) Domain name i. Check to see if domain is available or for sale / auction ii. Register domain with China Internet Network Information Center (CNNIC - organization that controls all Chinese domains (.cn)) iii. (.com) not registered with CNNIC, but if server and operator is in China, a recordal with the Ministry of Industry of Information Technology (MIIT) needs to be done (see part b) b) Recordal with MIIT i. Recordal with CNNIC to link website with owner and business ii. Hosting agency (usually 3 rd party) and IP addresses regulated by MIIT c) Online payment service i. Need a value-added telecommunications services (VATS) license ii. Usually use 3 rd party service: Alipay, Unionpay d) Social media networking i. E.g. WeChat and Sina Weibo are the most popular for businesses ii. Some also develop their own apps for consumers' convenience 19

20 Possible business models for products model III Model III: establishing a wholesale / online retail company in China II. Engage 3 rd -party e-commerce platform How to set up a store on Tmall? Step 1: Apply for a new Alipay account (for Tmall only) Step 1: Record and submit information to Tmall Wait 7 days for Tmall to get back to you Step 1: Sign Alipay witholding agreement and other business files Step 2: While waiting 3-7 business days can start to configure Tmall shop Step 2: Select name and domain name, and sign online service agreement Step 2: Pay annual fee Step 3: Sell your products 20

21 Possible business models for products model IV Model IV: Sales through free trade zone e-commerce platform FX Foreign Seller OEM Title Transfer Physical Delivery Online Payment Provider Free Trade Zone E-Commerce Platform bonded Warehouse OEM Cash / Payment Order RMB Customs declaration Goods remain in bonded status a) Foreign seller to contract with Chinese e-commerce platform registered in a Free Trade Zone (currently only Kua Jing Tong in Shanghai Free Trade Zone), which is specifically allowed to contract with foreign sellers. b) Goods may (i) be stored in a bonded warehouse inside the Free Trade Zone before distribution, or (ii) be directly shipped to China customers from overseas c) E-commerce platform undertakes consolidated custom declaration" for importation d) On-line payment provider collects RMB payment from customers and pays FX to foreign seller 21

22 Possible business models for products model IV a) Kua Jing Tong ( The first cross-border B2C e-commerce enterprise granted by Chinese government A platform registered in Shanghai PFTZ and supported by Shanghai customs, Shanghai CIQ and SAFE EasiPay as the on-line payment service provider, also with government investment Amazon and Yi Hao Dian have signed up with Shanghai PFTZ More FTZ e-commerce platforms expected b) Special customs procedure under new custom regulation E-commerce platform, FTZ warehouse operators, payment service provider and logistics service providers are connected to China customs' E-port system, and required to submit transaction data E-commerce platform and its agents should undertake to complete customs declaration procedure and withhold / pay off customs duty by cooperation with payment service provider Goods can be released to customers based on check list, while customs declaration can be conducted on consolidated and monthly basis Goods will be deemed as articles purchased by individual for assessment of custom duty, rather than merchandizes imported for business, and the custom duty rate generally will be lower 22

23 Possible business models for services, apps, software, etc. B) Sale of services, apps, software, etc. (i.e. non-trade items) Foreign Service Provider Online Payment Provider (Alipay, Unionpay, Visa, Master, Paypal) Online purchases of services, apps, and software (limits on type and amount of transaction) 23

24 Possible business models for services, apps, software, etc. Under relevant Chinese laws, certain service offerings such as the following require special operating licenses issued by MIIT (e.g. VATS license) a) Information services e.g., app store, online advertising, online games b) Store and forward services e.g. c) On-line data processing and transaction processing services e.g. e-commerce d) Domestic multi-party communications services e.g. video-conference and Internet conference e) Internet data center services e.g. server leasing or hosting f) Call center services 24

25 Possible business models for services, apps, software, etc. Service offerings such as the above would trigger VATS license requirements; there are generally 2 main issues in this regard: a) Difficulty of getting a VATS license if applicant is FIE b) Restriction on foreign ownership on application (mostly 50% cap on foreign ownership, with some exceptions) Current Chinese law is not clear whether the above requirements apply to non-chinese websites selling into China From our practical experience, in some locations in China, government officials interpret the above based on the following factors: a) Operator is in China? or b) Server is in China? 25

26 Possible business models for services, apps, software etc. Common business models to overcome the above issues: Variable interest entity (VIE) models Foreign Service Provider WFOE (profits stripping) service fee LLC Nominees VATS License management consultancy service / license (management control document) 26

27 Possible business models for services, apps, software, etc. Other issues if operating a non-chinese website only 1. Tax Whether foreign seller establishes a permanent establishment (PE) in China 2. Duties 3. Sensitive contents State secrets, politically sensitive content, etc. Chinese authorities can block access to non-chinese websites from China if there are issues 27

28 2. Consumer Protection in China

29 Consumer protection - overview Consumer protection in e-commerce in China is still relatively new, but given the e-commerce market growth in scale and in complexity, the Chinese government has been paying increasing attention on consumer protection and transparency and strengthening its supervision against unlawful behaviors on the Internet Key legislations: 1. Consumer Protection Law (Revised in 2013) 2. E-commerce Law (2014) 3. Anti-Unfair Competition Law (1993) 4. Anti-Monopoly Law (2008) 5. Advertising Law (1995) Consumer protection provisions might be repeated in multiple pieces of laws, rules and regulations, as applicable 29

30 1. Consumer Protection Law Law of the People's Republic of China on the Protection of Consumer Rights and Interests (Revised in 2013) promulgated by the Standing Committee of the National People's Congress and taking effect since 15 March 2014 First major overhaul to Chinese consumer protection law in 2 decades Source:technode.com 30

31 1. Consumer Protection Law Salient points re e-commerce Online purchases: consumers shall have the right to return goods within 7 days upon receipt of such goods (with exceptions) without giving any reason Returned goods shall be in good condition Seller to return payments within 7 days Online sellers shall provide consumers with information such as business address, contact number, product quantity/price, etc. Personal data collection / use: business operators shall expressly provide for the purpose, way and scope of the information to be collected / used, obtain consumers' consent, and keep personal data confidential Consumers whose rights are infringed shall have the right to seek compensation from the sellers / service providers; where online trading platforms fail to provide the real identity of the sellers / service providers; consumers may seek compensations from such online trading platforms 31

32 2. E-commerce Law Administrative Measures for Online Trading promulgated by the State Administration for Industry and Commerce and taking effect since 15 March 2014 Salient points Online business operators shall observe the Consumer Protection Law and shall not infringe on the consumers' legitimate rights and interests During their course of business, online business operators shall state information such as business address, contact details, product quantity / service quality, price / fees, payment method, return and replacement policy, safety precautions, risk warnings, after-sale services etc., and shall take safety measures to ensure that transactions are safe and reliable and provide goods or services as promised Information on goods or services provided shall be authentic and accurate - no false promotion or expression shall be made 32

33 2. E-commerce Law Salient points (cont'd) Returns of goods without reason within 7 days (see slide 29) Information collected, whether consumer personal data or trade secrets of operators, shall be kept strictly confidential Online business operators shall not engage in the following unfair competition acts by using online technical means or carriers: 1. to use, without authorization, the same or similar domain name, name or logo of a well-known website so as to cause misrecognition by consumers 2. to use or forge, without authorization, electronic logos of governmental departments or social organizations to conduct misleading and false promotion 3. to make lottery sales with virtual items as the prizes (the agreed amount of such virtual items in online market exceeds the limit allowed by the laws and regulations) 33

34 2. E-commerce Law Salient points (cont'd) 4. to improve the business reputation for themselves or others by fictitious transactions, deleting unfavorable evaluation or other means 5. to harm competitors' business reputation by malicious evaluation contrary to the facts after a transaction 6. other unfair competition acts as provided by laws and regulations Online 3rd-party trading platforms shall take necessary measures to protect the exclusive rights to use registered trademarks, enterprise name rights and other rights 34

35 3. Anti-Unfair Competition Law Anti-Unfair Competition Law of the People's Republic of China promulgated by the Standing Committee of National People's Congress and taking effect since 1 December 1993 Salient points Businesses shall not use advertisements or other means to falsely or misleadingly promote their products regarding their quality, ingredients, manufacturer, useful life, place of origin etc. Businesses shall not sell their goods below cost so as to exclude their competitors Businesses shall not make tie-in sale against the wishes of consumers, or attach other unreasonable conditions to a sale Businesses shall not fabricate stories in order to damage the goodwill of their competitors products or their business reputation Please refer to unfair competition acts under E-commerce Law (slides 31-32) 35

36 4. Anti-Monopoly Law Anti-Monopoly Law of the People's Republic of China promulgated by the Standing Committee of the National People's Congress and taking effect since 1 January 2008 (AML) Salient points "Monopolistic practices" include: 1. the conclusion of monopoly agreements between operators 2. the abuse of dominant market position by operators 3. concentration of operators which has or may have the effect of eliminating or restricting market competition "Monopoly agreements" include those on: 1. fixing or changing prices of goods 2. limiting production or sales volume of goods 3. dividing a sales market or sourcing market of raw materials 4. restricting purchases of new technology or new equipment or preventing the development thereof 5. boycotting trading 6. other monopolistic practices as determined by government enforcement agencies 36

37 4. Anti-Monopoly Law Price fixing Business operators are prohibited from concluding the following monopoly agreements with their trading counterparts: 1. fixing the prices for resale to a third party 2. restricting the minimum prices for resale to a third party; and 3. other monopoly agreements as confirmed by government enforcement authorities What about a minimum advertised price (MAP)? AML is not clear on whether the fix or restriction of the advertised price falls within the fix or restriction of the resale price; however, a general view is that such fix or restriction is permissible as long as it does not substantially affect the resellers' right to sell the products at the price they choose independently But what about a manufacturer suggested retail price (MSRP)? Each case needs to be considered on its own merits 37

38 5. Advertising Law Advertising Law of the People's Republic of China promulgated by the Standing Committee of the National People's Congress and taking effect since 1 February 1995 Salient points Advertisements shall not contain any false information and shall not deceive or mislead consumers Where an advertisement involves patented products or patented methods, the patent number and patent category shall be clearly indicated Advertisements shall not include any content denigrating the goods or services of other businesses Advertising companies, advertising agents and advertising publishers shall not engage in any form of unfair competition in the course of carrying out advertising activities 38

39 3. Evolution of Wholesale/ Retail Structures in China

40 Evolution of wholesale / retail structures in China Single FICE Structure (1) Sourcing or Sourcing + W/S Only tapping into retail (2) Sourcing + Wholesale ( W/S ) & Retail Only Multiple FICEs Structure (3) 1 Sourcing + W/S FICE & 1 Retail FICE (with branches) expanding retail business (4) 1 Sourcing + W/S FICE & Multiple Retail FICEs (with branches) LLC Sub Structure improved business model (5) W/S + Retail LLC Subs (with branches) 40

41 Scenario 1 - Centralized sourcing + wholesale structure When an MNC expands from pure sourcing operation to include wholesale, for better control / efficiency of various aspects of the sourcing and wholesale organizations a centralized sourcing + wholesale entity with improved risk management can work as follows: Overseas IP Owner RO 3 royalties Overseas Parent Sourcing Service 1 goods 3P Suppliers Offshore China Sourcing FICE W/S + Sourcing FICE 2 goods Centralized functions: - wholesale - import/export - sourcing/qc - shared services (accounting, treasury, tax, legal, etc.) - logistics 3 rd Party Resellers 3P Suppliers 1. FICE sources goods from overseas domestically 2. FICE sells goods to 3 rd party resellers 3. FICE pays royalties to overseas IP owner 41

42 Scenario 2 Single FICE with sourcing, wholesale and retail functions Adding Retail: Foreign brand wants to undertake direct retailing in China; can expand FICE to include "retail" in business scope; FICE (with sourcing, wholesale and retail functions) can set up self owned direct stores, and also could consign goods to department stores under retail consignment arrangement:- Overseas Supplier 1 4 retail consignment 2 FICE (W/S & Retail) 3 5 Overseas IP Owner Offshore China Sale of goods consignment Payment of royalties Department Stores Direct Stores 3 rd Party Resellers Retail Branches Consumer 1. FICE sources goods from overseas 2. FICE sells goods to end consumers through its own direct stores 3. FICE wholesales goods to 3 rd party resellers for retail 4. FICE consigns goods to department stores under retail consignment arrangement (Retail Consignment) 5. FICE pays royalties to overseas IP owner 42

43 Scenario 3 2-tier structure (separate wholesale + retail operations / entities) 2-Tier structure: Essentially, a two-tier structure would have the first-tier entity conduct sourcing/wholesale and the second-tier entity conduct retail Retail FICE sells directly in China through its direct stores, and through Retail Consignment Overseas Supplier 1 FICE (Sourcing + W/S) Overseas IP Owner 5 FICE (Retail) 3 retail consignment Offshore China 3 rd Party Resellers Direct Stores Department Stores Retail Branches Consumer 1. Sourcing + W/S FICE imports goods from overseas 2. Sourcing + W/S FICE sells goods to Retail FICE and the 3 rd party resellers 3. Retail FICE consigns goods to department stores under retail consignment arrangement 4. Retail FICE sells goods to end consumers through its direct stores 5. Retail FICE pays royalties to overseas IP owner Sale of goods consignment Payment of royalties 43

44 Scenario 4 2-tier structure (multiple retail entities) Variation to Scenario 3: PRC political reasons major cities (e.g. Beijing and Shanghai and some local governments) prefer foreign investors to set up separate retail FICEs (rather than branches) Also different brands in the same group might prefer to operate independent retail FICEs This two-tier structure under this Scenario 4 will have a first-tier entity to conduct sourcing and wholesale activities and multiple second-tier retail entities to conduct retail activities Overseas Supplier Overseas IP Owner Offshore FICE (Retail) FICE (Sourcing + W/S) 2 FICE (Retail) China Direct Stores Department Stores rd Party Resellers Consumer 4 Direct Store Department Stores Sourcing + W/S FICE imports goods from overseas 2. Sourcing + W/S FICE sells goods to each retail FICE and the 3 rd party resellers 3. Retail FICEs sell goods to end consumers through direct branches 4. Retail FICEs also consign goods to department stores (Retail Consignment) 5. Retail FICEs pay royalties to overseas IP owner Sale of goods consignment Payment of royalties 44

45 Scenario 5 Wholesale Consignment Structure Addressing VAT consolidation restrictions issues: Foreign brand seeks to manage restrictions on VAT consolication. Under this Scenario 5, Wholesale FICE does not "sell" goods to Retail FICEs but "consigns" the goods to FICE's HQ and to each direct store (sales branches of the retail FICEs) at "wholesale" price (wholesale consignment). In addition the retail FICE HQ consigns the goods to the department stores directly at "retail minus" prices (retail consignment) Overseas Supplier Overseas IP Owner Offshore 6 FICE (Retail) 3 1 FICE (Sourcing + W/S) 3 5 FICE (Retail) China 3 Direct Stores rd Party Resellers 4 Direct Store 3 Department Stores Department Stores Consumer 1. Sourcing + W/S FICE imports goods from overseas 2. Sourcing + W/S FICE sells goods to the 3 rd party resellers 3. Sourcing + W/S FICE consigns goods to Retail FICEs (Wholesale Consignment) for further consignment to department stores (Retail Consignment.) (back-to-back consignment arrangements) 4. Sourcing + W/S FICE consigns goods to direct stores (Wholesale Consignment) 5. Retail FICEs pay royalties to overseas IP owner Sale of goods consignment Payment of royalties 45

46 Scenario 6 LLC sub structure (further refinement to scenario 5) Alternative Structure (Further refinement to 2-Tier Structure): Foreign brand may set up separate retail entities in the form of limited liability companies under Sourcing / Wholesale FICE (LLC Subs basically Chinese owned LLCs in this case owned by Sourcing + W/S FICE). The LLC Sub each sets up its own direct stores in the form of branches This structure allows certain consolidation of cash flow and operational results, given LLC Subs are limited risk retailers 5 LLC Sub (Retail) Department Stores Direct Stores Overseas Supplier 1 FICE (Sourcing + W/S) 3 3 W/S consignment 3 retail consignment W/S consignment 4 W/S consignment 3 retail consignment Overseas IP Owner 5 LLC Sub (Retail) Department Stores Direct Stores 2 3 rd Party Resellers Offshore China Sale of goods consignment Payment of royalties Share holding 1. W/S FICE imports goods from overseas 2. W/S FICE sells goods to 3 rd party resellers Consumer 3. W/S FICE consigns goods to LLC Subs (Wholesale Consignment) which may further consign to department stores (Retail Consignment) 4. W/S FICE consigns goods to direct stores (Wholesale Consignment) 5. LLC Subs pay royalties to overseas IP owner 46

47 Selling into China: Business Models and Issues DLA Piper China Investment Services Daniel Chan, Partner, Hong Kong Windson Li, Senior Legal and Tax Manager, Hong Kong September 2014

48 Contents I. Regulations on foreign investment in commercial fields II. China distribution models and issues Scenario 1 Offshore indent sales Scenario 2 Onshore centralized distribution Scenario 3 Bonded zone centralized distribution Scenario 4 Onshore two-tier structure Scenario 5 Onshore two-tier consignment structure III. After-sales service models and issues IV. Prepaid card operation 48

49 Foreign investment in commercial fields Governing regulation The Administrative Measures for Foreign Investment in Commercial Fields, Order of the Ministry of Commerce [2004] No.8 Covering various foreign invested commercial activities" in China: commission sales, wholesale, retail (including retail through TV, telephone, mail, Internet and vending machines), franchising, auction, etc. These on-shore Commercial Activities can only be conducted through foreign invested entities inside China Restriction on special commodities Books and magazines, gas stations, automobiles, medicine, fertilizer, refined oils, food, vegetable oil, sugar, cotton, salt, cigarettes, etc. Separate and additional regulation on distribution of certain special commodities (e.g. books and magazines, medicine, gas, automobile) Requiring joint venture and restriction on % of foreign equity interest (medicine, pesticides, agricultural films, fertilizers, etc.) Retail of cigarette, and wholesale of sale and cigarette are prohibited for foreign invested enterprises 49

50 Foreign investment in commercial fields Separate and additional rules on auction and franchising The Administrative Regulations on Commercial Franchising The Measures for the Administration of Information Disclosure of Commercial Franchises The PRC Auction Law Favorable treatment of Hong Kong / Macao investors Relaxed restriction in distribution of some special commodities Generally applies to Set-up of new foreign invested enterprise and expansion of existing foreign invested enterprises' business scope acquisition of existing Chinese domestic commercial enterprises 50

51 Scenario 1 offshore indent sales Features Sales of industrial equipment, heavy machinery, industrial electronics and other non-consumer products Sales to China subsidiaries of international MNC customers Sales to a small number of customers in some specific industries / business sectors Highlights Offshore distributor not directly subject to China regulations Minimum local entrepreneur marketing and sales activities Minimum China establishment and administrative / compliance burden Unable to control wholesale / retail prices in China market Unable to control and ensure sales and aftersales service quality Products from China 3P suppliers have to be routed thorough offshore or a China logistics park Import Offshore Distributor Import 3P Wholesalers Products China Customers Goods Title Affiliates Sourcing Service Aft. Sales Service Sourcing Service Co. 3P Suppliers Products 3P Suppliers Service Offshore China Products 3 rd parties 51

52 Scenario 1 offshore indent sales Issues Customs and foreign exchange procedure Customs and foreign exchange compliance burden on China 3P Distributor and customer Preferred by customers enjoying special customs duty exemption, which however are diminishing Permanent establishment Permanent Establishment risk for overseas distributor, if 3P distributor recognized as an dependent agent of overseas distributor Government procurement Potential loss of opportunity in bidding for government procurement projects Government procurement rules in favor of "domestic procurement" and/or "domestic products, and this trend is expected to be further strengthened Logistics Lead time for distribution in China Others No onshore marketing or retail activities 52

53 Scenario 2 onshore centralized distribution IP Owner Offshore Entrepreneur Products 3P Suppliers Trademark royalty Import Offshore Sourcing Service China Affiliates 3P Wholesalers / Resellers Direct Service China Customers Wholesale Aftersales Service FICE (Wholesale / Retail / Sourcing) Consign ment Departme nt Stores Deemed sales FICE Branch Stores Domestic procure ment Products 3P Suppliers 3 rd parties Goods Title Service Royalty Retail Features Sales of consumer electronics, fashions, shoes, cosmetics and other consumer products Sales to a uncertain number of customers in certain local China market (Beijing / Shanghai / Guangzhou) Distribution of commodities that subject to substantial customs duty Business that requires consistent marketing and sales front MNCs that would like to have onshore control of distribution channels or set up self-owned stores 53

54 Scenario 2 onshore centralized distribution Highlights Can cover sourcing, wholesale, retail and after-sales service in one legal entity to enable centralized management control and improve management efficiency; to consolidate tax and legal administration and minimize compliance and maintenance burden; Branches need to: obtain retail license (i.e. with "retail" in approved business scope) for operating retail stores (Branch Stores) comply with branch tax filing rules Can transact with 3 rd -party distributors sell to 3P distributor (including 3P wholesalers and retailers) in parallel Can enter into "Consignment Wholesales Arrangement" with 3P department stores Products consigned to 3P department stores for retail Wholesale to 3P department stores is recognized and booked upon realization of retail Better flexibility to generate "domestic products" for catching government procurement projects based on domestically sourced products May operate in parallel with Scenario 1 offshore indent sales 54

55 Scenario 2 onshore centralized distribution Issues Custom duty on royalty FICE may pay trademark royalty to overseas IP owner based on sales in China Royalty payment from FICE to overseas IP owner may be deemed as dutiable, which could substantially add on the FICE's costs Branch tax filing Need to comply with branch tax filing rules, and conduct VAT and Enterprise Income Tax filings for Head Office and every branches Value Added Tax (VAT) Movement of products among Head Office and Branches in different cities will trigger deemed sales" and VAT. VAT compliance procedure could be very burdensome and tedious alone the increase of branch stores VAT consolidation only available within the same province and subject to approval of tax authority (cross-entity reconciliation is possible for recognized chain stores) Enterprise Income Tax (EIT) Should allocate 50% of overall EIT payable among the Branches based on proportion of each Branch's sales, assets, and personnel salary expenses Require IT system's ability to maintain separate book for Head Office and each Branch, as well as maintenance of separate P&L and balance sheets 55

56 Scenario 2 onshore centralized distribution Transfer pricing Decision has to be made on the characterization of FICE's distribution activity, from an overall point of view Full-fledged distributor? Import price usually determined based on cost plus or resale minus, relatively stable Marketing investment and expenses on FICE Usually fixed royalty fee/rate Limitation on profit expatriation Stripped risk distributor, or distribution service provider? Import price need to be monitor and frequently adjusted to reflect overseas entrepreneur's undertaking of market and business risk Marketing penetration expenses should be passed on the overseas entrepreneur Profit level of FICE expected to be stable Maximize profit expatriation through import price and royalty Frequent import price adjustment may lead to customs questioning Aftersales service (for stripped risk distributor, or distributor service provider) Separate transfer pricing arrangement, or as part of distribution? Pricing arrangement for warranty and non-warranty services? Sourcing service usually requires separate transfer pricing arrangement and justification 56

57 Scenario 2 onshore centralized distribution Profit expatriation Limited channels for profit expatriation: (i) royalty, (ii) IC service, (iii) product / store design service and (iv) dividends Comprehensive and synchronized planning is a must for the following ends to meet each other Financial target based on transfer pricing arrangement Feasible profit expatriation channels and practical restrictions (such as typical royalty rate range) Accounting cost alignment and business function allocation FX control over non-trade transactions have been relaxed, Profit expatriation through non-trade transactions are still subject to strict review of tax authority (although supposed to be recordal only by law) Political concern Local authorities may expect / require set up of entities, rather than branches Incentives No state level incentive specifically designed for distribution companies under the China tax law Local incentives are possible in form of financial subsidy or refund, which are subject to negotiation during entity set up 57

58 Scenario 3 bonded zone centralized distribution IP Owner Trademark royalty 3P Wholesalers / Resellers Direct Sales (RMB / FX) Bonded Zone Wholesale (RMB / FX) Offshore Entrepreneur Import Consignment (RMB) FICE Sourcing Service Deemed Sales (RMB) Transport sales Domestic procure ment Products Offshore China Products 3P Suppliers Affiliates 3 rd parties Goods Title Service China Customers Departme nt Stores Retail FICE Branch Stores 3P Suppliers Royalty Features Often used by MNCs engaged in distribution of equipment or industrial material sourced from overseas (or from China by way of import/toll processing) Preferred by distributors that are sensitive to customs duty and wants to maintain flexibility of inventory flow among Asia regions Preferred by distributors with a mixed China customer group that prefer either RMB (i.e. domestic) procurement or FX (i.e. import) procurement 58

59 Scenario 3 bonded zone centralized distribution Highlights Similar to Scenario 2, FICE can set up branch stores around the nation to conduct retail (subject to retail license) enter into consignment arrangement with department stores conduct direct sales to customers Unlike Scenario 2, FICE may also maintain bonded inventory and conduct transport sales conduct USD sales to China 3P distributors / customers (3P distributor / customer as importer) Issues Same as in Scenario 2 Subject to special customs and foreign exchange rules / practice in bonded zone Higher maintenance cost in bonded zone 59

60 Scenario 4 onshore two-tier structure IP Owner Offshore Entrepreneur Products 3P Suppliers Trademark royalty Import Sourcing Service Offshore China Deemed sales Retail FICE Branch Stores Features Retail FICEs (Retail and Aft. Sales) Retail Aftersales Service China Customers Wholesale Department Stores Consignment Wholesale FICE (Wholesale & Sourcing) Wholesale 3P Wholesalers / Resellers First tier to conduct import, sourcing and wholesale at nation level Domestic procure ment 3P Suppliers Affiliates 3 rd parties Goods Title Service Royalty Second tier to conduct retail and after sales service at locality level, and may use multiple retail FICEs for retail Often used for distribution of automobile (which by law should set up a two-tier structure for distribution) Often used for sales of consumer products, consumer electronics, fashions, shoes, cosmetics, groceries around the nation 60

61 Scenario 4 onshore two-tier structure Highlights Consolidated importation / procurement, wholesale and sourcing functions in the Wholesale FICE Wholesale WFOE may consolidate management and supporting functions (accounting, admin, legal, tax, logistics, etc.) consolidate consignment sales with 3P department stores Regional retail FICEs may help to address local authority's political concern/request need to separately apply for retail license at local level may set up multiple branch stores in its locality Aftersales service function may be distributed among retail FICEs or consolidated at wholesale FICE May use entrustment loan or cash pooling arrangement to improve cash flows among wholesale FICE and retail FICEs 61

62 Scenario 4 onshore two-tier structure Issues Custom duty Wholesale FICE as the importer Royalty payment may be made by retail FICE to reduce the customs duty risk (see discussion under Scenario 2) Separate royalty agreements between retail FICEs and overseas IP owner could significantly increase FX administration burden, depending on the number of retail FICEs VAT and Branch Tax Filing Movement of products (i) from wholesale FICE to retail FICEs, (ii) among retail FICEs, or (iii) from a retail FICE to a branch store in different city, will trigger VAT compliance VAT compliance procedure could become very burdensome and tedious alone the increase retail FICEs and branch stores VAT consolidation only available within the same province and limited to branches of the same entity VAT compliance burden could quite significant Retail FICE and its branches should also comply with branch tax filing rules (see discussion under Scenario 2) 62

63 Scenario 4 onshore two-tier structure Transfer Pricing Characterization of wholesale FICE and transfer pricing arrangement (similar to Scenario 2) Decision should also be made on the characterization of retail FICEs Relatively independent retailer vs. retail service provider Functions and risks should be properly allocated between wholesale FICEs and retail FICEs Profit fluctuation of each retail FICE should be justifiable Pricing policy between wholesale FICE and retail FICEs should be carefully considered in view of their characterization, as it has significant impact on profit distribution between wholesale FICE and retail FICEs, as well as their tax contribution to different local tax authorities Functions, operating expenses (including marketing expenses) should be properly allocated and aligned among wholesale FICE and retail FICEs, with due consideration to special factors to each retail FICE, if any Pricing policy for cross-entity charge should also be planned Allocation of supporting service charge from overseas affiliates "Shared services" provided by wholesale FICE's management, supporting and administration teams Movement of slow inventory from one retail entity to another 63

64 Scenario 4 onshore two-tier structure Income tax efficiency Consolidated income tax filing for all entities is not available Overall income tax efficiency depends on consistency of profit / loss level of retail FICEs and wholesale FICEs variation of profit level / status could result in high effective income tax rate for the entire China operation Adjustment on transfer prices between wholesale FICE and retail FICEs may help to improve overall income tax efficiency, but is subject to the restriction of characterization and transfer pricing policy, and could significantly add on VAT administration burden Advanced transfer pricing arrangement between wholesale FICE and retail FICE is critical for minimizing effective income tax rate 64

65 Scenario 4 onshore two-tier structure Inter-company transfer of inventory among retail FICEs "Deemed Sales" and cumbersome VAT compliance procedure could prevent inter-company transfer of inventory among retail FICEs Should set up appropriate internal inventory transfer mechanism in view of improving inventory turnover rate, and with due consideration to individual retail Entity's business concern. Reverse logistics and after-sales service Wholesale FICE would be responsible to pass on returned products to 3P suppliers for repair, replace and rework Need to take care of cumbersome "VAT Red Invoice" procedures for (i) return from retail FICE to Wholesale FICE, and then (ii) return from wholesale FICE to local 3P suppliers warranty responsibility and risk should be properly allocated to either Wholesale FICE or Retail FICE based on transfer pricing characterization Profit expatriation Significant administration burden for each retail FICE to separately conduct royalty agreement registration and recordal, and remit royalty to overseas IP owner Higher risk of administration difficulties if concentrate royalty payment at wholesale FICE 65

66 Scenario 5 two-tier consignment structure IP Owner Offshore Entrepreneur Products 3P Suppliers Trademark royalty Products Sourcing Service Offshore China Aftersales Service China Customers Retail FICEs (Regional Management) Retail Retail FICEs Branch Stores Wholesale Consignment Consignment Departme nt Stores Wholesale FICE (Wholesale & Sourcing) Wholesale 3P Wholesalers / Resellers Products 3P Suppliers Affiliates 3 rd parties Goods Title Service Royalty Features Wholesale FICE consigns products to branch store of retail FICEs for distribution (Wholesale Consignment) Head office of retail FICEs only undertakes regional retail management role, or also houses a retail store Retail FICEs recognize procurement and wholesale FICE recognize wholesales upon realization of retail to customers 66

67 Scenario 5 two-tier consignment structure Highlights This two-tier consignment structure is a refinement to the onshore two-tier structure, and may bring the following improvement VAT VAT payment by wholesale FICE and retail FICE could be postponed to realization of sales to customers IC inventory movement Inventory before sales may move freely among wholesale FICE and retail FICEs without triggering deemed sales and VAT Transfer pricing and income tax efficiency All retail FICEs will be characterized as consignment retail service providers Possible to control and enable a stable profit for retail FICEs Can concentrate profit / loss fluctuation at the wholesale FICE, and thus improve overall effective income tax rate 67

68 Scenario 5 two-tier consignment structure Issues Accounting Accounting-wise, retail FICEs need to recognize COGs based on value/price of consigned products before retail, based on expected retail price and "Retail Price Minus" Adjustment against COGs will be required, if the retail price is frequently fluctuating, which could significantly add on to accounting and VAT invoice administration burden Could be difficult to implement, if a retail FICE sells many different products with frequently fluctuating retail price and very different profit margin Transfer pricing Retail FICEs should be characterized as limited function consignment service providers, while wholesale FICE as risk taking wholesaler with all distribution and management functions Transform from the onshore two-tier structure to two-tier consignment structure could lead to significant change to the profit level of an existing Retail FICE, which could be questioned / challenged by local tax authority 68

69 After-sales service offshore service Return and rework China customers export the defective / broken products and reimport reworked / replacement products under the customs code of goods of no consideration" Exempted from customs duty Reworked / Replacement products Offshore Distributor (Repair Center) Defective / broken Products Offshore China Subject to strict customs supervision and procedure China Customers Offshore warranty and non-warranty repair China customers export products for warranty and non-warranty repair Customs duty may be exempted for reimport of products exported for warranty repair Customs duty exempted for warranty repair Heavy administrative burden for China customers to go through customs procedures for export of defective / broken products, and would not be acceptable if the goods are for daily operation purpose Repaired products Offshore Distributor (Repair Center) Non-warranty service fee China Customers Defective / broken Products Offshore China Goods Fee Service 69

70 After-sales service onshore service Onshore warranty repair (A) Use bonded warehouse to reduce lead time for provision of spare parts 3P / affiliate service provider conduct on-shore repair service and charge the offshore distributor, but does not take title of spare parts Customs duty may be exempted on spare parts for warranty service China customers still need to undertake customs procedure for importation of spare parts Onshore warranty repair (B) Use bonded warehouse to reduce lead time for provision of spare parts 3P / affiliate service provider keeps minimum spare part inventory to ensure immediate supply to customers Customs duty payable on imported spare parts 3P / affiliate service provider responsible for customs procedures Spare Parts Bonded Warehouse Spare Parts Bonded Warehouse Spare Parts Offshore Distributor China Customers Goods Defective / broken parts Offshore Distributor China Customers Spare Parts Repair service Defective / broken parts Repair service Fee Service Fee 3P / Affiliate service provider Service Fee 3P / Affiliate service provider Service 70

71 After-sales service onshore service Onshore non-warranty repair 3P / affiliate service provider import from overseas supplier 3P / affiliate service provider conducts onshore repair service and charge the China customer Spare Parts Bonded Wareho use Goods Overseas Supplier Spare part import price 3P / Affiliate service provider Repair service Fee Defective/broken parts Option 1 Return as components of original equipment Option 2 - Return as imported replacement components Option 3 Export sales of the defective spares to overseas (tax/pricing / forex) Disposition in China scrap / repair for domestic use/sale with different customs, tax, pricing and foreign exchange implications Service fee + Spare part price China Customers Service Non-repair after-sales services Maintenance, calibration, training, hotline service, technical support, etc., can be either rendered onsite of offsite, onshore or offshore 71

72 After-sales service onshore service Issues Customs If spare parts are sourced from outside of China or where repair has to be done offshore, customs procedure and lead time are critical for timely and efficient after-sales service, election of proper customs codes and procedure is important China customers are usually reluctant to undertake customs procedures Tax Some non-repair aftersales service are still subject to business tax, instead of VAT, which requires separate and accurate accounting for revenue derived from different after-sales service. Transfer pricing If a Chinese company undertakes both warranty and non-warranty service, the non-warranty service could be considered as an internal comparable for benchmarking the warranty service price Adds on the complication of transfer pricing planning and justification, if a China distribution company conducts after-sales service together with distribution activities 72