CHINA MARKET ENTRY HANDBOOK 2014 Edition

Transcription

1 CHINA MARKET ENTRY HANDBOOK 2014 Edition

2 About the Author 4 Sovereign China With offices in Shanghai and Beijing, Sovereign China was created by the merger of Sovereign s existing China operations and the JLJ Group in The JLJ Group was established in 2003 to accelerate international clients ability to understand and operate in the China market and has successfully assisted more than 600 companies from over 60 countries with their China market entry. Sovereign China provides a suite of services designed to lead investors through the market entry process and stay with them to develop long-term success in China. From assisting with understanding the market, developing a market entry strategy to establishing their operations and finally providing back office and compliance support services, we are with our clients from planning to execution. Disclaimer: The information provided in this guide is intended for general reference only and is not an exhaustive survey of China s regulatory environment. Just as China s economy continues to change rapidly, so do the laws and regulations. The following information reflects the regulatory guidelines at the time of its writing and is not intended as advice for specific circumstances. International Copyright, Sovereign China 2014 All rights reserved.

3 Contents 5 1. A Coversation about China 1 2. China Overview Market Overview Regions of China th Five-Year Plan Opportunities and Challenges 13 Clean-Tech China Establishing a Legal Entity in China Nature of the Investment Registration Steps Registered Capital Nature of the Business 18 Multi-National Malaise Taxation of Foreign Invested Enterprises in China Tax registration and Tax Entry Main Tax Categories for Foreign Enterprises Taxation of a Representative Office (RO) Tax Incentives Value-Added Tax (VAT) Manufacturing, Wholesale and Retail Annual Audit and Annual Examination Profit Repatriation 27 The Graft Spiral Employing Personnel in China Employee Contracts Employee Personnel File and Staff Handbook Basics of Compensation Sample Calculation of Social Benefits, Income Tax and Net Salary Terminating an Employment Relationship and Severance Payment Consequences of Breaching the Labour Contract Law China s New Labour Dispatch Rules Individual Income Tax (IIT) in China Local Employees Foreign Employees Annual Income Tax Filing Annual Income Tax Filing Procedures Repatriation of Salary Paid in RMB in China Protecting Intellectual Property (IP) in China Legal Protection Contractual Protection Practical Protection 43 The Case of the Shanzhai IP Agent 44

4 1 A Conversation about China 1 What general aspects of the China market should I be aware of? There are several generalities about China that impact upon a variety of industries. These include, but are not limited to: i. Geography and population China is an extremely large market. With a landmass roughly the size of the United States, its population is equivalent in size to the populations of North and South America, Western Europe, Norway, Sweden, Australia and New Zealand combined. It is also a highly diverse market because there are substantial regional differences. For example, tastes and the way of doing business in Shanghai are very different from Beijing or Shenzhen. This affects companies entering the China market because selecting a region for entry can have a significant impact upon future commercial success. ii. Uneven development In addition to these general regional differences, the Chinese government has focused, since economic reforms introducing market principles began in 1978, on developing the coastal regions, in particular three key economic development areas that are now typically more developed than those inland: Bohai Bay area in the north, near Beijing, Yangtze River Delta, which includes Shanghai, Zhejiang Province and Jiangsu Province; Pearl River Delta, which covers Guangdong Province and the surrounding areas, including Hong Kong; There are also significant differences in the development of cities. China has three Tier 1 cities Shanghai, Beijing, Guangzhou and about two-dozen Tier 2 cities Tianjin, Shenzhen, Nanjing, Hangzhou and most of the provincial capitals. These are now relatively developed, although less so than the Tier 1 cities. There are many further Tier 3, Tier 4 and Tier X cities. In addition to levels of infrastructure development, the Tier-level of a city can also have a profound impact on their familiarity with and receptiveness to foreigners and foreign brands. In B2C (Business to Consumer) sectors, the Tier 1 cities are very saturated with foreign brands and local brands competing for business. Many brands are now starting to focus on the Tier 2 cities as their wealth levels begin to approach those of Tier 1 cities. In B2B (Business to Business) sectors, the headquarters will generally be based in a Tier 1 city but the key business activities may take place in a lower tier city or an industrial zone or park. China has done a very good job of clustering industries within industrial parks and there are likely to be several such parks nationwide that cater to a specific company s sector. iii. Undeveloped or nascent industries Typically this means that industries are highly fragmented, sometimes with thousands of competing manufacturers, or it can mean that the supply chain is highly inefficient and unsophisticated. An additional challenge for many companies is that where industries are undeveloped, the regulations may be inconsistent or non-existent. This can sometimes impact upon how a company operates in China. iv. Constant and rapid change What was true about an industry last year may be completely different this year, whether in respect to the competitive or regulatory environment. It is important to understand that flexibility and the ability to adapt quickly is essential to a successful business in China. There are, of course, other areas that you may need to know about, but ultimately the market and industry conditions will greatly depend on your industry.

5 2 What industry specific information do I need to know? Besides the general information above, it is recommended that you should assess the following areas in your specific industry when approaching the China market: Market size, growth potential and possible opportunities for your products/services; Potential barriers or challenges to business entry, including market competition, protection of intellectual property (IP) or regulatory constraints; Identify target customers, pricing of products and services, key sales and distribution channels, and effective marketing activities; Market segmentation and regional differences in China; The optimal legal entity for your business needs; The best location for your business in China. It would, of course, be possible to just enter the China market and learn through trial and error but this can consume a great deal of time and resources that could be put to better use. A more efficient alternative is to conduct market research to analyse the market in a more accelerated time frame. See Clean-Tech China on page 14 for more information. How does China s business environment compare to other countries? China is an emerging market that has experienced unprecedented growth. Although it appears to be a modern and sophisticated country in the Tier 1 cities (Shanghai, Beijing, Guangzhou), it still suffers many of the same problems as other emerging markets: A lack of independent institutions non-governmental organisations (NGOs), consumer protection or judicial bodies which leads to an absence of transparency in both state and local government operations; A low trust-based society; Clear legislation that is enforced equitably encourages adherence to written, verbal and implied agreements. In China foreign-invested enterprises (FIEs) are in many cases held to a higher standard than locally-invested firms, which often have local connections to officials who have a vested interest in their success; The government s and ultimately the Chinese Communist Party s (CCP) paramount concerns are maintaining stability and its legitimacy of rule. How might this affect my ability to operate in China s markets? This means that you will need to be actively involved in monitoring your relationships with your suppliers, enforcing and protecting your IP and being explicit about the conduct expected of your local employees. Your contracts are therefore critical because they: Provide you with a framework to discuss your relationship with a distributor or supplier; Act as a last resort in the event that any dispute arises. You cannot assume that employees, business partners or government officials share the same values as you do or value your presence and investment as much as you think they should. Active involvement by senior management in your China operations can dramatically increase your chances for success. You should not expect simply to set up a China operation, hire local employees, set them a target and wait for the returns. China can be a lucrative market, but only for those who are willing to commit the necessary time and resources to understand and deal with the complexities of running a business in China.

6 3 See Multi-National Malaise on page 20 for more information. Are contracts in China enforceable? The ability to enforce contracts is increasing as China s commercial sector matures, particularly in those regions and cities that are popular destinations for FIEs. That is not to say that enforcement will be as straightforward as you could expect in your own country rather that while there is a possibility of having an agreement enforced in China with a contract, there is almost no possibility of having an agreement enforced without one. Is it possible to protect your intellectual property (IP) in China? Protecting IP is a serious concern for most companies in China both foreign and domestic. The key to protection is a combination of seeking legal protection through trademarks and patents and engaging in proactive rather than reactive enforcement. This entails educating employees, maintaining internal controls over access to your IP and identifying means to limit its external availability. Continuous innovation is often the best way to maintain an advantage over potential competitors. If the Chinese market is so risky and complex, do I belong there? It is and you might not. Analysing the strategic importance of China to your business and then assessing if you have the resources to execute your plan is generally the best way to determine if a presence in China makes sense. Remember, a China plan is not limited to setting up a company. You could begin by working with distributors in the market to ascertain if sufficient demand exists for your products before committing to a presence in the market, or you could hire a sourcing firm to assist with finding suitable and reliable contract manufacturers to produce your products to sell in your home country. Is it possible to operate from Hong Kong instead? Given its proximity to Mainland China, the Hong Kong Special Administrative Region could be a viable option for selling into or sourcing from China initially. However Hong Kong is a distinct commercial jurisdiction with different legislation, legal system and currency from Mainland China. You will not be able to hire local Mainland Chinese to work for you legally; issue official receipts (fapiao) recognised by the Mainland tax authorities to your Mainland Chinese clients; or spend a substantial amount of time on the Mainland developing and conducting business. As your business grows, you will have to consider a presence on the Mainland. Hong Kong may, however, be a good location to set up an offshore holding company for a Mainland China company. What would be the best vehicle if I decide that I do need a real presence in China? The most common entity for doing business in China is as a Wholly Foreign Owned Enterprise (WFOE): A limited liability company, fully invested in by one or more foreign investors; May conduct business activities and generate revenue based upon a limited business scope; Hire local employees directly and in many cases with no limits on the number of foreign employees; A minimum investment requirement that is dependent on the locality and nature of the business; Registered capital must be declared during the licensing phase of the registration process, which should cover initial investment expenses and may be used immediately for the company s operations; From commencement of the registration process, you should anticipate four to six-months before a company is fully operational, depending on location. A Representative Office (RO) can represent the interests of a foreign investor by acting as a liaison office for the parent company but has decreased in popularity due to its restrictions. ROs may conduct market research, develop partnerships and business channels, but all business transactions, including issuance of invoices, must be managed

7 4 by the parent company. An RO is taxed on its expenses and cannot generate revenue. The parent company must have existed for at least two years in order to be eligible to set up an RO in China; ROs may not hire local employees directly and must rely on a government-authorised employment agency; An RO is limited to four foreign employees; There is no investment requirement because ROs are not classed as a legal entity in China; The registration process takes around four months to complete, depending on location. Would an RO be a better choice because it s faster to set up and provides a presence in China? An RO may be suitable for businesses looking to establish a short-term presence in China with no need to generate revenue, or for very limited sourcing ventures. However an RO should not be regarded simply as a way for new entrants to China to minimise their exposure in the event of failure because, in most cases, ROs do not provide the optimum platform for success and have the following disadvantages: Liability An RO is not an independent entity but rather it is an extension of the parent company. As such, the parent company and the RO s Chief Representative take responsibility and liability for its operations. A WFOE provides greater protection because it is a form of Limited Liability Company (LLC) although it does not offer the same degree of protection as other jurisdictions, so an offshore holding company is often inserted between Chinese entities and their ultimate beneficiary. Capitalisation An RO has no registered capital requirement and instead generally pays taxes on its expenses (effective tax rate approximately 11%) because its purpose is not altruistic and it contributes indirectly to the revenue potential of its parent. If the Chinese tax authorities decide that an RO is generating revenues from outside its intended activities, they can levy a tax on its deemed revenues and income. A WFOE, on the other hand, is required to make an initial capitalisation, which is tax free, but is expected to pay taxes on both its revenues and profit. If a Chinese entity s expenditures exceed a certain threshold, a WFOE is in fact more tax efficient than the RO. Scope of activities ROs are limited to providing business development, market research and support activities (such as quality control for sourcing from China), while a WFOE is permitted to generate revenues from the commercial activities prescribed in its business licence. If a business operating through an RO decides to begin selling products or services in the future, it will be required to re-establish as a new company. As a WFOE, however, it is generally possible to expand the scope of business to accommodate this. Human resources ROs are not permitted to hire Chinese citizens directly but must use a licensed labour dispatch service provider. Furthermore, an RO is limited to no more than four foreign employees as Representatives, which includes the Chief Representative. A WFOE, however, may hire as many PRC citizens as it wishes while its ability to employ foreign nationals is based upon the size of its registered capital. Some local employees dislike being hired via a dispatch service provider and prefer direct hire relationships. Ongoing costs Generally speaking, the RO has fewer ongoing compliance costs than a WFOE, particularly in respect of accounting and tax compliance. However, depending upon the length of operations and the size of annual expenditure, a WFOE may be significantly less expensive to operate as a whole due to the lower effective tax rates and a five-year carry forward of losses. Marketability A WFOE is perceived as a more substantial market presence and suggests to prospective clients or partners that a business has made a long-term commitment to the Chinese market. Often overlooked by new market entrants, such a perception can be a significant barrier to business development. Office location ROs are limited to leasing office space in locations that are specifically licensed to host ROs. Typically this means paying Grade-A office rents. A WFOE, however, can lease any office space that is zoned for its intended business. Neither an RO or a WFOE should use a virtual office this is unlawful and will create problems at both the registration and operational phases. Parent company The parent company of an RO must be at least two years old before it is permitted to

8 5 establish in China. The Chinese government is discouraging the use of ROs and different locations may place additional restrictions upon the parent before an RO is permitted to establish. What is the minimum investment to set up a WFOE in China? China has recently amended its Company Law to abolish minimum capital requirements. However, nearly every city with significant foreign investment may impose its own capital requirements for setting up a company. Furthermore, if your business is subject to additional licences, then capital requirements may be imposed for licensing. For most companies, the amount of minimum capital will depend on the location and the nature of the business. In other words, the officials reviewing your application can determine whether the amount you intend to invest is sufficient for your business activity. Authorities in the Tier 1 cities Beijing, Shanghai and Guangzhou generally regard RMB1 million (approx. USD160,000) as a baseline and applications that match or exceed this amount are likely to be subject to less scrutiny. It should be borne in mind that a company s registered capital can affect more than its registration: Local employees residence permits With a low registered capital, companies may not be able to sponsor temporary residence permits for local employees who reside outside the administrative district where the company is located. This could forcibly limit a company s talent pool. Foreign employees Certain administrative districts in China will limit the number of foreign employees that a company can employ based on that company s registered capital. Future adjustments The ability to make changes to a company s structure or set up branch offices could be hindered by the registered capital. Tax bureau relationship If a company generates minimal tax revenue for the administrative district in which it is located, it may encounter problems with its local tax bureau. It may be that none of these four issues currently apply in the administrative district where a company is looking to establish. Conditions can change suddenly at a local level, however, which could have an impact on a company s operations. Is it necessary to invest the total amount and, once invested, can the funds be accessed? The sum invested covers both operating and capital expenses. China s company law has been revised to abolish the mandatory schedule for capital contributions. Restrictions may apply at the local level, however, so it is helpful to be aware of the previous schedule: for registered capital below USD2.1 million dollars, all funds were required to be paid up within six months of issuance of a business license or, if paid in instalments, 20% should be paid up within three months and the remainder over a maximum of two years from the issuance of the business licence. Should I invest only the minimum capital required by the local authorities? No. You should invest sufficient funds to sustain the company until such time as you expect it to be cash flow positive. Too many investors spend too much time finding ways to minimise their capital investments only to find out that business expenses are greater than anticipated. Operating in China is not cheap; office rent and remuneration of experienced hires can rival that of developed nations. Do I require a physical office address to set up a company? Yes, you are required to have signed at least a one-year lease agreement in most cities. Virtual office addresses are illegal and should be avoided. You need to identify a location with a unique address that is correctly zoned for your intended business. Some new ventures use virtual offices for their company setup because disreputable agents have misled them into believing the process is quick and cheap but potential problems often do not

9 6 manifest themselves until after the agent has left. Initial registration inspections Companies that trade in certain goods will require additional permits to operate. It is not uncommon for these permits to require a visit to your office by a government official. Approvals from State Administration of Taxation (SAT) Whether it s an application for VAT-payer status or to begin processing export VAT rebates, visits may be required from the local SAT bureau. Spot checks It is not uncommon for local authorities to visit offices to check the licences and certificates. If your company s license does not match your physical location, this could create problems and potentially lead to penalties. Disgruntled employee/competitor Either could inform that local authorities of your use of a virtual office, which could lead to an investigation into your company. As with the registered capital, it may be that the authorities in a particular district currently have a relaxed stance but attitudes can change quickly and often in line with the prevailing outlook towards foreign invested companies. You should consider that while locally invested companies may flagrantly breach the law, foreign invested companies are scrutinised more carefully. Chinese officials also often favour campaigns to discourage illegal practices instead of blanket enforcement. Foreign invested companies are almost always the first to be targeted. See The Graft Spiral on page 28 for more information. Is Shanghai s Pilot Free Trade Zone a good location to set up a company? The China (Shanghai) Pilot Free Trade Zone (FTZ) was formally launched in September 2013 in Shanghai s Pudong district. Covering an area of square kilometres, the zone comprises four existing bonded areas in Shanghai. The FTZ, like many Chinese government initiatives at launch, remains ill defined until the authorities gradually flesh out the details of how it will be administered. The intended goal of the FTZ is two-fold: To experiment with economic reforms that may eventually be rolled out nationwide (similar to the original Special Economic Zone in Shenzhen in 1980); and To advance the prospect of its participation in international trade and investment agreements such as the Trans-Pacific Partnership Free Trade Agreement. At present, a number of innovative polices on the FTZ are awaiting approval. The FTZ faces many challenges; including managing a relatively long negative list and devising a comprehensive system that combines in-event and after-event supervision. It is likely that more will be known by the end of 2014 when the government begins to release implementation rules and regulations. However, even if there is significant financial liberalisation within the FTZ, this may not be of benefit to companies that are primarily involved in engaging with companies located in China. Where should I set up my office? This is a complicated question but the main factors are likely to be proximity to your customers and suppliers, as well as to available talent. If you are producing equipment for mining, for instance, then setting up in northeast China probably makes more sense than south China. If you intend to establish in an area with little or no foreign investment, the challenges of operating in China will increase. Should I consider tax incentives offered by different districts? State sanctioned tax incentives were introduced in 2008 and focused on attracting specific kinds of foreign investment high tech, environmental, certain professional services etc. Many local governments also provide tax incentives but these are not necessarily sanctioned by the state. In other words, business decisions should not solely be based on local tax incentives because these can be easily withdrawn.

10 7 Should I consider an offshore holding company in Hong Kong? Hong Kong, or even Singapore, can provide a good base from which to access the China market. A Hong Kong entity can act as a buffer between the ultimate beneficiary and the China entity, which could be beneficial for tax optimisation and profit repatriation purposes. There is no tax on dividends or capital gains, while income tax is currently 16.5% and levied only on Hong Kong-source income. However there is a risk that the business could be deemed to be liable for taxes in China as follows: Effective Management Rule If SAT deems an offshore company s day-to-day management to be located in Mainland China, the offshore company may be subject to corporate income tax in Mainland China. Offshore company residence can only be achieved if the offshore directors, wherever they are located, are permitted to exercise effective management of the company. Reduced tax rate exclusions Offshore holding companies with no substantive business activities may be excluded from reduced withholding tax rates under tax treaties with Mainland China. Indirect transfer of assets An investor that has structured an equity interest in a Mainland China enterprise through an offshore holding company could, in the event that the investor sells interests in the offshore company, be subject to an additional tax burden within China.

11 2 China Overview Market Overview China is currently the second largest economy in the world behind the United States, with a Gross Domestic Product (GDP) of nearly RMB 57 trillion (USD 9.3 trillion) in 2013 and averaging 8.3% annual growth over the last three decades (see chart below). Much of this growth is attributed to two key factors: 1. The open-door policy, implemented in 1978, which committed China to adopting policies to promote foreign trade and set the foundation for future economic reforms; and 2. China s acceptance into the World Trade Organisation (WTO) in December 2001 further opened China and liberalised the market, leading to a surge in trade and Foreign Direct Investment (FDI). FDI inflows have increased rapidly since China joined the WTO; China is now one of the top destinations for FDI in the world, with FDI inflows reaching RMB 720 billion (USD118 billion) in The chart below illustrates the increase in FDI inflows, imports, and exports from 2001 to Import Export China's Trade & FDI Figures FDI FDI (RMB Billion) Imports (RMB Trillion) Exports (RMB Trillion) Source: Sovereign analysis based on multiple sources including the PRC National Bureau of Statistics i. Demographics With more than 1.3 billion people, representing 20% of the world s population, China is the world s most populous country. From 1950 to 1980, the population grew by a staggering 78%, which led the government to introduce the One Child Policy in 1979 to slow population growth. This policy has resulted in a steady decrease in the population growth rate over that last three decades, and the population growth in 2011 was only 4.8%. Although the policy achieved its goal, it has created other socio and economic challenges, such as a shrinking future workforce that will need to support a larger ageing population. In late 2013 the policy was changed to allow parents to have two children if one of them is a single child.

12 % Male % Female The chart below illustrates the stark shift in the demographic from 2013 compared with the projections for Age China s Population 2013 by Sex and Age China's Population 2013 by Sex and Age Group Age Group China s Population 2025 by Sex and Age China's Population 2025 by Sex and Age % Male % Female % Male % Female Source: Sovereign analysis of data from the US Census Bureau Age China's Population 2025 by Sex and Age ii. Group Urbanisation Urbanisation 100+ is linked with the modernisation of an economy, with people migrating from rural areas to live in cities, mainly in search of new job opportunities. This is a developing phenomenon in China, which has a current estimated urban population of 690 million, accounting for 51% of the total population in The urbanisation rate is expected to increase 1% per year for the next two decades, which is equivalent to urbanising 300 million people in 20 years. The map below illustrates the urban population percentage by province/municipality % Male % Female Heilongjiang Jilin Xinjiang Inner Mongolia Beijing Liaoning Urban Population Percentage >70% 60% ~ 69% 50% ~ 59% 40% ~ 49% <40% Tibet Qinghai Ningxia Shanxi Shandong Gansu Henan Shaanxi Jiangsu Shanghai Sichuan Hubei Anhui Chongqing Jiangxi Zhejiang Hunan Guizhou Fujian Yunnan Guangxi Guangdong Hainan Source: Sovereign analysis of data from the PRC National Bureau of Statistics

13 10 iii. Expanding middle-class China s emerging middle-class, which can be generally defined as those with an annual salary of over RMB 50,000 (USD8,000) is projected to exceed 400 million people by It is an influential group that is altering the dynamics of the economy, with its willingness to spend and the evolving adoption of a Western lifestyle. Furthermore, as China gradually transforms from an export-led to a consumer-driven economy, it will rely on its burgeoning middle-class to further support future economic development. 2.2 Regions of China i. China s Regional Divides China is divided into 34 provincial-level administrative units, with four direct municipalities Beijing, Chongqing, Shanghai and Tianjin. China also has two Special Administrative Regions (SAR), Hong Kong and Macau, which are both semi-autonomous and self-governing. The map below shows the key regions, provinces, and Tier 1 cities. Beijing Population 19.5 million With over 3,000 years of history. Beijing is the capital of China and considered the political and cultural centre Average salary is over RMB 64,000 (USD10,000) per year, above national levels. Heilongjiang Jilin Xinjiang Inner Mongolia Beijing Liaoning Tibet Qinghai Ningxia Shanxi Shandong Gansu Henan Shaanxi Jiangsu Shanghai Sichuan Hubei Anhui Chongqing Jiangxi Zhejiang Hunan Guizhou Fujian Yunnan Guangxi Guangdong Shanghai Population 23 million Shanghai is the largest city by population in China. Located in the Yangtze River Delta, the port of Shanghai, is among the busiest ports in the world. The city has attracted significant foreign investment and is considered a hub for international finance. %Share of GDP Eastern China 60% %Share of Population 45% Hainan Guangzhou Population 12.8 million Located on the Pearl River Delta, Guangzhou is the capital city of Guangdong province. Cantonese is spoken by a vast majority or residents. Central & North 16% 33% - Eastern China Western China 14% 22% Source: Sovereign analysis of multiple sources

14 11 BEIJING Population: 19.6 million With a history spanning over three millennia, Beijing is the second largest Chinese city by urban population after Shanghai and serves as the nation s political, cultural and educational centre. Located in northern China, Beijing is home to the headquarters of most of China s largest state-owned companies, and is a major transport hub. Beijing Capital International Airport is the second busiest in the world by passenger traffic. The average annual wage is over RMB 62,677 (2013). SHANGHAI Population: 23 million Shanghai is the largest city by population in China. Located in the Yangtze River Delta in East China, Shanghai sits at the mouth of the Yangtze in the middle portion of China s coast. The city has attracted significant foreign investment and is a global financial centre as well as a transport hub with the world s busiest container port. The average annual wage is RMB 56,300 (2013). GUANGZHOU Population: 12.8 million Located on the Pearl River, Guangzhou is located about 120 km north-northwest of Hong Kong. Guangzhou is the main manufacturing hub of the Pearl River Delta, one of Mainland China s leading commercial and manufacturing regions, and is a key national transportation hub and trading port. The majority of its residents speak Cantonese. The average annual wage is RMB 63,752 (2013). It is often assumed that China is well integrated; however, the China market is highly fragmented and is more similar to Europe, with each province having its own culture, tastes and dialect. Fiscal decentralisation during the 1980s increased local governments responsibility for economic management, thus encouraging local protectionism and competition amongst provinces. Despite a fragmented market, the economy has prospered, albeit tepidly in certain regions. China can be divided into three regions (as shown in the map above): Eastern China, Central and North-eastern China, and Western China. The coastal regions of Eastern China are by far the most prosperous and populated areas, with the Bohai Bay, Pearl River Delta and Yangtze River Delta forming the principal economic belts. Much of the success of Eastern China is a result of the market opening reforms set out by Deng Xiaoping, known as the paramount leader of the People s Republic of China from 1978 to 1992, and its easy access to overseas markets via the South China Sea and Pacific Ocean. The region has established several manufacturing centres and boasts some of the world s largest seaports. Growth in Eastern China has slowed in recent years, with increasing costs leading to some businesses relocating to Central China. The Central and North-Eastern regions are progressing steadily, with the central government allocating a larger portion of their budget on infrastructure spending. The high-speed railway network has improved inland logistics to the extent that a journey from Wuhan to Guangzhou, which would have taken 11 hours, now takes only three. Traditional labour exporter provinces such as Anhui and Jiangxi are also now benefiting from this development as workers move closer to home.

15 12 Compared to Eastern China, development in the Western regions has lagged considerably. This induced the government to implement its Go West policy in 2000 to attract foreign investment, improve infrastructure and retain talent. Although significant investment has been injected into the region, including a recent package promising to invest RMB 682 billion (USD 108 billion) on infrastructure development, the effects have been limited and the economic gap between Eastern and Western China continues to grow. However, as labour costs rise in coastal regions, manufacturers are beginning to move west. With cities such as Chengdu and Chongqing providing relatively cheaper labour and better access to inland markets, these Western regions are becoming more attractive as an alternative to the East. ii. Cities in China Cities in China are characterised by a tier system, which can be dependent upon population, economic size, history and other factors such as levels of economic development and infrastructure. Although there is no formal definition of what constitutes a Tier 1, Tier 2, or Tier X city, it is generally acknowledged that the Tier 1 cities consist of Beijing, Shanghai and Guangzhou. They are all highly populated, with income levels typically above the national average RMB 53,000 (USD 8,400), have highly developed infrastructures and more developed markets. While Tier 1 cities have received a significant amount of attention from foreign businesses and media, major growth opportunities also lie in Tier 2 cities (e.g. Shenzhen, Hangzhou, Tianjin, and Suzhou, as well as most provincial capitals) and Tier 3 cities (e.g. Jiangmen, Changshu, Dandong, Wuxi, etc.). The central government has significantly increased spending on housing projects and infrastructure as part of its initiative to develop the lower tier cities th Five-Year Plan Commencing in 1953, the Five-Year Plans set out the proposals established by China s central government to promote and guide economic and social development. In the current 12th Five-Year Plan ( ) the dominating feature is domestic consumption, with China s government aiming to transform the economy from an export-led to a consumer- driven economy. The central government set out several key themes for the 12th Five-Year Plan as detailed below (Source: Sovereign analysis of multiple sources): Maintain economic growth GDP is targeted to grow by 7%, as opposed to the 7.5% target in 11th five-year plan. Domestic consumption Domestic consumption is expected to contribute to 40% of GDP; this will be partially achieved through consumer subsidies and accelerated wage growth. Upgrading social welfare Increases in state support for education, healthcare and social security. Lower energy consumption Aims to reduce energy consumption per unit of GDP by 16%. Western development strategy To continue the development strategy for Western China, with an emphasis on natural resources, migration of industries and improved transportation. Develop the services sector To implement a series of tax reforms to lessen the burden on the services sector in order to expand service industries to 47% of GDP. In addition, the central government selected seven Strategic Emerging Industries (SEIs) for significant economic development: new materials, biotechnology, energy conservation and environment protection, information technology, high-end equipment manufacturing, new energy and alternative energy vehicles. The central

16 13 government was to invest heavily in these areas and implement favourable policies such as preferential tax treatments in order to develop the SEIs. Although plans set out in the 12 th Five-Year Plan are typically general, they do provide a good indication of the potential opportunities for certain industries. 2.4 Opportunities and Challenges i. Selected opportunities Commercial opportunities exist across several sectors of the China market, including the three examples below: Luxury Goods China is the world s fastest growing luxury goods market, experiencing 30% growth in recent years, as China s expanding middle-class exhibits an insatiable appetite for luxury goods. This trend is likely to continue as Chinese citizens become more affluent and consume more luxury goods in an image-conscious society. Logistics Presently only 15% of local companies use third-party logistics providers (3PLs); however, the gradual emergence of 3PLs should improve efficiency and the market is expected to become the largest in Asia by 2014, worth RMB 183 billion (USD 29 billion). Healthcare China s aging population has put an increasing strain on the retirement system, resulting in a change from six workers supporting one retiree in 1975 to an estimated one worker per retiree by 2035; to satisfy the needs of an elderly population, the government has introduced various measures that include permitting foreign investments in hospitals and the provision of basic medical insurance. ii. Business challenges Foreign investors face several challenges when entering the China market. Although these hurdles will vary, depending on the specific company, sector and location, there are three key issues that are common to all enterprises starting up in China: Relationships It is important to invest in cultivating relationships in order to understand and overcome any of the cultural differences that exist between China and the West; establishing a business presence in China when building such relationships usually makes this process smoother. Prohibited/restricted industries The National Development & Reform Commission (NDRC) and the Ministry of Commerce (MOFCOM) regularly issue a catalogue classifying industries that are encouraged, restricted or prohibited from foreign investment. Companies are recommended to examine which category their industry and business scope falls within. Regulations There are situations when regulations may be difficult to understand or are inconsistently enforced. This is often due to loosely interpreted regulations or the involvement of multiple authorities in oversight. Companies must ensure that they fully understand the regulatory environment before entering the China market. China is notorious for its bureaucracy and the process of business registration is not immune to this inclination for regulation. Unlike many other countries, registering a business in China may require the assistance of an agency authorised by the government to assist with the process. Prior to October 2004, companies were required by law to use an authorised agent. With China s constantly changing regulations and inconsistencies of interpretation and enforcement, together with the general lack of transparency, the process of establishing an entity so as to ensure against future problems is far more complicated than in more developed markets. Engaging the services of a qualified consultant can substantially improve the chances of avoiding problems with compliance as well as decreasing the time to get established.

17 Case: Clean-Tech China 14 A mid-sized chemical company focused its attention on China as the next market into which to launch its clean-tech products. The company s traditional customers in North America are power plants and the company assumed that China would be the same. The company chose to conduct research into the market to assess the needs of their potential customers and also review any potential regulatory barriers that might prevent it developing business. During the research, the company found that power plants in China were not an ideal target customer because most operate at a loss and are unwilling to invest in new equipment or services unless ordered to do so by the government. However, they did find an alternative customer base that made China an even more significant market than they had anticipated. By investing resources upfront to understand the market, the client was able to save time and money by targeting the right customers for their go-to-market strategy.

18 3 Establishing a Legal Entity in China Nature of The Investment When a foreign investor chooses to enter the China market they will first need to decide whether to launch their business by establishing a legal entity with a capital investment in China or to start more cautiously by testing the market, building networks and/or hiring local representatives. If a legal entity is the preferred route, the foreign investor will have to consider, in addition to the general commercial and strategic considerations, the business sector, the amount to be invested and whether a Chinese partner is desirable or even mandatory. Government rules for specific industries may affect the size and form of the investment. For instance, media, automotive and telecom industries are all industries that may require foreign invested enterprises to have local partners. i. Representative Office (RO) A Representative Office (RO) can represent the interests of the foreign investor by acting as a liaison office for the parent company. ROs can conduct market research, develop partnerships and business channels and, since they do not have a minimum investment requirement, ROs are not considered to be a Foreign Invested Enterprise (FIE). ROs are the least complicated way for a foreign firm to have a legal presence in China and were, at one time, the first choice for foreign companies with little or no previous experience in the country. However all business transactions, including issuance of invoices, must be managed by the parent company and ROs can only hire a maximum of four foreign employees. Any local employees must be hired through governmentauthorised employment agencies. ROs are usually taxed on a proportion of gross monthly expenses. Given the restrictions on transactions, employment and the taxation on expenses, Wholly Foreign Owned Enterprises are typically now considered a better option for entrants seeking to develop their business in the China market. ii. Wholly Foreign Owned Enterprise (WFOE) A WFOE is a limited liability company (LLC) fully invested by one or more foreign investors. Along with the rights afforded to a RO, a WFOE may also legally conduct business transactions within China and hire local employees on its own accord. However, foreign investors do have to make an investment into the company and, depending upon the business activity, there may be a minimum capital requirement. WFOEs have begun to outpace joint ventures as the most popular vehicle for a China presence. iii. Joint Ventures (JVs) There are two types of joint venture structure in the China market: Equity Joint Venture (EJV) EJVs have capital investments from both local and foreign firms. The percentage of the capital investment determines the amount of profit and risk that both the foreign and local company assumes. Foreign firms entering business sectors where WFOEs are prohibited often use EJVs, although this is becoming less prevalent as more and more sectors are being opened up to WFOEs. Cooperative Joint Venture (CJV) CJVs are also partnerships with a local company; however, the amount of risk and profit shared by each party is not determined by capital investment, but rather it is agreed upon at the beginning of the partnership. CJVs were used more frequently in the 1990s when the Chinese economy was not as developed. International companies often injected funds, while local Chinese companies provided equipment and other necessities. Laws, regulations and procedures for establishment can vary substantially between sectors. The common risks associated with entering into partnerships also apply in China but this is often exacerbated by disparities in the culture and business practices between the foreign and local partners. Foreign companies

19 16 should enter into JVs only when both parties have established a clear understanding of the business objectives and appropriate exit strategies have been developed. iv. Mergers and Acquisitions (M&A) Finally, M&As have become an increasingly popular route to invest in China in recent years. There are many options for M&A in China, including equity and asset acquisitions, as well as mergers. As a form of foreign direct investment, the general rules on establishment of FIEs also apply to any M&A. 3.2 Registration Steps Set out below is the typical process for setting up both FIEs and ROs in China. The government offices involved in this process include the Ministry of Commerce, the Administrative Bureau for Industry and Commerce, the State Administration of Foreign Currency, the Tax Bureau, the Customs Office and the Statistics Bureau. Company Registration Process Stage I: Licensing { Company s Chinese Name Approval* Approval to Establish Company* Registration of Business License { Filing and Carving of Seals Enterprise code Certification Stage II: Registration with Tax Bureau Foreign Exchange Approval Post Licensing Statistics Bureau Registration** Open RMB & Foreign Currency Bank Accounts Stage III: Post - Capital Injection*** { Capital Verifiction Update Business License Financial Registration Customs Registration * These steps are not required for the establishment of a Rep. Office. ** This process is usually completed following foreign exchange approval and registration with the Tax Bureau. *** Capital Verification and Updating the Business License may still be required for certain business activities.

20 Registered Capital Prior to March 2014 all FIEs were required register a minimum capital amount and to pay-in their capital over a prescribed period of time. With the introduction to China s amended company laws this year, both minimum capital requirements and the prescribed investment schedule have been abolished in favour of a subscribed capital system for companies that are not engaged in business activities that require special approvals. How these changes will impact other registration procedures remains to be seen at the time of this writing. The amount of registered capital must be declared during the licensing phase of the registration process. The total investment figure is represented by the ratio between foreign contributed capital and debt. The registered capital should cover all the FIEs initial investment expenses and may be used immediately for the newly formed company s expenses. It is unlawful to inject the funds as stated and then withdraw them. One purpose of the registered capital is to provide confirmation to creditors of the company s financial adequacy. Total Investment (USD) Registered Capital (USD) Less than 3 million No less than 70% of total investment, with a mininum of 4,800 Between 3 and 10 million No less than 50% of total investment with a mininum of 2.1 million if total investment is below 4.2 million Between 10 and 30 million No less than 40% of total investment with a mininum of 5 million if total investment is below 12.5 million Between 30 and 36 million No less than 1/3 of total investment with a mininum of 12 million Although the Chinese government has abolished minimum capital requirements, local bureaus may in practice still require foreign investors to commit to a minimum amount, based upon previous investment expectations, before they grant approval. In general, the investment required is dependent upon the business scope, volume of sales, company size and location of setup, and is judged on a case-by-case basis by the local authorities. The Chinese authorities are likely to assess what would be a reasonable capital injection for each specific project.