Trading Places: CEPA and the New Procedures on Foreign-invested Commercial Enterprises

Some observers and market participants are wondering of how much benefit CEPA actually is today to the average Hong Kong trading company, given that CEPA only became effective on January 1 2004 and that the Hong Kong Trade and Industry Department (TID) directives on how to obtain the HKSS certificate were only issued in November 2003. Many potential HKSSs are still sorting out their documents for the HKSS certificate application and must now be asking whether it is even worth doing so given the possibility of establishing a 100% foreign-owned FCE (in most cases) in six months' time without the need for such certification.

Type of Business

An FCE established under the Procedures appears to be able to conduct all forms of trading and distribution that could be conducted by an enterprise established by an HKSS, namely commission agency services, wholesale, retail, franchising and ancillary activities relating to these types of business.

Degree of Foreign Equity Participation

An FCE established under the Procedures can be a Sino-foreign equity or cooperative joint venture (JV) or a wholly foreign-owned enterprise (WFOE). CEPA permits an HKSS to establish the same types of enterprises. There is a difference, however, as to the time at which WFOEs can be established by an HKSS and any other foreign investor (non-HKSS investor).

Subject to certain particular exceptions and restrictions, HKSSs are permitted to establish WFOE FCEs immediately pursuant to the Procedures and it would appear that, in doing so, they can benefit from the Procedures' reduced minimum registered capital requirements. (We say "immediately" since CEPA permits the establishment of a WFOE by an HKSS from January 1 2004, five months before the effective date of the Procedures.) Subject to particular product exceptions and restrictions,² non-HKSS investors can establish foreign majority investment JVs under the Procedures now but they must wait until December 11 2004 in order to catch up with HKSSs and establish WFOE, as opposed to JV, foreign-invested commercial enterprises. The general limit of 49% foreign ownership in JVs in the relevant sectors was removed at the end of last year on the basis of the PRC's WTO accession commitments as of two years after accession. The Procedures stipulate an ongoing limit of 49% foreign ownership in particular cases (discussed below in relation to the automobile retail sector).

As far as equity participation is concerned, then, an HKSS generally combines the benefits of CEPA with those of the Procedures by establishment of a WFOE immediately while other foreign investors must wait until December 11 2004 to establish a 100% foreign-owned subsidiary.

The TID CEPA Notice No. 3 of May 20 2004 (the Notice) helps to accelerate the preliminary HKSS certificate process and assists HKSSs in their short-term time advantage. The Notice streamlines the application requirements by eliminating the need for a designated professional's reports relating to staff and premises,³ as well as the need for submission of original annual reports (for a listed company) or audited financial statements (for an unlisted company).⁴ The Notice also makes it possible for more Hong Kong companies to qualify as HKSSs due to its provisions on group companies. While the HKSS itself must be a Hong Kong incorporated company, holding a valid business registration for the relevant number of years, it is now possible for either the HKSS, or its wholly owned subsidiary, to have conducted the substantive business required by CEPA Annex 5.⁵ Moreover, premises used for the substantive business may be owned/rented by the HKSS's holding company or another subsidiary within the same group.⁶ The staff used to carry out the substantive business may also be employed by a group company and do not have to be directly employed by the HKSS.

On the other hand, non-HKSS investors, who wish to establish WFOE FCEs, need not remain idle during the HKSS six-month head start period. They can work towards set up of a WFOE FCE before December. They might prepare to convert an existing production WFOE into an FCE at the end of the year, since Article 24 of the Procedures specifically permits conversion of an existing PRC foreign-invested enterprise to an FCE, provided the scope of business is amended and the Procedures are complied with. This might be faster than establishing a new FCE. It is important, however, to consider the consequences, such as the potential impact on tax holidays, which would depend on the resulting ratio of commercial to manufacturing activity. Alternatively, a JV FCE can now be set up under the Procedures with an option in the joint venture contract to purchase the PRC partner's participation at the relevant time. A consultancy WFOE might be established now allowing for research, hiring of staff and renting/purchasing a site with a view to conversion to an FCE later.

Registered Capital and Other Financial Requirements

CEPA Annex 4 stipulates that a wholesale commercial WFOE must have a minimum registered capital of Rmb50 million and a retail commercial WFOE must have Rmb10 million (there are correspondingly lower minimum registered capital levels for establishment of enterprises in the central and western regions). These levels are lower than under prior requirements (Rmb80 million for a wholesale commercial enterprise and Rmb50 million for a retail commercial enterprise), but still they remain prohibitively high for many.

The Procedures, on the other hand, stipulate that the minimum registered capital levels for all FCEs are as stated in the PRC Company Law(中华人民共和国公司法). The national standard minimum registered capital under the Company Law is Rmb500,000 for wholesale enterprises and Rmb300,000 for retail enterprises. These figures should, however, be considered as bare minimums. Financial project planning should take stock of the following factors.

It is possible that local regulations may seek to increase the minimum registered capital to some extent. It should also be noted that an FCE requires MOC approval and this is based, among other things, upon a feasibility study. In effect, it will therefore be the nature and extent of the FCE project that will determine the minimum amount of registered capital required over and above the amount mandated under the Company Law. For example, if a retailer wishes to open a large number of outlets in a short period of time, the required registered capital requirements could be higher than the national standard.

The Procedures stipulate that the FCE is required to comply with PRC regulations on registered capital and total investment for foreign-invested enterprises. This would appear to include compliance with such matters as time frames for capital contributions, as well as the SAIC's Sino-foreign Equity Joint Venture Ratio of Registered Capital to Total Investment Tentative Provisions, which stipulate the minimum ratio of registered capital to total investment. The foreign investor will therefore have to make provision for its total investment figure, and not just for the registered capital. In the case of a total investment up to US$3 million, the registered capital must be at least 70% of the total investment. While in theory at least it can equal 100% of the total investment, it is advisable to establish a total investment figure that leaves room for the injection of working capital (provided by external loans, for example, over and above the amount of the registered capital itself). Establishing a total investment figure provides for expansion and guards against the possibility that the FCE will run out of operating funds and may need to apply to increase its registered capital, which is subject to approval.

Nevertheless, even after taking into account the caveats noted above, there is a substantial difference in basic minimum registered capital requirements under CEPA and the Procedures. It is our view that numerous Hong Kong trading companies, which could not have reached CEPA's levels of minimum registered capital, could enter the field under the Procedures.

Moreover, minimum registered capital is not the only financial hurdle that potential HKSSs face under CEPA. CEPA Annex 4 stipulates high financial thresholds for the foreign investor itself, quite apart from the high minimum registered capital levels mentioned above. As with minimum registered capital requirements, the foreign investor requirements are lower under CEPA than under the PRC's previous requirements but they are still high. Under CEPA, for wholesale and retail commercial enterprises, the investor's average annual sales value in the three years preceding establishment of its enterprise in the PRC is required to be at least US$30 or $100 million, respectively (as opposed to the previously required US$2.5 billion or $2 billion) and the preceding year's assets are required to be at least US$10 million for both wholesale and retail (as opposed to the previously required US$300 or $200 million).

Apart from the retail automobile sector (addressed below), it appears that an HKSS is permitted to establish a WFOE immediately not only with the benefit of the Procedures' lower levels of minimum registered capital, but also without having to satisfy CEPA Annex 4's financial thresholds relating to the foreign investor, thereby making WFOE establishment far more financially viable than previously. Article 6 of the Procedures specifically sets out the requirements relating to the foreign investor that establishes the FCE and these requirements do not refer to financial thresholds. They simply mention the need for good reputation and a clean legal record and the fact that economically strong foreign investors, with advanced commercial administrative management experience, marketing technology and extensive international sales networks are encouraged.

With respect to the retail automobile sector, however, HKSSs must comply with all of CEPA's financial requirements. The Procedures stipulate that HKSSs may establish a retail automobile WFOE with immediate effect but they also expressly reiterate in full CEPA Annex 4's retail financial thresholds, not only for the minimum registered capital of the proposed WFOE, but also in relation to the foreign investor, as set out above.

On the basis of the normal rules of statutory interpretation, the express stipulation of financial thresholds in the case of the retail automobile sector supports the view that in other sectors (where no such stipulation is made), HKSSs may take advantage of the Procedures' lower minimum registered capital requirements and absence of financial requirements for the foreign investors.

Geographic Limits

For wholesale FCEs there are no geographic restrictions in either CEPA Annex 4 or the Procedures. As far as retail FCEs are concerned, both CEPA Annex 4 and the Procedures make clear that HKSSs are currently permitted to establish retail FCEs in cities at the prefecture level (地级市) generally, and in Guangdong province, at the county level (悬级市). Non-HKSS investors are currently restricted under the Procedures to the establishment of retail FCEs in the capital cities of PRC provinces and of autonomous regions and in centrally governed municipalities, single plan cities and special economic zones. All geographic restrictions will be removed for all foreign investors from December 11 2004.

Automobile Retailing and the Foreign Minority Rule

Distribution of books, newspapers, magazines, automobiles, pharmaceuticals, pesticides, mulching films, chemical fertilizers, processed oil, grain, vegetable oil, sugar and cotton (Restricted Products), in addition to some other products, remain subject to various reservations stipulated in the PRC's WTO commitments and which continue to apply equally under CEPA and the Procedures. The Procedures' provisions on automobile retailing are interwoven with those relating to the other Restricted Products. The restrictions themselves vary among the groups of Restricted Products. CEPA's concession (reiterated in the Procedures) permitting HKSSs to establish retail automobile WFOEs from January 1 2004 was hailed as a major concession to Hong Kong in this restricted and important product category. We will therefore focus on automobile retailing in this section, without specifically addressing the various limitations on the other Restricted Products.

The Procedures' provisions relating to automobile retailing and their interaction with CEPA are complex. Article 18 of the Procedures, dealing with retail automobile FCEs and Restricted Product retail, is one long sentence separated only by commas and reads in part:

"If the same foreign investor having over 30 PRC outlets, engages in the distribution of books, newspapers, magazines, automobiles (this restriction will be cancelled from December 11 2006), pharmaceuticals, pesticides, mulching films, chemical fertilizers, processed oil, grain, vegetable oil, sugar and cotton and in addition (且) the above products are of different brands and emanate from different suppliers, the proportion of the foreign investor's investment is not permitted to exceed 49%."

It is unclear whether it is necessary a) to have not more than 30 outlets and b) to sell only single-brand, single-supplier automobiles in order to avoid the minority foreign participation limit of 49% for retail automobile FCEs established before December 11 2006. Article 17 of the Procedures states that specific implementing rules will be issued in this sector. General implementing rules for the Procedures are also expected soon and these may also shed some light on such ambiguities. In the meantime, our view is that a chain with over 30 outlets could establish a retail automobile FCE prior to December 11 2006 under the Procedures, with over 49% foreign investment, provided it sold only single-brand, single-supplier vehicles. We are of the view that the foreign minority rule applies only to chain store FCEs with over 30 outlets and that sell multi-brand automobiles from different suppliers. Assuming this is correct, where does it leave the HKSS and its right under both CEPA and the Procedures to establish a retail automobile WFOE immediately?

CEPA Annex 4 refers back to "the mainland's commitments to WTO members" with respect to retail automobile WFOEs having over 30 outlets. The PRC's Schedule of WTO Commitments in turn stipulates the foreign minority rule as being applicable until December 11 2006 for retail automobile chains with over 30 outlets selling multi-type, multi-brand, multi-supplier vehicles. Although the language is slightly different from that in Article 18, the same basic intention seems to underlie both sets of provisions. HKSSs therefore do not appear to gain any additional advantage in foreign investment proportion if they fall within the over 30 outlets multi-brand, multi-supplier rule. Moreover, Article 25(3) of the Procedures states that an HKSS can establish a retail automobile FCE "in accordance with the relevant provisions of these Procedures" (依据本办法的相关条款). As mentioned above, the Procedures maintain CEPA's high financial requirements both in relation to minimum registered capital and the foreign investor for automobile retail.

In brief, it appears to us that, while an HKSS should be able to establish a retail automobile WFOE with over 30 outlets immediately, it can only do so if the said outlets confine themselves to selling single-brand, single-supplier vehicles. Moreover, even an HKSS WFOE with fewer than 30 outlets would still be bound by CEPA's high minimum registered capital and foreign investor financial requirements.

Range of Activity

The Procedures, unlike CEPA, raise the thorny issue of services ancillary to the principal service provided. Article 3 of the Procedures permits "related ancillary services" (相关附属服务) and "other related ancillary business" (其他相关配套业务) is permitted under Article 9(2)(4) of the Procedures. It would seem logical to assume that these concepts are linked to the WTO definition of "varied related subordinate services" (多种相关分部门服务) that accompany distribution services. These are: inventory management; assembly, sorting and grading of bulk lots; breaking bulk lots and redistributing into smaller lots; delivery services; refrigeration, storage, warehousing; and garage services' sales promotion, marketing and advertising, installation and after sales services including maintenance and repair and training services. It would appear at least arguable that both HKSSs and other foreign investors could try to include other relevant services within their FCE's scope of business. These would include not only the WTO list of related activities, but others also, such as quality control, since the WTO list is non-exhaustive. It "includes" (包括) the listed services and it refers to a "variety" of services (多种).

Individual Retail Outlets

CEPA Annex 4 permits individuals who are Hong Kong permanent residents with PRC citizenship to open individually owned retail stores (excluding franchising) with a sales area of up to 300 square feet, but only within Guangdong province.

Article 25(4) of the Procedures reiterates this concession but does not mention the restriction within the boundaries of Guangdong province. It does expressly state, however, that such individual retailing activities must be in accordance with relevant mainland laws (依照内地有关法律). This has led to the conclusion that CEPA's restriction to Guangdong province prevails, as CEPA is a part of PRC, as well as Hong Kong, law.

Reconciling CEPA and the Procedures

Clearly the overall CEPA advantage under the Procedures is the ability of an HKSS to establish a WFOE FCE, as opposed to a JV FCE, before December 11 2004, while taking advantage of the Procedures' financial requirements that are substantially lower than those stipulated under CEPA.

The CEPA advantage under the Procedures is subject to a relatively short time frame. Even with the recently introduced streamlined TID HKSS application procedures, those who have already obtained, or are on the point of obtaining, the HKSS certificate will benefit the most. For others, who are still completing the application form and arranging for certifications, there will be very little time for establishing the WFOE before December 11 2004. By then, not only will WFOE establishment be open to all appropriately qualified foreign investors, but also the remaining geographic restrictions on retailing locations will have been removed.

It would, however, be short sighted to state categorically that all potential HKSSs should forego their applications for the HKSS certificate. A far-sighted pragmatic approach is to be preferred.

Foreign investment applications in the PRC are likely to increase dramatically as December 11 2004 approaches. Guangdong province is already reported to be considering measures to limit excessive investment in order to prevent inflation and is said to be formulating curbs on the approval of certain types of investment.⁷ Securing a foothold in the PRC has therefore become more important than ever at this moment in time. Getting there even at the eleventh hour before the floodgates open may provide a strategic advantage, or might even constitute the difference between obtaining and not obtaining approval for a project.

The spirit and underlying principles upon which CEPA is based and upon which it was executed should not be overlooked. CEPA Article 1 posits its objectives as "to strengthen trade and investment cooperation between the Mainland and the Hong Kong Special Administrative Region and promote joint development of the two sides, through the implementation of the following measures". Even if, as some allege, CEPA failed to give a concrete advantage to many Hong Kong companies in entering the PRC market, CEPA remains a positive demonstration that China views Hong Kong as playing a key role in the future development of its economy.

We have seen concrete proof that CEPA is a flexible instrument, and not a set of contractual provisions cast in stone. The PRC government has enlarged the concessions in various ways since the signing of CEPA on June 29 2003. One example is the expansion of the number of locations from which PRC citizens can visit Hong Kong as individual tourists rather than in tour groups. Another example was the addition, in October 2003, of telecommunications to the list of service sectors benefiting from CEPA concessions. It is not therefore inconceivable that in the future an HKSS certificate may confer on its holder advantages that are not yet known at this point in time. The Hong Kong General Chamber is reported to be working on a further "CEPA wish list".⁸

When seeking approval to establish an FCE in the PRC, it certainly cannot hurt to show that one is a committed, locally integrated and active Hong Kong corporate citizen. This can be demonstrated by an HKSS certificate, issued by the Hong Kong TID and verified by the relevant PRC authorities. It would seem prudent to take advantage of the opportunities while they are on offer, and to see them as potential building blocks for future expansion.

Endnotes

1 Possessing an HKSS certificate, issued by the Trade and Industry Department, is a requirement for accessing CEPA's concessions in the relevant service sectors.

2 Wholesale and retail of tobacco are prohibited as is wholesale of salt. Varying restrictions apply as to starting date for establishment of a wholesale/retail FCE and/or restrictions on the proportion of foreign investment in enterprises engaged in trade of books, newspapers, magazines, automobiles, pharmaceuticals, pesticides, mulching films, chemical fertilizers, processed oil, crude oil, grain, vegetable oil, sugar and cotton.

3 Documents relating to staff and premises must nevertheless be certified by a designated professional, namely a Certified Public Accountant or a China Appointed Attesting Officer.

4 Copies of documents certified by a designated professional will now suffice.

5 The holding-subsidiary relationship must have been maintained throughout the number of years required by CEPA Annex 5. For the sectors we are concerned with, three years is the required length of time.

6 Companies Ordinance s. 2 defines "group of companies" as "any two or more companies...one of which is the holding company of the other or others".

7 "Guangdong to Restrict Investment," South China Morning Post, May 12 2004.

8 "CEPA has Many Benefits, which Must be Seized", South China Morning Post, May 27 2004.