Almost There with Distribution Services in China

Words of Comfort

Faced with growing concern among the international community of perceived delays in China's implementation of its WTO commitments with respect to distribution rights, the Ministry of Commerce (MOFCOM) orally commented in late March on a number of key points. Specifically, MOFCOM committed to issue instructions to its local branches on processing applications under the Commercial Procedures. But MOFCOM also intimated that establishing a new foreign-invested commercial enterprise - a stand alone distribution company - under the Commercial Procedures will be quicker than seeking to expand an existing manufacturing enterprise's business scope to include distribution activities (e.g., to include buying and selling goods on a commission basis, and/or act as a wholesaler for goods other than those that are "self-manufactured").

MOFCOM's words of comfort follow their issuance of the Commercial Procedures, and the revision of the PRC Foreign Trade Law (中华人民共和国对外贸易法)(July 2004). Read together, these provide the basic framework for foreign companies to depart from the traditional multilayered model for sourcing from, and selling into, the China market. Indeed, foreign companies in China have long had to bifurcate their manufacturing and other procurement and sales activities, both structurally and legally, with the latter traditionally being carried out via a limited number of authorized import and export agents. Foreign companies have in recent years increasingly turned to alternatives such as trading companies established in free trade zones like Waigaoqiao outside of Shanghai and the use of holding companies, regional headquarters, etc. as a means of centralizing and streamlining procurement and distribution operations. However, the benefit of these alternatives pales in comparison to the post-December 11 2004 opportunities for participation in the distribution sector as per China's WTO commitments.

The Tax Man Cometh

MOFCOM's recent informal comments confirmed what many had suspected was a very practical impediment to the implementation of China's WTO liberalizations in the distribution sector - that is, ongoing inter-governmental coordination, particularly with respect to the appropriate tax treatment of enterprises with "mixed scope" operations. While the State Tax Administration has yet to issue any formal notice or guidance with respect to this matter, indications are that if FIEs maintain a certain minimum percentage of turnover from manufacturing activities (rumoured to be anywhere from 70% to 50%), they should continue to enjoy preferential tax rates otherwise available to "pure" manufacturing enterprises. Stand-alone distribution companies do not currently enjoy any tax breaks under national law but benefits could inure depending on the relevant location of the company.

Open Issues

MOFCOM has indicated that manufacturing FIEs looking to expand their business scopes to include certain distribution services will be restricted to dealing in products that are in the "same category" as those that they manufacture. Some local officials have already developed their own interpretation, referring to the requirement that manufacturing companies deal in "related products". How product-related restrictions in this regard play out could have significant repercussions for foreign companies seeking to run centralized distribution centres for diverse businesses units.

Another open issue is the extent to which holding companies, particularly holding companies approved as regional headquarters (RHQs), can engage in distribution activities. Unofficial comments from MOFCOM have indicated that RHQs will be permitted to engage in a broad range of distribution activities, while applicable law currently permits RHQs to distribute only products of their subsidiaries, their foreign parent and affiliates controlled by the foreign parent, with non-RHQ holding companies even further restricted in terms of whose products they may distribute.

At a macro level, the fate of China's numerous free trade zones is also an open issue. Many, such as Waiagaoqiao, are quietly launching logistics zones, and are otherwise grappling with other ways of attracting foreign investment in concentrated regional hubs.

And Now, We Wait

MOFCOM may well soon issue instructions on the processing of applications under the Commercial Procedures. But how quickly the queue of backlogged applications will be processed remains to be seen as does the ease with which companies will be able to expand their existing operations to benefit from the opportunities laid out in the Commercial Procedures. Challenges also remain on other issues, including tax and Customs considerations, which are to be hammered out among the various governmental bodies.