Expansion of Trading Rights for FIEs: Further Steps in China's WTO Accession

The Circular allows manufacturing FIEs to purchase non-quota and non-franchised goods for export, and to participate in bidding for the export quotas of their own products.

Prior to this Circular, manufacturing FIEs were only allowed to purchase and import raw materials and equipment for their own production needs, and to sell their own products in domestic and export markets. They were prohibited from trading any third party products, regardless of whether such products were made in China or overseas. Furthermore, for their own material/equipment imports and product exports, the FIEs had no right to receive direct allocation of import and export quotas, as by practice MOFTEC only allocated import and export quotas through their local offices to various state-owned import and export companies. This practice forced many FIEs to pay substantial fees to purchase such quotas from companies that received direct allocation of quotas free of charge, thereby greatly increasing such FIEs' costs of doing business and decreasing their competitiveness in both domestic and foreign markets.

In the November 1999 US-China bilateral agreement, which laid the groundwork for the final terms of China's accession to the WTO, the PRC government undertook to gradually eliminate restrictions on market access. For example, in wholesale trade services, effective from the date of its accession to WTO, the PRC government will allow foreign investors to establish joint ventures with up to 50% ownership within the first year, majority foreign ownership with no geographic and quantitative restrictions within the second year, wholly foreign ownership within the third year, and will lift all restrictions on market access from the fourth year. However, for the existing manufacturing FIEs' wholesale and retail rights, the PRC government only committed in the US-China bilateral agreement "to permit them to distribute their products manufactured in China... and to provide subordinate services". This merely confirmed the status quo, without giving the manufacturing FIEs additional benefits under the agreement until after the end of the third year from China's accession to WTO.

Limited Expansion

The Circular then is clearly a further step forward in expanding trading rights of the existing manufacturing FIEs. However, it should be noted that even if the Circular includes expansion of both import and export rights, for manufacturing FIEs it only expands their export rights from exporting self-made products without export quotas to (i) exporting third parties' products not subject to export quotas, and (ii) participating in bidding for export quotas for their own products. The Circular does not yet allow manufacturing FIEs to import any products to China. Most manufacturing FIEs have been awaiting the right to import their foreign parent or affiliates' products for sale in China, which can supplement their self-made products to better serve their customers' needs; under current PRC law they still cannot engage in such activity. As a result, many foreign companies either have established companies in Waigaoqiao or other free trade zone areas to trade foreign parents' or affiliates' products or use representative offices to service their import, marketing and sales activities. It seems that this trend will continue in parallel with the graduate elimination of restrictions on market access until the end of the third year after China's accession to WTO, at which time, foreign companies may restructure their free trade zone trading companies and representative offices according to new strategic needs.

Significance

The right that manufacturing FIEs now have to participate in bidding for the export quotas of their self-made products is very important, particularly to those FIEs who largely had to export their products subject to export quotas. In such a case, the expanded rights will substantially reduce such FIEs' quota purchasing costs and the hassles involved in locating and obtaining such quotas, thereby levelling the field for more equitable competition with those state-owned import and export companies who have traditionally received such quotas by allocation without cost.

To be eligible to conduct these expanded activities, manufacturing FIEs must: (i) have an annual export volumes over US$10 million; (ii) have no record of violation of law in the previous two consecutive years; (iii) employ international trade professionals; and (iv) amend their Joint Venture Contracts/Articles of Association to expand the scope of business and obtain approval from the original approval authorities.

Import Rights for Holding Companies

Trading rights for foreign investment holding companies have seen a gradual expansion. Since April 1995 when the PRC government allowed foreign investors to establish such holding companies by promulgating the MOFTEC, Establishment of Companies with an Investment Nature by Foreign Investors Tentative Provisions, many foreign investors have established holding companies in China with the expectation that they can act as the focal point to manage all business activities in China, including but not limited to centralized sales and marketing of products made by their invested enterprise and the investors. Some foreign investors even discussed with and received verbal promises from MOFTEC that they would be allowed to do so. However, after their establishment, it became clear that holding companies could initially only assist in marketing and selling their invested enterprises' products as agents, not as distributors, nor selling their foreign investors' or affiliates' products made outside China. In August 1999 MOFTEC amended the holding company regulation to expand their rights to include selling their invested enterprises' products as distributors by taking title, and to purchase non-quota and non-licence controlled commodities in China for export. However, in practice, such expanded trading rights have not been extensively exercised by most holding companies. One of the factors holding them back is the high income tax (33%) assessed on holding companies compared with the lower rates of income tax (15% or 24%) applicable to most manufacturing FIEs.

The Circular, by reference to the Establishment of Companies with an Investment Nature by Foreign Investors Tentative Provisions> Supplementary Provisions (2) 《关于外商投资举办投资性公司的暂行规定》的补充规定（二）issued by MOFTEC on May 31 2001, further expanded the trading rights of holding companies to include the following:

System Integration of FIE Products

Holding companies are now allowed to purchase products from their invested enterprises for system integration and sell entire systems in China or overseas. If their invested enterprises' products cannot fully satisfy their needs for system integration, then holding companies can purchase peripheral products from China or overseas markets for integration purposes, but the total value of such purchased periphery products shall not exceed 50% of the total value of the products required for such system integration. This expanded trading right may enable holding companies to leverage their various invested enterprises' products for centralized sales in order to better satisfy customers' needs under the right circumstances, and thus may achieve more competitive marketing advantages that cannot be otherwise achieved by their individual manufacturing FIEs due to the above legal restrictions. But to what extent holding companies will exercise such expanded trading rights will depend on the industry and the needs of their customers. Thus, it would be prudent to analyze the situation on a case-by-case basis and balance the synergy realized by such system integration and other factors, including but not limited to the higher income tax applicable to holding companies, and geographical locations of the customers, the invested enterprises and the holding companies.

Import Products for Pre-Marketing

The Circular also allows holding companies to import small amounts of the same or similar non-quota products from their parent companies for test-marketing purposes before their invested enterprises start production or produce new products. This new trading right will enable holding companies to effectively help their invested enterprises to enter the market quickly at the right time while they are focusing on start up activities. Most of the newly established manufacturing FIEs will need an average of one year from receiving a business licence to the completion of construction of manufacturing facilities and commencement of production. As a result, market demand may change during this process, particularly in an extremely time-sensitive market. In such a case, having the holding company assess the market demand and supply early on according to the business plan of the newly established invested enterprises will help them to achieve a smooth start up, thereby paving the way for their long term success. This is especially true where the initial sales year results as forecasted in the feasibility study will play a major role in the viability and long-term success of the invested enterprises.

Relationship with Representative Office

After this expansion of holding companies' trading rights, do foreign investors who have both holding companies and representative offices in China still need the latter? Can we de-register representative offices immediately and replace their roles with holding companies now? These frequent questions have only been answered inconsistently by various authorities. Certain local government agencies tend to interpret the roles of holding companies and representative offices liberally, and thus even proposed to some holding companies several years ago that they de-register and replace their local representative offices with holding companies in their jurisdiction. However, a strict interpretation of the current laws and regulations supports the position usually taken by MOFTEC, i.e., holding companies currently can only conduct investment-related activities to the extent of their scope of business as expanded by the Circular, but cannot conduct regular trading in foreign goods outside their expanded trading rights, while representative offices should conduct liaison activities for the regular trading of their foreign parents' products. Thus, for foreign investors who have both holding company and representative offices in China, it would be more prudent to keep one representative office in the country, and de-register and replace it with a holding company only if such holding company' trading rights are further expanded by MOFTEC to include such regular trading, or otherwise wait until the end of the third year after China's accession to WTO, when all restrictions on market access will be eliminated.

Import Rights to FIE R&D Centres

The same Circular also allows FIE research and development (R&D) centres to import and sell in the China market small amounts of high and new technology products from their parent companies for test marketing of their R&D products. As the world is changing to a more customer-centric and profit-centric environment, it is important to avoid high growth with a bad R&D strategy and business design, as it will only destroy value faster and expand the business in a potentially non-profitable way. Thus, this new trading right for FIE R&D centres is particularly important, as it can help them to test the market earlier in order to find what is most important to customers and what is most profitable, and work their way back to transform R&D activities so as to be more effectively aligned with the critical needs of the customers and link their technology development to those specific needs.

For holding companies and FIE R&D centres to be eligible to conduct said expanded activities, both are required to amend their Articles of Association and Joint Venture Contract (if any) to expand their business scope, and obtain approval from the original approval authorities. In addition, holding companies must have fully paid up registered capital of not less than US$3 million; and both of them must have conducted their business legally without any record of violation.

Amendments to Three Major FIE Laws and Implementing Regulations Completed

In July 2001, the PRC State Council issued the PRC Sino-foreign Equity Joint Venture Law Implementing Regulations (3rd Revision) (中华人民共和国中外合资经营企业法实施条例（第三次修订）) (EJV Implementing Regulations). This marks the completion of the amendments to the three major laws and regulations governing EJVs, CJVs and WFOEs. There are 45 amendments to the EJV Implementing Regulations, primarily in four areas.

Conforming to the Amended EJV Law

This is done by eliminating all requirements on export performance, local sourcing priorities, foreign exchange balancing, and restrictions on domestic sales and foreign exchange income and payment. As amended, the EJV Implementing Regulations are now in conformity with the amended EJV Law, and also consistent to the amendments made to the CJV Law, the WFOE Law and its implementing regulations.

Amending Provisions Inconsistent with WTO Rules or China's External Commitments

This mainly includes (i) deleting the local replacement requirement on foreign investors' capital equipment and export performance requirements on their industrial property contribution; (ii) replacing detailed provisions regarding foreign investment industries with Foreign Investment Industrial Guidance Catalogue (Revised) (外商投资产业指导目录); (iii) revising requirements that EJV insurance be "furnished by Chinese insurance companies" to "to be furnished by insurance companies within the territory of China"; (iv) amending arbitration provisions by allowing EJVs to resolve disputes by arbitration in China or outside China per their arbitration agreement; and (v) deleting recommendations to any particular arbitration committee.

Amending Provisions Inconsistent with China's Current Laws and Regulations

This primarily includes complying with current PRC laws, regulations and State Council rules, by amending inconsistent or outdated provisions with respect to: (i) EJV industrial and commercial registration; (ii) acquisition and transfer of land use rights; (iii) exemption or reduction of customs duties and industrial consolidated taxes; (iv) labour management; (v) duration and liquidation; (vi) deleting requirements that the chairman of the board of directors be designated by the Chinese party; (vii) amending provisions prohibiting registered capital reduction to allow capital reduction where necessary in case of changed circumstance; (viii) amending provisions regarding foreign currency accounting and financial reports to allow EJVs using foreign currency in accounting to convert the foreign currency into RMB in financial statements, rather than requiring a second set of accounting booked in RMB in daily operations; (ix) amending provisions governing taxation on liquidation income; and (x) also removing the delegation of power of interpreting the EJV Implementing Regulation to MOFTEC.

Amending Provisions Inconsistent with the Results of Organizational Reform and Economic Development

This primarily includes: (i) conforming to the government organizational structure and function reform, by deleting all approval or supervision roles of government departments in charge in the establishment and operation of EJVs; (ii) conforming to the market economy development requirement by deleting provisions regarding the necessity of following specific channels for finding EJV partners and for supplies and sales of products, and regarding price controls and reporting; (iii) conforming to the reformed foreign exchange and finance control systems by amending provisions regarding foreign exchange conversion rates for capital contributions to be governed by the standard rate set by the People's Bank of China, and amending provisions regarding opening of foreign exchange accounts and managing foreign exchange income and payment, and deleting requirements that EJVs use the Bank of China or other designated banks for opening and operating their bank accounts, to allow them to use any banks within the territory of China for such purpose.

It is indicated by both the PRC State Council and MOFTEC that CJV implementing regulations will not be amended, as their promulgation was more recent, and thus do not contain clearly WTO-inconsistent provisions. As such, the amended EJV Implementing Regulations mark the completion of the amendments to all three major laws and implementing regulations governing FIEs. Now as China's WTO negotiations approach final success, we will likely see enormous and expedited legal reforms unfolding as part of the implementation of its WTO commitments. This will present all of us doing business in China with great challenges, as there will be a huge task for legal education and restructuring, in addition to business challenges as the market sees a much higher level of competition.