Investing in a Distribution Channel: Current Legal Framework and Implications after WTO

Any establishment of a JVDE shall comply with the commercial development plans of the cities where such a JVDE is located, which is regulated by the government.

Approval Authority

The JVDE is subject to the approval of the central government level. A local government, either municipal or provincial, is not authorized to award such approval.

Business Vehicles

Equity joint ventures and cooperative joint ventures are the only business vehicles available for the JVDE. No wholly foreign-owned distribution enterprise is currently permitted.

Open Regions

The State Council shall decide the regions open for the establishment of a JVDE. At the present time, such regions are limited to the capital cities of provinces and autonomous regions, municipalities directly under the central government, municipalities with independent planning and special economic zones, all of which are defined as "Pilot Regions".

Qualification of Foreign Investors

a) A foreign investor or the major one of the foreign parties shall have the economic strength, advanced commercial management expertise and marketing techniques, extensive international distribution network, good reputation and business performance, and shall be able to promote the export of Chinese products through the proposed JVDE;

b) The average annual sales volume of such foreign investor shall exceed US$2 billion for three consecutive years preceding the application for the establishment of a JVDE and shall have assets worth not less than US$200 million during the year preceding the application; and

c) Notwithstanding the foregoing, the foreign investor which intends to engage in wholesaling shall have an average annual sales volume exceeding US$2.5 billion for three consecutive years preceding the application for the establishment of JVDE, and assets worth not less than US$300 million the year preceding the application;

Qualifications of Chinese Partners

a) A Chinese partner or the major one of Chinese parties shall be an enterprise that is engaged in the circulation of merchandise and shall have the economic strength and good business ability;

b) The average annual sales volume of the Chinese partner or the major one shall exceed Rmb300 million for three consecutive years preceding the application for the establishment of the JVDE, or Rmb200 million if located in central or western China; and if the Chinese partner is a foreign trade enterprise, the average annual volume of imports and exports for its own account shall exceed US$50 million for three consecutive years preceding the application, with no less than US$30 million of export for its own account; and

c) The Chinese partner shall have assets worth not less than Rmb50 million during the year preceding the application, or above Rmb30 million if located in central or western China.

Registered Capital

The registered capital of a JVDE engaged in a retailing business shall not be less than Rmb50 million, or Rmb30 million in central or western China; and the registered capital of a JVDE engaged in a wholesaling business shall be not less than Rmb80 million, or Rmb60 million in central or western China.

Equity Share

a) A foreign investor in a JVDE having three outlets or less or operating as a chain of convenience stores, specialist stores and exclusive stores may hold the equity share up to 65%;

b) A foreign investor in a JVDE having more than three outlets (excluding convenience stores, specialist stores and exclusive stores) may hold the equity shares up to 49%; however, if the foreign investor has already purchased large amounts of domestic goods and further expands the export of Chinese products through its international marketing network, such foreign investor may be permitted to hold the majority shares, subject to the approval of the State Council; and

c) A foreign investor in a JVDE engaged in a wholesale business (including a retail enterprise which is engaged in wholesaling as a sideline) is permitted to hold no more than 49% equity share.

Form of Outlets

The outlets of a JVDE shall take the form of a "direct chain", which shall be invested and operated by the JVDE directly. No other form of chain store such as voluntary chain stores and franchised chain stores is permitted for the time being.

Joint Venture Term

The term of the JVDE shall not exceed 30 years, or 40 years in central or western China.

Business Scope

The 1999 Measures allow a greater scope of business in comparison with the 1992 Official Reply.

a) The business scope for a JVDE engaged in retailing services is as follows:

• commercial retailing, including sales on an agency or commission basis;

• organizing the export of domestic products;

• import and export of self-operating merchandises; and

• engagement in the related subordinate services.

b) The business scope for JVDE in wholesaling services is as follows:

• domestic wholesale of domestic merchandise and merchandise imported for its own account; and

• organization of the export of domestic products.

The JVDE in retailing services may also be engaged in wholesaling as a sideline subject to the approval of the relevant government authority.

Restriction on Import and Export

The JVDE shall not engage in the business of an import and export agency. The JVDE shall obtain the relevant approval of the government authority, if it deals in merchandises governed by special state regulations or in import and export goods subject to quotas and licensing. Moreover, the total annual amount of goods imported by the JVDE shall not exceed 30% of its sales amount for that year.

Licence Fee Restrictions

The trademark or trade name licence fee collected by the foreign investor from the JVDE shall not exceed 0.3% of the JVDE's sales volume (net of VAT) during the year concerned, and the period for the collection shall not last for more than 10 years.

THE ISSUES IN PRACTICE

Though the 1992 Official Reply and 1999 Measures set up a general legal framework for the establishment and operation of a JVDE, many practical issues haven't been addressed. The following are the major concerns of foreign investors in their distribution businesses in China.

Restriction on Local Approval

Many foreign investors have bypassed the central regulations and established JVDEs or even WFODEs with approval of local governments. Actually, local governments have approved 316 JVDEs and WFODEs since 1992, compared to only about 30 JVDEs approved by the central government for the same period. In September 2001, the State Economic and Trade Commission (SETC), the Ministry of Foreign Trade and Economic Cooperation (MOFTEC) and the State Administration for Industry and Commerce issued a notice requiring reorganization of all locally approved JVDEs and WFODEs. Foreign investors were required to assign their shares in locally approved JVDEs to a Chinese party or close their WFODE businesses.

Geographic Restriction

Currently, pilot JVDCs are permitted to operate in Pilot Regions only. In 1998, 32 locally approved JVDCs obtained the approval of the central government after reorganizing their businesses and equity structures. However, they are not recognized as "pilots" under central approval and cannot enjoy free import and export rights, cannot undertake wholesaling businesses, cannot expand their business scope and size, cannot open outlets and extend the terms of their joint ventures and are not exempt or cannot deduct tax liabilities for their self-use imported equipment and raw materials (the Five "No" Policy). The 2001 Notice reiterated this policy, but permitted the non-pilot JVDEs located in Pilot Regions or in western China to apply to the central government for approval as pilot JVDEs.

Restrictions on Shares

Many foreign investors are not satisfied with current restrictions on foreign ownership imposed by the government. The 1999 Measures provide that the foreign investors that have purchased a great quantity of domestic products and have promoted export through their distribution network worldwide may hold majority shares in a JVDE. Actually, some giants in distribution have been given approval to hold majority shares due to their good performance in domestic purchasing. For example, Carrefour, the world's second largest retail firm, has purchased domestic products up to US$1.5 billion in 2001 and is permitted to hold up to 65% equity in some JVDEs; Wal-Mart, the world's largest retailer, is permitted to hold up to 70% equity in JVDEs due to its domestic purchase of up to US$10 billion. The government holds the domestic purchase of Rmb1 billion as a minimum for any approval of foreign majority ownership. However, foreign ownership significantly higher than 51% shall be subject to the special approval of State Council.

Quantitative Restrictions

The 1999 Measures do not provide for the number of outlets per foreign investor. This does not mean, however, that a foreign investor can set up as many as outlets as it wishes. The government in fact has an unwritten rule regarding such a number: up to 30 outlets per foreign investor. Under this rule, Wal-Mart, which now has 15 outlets and has won approval to open an additional 3 outlets in 2001, and Metro, which has opened 15 outlets, still have room for expansion, but Carrefour, which has 27 outlets in 15 Chinese cities, is near its limit.

Restriction on Local Partners

When a JVDE is incorporated in one city but needs to open outlets in other cities, foreign investors are in a dilemma because of differing policies between the central and local governments. The central government prefers that the outlets of the JVDE opened in additional cities take the form of affiliates under one licence, but local governments prefer that foreign investors establish a new JVDE directly with local partners. In practice, if foreign investors open outlets in different cities and apply for the establishment of a JVDE in each city, the central government may not award approval. However, if they do not satisfy the requirements of a local government, they may lose favour with the local government and might be prevented from entering the distribution market there.

Size Restriction

Neither the 1992 Official Reply nor the 1999 Measures stipulate the physical size of a JVDE store. However, the Chinese government has another unwritten rule limiting the size per store at 20,000 square metres.

Double Approval

The establishment and operation of a JVDE is subject to double approvals. While the SETC issues approval of market access and the number of outlets, MOFTEC issues approval of the establishment of any Sino-foreign joint venture enterprises and any increase in registered capital. After receipt of double approvals for establishment, foreign investors have to pass through double approvals again each time they need to open additional outlets and increase the registered capital accordingly. As might be guessed, this process is extremely time consuming and expensive.

IMPLICATIONS AFTER WTO

The government is committed to promoting an open door policy regarding distribution in favour of foreign service suppliers and abolish any limitations on market access within five years after China's accession to the WTO. These commitments are noted in the report of the Working Party on the Accession of China dated October 1 2001 (cf. page 24-27, WT/ACC/CHN/49/Add.2).

Distribution trade services are composed of four main sub-sectors under WTO legal documents: (i) commission agents' services; (ii) wholesaling services; (iii) retailing services; and (iv) franchising services. As compared with the legal framework given in the 1992 Official Policy and 1999 Measures, the foreseeable changes in China's legal regime governing distribution to meet China's commitments are as follows.

Commission Agents' Services and Wholesale Trade Services

a) Business Vehicle

• within one year after China's accession to the WTO, foreign service suppliers may establish a JVDE to engage in commission agents' business and wholesale business; and

• within three years after accession, a WFODE will be permitted.

b) Business Scope

The above JVDE or WFODE is permitted to:

• upon establishment, engage in the business of all imported and domestically produced products (excluding salt and tobacco) and provide the full range of related subordinate services, including after sales services for the products they distribute, except the products subject to the immediately following schedule;

• within three years after accession, engage in the distribution of books, newspapers, magazines, pharmaceutical products, pesticides and mulching films;

• within three years after accession, wholesale trade services away from a fixed location will be permitted; and

• within five years after accession, engage in the distribution of chemical fertilizers, processed oil and crude oil.

Excepting salt and tobacco, no restriction on distribution of products will apply from the sixth year after accession.

c) Equity Share and Ownership

• within two years after accession, foreign majority ownership will be permitted; and

• within three years after accession, there will be no restriction on equity/form of foreign establishment.

d) Geographic and Quantitative Restriction

Within two years after accession, no geographic or quantitative restrictions will apply.

Retailing Services

a) Business Vehicles

WFODEs will be permitted not later than three years after accession.

b) Business Scope

Foreign service suppliers will be permitted to:

• upon accession, engage in the retailing of all products (excluding tobacco) and provide the full range of related subordinate services, including after-sales services for the products they distribute, except for the products subject to the immediately following schedule;

• within one year after accession, engage in retailing of books, newspapers and magazines;

• within three years after accession, engage in retailing of pharmaceutical products, pesticides, mulching films and processed oil;

• within three years after accession, retail trade services away from a fixed location will be permitted; and

• within five years after accession, engage in retailing of chemical fertilizers.

Excepting tobacco, no restriction on business of products will apply from the sixth year after accession.

c) Equity Share and Ownership

• within two years after accession, foreign majority ownership will be permitted;

• within three years after accession, there will be no restriction on equity/form of foreign establishment; and

• for chain stores which sell products of different types and brands from multiple suppliers with more than 30 outlets, foreign majority ownership will not be permitted if those chain stores distribute any of the following products:

- motor vehicles (for a period of five years after accession at which time the equity limitation will have been eliminated);

- products mentioned under "b" above in this section; and

- 84 products subject to State Trading (Import) and 134 products subject to State Trading (Export) listed in Annex 2a of the protocol of China's WTO accession.

d) Geographic and Quantitative Restrictions

• upon accession, besides the Pilot Regions, two large cities, Zhengzhou and Wuhan, will be immediately open to JVDEs; in Beijing and Shanghai, a total of no more than four JVDEs in retailing services are permitted, among which two may set up their branches in the same city; in each of the other cities, no more than two JVDEs in retailing services will be permitted; and

• within two years after accession, all provincial capitals, as well as Chongqing and Ningbo, will be open to JVDEs, and geographic or quantitative restrictions will no longer apply.

e) Restriction on Size

upon accession, the 20,000 square metre restriction on the size of stores will be removed.

f) Restriction on Chinese Partners

Within three years after accession, foreign chain store operators will have the freedom of choice of any partner legally established in China according to Chinese laws and regulations.

Franchising

Within three years after accession, franchising will be permitted. No special restriction will apply, provided that the franchising operation complies with the rules applicable to general distribution services.

Right to Foreign Trade

Also, with regard to a JVDE's import and export rights, China will transform the foreign trade system in a manner consistent with the WTO Protocol and will progressively liberalize the availability and scope of trading rights. Within three years after accession, all enterprises in China, including JVDEs or WFODEs, shall have the right to trade in all products throughout the customs territory of China, except for those products subject to state trading.

CONCLUSION

With China's WTO accession and the corresponding relaxation of restrictions on distribution services, foreign investors will have a greater opportunity to expand their businesses. In 2001, foreign investment in the distribution sector accounted for only 1% of China's total foreign capital inflow, and the total turnover of JVDEs accounted for just 4% of China's total retail sales volume. Quite obviously, there is big potential for growth. However, investors looking for immediate change need to have patience.

According to SETC officials, big changes won't be seen until two years after China's accession; before that time, the 1999 Measures will remain the basic regulations covering foreign investment in distribution services. The Chinese government needs time to complete all the necessary legislative procedures to implement the provisions of China's commitments during the two-year transition period. While China's new legislation will remove the middle-term concerns of foreign investors, the restrictions entailed in the government's commercial development plan, the requirements of foreign investor's qualifications and registered capital and the cap on licence fees continue to exist, and the complexity of licensing and approval procedures will not be changed immediately.