Business Structures to Overcome Obstacles in China

By Paul Folta, Folta Associates

In China, the profitability of foreign investments is growing and the business environment is improving. Yet, China is a complicated place to do business. Many companies are walking away from business opportunities, agreeing to disadvantageous business deals, or unnecessarily waiting for further government business reforms.

Knowledge of how to overcome highly challenging business situations in China alters this experience. For example, a U.S. hospital group decided not to pursue a venture in China when they concluded that they could not overcome China's restrictive regulations for foreign investment. In the same timeframe, another foreign healthcare group, who was expert in alternative business structures in China, was signing agreements with Chinese hospitals for specialized medical services and operating these ventures successfully.

Companies often make one of the following choices: decide to wait a few years for regulations to change, accept an Equity Joint Venture (EJV) structure with less control, or work with a more malleable but less attractive partner. Waiting can be wise. Waiting can also cause loss of market leadership; deals with priority partners can be lost to competitors.

Challenging Business Situations

China poses many challenging situations that often discourage foreign investors.

• Restricted sectors: Many business sectors have restrictions on foreign ownership. For example, distribution, logistics, construction, healthcare services, financial services, mining, higher education, media, retail, and infrastructure place limits on foreign ownership levels or constrain foreign investment. Alternative business structures are required for foreign entities to do business in these sectors.
• "Hard-to-get" priority partner: Many leading Chinese players do not want to give up control. For example, a priority Chinese partner might insist on a technology transfer and original equipment manufacturing (OEM) production licensing arrangement. Alternatively, a prospective Chinese partner could insist on forming a Joint Venture with an interested foreign company, not allowing the foreign company to acquire them or buy a division of their company. Each of these circumstances could mean inadequate intellectual property protection or inadequate management control for the foreign company.
• Capital and asset issues: Sometimes Chinese companies do not have the capital needed to purchase equipment required for a project with a foreign company. The foreign company's arrangement of a lease for equipment or a loan to a Chinese partner may not be an attractive option. This is due to required government loan approvals and there would be significant recourse challenges in cases of default.
  
  It also is difficult to agree on the value of assets, which is required in some ownership structures. This is particularly sensitive when either partner contributes technology to an equity venture.

China's investment environment continues to improve. Relaxed regulations have encouraged an increase in Wholly Foreign-Owned Enterprises or WFOEs, making up over 62% of new ventures in China. WFOEs are not always a magic bullet. Foreign companies sometimes have no alternative but to consider a Joint Venture (JV) structure. China's government still might require Chinese company participation or control. In other cases, a Chinese partner might have capabilities (central and local government support, brand reputation, land, licenses, distribution, access to suppliers or other assets) that could reduce risk and might be critical for a foreign investor's success. Most JVs are Equity Joint Ventures (EJVs), and are well understood around the world. Yet, EJVs do not always effectively address challenging business situations.

Foreign investors have options available that are not often tapped. Savvy investors may use the Cooperative Joint Venture or Contractual Joint Venture (CJV) structure. Unfortunately, it is overlooked or little-understood by newcomers to China.

An Alternative: The Cooperative Joint Venture or Contractual Joint Venture (CJV)

In China, a CJV* is a well-accepted solution by the Chinese government, and remains untapped by many. The most important benefit of CJVs over EJVs in China is that the CJV parties' profit, control, and risks are divided according to the 'negotiated' contract terms. In contrast, an EJV's profit, control and risk are in proportion to the equity shares invested by the parties.**

CJVs and EJVs are very similar in many other respects. The formal government-required process, approving authorities, format of agreements, tax breaks, legal standing, and recourse are identical. The general management structure and governance procedures are virtually the same particularly when carefully spelled out in the JV contract.

How is a CJV Advantageous?

CJVs can have flexibility for both the foreign and Chinese parties in the following possible ways:

• Restricted Sectors: Assets and licenses restricted from foreign ownership or assets not desired by the foreign partner can be held by the Chinese partner and "lent" to the CJV - until the venture terminates or the rules are relaxed. These may include assets with a high transfer tax, or those too complicated or costly to obtain for the foreign investor, like land. A Chinese company could "lend" its license to a CJV in a value-added telecommunication network. This is not allowed in an EJV, because the license would be considered part of the whole company's assets. In China, such a license is restricted from foreign ownership.
• Capital Contribution Problems: Expensive western technologies and equipment, such as costly hospital diagnostics equipment, can be contributed or leased to the CJV by the foreign partner. The foreign partner can be repaid at an "advanced rate" from revenues before profit sharing. This applies for cases where foreign ownership caps are required and/or the Chinese side cannot afford to fund assets up front. This is impractical or impossible under an EJV ownership structure.
• Management Control Issues: Management and other specific rights are more flexibly structured into the articles of association with less reference to equity stakes than in EJVs. These may include voting on key issues or determining management positions. This provides the control often required by the foreign side (presuming such control does not violate Chinese law).
• Approval Process Reduces Risk: Approvals are required for any foreign investment. Government approvals of the CJV ensure that the venture can legally engage in the specified business scope, within the licensed areas. Since CJV contracts must be detailed, government concurrence with specific agreements deters local partner non-compliance; therefore, it commonly provides better recourse than in an EJV.
• Simpler Termination: Ending a CJV may be easier than ending an EJV - particularly if assets are held separately by the parties, and contingency dissolution terms are clarified in advance.
• Controversial Expenses: Expenses required by the foreign party that the Chinese party might disapprove of in an EJV, may be structured as a contribution by the foreign party in a CJV. Such as, the sticky issue of the high cost of expatriates, whom the Chinese partner might feel are not needed, may be resolved more easily by a CJV.
• Tax Advantages: While CJVs and EJVs have the same tax advantages, some benefits exist in a CJV, like avoiding the asset transfer tax. To obtain the benefits and protection afforded to Foreign Investor status, in both CJVs and EJVs, the foreign side's investment must make up at least 25% of the venture's capital.

Examples of CJVs in China

Technology Transfer:
In the fall of 2002, a Canadian auto parts technology company and a major Chinese industrial group announced their plans to form a CJV. This CJV was formed to make and sell automotive components in China. After quality targets were met, they planned to provide components to the Canadian company for distribution in Europe and North America. The Chinese party provided an initial investment for the venture of US$1 million, plus working capital. The Canadian firm provided its patented technology and additional capital, less than provided by the Chinese side. The Chinese party provided greater cash investment, described itself as the major shareholder and may receive a higher distribution of profits. The CJV's operating board is headed by the Canadian firm as part of the CJV agreement. With the Canadian company in control of management, they can keep quality up for distribution in Europe. The Canadian company retained ownership of its technology and avoided the sticky issue of determining the value of its technology.

Restricted Sector:
In early 2004, a U.S. company with wireless security technology for smart cards signed a CJV agreement with two Chinese companies in the telecommunications and media sectors to:

1) operate value-added networks for application of the smart card technology
2) promote the system and technologies in the government and financial sector, and
3) maximize the technology's usage in as many fields as possible.

Given the sensitivity of this sector for both the Chinese and U.S. governments, both had to apply for the necessary licenses, approvals and permits within China, and for export permission or exemption from U.S. authorities. The Chinese government has stated that certain value-added services in the restricted telecommunications sector would be approvable.

In this case and often in telecommunications, by law, ownership and operation of the technology related to interconnect with the public network must remain with the Chinese party. The legal structure of an EJV would prevent full Chinese ownership, which further confirms the importance of CJVs in sensitive sectors.

The Chinese government can be more favorably disposed to CJVs where each party owns the assets it contributes in sensitive sectors like this, and where CJVs specifically define what each party can and cannot do.

More and More Companies are Doing Business in China

Although stories of China's challenging business environment abound, foreign companies continue to be attracted to China. China has a GDP of $1.4 trillion, the sixth largest economy in the world. In 2003, foreign companies invested $57 billion in China and contracted to invest $115 billion, 39% increase over 2002. Three-quarters of 251 member firms of the American Chamber of Commerce in China claimed to be profitable in 2002. In 2002, 40% of these firms said their margins were higher in China than in their global operations.*** [Economist, 2004 & Observer, 2003]

China's laws and regulations are changing rapidly, so it is wise to obtain advice from experts with deep experience in China and who specialize in specific sectors. Starting the approval process early in the CJV formation helps to ensure that the structure is acceptable and increases the probability of the government's approval.

In summary A CJV may offer an attractive way to enter China when traditional WFOE or EJV structures won't allow a company to address challenges to fundamental business requirements.

Footnotes:

* Note: Contractual JVs are not unique to China, but countries' CJV regulations may not be the same.

** "Detailed Rules for the Implementation of the Law of the People's Republic of China on Sino-Foreign Cooperative Enterprises," promulgated by the Ministry of Foreign Trade and Economic Cooperation in September 1995 and amended in October 2000.

*** "A Survey of Business in China," Economist , March 20, 2004, pp. 3 and 9; "China Ahead in Foreign Direct Investment," OECD Observer , No. 237, May 2003-Published August 20, 2003.

Paul H. Folta, Ph.D., is the founder of Paul H. Folta & Associates, LLC
(www.foltaassociates.com) experts in overseas business development. Paul can be reached at pfolta@foltaassociates.com or tel +1-908-903-0811.