Establishing a Business in China. Special Report. A guide for international business MELBOURNE SHANGHAI SYDNEY ADELAIDE

Transcription

1 Special Report Establishing a Business in China A guide for international business 2010 ADELAIDE AUCKLAND BEIJING BRISBANE CANBERRA DARWIN GOLD COAST HONG KONG LONDON MELBOURNE PERTH SHANGHAI SYDNEY WELLINGTON

2 Contents 1. Introduction 3 2. Investment vehicles in China 4 3 Permitted and restricted investments 5 4 Foreign invested enterprises 6 5 Special purpose vehicles 13 6 Other business structures 15 7 Business scope 17 8 Registered capital 18 9 Debt Acquisitions in China Anti-Monopoly Other issues Definitions 39 About Minter Ellison 40 Contacts 42 2 MINTER ELLISON ESTABLISHING A BUSINESS IN CHINA

3 1 1. Introduction With China s entrance into the World Trade Organisation in 2001 and move towards a market-oriented economy, foreign investment in China continues to grow. With the overhaul of Chinese laws and regulations affecting trade and business, many state-owned enterprises have consolidated and turned their attention to acquisition activities, or have themselves become targets for acquisitions by foreign investors. Large numbers of wholly foreign owned businesses and joint ventures with foreign investors now operate in China and they are rapidly increasing. However, many foreign investors find it difficult to understand the regulatory system governing foreign investment and business in China, which differs in many important ways from its Western counterparts. Foreign investors need to consider many factors when planning their investments in China. There are many restrictions which apply only to them. In addition, the complex approval processes, layers of government bureaucracy and consequent time delays are often difficult for investors unfamiliar with doing business in China to grasp. This booklet is now in its second edition and presents the law as at 1 March It is intended to: be an introductory guide to doing business in China (factors which are relevant to particular circumstances including industry specific regulations are not covered) answer frequently asked questions. We recommend that specific and tailored professional advice is sought prior to commencing business in China. Comprehensive professional advice is available from our lawyers in our Greater China region, or any of the Minter Ellison Legal Group offices. Contact details are at the back of this guide. ESTABLISHING A BUSINESS IN CHINA MINTER ELLISON 23

4 2 2. Investment vehicles in China A foreign investor may establish a presence in China in a variety of legal forms. The most common investment vehicles are listed below. Wholly foreign owned enterprise (WFOE): A limited liability company owned 100% by the foreign investor. Sino-foreign joint venture (JV): Usually a limited liability company with equity interests held by foreign and Chinese investors but can also include an unincorporated venture. JV s usually take one of two forms, an equity joint venture or a cooperative joint venture. Foreign invested company limited by shares (FICLS): a company limited by shares. Foreign invested partnership enterprise (FIPE): A partnership of foreign investors or foreign and Chinese investors. In China, WFOEs, JVs, FICLS and FIPEs are collectively referred to as foreign invested enterprises. Foreign Investors will often choose a WFOE when making their first investment in China. WFOEs offer an investment structure that is not too dissimilar to Western counterparts and 100% control. However, for some industries, the Catalogue for Guiding Foreign Investment requires that a Chinese partner must be involved, in which case a JV, FICLS or sino-foreign FIPE will be required. The key characteristics, advantages and disadvantages of each foreign invested enterprise are set out in sections 4 and 5. Foreign investors may also establish a presence in China using: a representative office: often the first presence established by a foreign investor in China. A representative office is not a separate legal entity, but simply an outlet of the foreign company. It is permitted to liaise with customers or suppliers and promote or procure products or services. However, it cannot carry on business. a branch: similar to a representative office but is permitted to carry on business. Availability is restricted and is currently only available to banks, insurance companies, and oil companies. a regional headquarters: permits a multinational company to import and wholesale products of the multinational company in China. Only applicable to Foreign Invested Holding Companies. business activity registration: an authorisation in favour of a foreign company to carry on its business activities in China. Availability is restricted and is currently only available to foreign companies undertaking the mining of petroleum or other resources and construction work. Further details on these business structures are set out in section 6. 4 MINTER ELLISON ESTABLISHING A BUSINESS IN CHINA

5 1 3 Permitted and restricted investments Foreign investments in China are regulated according to the industry the investment is in. The Catalogue for Guiding Foreign Investment (Investment Catalogue) issued by the Ministry of Commerce and National Development and Reform Commission sets out the specific industries which are classified as encouraged, restricted or prohibited for foreign investment. Industries not specified in the Investment Catalogue are classified as permitted for foreign investment. A consideration of the Investment Catalogue is one of the first tasks which should be undertaken by a foreign investor contemplating an investment in China. Whether an industry is permitted, encouraged or restricted will determine the type of investment vehicle to be used and the approvals required from government authorities. For some industries, the Investment Catalogue also requires that the Chinese partner must have either a controlling interest (meaning the Chinese party or parties must hold an aggregate interest of at least 51%), or a relative controlling interest (meaning the aggregate interest of the Chinese parties must be greater than that held by any single foreign investor). Where an investment relates to the Central-Western Region of China, foreign investors must also consult the Catalogue of Industries in the Central-Western Region of China with a High Priority for Foreign Investment (Central Western Region Investment Catalogue) which sets out industries which are encouraged for foreign investment in the Central-Western Region of China. Additional restrictions and requirements are also proscribed by specific laws and regulations for certain industries including: logistics (including road transportation, water transportation and air transportation) resources surveying & mining telecommunications wholesale & retail financial services. These specific laws and regulations also set out the type of investment vehicle permitted to be used, the proportionate interest permitted to be held, and the governmental approvals required. If there is inconsistency with the Investment Catalogue, the specific law will prevail. The Investment Catalogue and the Central-Western Region investment Catalogue are amended from time to time by the relevant government authorities. The most recent edition of Investment Catalogue was issued on 31 October The latest edition of the Central-Western Region Investment Catalogue was issued on 23 December ESTABLISHING A BUSINESS IN CHINA MINTER ELLISON

6 4 Foreign invested enterprises The most common investment vehicles encountered by foreign investors are WFOEs, JVs and FICLS. With effect from 1 March 2010, foreign investors will also be able to establish a FIPE. These investments vehicles are collectively referred to as foreign invested enterprises (FIEs). The following is a brief summary of their key characteristics, relative advantages and the basic procedures involved in setting them up. 4 Wholly foreign owned enterprise (WFOE) Key characteristics foreign ownership control limited liability separate legal status corporate governance no shares employees 100% ownership by one or more foreign investors without participation by a Chinese partner. 100% ownership gives the foreign investor greater control over management and direction of the enterprise. Takes the form of a limited liability company, the foreign investor s liability being limited to the registered capital of the WFOE. An independent subsidiary with separate legal status. Ordinarily has a board of directors. In some instances (i.e. a small enterprise or one investor), it may have one executive director instead of a board of directors. The Articles of Association can be customized to suit the investor. No shares are issued. Ownership takes the form of equity interests, being a proportion of the registered capital. Can employ people directly. Establishing a WFOE pre-register the WFOE s name with the Administration of Industry & Commerce prepare the application, Articles of Association and feasibility study submit the Articles of Association and feasibility study to the Ministry of Commerce or local office carry out registration with State Administration of Industry & Commerce or local office carry out post-registration formalities with tax, foreign exchange, and other relevant authorities. 6 MINTER ELLISON ESTABLISHING A BUSINESS IN CHINA

7 WFOEs are a popular investment vehicle for foreign investors familiar with doing business in China. One hundred percent ownership and control means that a foreign investor is free to implement decisions in relation to its investment without the involvement of a local partner. However, please note that: for some industries, WFOEs are not permitted (see section 3) a WFOE may lack the connections with government and business that may come with a Chinese partner a minimum capital contribution of RMB100,000 will be required to set up the WFOE depending on the business scope and the industry in which the WFOE operates, increased capital requirements may apply capital cannot be removed from China unless the WFOE is liquidated tax will be payable on the profits of the WFOE (currently 25%). 4 Joint venture (JV) JVs usually take the form of a limited liability company with equity interests being held by one or more foreign investors and one or more Chinese parties. A JV can be set up in one of two forms: an equity joint venture (EJV) or a cooperative joint venture (CJV). Key characteristics of an EJV sino-foreign ownership limited liability separate legal status profits corporate governance decision making no shares equity transfers Joint ownership between one or more foreign investors and one or more Chinese parties. Liability of investors is limited to their respective interests in the registered capital. An entity with separate legal status. Profits and losses must be shared by the investors in proportion to their respective interests in the registered capital. The board is the governing authority of an EJV. Board representation must reflect the proportion of an investor s equity interest in the registered capital. There is no active shareholder level of management and no shareholder meetings. Unanimous consent of the board is required for amending the Articles of Association, termination and dissolution of the EJV, increasing or reducing the registered capital and any merger or division of the EJV. In all other cases a simple majority consent is required. No shares are issued. Ownership interests are in the form of equity interests (i.e. a proportion of the registered capital). Transfer of an investor s equity interest in the registered capital is subject to the pre-emptive rights of the other parties to the joint venture. ESTABLISHING A BUSINESS IN CHINA MINTER ELLISON 67

8 Key characteristics of a CJV 4 sino-foreign ownership legal status liability corporate governance profits capital equity/rights transfers Joint ownership between one or more foreign investors and one or more Chinese parties. Can take the form of a limited liability company or unincorporated joint venture in the form of a contractual joint venture. The liability of investors in an incorporated CJV is limited to their respective interests in the registered capital. The liability of investors in an unincorporated CJV is unlimited. The board is the governing authority of an incorporated CJV. The management committee is the governing authority of an unincorporated CJV. Profits are not necessarily distributed in the same ratio as the parties interests in the registered capital, but can be negotiated between the parties. Returns of capital may be made prior to the termination of the CJV, but such capital distributions may be recalled should the CJV subsequently require funds. The transfer of an investor s equity interest in the registered capital of an incorporated CJV is subject to the pre-emptive rights of the other parties to the joint venture. If the CJV is unincorporated, a transfer of contractual rights requires the consent of the other parties. Note: CJVs are in practice, rarely used. Approval is generally limited to ventures related to oil exploration, major mining projects and large infrastructure projects, and the government permit, contract or concession dictates the scope, rights and requirements of the CJV. 8 MINTER ELLISON ESTABLISHING A BUSINESS IN CHINA

9 Establishing a joint venture negotiate and sign a letter of intent pre-register the JV s name with the State Administration of Industry & Commerce prepare a project proposal and feasibility study report submit the project proposal and feasibility study to the National Development & Reform Commission or local office negotiate and sign a joint venture contract, Articles of Association (if incorporated), and related contracts (i.e. technology licensing, land purchase/licences and key employee contracts) submit the joint venture contract and Articles of Association (if incorporated) for approval by the Ministry of Commerce or local office register with the State Administration of Industry & Commerce and obtain a business licence carry out post-registration formalities with the authorities in charge of tax, public security, foreign exchange, labour and customs. 4 Note: In many cities, the approval of the project proposal and feasibility study is consolidated with the approval of the joint venture contract and Articles of Association in order to simplify the approval procedures. Foreign invested company limited by shares (FICLS) A FICLS is different from a sino-foreign JV in that it is a company limited by shares, the governance of which is largely dictated by corporate statute. Key characteristics form sino-foreign ownership listing term corporate governance Unlike a WFOE or JV, a FICLS takes the form of a company limited by shares. Requires a minimum foreign equity of 25% (must not be less than 10% after any listing). The only form of FIE that can be listed on a stock exchange in China (other forms of FIE must be converted into a FICLS before listing). Unlike WFOEs and JVs, there is no fixed term. There is a clear separation between owners and management with functions and powers being clearly allocated between the board, the shareholders and a board of supervisors. ESTABLISHING A BUSINESS IN CHINA MINTER ELLISON 89

10 board shareholders A board of between 5-19 members is elected by the shareholders. The actions of the board are monitored by a supervisory board of at least three members (which includes representatives of the shareholders and the employees). The shareholders must meet at least once a year in general meeting. Important decisions are decided by a two-third majority. 4 Establishing a FICLS A FICLS may be established by way of incorporation or transformation the incorporation method requires: at least two promoters, one of whom must be a foreign shareholder a minimum registered capital of RMB30 million a promoters agreement (similar to a joint venture contract), Articles of Association and related contracts submitting the promoters agreement, Articles of Association and other related documents to the provincial office of MOCOM for approval subscribing for shares (must be fully paid up), electing the board and electing the supervisory board registering with the State Administration of Industry and Commerce and obtaining a business licence carrying out post-registration formalities with authorities in charge of tax, public security, foreign exchange, labor and customs. further requirements may be applicable to the extent that an incorporation involves a general offer of shares under the transformation method, a WFOE, JV, State-owned enterprise or a domestic company limited by shares is transformed into a FICLS the requirements applicable to the promotion method apply equally to the transformation method, plus the following: the FIE wishing to transform into an FICLS must have a profit record for the last three consecutive years the investors in the original FIE act as the promoters and must sign the promoters agreement and the Articles of Association the obligations and undertakings of the investors in the original joint venture contract and Articles of Association must be included in the promoters agreement and the Articles of Association of the proposed FICLS. 10 MINTER ELLISON ESTABLISHING A BUSINESS IN CHINA

11 Foreign invested partnership enterprise (FIPE) With effect from 1 March 2010, foreign investors can establish a FIPE. A FIPE can be a partnership of foreign investors (wholly foreign owned partnership) or a partnership of foreign and Chinese investors (sino-foreign partnership). Key characteristics legal status Unlike JVs, WFOEs and FICLS which are regulated by the Company Law and the respective special laws, a FIPE is a partnership enterprise regulated by the Partnership Enterprise Law and the Administration Measures for Partnership Enterprises Established by Foreign Enterprises or Individuals. 4 form of ownership liability capital profits tax Under the Partnership Enterprise Law a partnership enterprise may be a general partnership or a limited liability partnership. A FIPE can be a wholly foreign owned partnership or a sino-foreign owned partnership. The partners in a general partnership have unlimited joint and several liability for the obligations of the FIPE. The general partner in a limited liability partnership has unlimited liability for the obligations of the FIPE whilst limited partners are liable up to the amount of their capital contribution. The Administration Measures for Partnership Enterprises Established by Foreign Enterprises or Individuals are silent on minimum capital requirements but do state that a FIPE must have sufficient assets to carry on its business. 1 Entitlements to profits are as set out in the partnership agreement and do not have to be distributed in the same ratio as the parties capital contributions. Under the Partnership Enterprise Law, partnership enterprises are entitled to a pass-through tax treatment such that income is taxed in the hands of the individual partners. 2 1 At the date of this publication the Administration Measures for Partnership Enterprises Established by Foreign Enterprises or Individuals were silent on whether, under the Partnership Enterprise Law, capital contributions to FIPEs can be made in monetary and non-monetary forms. 2 At the date of this publication it was still unclear how this will apply to non-resident partners in a FIPE. ESTABLISHING A BUSINESS IN CHINA MINTER ELLISON 11

12 corporate governance The management of a FIPE is governed by the terms of the partnership agreement. In the absence of management provisions, partners will have equal rights in relation to the management of the FIPE. 4 Establishing a FIPE pre-register the FIPE s name with the State Administration of Industry and Commerce prepare an application for registration and negotiate and sign a partnership agreement and related contracts submit the application letter, partnership agreement and identification documents for each partner to the State Administration of Industry and Commerce and obtain a business licence carry out post-registration formalities with authorities in charge of tax, public security, foreign exchange, labour and customs. Note: Unlike other foreign invested enterprises, MOFCOM approval is not required to establish a FIPE although additional approvals may be required where the FIPE proposes to invest in real estate or carry on a business in private equity or venture capital investment. 12 MINTER ELLISON ESTABLISHING A BUSINESS IN CHINA

13 5 Special purpose vehicles Foreign invested holding company (FIHC) Foreign investors with multiple investments in FIEs may wish to establish a holding company to consolidate their ownership and management of the FIEs in which they have an investment. Key characteristics form Can be set up as a WFOE or JV with limited liability. prohibited activities permitted activities permitted investments Generally cannot undertake any direct business. Can not invest in industries restricted for foreign investment or under the macro control of the state (e.g. real estate). Subject to the unanimous consent of the board of each FIE in which it holds at least a 10% equity interest, an FIHC may undertake activities for the benefit of those FIEs, including: centralizing the purchase of raw materials and equipment by each FIE managing the financing and foreign exchange requirements of each FIE providing administrative support, training and consultancy services to each FIE transporting, warehousing and distributing products of each FIE in China and abroad (subject to having at least USD30 million registered capital and government approvals). Can take equity stakes in FIEs and research and development centres (see below). Can also take strategic stakes of 10% or more in companies listed in China (subject to government approvals). 5 Establishing an FIHC Stringent conditions must be satisfied, including: the foreign investor must demonstrate a good credit status and the financial capacity to establish and maintain an FIHC. the foreign investor must: have USD400 million in total assets in the year prior to application, and have set up an FIE in China with the paid-up capital of at least USD10 million; or have 10 or more investments in FIEs in China with an aggregate paid-up capital of at least USD30 million. ESTABLISHING A BUSINESS IN CHINA MINTER ELLISON 13

14 if the FIHC is a JV, the Chinese partner must: demonstrate a good credit status and the financial capacity to establish and maintain an FIHC, and have at least RMB100 million in total assets in the year prior to application. the registered capital of the FIHC must not be less than USD30 million. Regional headquarters of a multinational 5 A FIE (usually a FIHC) can, subject to certain restrictive requirements in Beijing, Shanghai and Guangzhou, qualify as a regional headquarters of a multinational. The benefits of such qualification include the ability to: import and wholesale products of the multinational company provide outsourcing services to domestic companies and FIEs engage in logistics and distribution for export products set up a financial company (subject to approval from China Banking Regulatory Commission) to provide financial services to the subsidiaries of the FIE. Research and development centre Research and development centres can be established by a foreign investor to engage in research and development and experimental development in scientific and technological areas. Research and Development Centres generally take the form of a WFOE, JV or branch of an existing WFOE or JV (see below) with a limited business scope. Research and Development Centres are eligible for certain income tax, business tax and customs duties exemptions. 14 MINTER ELLISON ESTABLISHING A BUSINESS IN CHINA

15 6 Other business structures Representative office Representative offices are one of the oldest and most common methods for foreign investors to establish a presence in China. They are inexpensive to set up and a popular vehicle for foreign investors making their first entry into China without the financial commitments associated with an FIE. Key characteristics legal status term prohibited activities permitted activities employees capital Not a separate legal entity. The liability of the foreign investor is unlimited. Three years and must be renewed prior to expiration. However, specific laws, regulations and approvals which are relevant to some industries, (i.e. law, insurance and financial institutions) may prescribe shorter terms. May not carry on direct business in China. Allows a foreign investor to procure manufactured products in China, liaise with manufacturers and customers and to conduct promotional and product marketing activities. Cannot directly hire local residents as employees. It must enter into an agreement with a labour agent such as the foreign enterprise service company (FESCO), a government supported entity responsible for supplying staff on secondment and other services to foreign representative offices (see section 12). Unlike FIEs, there are no capital requirements. 6 ESTABLISHING A BUSINESS IN CHINA MINTER ELLISON 14 15

16 Establishing a representative office submit an application and supporting documents to the appropriate approval authority (usually the local foreign economic cooperation and trade office) for approval after approval, obtain a registration certificate from administration for industry and commerce carry out post-registration formalities with authorities in charge of tax, public security, foreign exchange, labour and customs. Branches of foreign companies 6 A branch of a foreign company is similar to a representative office except that it is able to carry on direct business in China. Again, a branch is not a separate legal entity and the foreign company will be directly liable for its activities in China. Branches are not common and are not easy to establish. Generally approval is only granted to commercial banks, insurance companies and oil companies. Business activity registration Foreign investors can in certain circumstances obtain registration from the State Administration of Industry & Commerce or its local office to carry on their business activities in China. Registration does not result in the creation of a separate legal entity and the foreign investor will have unlimited liability. Foreign investors can only obtain a business activity registration to undertake the mining of petroleum or other resources, construction work, or the management of an FIE. 16 MINTER ELLISON ESTABLISHING A BUSINESS IN CHINA

17 7 Business scope All entities carrying on business in China (both FIEs and domestic entities) are required to operate within the terms of their business scope which must be approved by the relevant government authorities. An approved business scope is evidenced by a business licence issued by the State Administration of Industry & Commerce or its local office. The business scope is also required to be set out in the Articles of Association of a company. Business scopes are generally restricted to defined activities (e.g, road transportation for goods). As an entity may not act beyond its business scope, it is important that in determining the business scope, it is not defined so narrowly that it restricts the permitted operations of a company. Conversely, it is important that a business scope is not defined too broadly, as it may not be approved by government authorities. It is not unusual for preliminary discussions to be held with relevant government authorities to determine an appropriate business scope. In some highly regulated industries (including financial services, construction, transportation, and telecommunications) an additional approval may be required to carry on a particular business activity, even if the business scope may include the relevant activity. 7 Different legal consequences arise when a company acts beyond its approved business scope. A company may be directed to stop the unauthorized activity by government authorities and may be liable for fines (depending on the applicable category of the unauthorized activity set out in the Investment Catalogue). In some circumstances, business contracts may also be held by a court to be invalid. Any change to the business activities of a company must be approved by government authorities. A new business licence must be issued and the Articles of Association amended. ESTABLISHING A BUSINESS IN CHINA MINTER ELLISON 16 17

18 8 Registered capital Minimum registered capital requirement The equity contributed by investors to a FIE is known as the registered capital. Contributions of registered capital are subject to numerous requirements including the minimum registered capital required. The rationale for FIEs having a registered capital is to prevent fraud by so called $2 companies. As a general rule, for limited liability companies with multiple investors, the minimum registered capital can be as low as RMB30,000. For WFOEs with a single investor, the minimum registered capital is RMB100,000. For a FICLS, the minimum registered capital requirement is RMB30 million. For a FIPE, there is currently no minimum registered capital requirement. However, depending on the business scope, the industry in which an FIE operates and the city in which an FIE is located, specific regulations or local authorities may require a higher minimum registered capital. 8 In addition, regulations require that registered capital represent minimum ratios of the total investment of an FIE. The total investment of an FIE is the aggregate of the equity and debt (whether in the form of related party loans or loans from third parties) necessary to establish and carry on an enterprise. Table 1 provides a summary of the required ratios. Table 1: registered capital ratios Total investment Up to USD3 million Between USD3 million and USD10 million Between USD10 million and USD30 million More than USD30 million Minimum registered capital At least 70% of the total investment. The greater of USD2.1 million and 50% of the total investment. The greater of USD5 million and 40% of the total investment. The greater of USD12 million and one-third of the total investment. 18 MINTER ELLISON ESTABLISHING A BUSINESS IN CHINA

19 Timing of capital contributions Investors in an FIE can agree to make capital contributions in a single payment or in instalments. Single payments must be contributed within six months of the issuance of the business licence. Where contributions are to be made by instalments, 15% 3 of the total registered capital must be contributed within three months of the issuance of the business licence (subject to that amount not being less than the minimum registered capital required by law for a particular FIE) and the balance must be contributed within two years 4 of the issuance of the business licence. Form of capital contributions Contributions to the registered capital may take the form of cash or in-kind contributions. Cash contributions must comprise at least 30% of the registered capital. In-kind contributions are generally agreed by the investors in an FIE and include buildings, factory premises, equipment or other materials, industrial property, proprietary technology and land use rights. Contributions to the registered capital must be confirmed by an independent qualified accountant registered in China. Confirmations are evidenced through the issuance of a contribution certificate which must be lodged with the relevant approval authority. Deciding the amount of the registered capital Registered capital is generally not returned to investors until the dissolution of an FIE. Whilst registered capital is permitted to be reduced, a reduction is subject to governmental approval. A reduction of capital will only be approved on justifiable reasons and on the condition that the reduction does not affect the normal business operations of the FIE and the interests of its creditors. 8 Foreign investors do not usually appreciate this, and at the commencement of an enterprise, may contribute more capital than is required. This can result in an unnecessary tie-up of capital. It is therefore important that foreign investors are involved in the process of deciding the amount of the registered capital of an FIE rather than leaving the calculation to its local partner. Whilst minimum registered capital requirements apply, it is important to be aware that an FIE s registered capital may always be increased, subject to the unanimous approval of the board of the FIE and the approval of the relevant approval authority. Careful planning can minimize the unnecessary tie-up of capital. 3 20% for FICLS 4 5 years for an FIHC ESTABLISHING A BUSINESS IN CHINA MINTER ELLISON 18 19

20 9 Debt An FIE can be debt funded. Current regulations, however, require that the total amount of foreign exchange debts that an FIE may borrow may not exceed the difference between its total investment and registered capital (see section 8). If an FIE stays within this ratio, it is free to enter into foreign exchange loans, subject to such loans being registered with the State Administration of Foreign Exchange or its local branches. A failure to register foreign exchange loans and related security agreements may make the arrangements unenforceable. Shareholder loans must go through the same registration process MINTER ELLISON ESTABLISHING A BUSINESS IN CHINA

21 10 Acquisitions in China Types of acquisitions An acquisition of an existing domestic enterprise (or part thereof) is an alternative for foreign investors wishing to gain a foothold in China. Foreign investors typically acquire assets in China by a direct acquisition or an indirect or offshore acquisition. A direct acquisition involves either an equity interest in a Chinese company, or its assets in China. An indirect or offshore acquisition involves shares in an offshore vehicle with an interest in the equity interest or assets in China. Chinese laws and regulations on mergers and acquisitions are typically concerned with direct acquisitions. With the exception of anti-monopoly regulation (see section 11 below), the Chinese legal framework does not cover indirect or offshore acquisitions, which are governed by the jurisdiction of incorporation of the offshore target company, making them simpler to complete. This section is concerned with the regulation of direct acquisitions. The Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (M&A Rules) (revised in 2009) jointly promulgated by the Ministry of Commerce (MOFCOM), set out the specific requirements and procedures for foreign investors making direct acquisitions. Under the M&A Rules, there are two types of acquisitions, equity acquisitions and asset acquisitions. Equity acquisitions An equity acquisition involves the acquisition of all or part of the existing equity of a domestic company by purchase or by subscription of the increased capital of the domestic company. As a result, the domestic company is converted into an FIE which assumes all of the assets and liabilities of the domestic company. Equity acquisitions must be approved and registered by the relevant approval authority. MOFCOM is generally the relevant approval authority and SAIC is responsible for registration. Additional reporting obligations apply to transactions that: relate to a key industry have or may have an effect on national economic security involves a famous trademark or time honoured brand. 10 ESTABLISHING A BUSINESS IN CHINA MINTER ELLISON 20 21

22 In these cases, the transaction must be reported to MOFCOM, who has the power to block or modify a transaction. Foreign investors should also check the Investment Catalogue to determine whether the industry in which the target is engaged is permitted, encouraged, restricted or prohibited for any restrictions on the terms of their acquisition or the post acquisition equity structure. The purchase price of the acquisition must be based on a valuation of the target issued by a licensed valuer, not more than one year prior to the acquisition. In practice, it is usual for parties to agree on a purchase price before appointing a valuer. It is also common practice for foreign investors to share the cost of a valuation. The benefit of this practice is the foreign investor can be involved in the selection of the valuer and make submissions on the valuer s draft report before it is finalised. Additional procedures are applicable to the acquisition of interests in state owned enterprises. The acquisition may also be subject to anti-monopoly restrictions (see section 11). Asset acquisitions If a foreign investor wishes to acquire assets of a domestic company in China, it must do so through the establishment of an FIE. An acquisition of assets in China by an FIE is subject to the same requirements applicable to equity acquisitions. Special procedures may be applicable to the transfer of assets under specific laws and regulations. Due diligence 10 Clearly, due diligence investigations are important in mitigating the commercial risks arising from mergers and acquisitions in China. Whilst warranties and indemnities are common in purchase documentation, in reality, suing for breach of warranty presents difficulties, particularly where the continued goodwill of a joint venture party is necessary for the success of an enterprise. However, many target companies are unfamiliar with due diligence processes or are reluctant to disclose information on their business and assets. This can make carrying out investigations to foreign standards, drawn out and challenging for foreign investors and their advisors. As in other jurisdictions, to obtain a proper understanding of a target company, a combination of legal, financial and commercial due diligence is necessary. Legal due diligence typically involves an investigation of ownership, corporate structure, government approvals and registrations, loans and guarantees, material contracts, title to land and buildings and other assets, environmental matters, business permits and qualifications, 22 MINTER ELLISON ESTABLISHING A BUSINESS IN CHINA

23 taxation, claims, disputes and labour arrangements. However, the scope of a due diligence investigation should be tailored on a case by case basis. Vendor due diligence is rare in China and investors should be prepared to address some reasonably fundamental issues as preconditions to their investment. Table 2 lists some of the issues commonly revealed in most legal due diligence investigations. Table 2: due diligence issues for investors The establishment process has not been carried out properly Articles of Association have not been altered to reflect changes in equity holdings The target is operating outside the scope of its business licence The target does not hold the permits necessary to carry on a restricted business The target does not own or hold any formal right to occupy land and buildings used by the target Loans and guarantees are insufficiently documented Material contracts have expired or are insufficiently documented Labour contracts do not comply with the law. Purchase consideration Consideration for the acquisition of equity or assets usually takes the form of cash or assets. Western style share swaps where shares in the acquirer are exchanged for shares or equity in the target, are permitted with MOFCOM s approval where the acquirer is a listed company whose shares have been steadily traded for the 12 months to the date of the issue. In practice, the structure of an acquirer s acquisition (i.e. establishing a special purpose vehicle to acquire the interest as opposed to a direct acquisition by the listed acquirer) makes the pre-condition difficult to satisfy and as such, approvals are rarely granted by MOFCOM. 10 Where the consideration is to be paid in cash by a foreign investor to a Chinese seller, and payment involves a foreign exchange transaction, the payment must be made into a special foreign exchange account set up by the seller and registered by the foreign investor with the relevant authority (i.e. SAFE). Registration is conclusive evidence of payment by the foreign investor. ESTABLISHING A BUSINESS IN CHINA MINTER ELLISON 23 22

24 11 Anti-Monopoly The Anti-Monopoly Law (AML) came into force on 1 August The AML s antimonopoly provisions are comprehensiveincluding but not limited to anti-competitive conduct (including anti-cartel provisions), abuse of dominance and regulation of mergers and acquisitions activity in China. Given the heavy financial penalties for non-compliance, foreign investors wishing to enter or expand their operations in China must ensure compliance with the AML. Application Subject to certain exemptions, including the agricultural sector, the AML applies equally to domestic as well as foreign enterprises operating in China. The AML also applies to foreign enterprises operating outside China whose operations have the effect of restricting or eliminating market competition within China. Regulatory bodies The Anti-Monopoly Commission of the State Council is primarily responsible for formulating anti-monopoly policies and guidelines, and coordinating the work of the enforcement authorities. There are three anti-monopoly enforcement authorities: MOFCOM, SAIC and NDRC. MOFCOM has set up an Anti-Monopoly Bureau (AMB) which is primarily responsible for reviewing concentrations. The AML sets out strict penalties for non-compliance with the concentrations notification requirements. AMB has the power to unwind transactions and to impose large fines where the concentrations provisions have been breached. Foreign investors intending to acquire ownership or control over Chinese entities will need to factor compliance with the requirements of AML and its subsequent implementation measures into their strategic business and investment planning. 11 SAIC has set up an Anti-Monopoly and Anti-Unfair-Competition Enforcement Bureau which is responsible for administering non-price-related anti-competition actions. It may carry out investigations into cartel arrangements, abuse of a dominant market position and abuse of administrative power to eliminate or restrict competition. NDRC is responsible for administering price-related anti-competition actions. There exists considerable overlap between the enforcement authorities. Some commentators are calling for the creation of a single AML enforcement agency, but as yet there is no proposal before the State Council. 24 MINTER ELLISON ESTABLISHING A BUSINESS IN CHINA

25 Prohibited conduct The AML prohibits certain types of monopolistic conduct. Examples are as follows: Monopoly agreements Entry by business operators into certain horizontal and vertical monopoly agreements are prohibited. Monopoly agreements which are prohibited between competing business operators (i.e. horizontal agreements) include agreements: fixing or changing the price of commodities restricting the production quantity or sales volume of commodities dividing the sales market or the raw material procurement market restricting the purchase of new technology or new facilities or the development of new technologies or new products jointly conducting boycott transactions. Certain vertical monopoly agreements are also prohibited including agreements fixing or setting a minimum resale price and other agreements identified by the regulatory authorities. A monopoly agreement may be exempt from the prohibition if the business operators can show that their agreement: has certain prescribed effects (for example, improving technology, improving the quality or efficiency of goods or enhancing the competition of small and medium sized businesses) will not substantially restrict competition will enable consumers to share the benefits from the agreement. The AML also provides a broad exemption in the case of agreements for the purpose of protecting the legitimate interests of international trade and foreign economic cooperation. The State Council may prescribe other circumstances in which an exemption may apply. Abuses of dominant market position The AML prohibits business operators who occupy a dominant market position (those who have the ability to control the price or quantity of goods or restrict the entry into a relevant market) from engaging in abusive conduct, including trading at unfair prices, unfair dealings with counter-parties (including tie-in obligations and price discrimination), and other abuses determined by the regulatory authorities. 11 ESTABLISHING A BUSINESS IN CHINA MINTER ELLISON 25 24

26 The AML sets down qualitative as well as quantitative criteria for assessing whether a business operation holds a position of dominance. It requires consideration of the competitive advantages of a particular operation in a given market as well as the bars to entry for new business operators. Contrary to common practice the AML also provides that a business operator or several business operators may be deemed to have a dominant market position if: the market share of one business operator accounts for 50% or more the combined market share of two business operators accounts for two-third or more the combined market share of three business operators as a whole accounts for 75% or more in the relevant market. However, any business operator with a market share below 10% is not deemed to have a dominant market position. The presumption of dominance can be rebutted by proving the absence of dominant market position. All illegal gains from breach of the monopoly agreement and abuse of dominance provisions may be confiscated and fines up to 10% of sales revenue in the preceding year (in the relevant market) may also be imposed. Mergers and acquisitions: concentrations The AML prohibits the formation of certain concentrations which would have the effect of restricting or eliminating competition unless prior approval has been obtained from the AMB. 11 Concentrations are defined as: mergers of business operators the acquisition of control by a business operator over another by way of acquiring the equity or assets of the latter the acquisition of control by a business operator over another by way of acquiring the ability to exercise a decisive influence over the latter (whether by contract or otherwise). The thresholds for triggering the notification procedure to obtain approval are: the total turnover of all the business operators (including the turnover of business operators directly or indirectly controlled by or who control the relevant business operators) in the concentration exceeds RMB10 billion globally or RMB2 billion within China, in the last accounting year, and at least two business operators (together with the business operators directly or indirectly controlled by or who control the relevant business operators) in the concentration each have a turnover of more than RMB400 million within China in the last accounting year. 26 MINTER ELLISON ESTABLISHING A BUSINESS IN CHINA

27 Where the notification procedure applies the implementation of concentrations is prohibited until approval has been granted. Even where the thresholds are not reached, an investigation may be initiated if the transaction has, or may have, the effect of eliminating or restricting competition. However, if the business operators can establish that the concentration is in harmony with public interest or that the beneficial effects of the concentration on competition will outweigh its detrimental effects, the AMB may exercise a discretion to allow a concentration. Definition of relevant market Central to a consideration of whether or not a violation of the AML has occurred is what is meant by the concept of a relevant market. On 7 July 2009 the Anti-monopoly Commission of the State Council published the Guidelines on the Definition of Relevant Market (Guidelines). In an approach that is generally consistent with international practice, the Guidelines define a relevant market by reference to an analysis of both the relevant geographic and product markets of a business. They go on to set out factors to be considered in defining these markets. In undertaking this analysis, the Guidelines require a consideration of the demand substitution and supply substitution of a product. The Guidelines provide that demand substitution is analysed from the perspective of the customer, to determine the degree of suitability among different products based on a customer s demand for the product s function and usage, quality and price acceptance as well as accessibility to the products. In principle, they provide that the higher the substitutability between products, the stronger the competition between them and the more likely that they belong to the same relevant market. The Guidelines provide that supply substitution is analysed from the perspective of the undertakings to determine the possibility of shifting to production of other products of close substitutes within a short time frame without requiring significant investment to retrofit or adjust production facilities or incur significant risks. In principle, they provide that the less investment required to retrofit or adjust the production facilities, the lower the additional risks, the faster the ability to switch to supply products of close substitute, and the more competitive such products will be in the market, the higher the degree of supply substitutability and the more likely that they belong to the same relevant market. 11 The Guidelines require that demand substitution first be analysed and that it be ESTABLISHING A BUSINESS IN CHINA MINTER ELLISON 26 27

28 supplemented with a supply substitution analysis, if necessary. In complex cases, where the scope of the market in which the businesses compete is not clear, or is in dispute, the Guidelines suggest that a Hypothetical Monopolist Test be employed to define the relevant market with the assistance of economic analysis. A detailed overview of the Hypothetical Monopolist Test is contained in the Guidelines. Whilst the Guidelines are an important step towards international standards and transparency in the considerations relevant to enforcement actions by the three antimonopoly enforcement authorities: MOFCOM, SAIC and NDRC, in practice the authorities will continue to have considerable discretion in their assessment of monopolistic conduct and the factors to be taken into consideration in making that assessment. For foreign investors, this could lead to some unexpected outcomes. Powers of regulatory bodies The AML sets out strict penalties for non-compliance with the concentrations notification requirements. The AMB has the power to unwind transactions and to impose large fines where the concentrations provisions have been breached. Foreign investors intending to acquire ownership or control over Chinese entities will need to factor compliance with AML requirements into their strategic business and investment planning. Application for review The AMB has issued detailed guidelines on the application process under the AML. There are strict and extensive requirements for the information which must be submitted. All documents submitted must be in Chinese and the original foreign language (if applicable). The AMB will not commence a review unless the application and information complies with the AML and administrative regulations, and is complete. Where an application and supporting documentation is so compliant and complete, the AMB may take up to a maximum of 180 days in scrutinizing a proposed concentration. If they fail to make a decision within that time the concentration may proceed. 11 Reasons must be published where a regulatory authority withholds approval or applies conditions to a concentration. National security The State Council may scrutinize a concentration proposed by a foreign investor if it affects national security. There are currently no guidelines as to what circumstances trigger the operation of the provision or what such a review will entail. 28 MINTER ELLISON ESTABLISHING A BUSINESS IN CHINA