When Deng Xiaoping opened the Chinese economy to foreign
investors in the late seventies, he paved the way for
regulations permitting ventures between Chinese and foreign
companies. Those regulations however, did not go so far as to
permit foreign players to engage in cross-border activities.
Foreign companies were effectively locked out from making
investments if they did not have a physical presence in
The next decade of economic liberalization resulted in big
increases in the number of foreign invested enterprises (FIEs)
being established. They took the form of equity joint ventures
(EJV), cooperative joint ventures (CJV), or wholly
foreign-owned enterprises (WFOE).
In the wake of these changes, regulations were adopted that
set the stage for joint venture companies to be established
through M&A transactions. A regulatory framework for these
activities was created, where none existed before.
China's accession to the World Trade Organization in 2001
has helped enormously to level the playing field in China for
foreign investors, by further opening previously closed sectors
of industry to foreign investment.
By gradually lifting restrictions on foreign players,
particularly in the service sector, and increasing the number
of industries where WFOEs are now allowed, the Chinese
government has well and truly let the foxes into the hen house.
It has also altered the need for foreign investors to resort to
using joint ventures companies involving a Chinese partner.
In this changing landscape have joint ventures suddenly
The Catalogue for foreign direct investment
To implement its WTO commitments, from time to time China
promulgates an updated version of the Catalogue for the
Guidance of Foreign Investment. The Catalogue classifies
foreign direct investment projects into three categories:
encouraged, restricted and prohibited. All foreign investments
that are not included in the Catalogue are permitted. The level
of approval for the project and the availability of tax
holidays are both derived from this all-important
The Catalogue, together with the applicable regulations in
each sector, also nails down the permitted levels of foreign
ownership and the corporate form for project companies. In
limited liability companies (LLCs), which include EJVs, CJVs
and WFOEs, registered capital is exchanged for equity
interests. In contrast the registered capital of companies
limited by shares (CLS) is divided into shares. However,
investors' liabilities in both types of companies are capped at
their contributions to the registered capital.
A CLS possesses a striking similarity to western stock
companies. It is governed by a board of directors under the
supervision of its shareholders assembly. In contrast to LLCs,
no decisions in a CLS need the unanimous consent of its
shareholders. Also, a CLS may be listed on a PRC stock
Depending on the provisions of the Catalogue, the exact form
of an LLC (either an EJV or a CJV) may either be allocated or
left to the investors' discretion. While the rules governing
both entities are slightly similar, the regulations applicable
to CJVs offer some additional benefits, including more
flexibility for the investors in determining their
relationships within the company.
For example, EJV regulations are firm on the point that both
the number of directors and the division of profits should
strictly reflect the investors' shareholdings. This requirement
does not exist for CJVs, which allow investors to arrange
voting rights and the dividend rights differently. CJVs are
commonly recognized as useful tools for infrastructure or
energy projects where investors wish to get together on terms
that are not commonplace in China.
Investors might also elect to establish a CJV that has no
separate legal identity to investors. In this situation, each
investor is responsible for contributing to the venture, paying
its own taxes on profits derived from the venture, and bearing
its own liability for risks and losses. However, this category
of CJV is rare.
Often, instead of being a business option, resorting to a
joint venture is an obligation. The Catalogue frequently gives
no other choice to foreign investors who wish to invest in a
wide range of industries (life insurance, energy, construction
of transportation facilities, higher education and
October 2004 was noteworthy for the Interim Foreign
Investment Project Ratification Administrative Procedures
promulgated by the National Development and Reform Commission
(NDRC). The Procedures provide that foreign investment projects
will be dealt with as follows, depending on their level of
total investment (including increases in capital) and
classification in the Catalogue:
- Projects with either: (i) a total investment of $100
million or more in the encouraged or permitted categories; or
(ii) $50 million or more in the restricted category, must be
reported to NDRC for ratification.
- Applications for projects that are either: (i) in the
encouraged or permitted categories and have total investment
amounting to $500 million or above; or (ii) are in the
restricted category and have total investment amounting to
$100 million or above, will be submitted to the State Council
for final verification after initially being examined and
verified by the NDRC.
- Encouraged or permitted category projects where the total
investment is below $100 million and restricted category
projects where the total investment is below $50 million must
be ratified by the local NDRC. These restricted category
projects must also be ratified by NDRC at the provincial
As far as the approval process is concerned, recent
proposals have been made by several ministries aimed at
boosting control and approval conditions for foreign investment
in certain industries. They include shipbuilding, nuclear
activities, and equipment for the petrochemical and steel
To circumvent this hurdle, foreign investors often decide to
select a Chinese ally to dissuade administrative bodies from
raising difficulties or delaying the approval of the project.
Chinese partners also frequently undertake to supply both the
joint venture and the foreign investor with market knowledge,
contacts and legal and political information that would
ordinarily be out of reach to the foreign party. These types of
obligations can greatly assist with approval processes and
formalities as well the smooth operation of the company.
In particular, land use rights needed by the joint venture
might already be owned or could be acquired faster by the
Chinese partner than by a foreign company wishing to establish
an FIE as a sole investor.
Lastly, to a certain extent the Chinese investor is in a
better position to champion the rights of the joint venture
than the joint venture itself, should difficulties arise in the
course of operations.
Establishment by acquisition
Foreign investment in China has traditionally taken the form
of greenfield joint ventures. Yet after 2003, the popularity of
M&A transactions skyrocketed among foreign investors
wishing to enter the Chinese market immediately or to control
their supply chains in China.
Foreign investors have two options when purchasing equity:
either investing in an FIE or in a Chinese company with no
foreign investment. This Chinese company is then transformed
into an FIE after the acquisition.
Any acquisitions require the approval from Ministry of
Commerce (Mofcom) or its local branches. Additional approval
from agencies in various sectors of the economy might also be
required. For example, transactions in the banking sector must
get a green light from the China Banking Regulatory Commission,
while transactions in the insurance sector require the China
Insurance Regulatory Commission's approval.
In this regard, in August this year Mofcom revised the
regulations on M&A transactions (Provisions on the
Mergers and Acquisitions of Domestic Enterprises by Foreign
Investors). Those revised regulations will require new
regulatory approvals for transactions involving offshore
special purpose vehicles.
After an investment project is approved, the investors can
proceed with registering the project company with the
administration for industry and commerce. This agency will also
issue a business licence to the joint venture, which is needed
before the joint venture company can open for business.
Means and amount of contributions
Joint ventures and WFOEs have a limited capacity to become
indebted. As a result, their registered capital must never be
less than a certain proportion of their total investment. In
this context, total investment refers to the sum of the
registered capital and the amount of the company's medium- and
long-term debts (see Table 1).
Capital contributions can be made in cash, patented and
unpatented technology, materials and equipment or other
property rights. Investors to a CJV (usually Chinese investors
with insufficient financial facilities) may also contribute
cooperative conditions in exchange for an agreed share
of the profits. These could consist of access to or use of
certain assets or rights that are not formally transferred to
the CJV, including market access rights or undertakings to
supply certain services that will drum up business for the
1: Investment-capital ratios
||Up to $3 million
||At least 70% of the
||From $3 million to $4.2
||At least $2.1
||$4.2 million to $10
||At least 50% of the
||$10 million to $12.5
||At least $5 million
||$12.5 million to $30
||At least 40% of the
||$30 million to $36
||At least $12
||More than $36
||At least 33.33% of the
Corporate governance and exits
Two separate regulatory systems exist for FIEs and purely
domestic Chinese companies. FIEs fall under several regulations
that govern the incorporation and operation of FIEs. However,
the new Company Law (the New Law) issued by the People's
Congress became effective in January 2006. The New Law governs
domestic companies but also supplements the laws and
regulations applying to FIEs. If there is a conflict between
the provisions in the regulations on foreign investment and the
New Law, the regulations prevail. Consequently, the New Law
only applies to joint ventures in areas where the existing
regulations on FIEs are silent.
For example, the New Law makes a general provision
broadening the range of methods by which investors can
contribute to registered capital in companies. Contributions of
"non-cash assets which have a monetary value and are legally
transferable" can now account for up to 70% of the new
company's total registered capital. However, the New Law does
not specify whether non-cash assets include shares.
Unfortunately, as a result, this new rule will not benefit
foreign investors establishing joint ventures until changes are
made to the current FIE regulations. However it will
immediately benefit foreign investors establishing CLS, as
regulations for this type of company do not address
From a business perspective, the management structure EJVs
and CJVs is similar. Both function with a board of directors
(or a joint management committee for a CJV) and a general
management department that is supervised and directed by the
board of directors. However, these entities also share many
characteristics of a partnership in that the parties appoint
directors roughly in proportion to the investors' respective
shares. There is no concept of a shareholders meeting where the
power is concentrated at board level.
In practice legal-person CJVs typically adopt the
board of directors model. The CJV law also permits management
of a CJV to be delegated to a third party with government
approval. This arrangement has been the standard mode of
operation for the hotel industry. It has the potential to be
used in other industries as well, although it is not
Associations with a Chinese partner can become tricky when
unanimous decisions by the board required for the following are
- amendments to the articles of association;
- termination and dissolution;
- increases or reductions of the registered capital;
- mergers or divisions;
Negotiating an exit from a joint venture company could be
problematic as transfers of equity interests require: (i)
partners' consent; (ii) waivers of pre-emptive rights; and
(iii) approval from Mofcom or local agencies.
Lastly, it is true that the parties generally negotiate the
events that will trigger the termination of a joint venture.
However, as a practical matter, termination usually requires
action by consensus embodied in a unanimous board resolution.
Even where parties are obliged to make sure their appointed
directors approve a resolution in agreed circumstances, they
could still instruct their directors to breach these
obligations and drag their feet on the exit process.
From a taxation perspective, the selection of a joint
venture or a WFOE is neutral. FIEs and other foreign
enterprises that are present in China and engaged in production
activities are subject to foreign enterprise income tax (FEIT)
at the rate of 33%. Reforms to the FEIT system are under
discussion and FEIT is expected to be reduced to 24% or 25%. No
particular timetable for this change has been announced, but it
will probably not come into effect before 2007.
FIEs are able to take advantage of systems of national and
local tax incentives depending on their locality and
activities. The most common incentives include, for FIEs
engaging in manufacturing activities, a two-year exemption
followed by a three-year 50% FEIT reduction starting from the
first profit-making year.
Tax relief may be also obtained for investments in certain
industries, localities or zones, such as in western China.
However, these tax incentives are expected to evaporate in line
with the FEIT reforms. The good news for FIEs established under
the current FEIT regime is that they are expected to be able to
keep their current tax benefits after the reforms are
Foreign investors who are not present in China, might have
FEIT of around 10% withheld from certain income streams
including interest from loans, rental income and royalties from
trademarks or copyrights.
Joint ventures still of use
It is widely acknowledged that there are some significant
pitfalls associated with joint ventures, namely irregular tax
treatment and possible snags in unanimous decision-making.
Another element that foreign investors should take into
account is how the costs and economic risks linked to the
investment project can be shared. Foreign investors whose
financial capacity and expertise of the Chinese market are
satisfactory can afford to set up a WFOE on their own when a
joint venture is not mandatory under the Catalogue.
However, all these things might also influence the foreign
investor's decision to team up with a Chinese partner who can
contribute assets and put precious knowledge and market shares
in the basket of the foreign investor, which would otherwise be
unreachable. From this perspective, the establishment of a
joint venture in association with a valuable Chinese partner
will always have some practical benefits compared with
Gide Loyrette Nouel
David Boitout has been the managing partner of the
Shanghai office since January 2004. He was a member of
the mergers and acquisitions department of GLN's Paris
office from 1996 to 2000, before joining the Shanghai
office, where he has been based since the end of 2000.
David Boitout's practice focuses on international
mergers and acquisitions, including cross-border
acquisitions, joint ventures and corporate
restructurings. He has been involved in major foreign
direct investments and acquisitions in China by
prominent European groups from several industries
including catering services, automotive, distribution,
manufacturing and chemicals. His experience within the
firm in Paris and in Shanghai has enabled him to
develop specific expertise in all matters relating to
acquisitions by either share deals or asset deals, in
the context of China's rapidly changing regulatory
environment. Boitout is recommended by the Asia
Pacific Legal 500.
He was admitted to the Paris Bar in 1998. He holds a
postgraduate degree (DEA) in private law (1996) and an
honours degree (Maîtrise) in business law (1995).
He speaks French, English, Spanish and Chinese.
Gide Loyrette Nouel
Bastien Trelcat is an associate based in Shanghai.
He graduated with an LLM in international business law
from the City University of Hong Kong, an Advanced
Specialized Degree (DJCE-DESS) in business and tax law
and a Master (Magistère) in business, taxation
and accountancy from the University of Aix-Marseille
III before joining a firm of solicitors in Hong Kong.
He worked with English and US firms in Paris before
joining the Project finance team of GLN Paris in 2004
and GLN's China team in 2005. He specializes in
corporate and foreign investment law.