Establishing Joint Ventures in the People's Republic of China

This article sets out the main legal issues that foreign investors should consider when establishing joint ventures ("JVs") in Mainland China. Joint ventures may take a number of forms and we comment on the following:

• Equity Joint Ventures ("EJVs");
• Contractual (Co-operative) Joint Ventures ("CJVs");
• The Main Differences between EJVs and CJVs;
• The Major Common Features of EJVs and CJVs;
• Ongoing Obligations and Liabilities

1. Equity joint ventures ("EJV")

The key basic features of an EJV are as follows:

• An EJV is a joint venture between foreign and Chinese parties where the profits and losses are distributed between the parties in proportion to their respective capital contributions to the JV.
• Under Chinese law, the foreign party shall hold more than 25% equity interest in the registered capital of the JV.
• An EJV is a Chinese enterprise legal person with limited liability.

2. Contractual (co-operative) joint ventures ("CJV")

The key basic features of a CJV are as follows:

• A CJV is a joint venture between foreign and Chinese parties where the profits and losses are distributed between the parties as agreed in the joint venture contract, and not necessarily in proportion to their respective equity contributions in the JV.
• Under Chinese law, a CJV may be organised as a Chinese enterprise legal person with limited liability, or a business organization with a joint management committee but with no separate legal personality.
• Where a CJV is organised as a Chinese enterprise legal person with limited liability, the foreign party is required to contribute more than 25% to the registered capital of the CJV.
• Where a CJV is not organised as a Chinese enterprise legal person, it will be similar to a partnership arrangement. The investors would not enjoy limited liability in such cases. However, the PRC Partnership Law is not considered to apply to CJVs.

3. The Major differences between EJVs and CJVs

We set out below the main differences between EJVs and CJVs as follows:

• An EJV is registered as a PRC enterprise legal person with limited liability, whereas a CJV may be either an enterprise legal person with limited liability or an enterprise with no separate legal personality. The latter arrangement is similar to a partnership with unlimited liability.
• The parties to the EJV share profits and losses in proportion to their respective equity interests in the EJV, whereas in a CJV, the profits and losses may be distributed as agreed in the joint venture contract. Under certain circumstances the foreign party to the CJV may recover its investment in the CJV ahead of the Chinese party. A foreign party may recover its investment in the CJV from the earnings before tax subject to the prior approval of relevant tax authority (rarely given).

4. The Major Common Features of EJVs and CJVs

While there are significant structural differences among EJVs and CJVs as mentioned above, the two forms of JVs do share many common characteristics and are in many instances subject to the same or similar requirements under PRC law as follows:

Capitalization

As mentioned, PRC law requires that in either an EJV or a CJV the foreign party hold a minimum of twenty-five percent (25%) of the company's registered capital. In addition, both EJVs and CJVs must comply with debt/equity ratios. Please let us know if you would like more information regarding the debt/equity controls.

Scope of Operations

Foreign-invested enterprises such as EJVs and CJVs are generally restricted to selling only those products that they themselves manufacture. Without special approvals, this means that JVs may generally not, for example, import products of the foreign investor for on-selling in China or provide services in respect of products that are not self-manufactured.

In addition, companies in China are legally permitted to engage only in the activities explicitly approved by the relevant approval authority and contained in the "scope of business" as it appears on the company's Business License. Unlike in some other jurisdictions, it is not possible in China to include in one's business scope a sweeping catch-all phrase permitting the company to engage in "all other legally permitted activities". Therefore, the description of an FIE's proposed activities in the establishment documents will need to be broad enough to include all contemplated activities of the FIE, while at the same time, narrow enough to be acceptable to the government approval authorities.

Approval Authority

The approval authority for foreign direct investment in China is ultimately vested in the Ministry of Foreign Trade and Economic Co-operation ("MOFTEC"). MOFTEC delegates the authority to approve foreign investment projects to its local branches, the Commission of Foreign Trade and Economic Co-operation ("COFTEC"), according to the amount of the investment and the nature of the investment project. Please let us know if you would like more information about securing approval for foreign investment projects in China.

Form of Capital Contribution

Capital contributions to the JVs may take several forms. As mentioned above, capital contributions include cash, buildings, contributions in kind, equipment and machinery, technology and land use rights. Different requirements and restrictions apply to different types of capital contribution, for example:

(i) Where technology is contributed as capital to joint venture, the technology shall not exceed 20 percent of the total registered capital unless special approval is secured. Evidence of ownership, such as patent and trademark registration certificates, is required to support valuation and ownership of intellectual property.

(ii) Machinery, equipment and other materials may be contributed to the registered capital only if they are (a) indispensable to the production of the FIE; or (b) that they cannot be manufactured in China; or they can only be manufactured in China at too high a cost or in a way which they are unable to meet demand in terms of technical performance and delivery time. Leased equipment and machinery can not be used as capital contribution. Again, evidence as to its ownership needs to be shown. It may be possible for JVs to import machinery and equipment exempt from PRC import duty and other taxes in certain circumstances.

Assignment of equity interest

If either party to the JV intends to assign all or part of its equity interest to a third party, written consent must be obtained from the other joint venture party. The assignment is subject to the unanimous board resolution and the approval of the original approval authority. Such assignments by one party of all or part of its equity interest in the registered capital of the joint venture to a third party is generally subject to the other party's pre-emptive rights.

Changes to registered capital

Change of registered capital must be carried out in compliance with the relevant PRC laws and regulations and subject to the approval of the PRC approval authorities. Any change of registered capital without going through the approval procedure is invalid.

Preferential Treatments

Foreign-invested enterprises are given protection and encouragement under Chinese laws, and is made subject to a more lenient system of controls than investment solely by Chinese parties. The following are some protection and encouragement offered by the Chinese government:

(i) Tax Incentives

A number of tax incentives have been made available by the Chinese government to foreign-invested manufacturing enterprises in the PRC. For example, a manufacturing company that has had approval to operate for at least 10 years is exempt from income tax for 2 years starting from its profit-making year and is entitled to a 50% reduction in the normal tax rate in the subsequent three years.

(ii) Import and Export

Foreign-invested manufacturing enterprises have international trading rights automatically and can conduct import and export transactions related to their production business.

Foreign companies can establish trading companies in selected Free Trade Zones in China.

(iii) Right to borrow

Subject to debt:equity controls and registration/reporting requirements, foreign-invested enterprises have the authority to borrow in both local and foreign currency.

Repatriation of capital and profits

The following types of payment may be repatriated:

(i) Dividends

The net profit received by investors in wholly foreign-owned enterprises or foreign parties to joint ventures can be remitted abroad in accordance with Chinese foreign exchange control regulations if the enterprise is in compliance with the laws and regulations. However a practical problem lies with the sufficiency of the supply of foreign exchange within PRC, as RMB may not be remitted abroad. In recent year, the supply has generally been sufficient.

(ii) Capital

If a foreign-invested enterprises is legally terminated because the business term expires or because the investor wishes to discontinue the business, it may be liquidated. Upon liquidation, the portion of residual investment belonging to the foreign investors would be converted into foreign exchange to be remitted outside China after payment of tax. Alternatively, the business may be sold. The proceeds of sale can be repatriated, but there is no legislation to assure conversion into foreign exchange. In recent year conversion has generally been available.

(iii) Royalties

With proper documentation and authorizations, it is also possible for JVs to remit royalties under contracts such as trademark licences to foreign investors.

Corporate Governance

The relevant PRC law governing JVs does not adopt the system of shareholders' meeting. Instead, the function of shareholders meeting is incorporated into the function of board of directors (BOD).

The BOD is the highest authority of a joint venture. It decides all major corporate issues concerning the joint venture, including (a) the appointment of general manager, (b) strategic planning and budgeting, (c) employee compensation and welfare, (d) distribution of after-tax profits and (e) dissolution of the joint venture.

Chairman of the BOD is the legal representative of the joint venture. The legal representative of a FIE has the power to: (a) enter into business dealings; (b) execute contracts which will be binding on FIE; and (c) call, convene and preside over board meetings.

In the case of some CJVs, a JMC instead of a BOD is formed as the body with highest power of the CJV. Such committee has almost the same function and power as that of a BOD. Therefore the discussion above on the composition, function of the BOD will also apply to JMC.

The management group headed by a general manager is responsible for the day-to-day management of a joint venture. In the case of an EJV, several deputy general managers must be appointed to assist the general manager in his work. The positions of either general manager or deputy general manager(s) may be held by Chinese citizens or foreign citizens. Any directors may concurrently be the general manager, deputy general manager or other senior management personnel, provided that he is appointed by the BOD.

Expropriation of investments

One concern foreign investors often have is whether their investments in the PRC are at risk of being expropriated by the Chinese government. The PRC Law on Sino-foreign joint ventures and the PRC Law on Wholly Foreign-owned Enterprises expressly provide that except under exceptional circumstances, the State must not expropriate these enterprises or assets. If it is necessary to do so in the public interest, PRC law sets out legal procedures governing this act and provides for compensation to be paid as is considered reasonable by the State.

5. Ongoing Obligations and Liabilities

We briefly comment on the ongoing reporting obligations and liabilities in the context of JVs.

Ongoing Reporting obligations

JVs have various ongoing reporting obligations such as filing of annual returns with the Administration of Industry and Commerce ("AIC"). We would be to provide detailed comments on these reporting obligations if required.

Liabilities

We briefly comment on the liabilities of foreign investors in JVs, directors and legal representatives as follows:

(i) Liabilities of Foreign Investors in JVs

EJVs and legal person CJVs enjoy the status of limited liability companies under PRC law. As such, foreign investors would generally not be liable for the debts of such JVs. That said, foreign investors may be liable if they breach their obligations under investment-related contracts with PRC partners such as joint venture contracts and technology license contracts.For example, foreign investors might be liable to their PRC partner for breach of contract if the foreign investors fail to contribute capital in accordance with the joint venture contract.

(ii) Liabilities of Directors

Individuals appointed to the board of directors of JVs may face personal liability in limited cases. Unlike the common law system, China does not have a general "directors' liability" law and the relevant case law is not binding under China's civil law system. However, directors are potentially exposed to liability. For instance, the PRC Company Law provides certain duties of directors. The critical duties provided in the Company Law include:

• Personal Interests Directors shall perform their duties and protect the company's interests, and they shall not use their position and authority in the company for personal profits. Directors shall not receive any bribe or other illegal gains by virtue of their position in the company and shall not appropriate the company's property or assets.
• Conflict of Interests Directors shall not operate (either for themselves or others) a business with a similar nature to the company's business or engage in any activities which may harm the company's interests. Any income obtained from such business or activities shall be deemed to be the company's income. Directors shall not enter into contracts or any transactions with the company unless otherwise permitted in the company's articles of association or shareholders'; meetings.
• Appropriation of the Company's Funds Directors shall not make any appropriation or lend the company's funds to any third parties. Directors shall not deposit the company's funds in a bank account opened in their name or any other person's name. Directors shall not provide any guarantee with the company's funds for any shareholder of the company or other individuals.
• Confidentiality Directors shall not disclose the company's secrets unless otherwise specified by the laws or otherwise permitted.
• Exposure Under article 63 of the Company Law, if Directors breach the law, administrative regulations or the company's articles of association in performing their duties and such breach causes loss or damage to the company, the directors shall be liable for the loss or damage. Accordingly, directors shall be liable for any loss or damage caused to the company due to their failure to perform any of the directors' duties specified in the Company Law.

Please feel free to contact us if you would like a more comprehensive analysis of directors potential liability under PRC law.

(iii) Liabilities of Legal Representatives

PRC law also contains provisions which prescribe liabilities for chairmen/legal representatives of economic entities such as JVs. For example, the PRC Civil Law provides that legal representatives may be subject to administrative sanctions, fines or criminal offences (if their acts constitute crimes) in the following circumstances:

i. the enterprises contract outside their business scopes and conduct illegal business operations;

ii. the enterprises conceal facts from the registration and tax authorities and practice fraud;

iii. the enterprise secretly withdraws funds or hides property to evade repayment of debts;

iv. property is disposed of without authorization after the enterprise is dissolved, disbanded or declared bankrupt;

v. there is a failure to apply for registration and make a public announcement promptly when the enterprise undergoes a change or terminates, thus causing interested persons to suffer heavy losses;

vi. the enterprise engages in other activities prohibited by law, damaging the interests of the state or the public interest.

Please let us know if you would like a more comprehensive analysis of the legal representatives potential liability under PRC law.

We hope these comments are helpful. If you have questions or comments, please feel free to contact us.

To learn more about these issues and what investment vehicle will suit your business needs, please contact Luke Filei in Beijing on + 86 21 628 96363 or email address luke.filei@cms-cmck.com.

© CMS Cameron McKenna 2002