Market Entry Strategy In China: Distribution - Key Factors And Regulations.

13 January, 2016

 

 

摸着石头过河 - Crossing the river by feeling the stones - Deng Xiaoping 

 

Introduction

 

The rise of e-commerce and most generally internet sales through social digital platforms has had a significant impact on the traditional models and structures for distributing goods and services in China. Surely foreign investors, whatever their business, “must” consider the development of their online presence in China as useful channel or crucial element of their market entry strategy, learning how it works and facing the particular issues due the Chinese internet restrictive policies. But if nowadays the Chinese market “seems” more accessible, the choice of the most suitable and profitable strategy-business model to entry into the Chinese market is still based on a careful evaluation process of several heterogeneous factors which directly and indirectly affect a specific business.    

 

The initial selection of a direct or indirect method (or combination of both) and the e-commerce to distribute products and services cannot be taken without considering the full compliance with the different laws and regulations required by the Chinese legal system, the effective cost of the selected method, its real ability to generate profits for that business in China, the tax consequences of different business strategies in China, the risks exposure and the defensive instruments available for the investor. Nevertheless market analysis cannot be separate from the study-evaluation-balancing of the fundamental laws which govern the same market.

 

The fashion and luxury goods industries and their internet sells in China are emblematic examples of the connection and dependency of all these several different factors. In fact, the impact of anti-bribery measures of last five years jointly with the soaring number of Chinese rich consumers traveling abroad, has been devastating. From 2012, iconic luxury brands have seen their sales growth dropped from 30 percent in 2011 (including Hong-Kong, Taiwan and Macau) to just 7 percent in 2012, showing a sudden slowdown in the Chinese luxury consumption. This negative trend over the years has forced iconic luxury brands to stop and reduce their expansion whilst cheaper fashion retail chains have increased extraordinarily their profits.

 

Another relevant factor that foreign investors should take it into account is the government involvement in Chinese economy which is much greater than in many other countries. The government still owns and controls many large state-owned enterprises (SOE) and appoints the members of those SOEs’ boards of directors. Many large SOEs continue to hold monopolies in key industries and the manufacturing of strategically important products, such as coal, petroleum and steel. It should also be noted that support from national and regional governments plays a significant role in establishing-entry, developing and operating in China. This support is often the key to determining market access for products as well as any regulatory or commercial risks.

 

Foreign investors should also be aware of the many legal restrictions on distribution contracts in China (e.g. restrictions on pricing, resale price maintenance, exclusive supply arrangements, exclusive purchase arrangements, retailer fees etc.). The distribution contracts govern the relationship between suppliers and distributors and their correct drafting is decisive for the success of any business strategy.    

 

Thus, in this article I introduce the most relevant regulations and factors from which starting to plan a correct (and more realistic) market entry strategy in China.

 

Market entry methods in China

 

A) The indirect entry method: Importing into China and customs clearance

 

Foreign companies can sell their products in China directly or indirectly. The direct method requires a company to establish a presence in China and undertake the import or manufacture and subsequent distribution of its goods. The indirect method scheme involves a Chinese buyer that resells the goods in China or appointing a commercial agent in China that introduces buyers to the foreign company.

 

It is important to point out that Chinese buyers often do not hold the related import and export license(s) and thus they hire a Chinese registered foreign trade agent to undertake all the import formalities.

 

The trading rights of the business scope of a trading company are different from a trade license issued by customs. A foreign trade license issued by customs entitles the license holder to deal with customs formalities by itself without engaging a customs broker, while the trading rights within a company’s business scope indicate that the company is legally permitted to engage in the business of trading but it needs a customs broker to deal with customs formalities. The customs broker must be a lawfully established declaration entity.    

 

However, import and export in China are regulated by China Customs and People's Republic of China General Administration of Customs. Briefly, the Chinese customs system consists of three levels:

 

  • The General Administration of Customs in China (GACC) under the State Council at the highest level
  • a branch office in Guangdong, two special commissioner offices in Shanghai and Tianjin, forty-one directly governed customs authorities and two customs colleges as the second level
  • 562 customs agencies under the forty-one directly customs authority as the third level


The customs clearance procedure for importing goods into China consists of three steps that are jointly performed by the provincial and local customs offices: a) documentation; b) inspection;) release of goods.

 

During the documentation phase, the importer or customs broker must fill first the customs declaration. The data of the local customs declaration are transmitted electronically to the electronic data examination center, which checks the format of the data, then transfers it to different customs officers according to the types of goods that were declared. The customs officers check the valuation and classification of each entry, and that data is released and sent back to the local customs house. The importer or customs broker then provides the customs officer at the local customs port with the paper declaration form, together with all other required documents.

 

After the documentation duties are accomplished, the local customs office determines whether a physical examination is necessary and, if so, how it should be completed. The examination can be performed at an examination station, a customs facility or, if arrangements are made, the importer’s premises.

 

Finally, if all customs duties and import taxes are paid, the imported goods will be released. In some circumstances, goods can be released prior to the completion of customs formalities if the importer provides a guarantee.

 

Commercial Agents

 

Another indirect way of penetrating the Chinese market is the use of a commercial agent in China to import and distribute products. This entry way is nowadays the most inefficient and unreliable, especially if we consider it under the new scenario created by e-commerce and internet sales.

 

First of all commercial agents, because of some legal limitations, are more similar to representative offices. As a representative office in fact, a commercial agent cannot sign legally binding contracts. They cannot purchase products and resell it. Their powers are limited to promote products, introduce buyers and facilitate sales in China. Furthermore a commercial agent does not hold an import and export license, and therefore pays a commission to a license holder to facilitate the importation of foreign products.

 

In addition, commercial agents usually do not have the experience and interest required to ensure that the trademark and its goodwill are properly protected, as well as cannot guarantee that marketing and the activities needed to reach the market of a specific product are carried out professionally and with results.

 

B) The direct entry method. Foreign Trading Companies.

 

Foreign companies that want to deal with the sell-distribution of their products directly in China may establish a Foreign-invested Commercial Enterprise (FICE). An FICE is a foreign entity allowed to do trading and distribution without the support of a Chinese partner-buyer-agent.

 

The possibilities of FICEs have been further expanded by the new Measures for Foreign Investment in Commerce promulgated by China’s Ministry of Commerce (April, 2014). According to the measures, foreign-invested commercial enterprises can distribute imported and locally manufactured products through their own wholesale, retail and franchise systems and provide a host of related services, including storage, warehousing and garage services, inventory management, repairs, maintenance, training and delivery. Wholesaling and agency operations with commission are also permitted.

 

Distribution in China: Wholesale, Franchising, Direct Selling with or without a permanent presence in China, e-commerce

 

Wholesale Distribution

 

As the import of goods, the wholesale distribution can be managed directly or indirectly. In this last case, the foreign company contracts a Chinese company that acts as distributor of the foreign supplier, reselling its goods to other Chinese distributors or retailers.

 

If a foreign company wants to establish independent wholesale distribution in China, as I mentioned above, it may establish a FICE in the form of wholly foreign-owned enterprise (WFOE) and deal directly with Chinese retailers or distributors in China.

 

With limited exceptions in sectors such as oil, salt, tobacco and fertilizers, a wholesale FICE can distribute as a wholesaler without the involvement of third party agents or organizations by taking the following actions:

 

  • Buying and selling goods through a Chinese company, including through another foreign-invested enterprise (FIE), and issuing value-added tax (VAT) invoices and offset VAT
  • Engaging in the buying and selling of goods with a foreign company and directly undertaking customs clearance and procedures
  • Conducting general after-sales services, repair and maintenance, as well as buying or selling parts and components incidental to after-sales services

 

Retail Distributions

 

Since December 2004, foreign companies have been allowed to engage directly in retail distribution, establishing a "retail FICE". A retail FICE may undertake the following activities:

 

  • Retailing
  • Importing merchandise that it sells
  • Sourcing and procuring goods for export, if they are produced in China
  • Telemarketing, mail order sales, internet sales and vending machine sales
  • Conducting related ancillary services


Franchising

 

The legal framework of franchising in China is provided basically by the Regulations on the Administration of Commercial Franchise Operators (Franchising Regulations), the Contract Law, the Anti-Monopoly Law and other antitrust-related laws. Franchising Regulations apply to commercial franchising operators. According to the Franchising Regulations, a franchisor must have the following requirements: 

 

  • be an enterprise
  • be capable of providing the franchisee with long-term guidance and support with training
  • has at least two directly operated stores for one year
  • has a well-established operation model


Franchise agreement is defined as “an arrangement whereby a franchisor, by contract, authorizes a franchisee to use its operational resources, such as its trademark, trade name, patent, proprietary know-how; and the franchisee conducts business in accordance with the franchisor’s standardized business model and pays franchising fees in accordance with a franchising agreement.”

 

A franchise agreement shall be subject of a written contract containing provisions dealing with a list of items, including the nature of the franchise, fees, protection of consumer rights and liability for breach. There are several mandatory provisions protecting the franchisee that must be included in the contract, as well as a number of pre-contractual disclosure requirements.

 

China has introduced additional administrative measures based on the Franchising Regulations that deal with the filing of a franchise contract and records with the Ministry of Commerce (MOFCOM), as well as a long list of detailed information disclosure requirements. The franchisor must comply with the information disclosures by providing the relevant information to the franchisee at least 30 days prior to the franchisee’s signature of the franchise agreement. These disclosures must also be made at least 30 days before the renewal of agreement, unless the renewed franchise agreement is on the same terms as the original. Failure to make the disclosure or providing false information to the franchisee, even if done unintentionally, entitles the franchisee to rescind the franchise contract.

 

Franchising model involves the franchisee (a reseller) selling products with specific characteristics through a particular method of sales. This method involves the use of trademarks, and the franchisor often provides commercial or technical assistance (proprietary know-how). The licensing of intellectual property (IP), such as trademarks and proprietary know-how, normally involves payment of a franchise fee for the use of the particular business method and other IP rights. A franchise agreement usually contains restrictions on competition, such as non-compete or exclusive distribution clauses that include obligations to purchase certain products or services only from the franchisor or from a person designated by the franchisor.

 

Direct Selling with a permanent establishment in China

 

Direct selling in China is basically regulated by the Regulations of Administration of Direct Selling (Direct Sales Regulations) and the Regulations on the Prohibition of Pyramid Selling (Anti-Pyramid Regulations). According to the Regulations of Direct Sales, direct selling is defined as a “method of distribution whereby a direct salesperson recruited by a direct sales enterprise promotes its product, outside any fixed place of business, directly to an ultimate consumer.” The allowed products for direct selling in China are:

 

  • Cosmetics
  • Health instruments and devices
  • Health foods
  • Cleaning products
  • Personal hygiene
  • Daily use products
  • Small kitchenware

 

A direct seller may only sell products that the direct seller, its parent companies or its parent’s holding companies have produced. Unfortunately the law is not clear about the possibility for the seller to sell products produced by other affiliated companies of the direct sellers. Direct sellers are subject to licensing requirements:

 

  • The investors must have a good commercial reputation and must have no record of a major violation of Chinese laws in the five years immediately preceding the license application
  • If the investor is a foreign investor, it must have at least three years of experience in direct selling activities outside of China
  • If it is a foreign company, a registered capital of no less than RMB 80 million must have been paid into the FIE (not always)
  • A bond of RMB 20 million must have been paid in full at a designated bank at the time of incorporation
  • Information and disclosure systems must have been established in accordance with the law

 

The Ministry of Commerce (MOFCOM) is the authority in charge of approving any establishment of a WFOE that is engaged in direct selling. The WFOE is required to establish a branch in any province in which it wishes to directly sell, unless the enterprise itself is already registered in that province. A service outlet must also be established in each such province. The purpose of the service outlet is to provide information to customers regarding pricing, return policies and after-sale services. Each branch office and service outlet must meet the requirements of its local government. When a direct seller or branch thereof recruits a direct salesperson, it must execute a sales promotion contract with the salesperson and ensure that the salesperson engages in direct selling activities only in a region where a service outlet has been established.

 

Direct Sales without a permanent establishment in China

 

Most of foreign SMEs and individual entrepreneurs use an offshore company to sell directly their products in China. Under this structure, sales are made by the offshore company, which is usually registered in Hong Kong, directly to Chinese buyers. However, this method involves different issues which should be assessed carefully.

 

First of all, this structure could be deemed to be conducting business activities without proper authorization or registration, leading to penalties by the local branch of the State Administration for Industry and Commerce (SAIC). In addition, the foreign suppliers, their staff and products as well as their rights may not receive the proper legal protection in case of disputes because their irregular status and their unlawful conduct.

 

Electronic Commerce (e-commerce)

 

E-commerce in China is probably one of the fastest growing sectors nowadays. The global success of Alibaba Group and the impressive growth of online sales have showed the extraordinary potential of digital platforms in China. However, e-commerce for foreign companies in China has some limitations that should be taken into account by investors (apart the government censorship).

 

First of all the relevant regulatory framework is still confused and incomplete. For instance a foreign company which wants to sell its own products using its own online platform is required to register the online platform. If the company has an online platform that allows third parties to set up online shops selling their respective products, a license is required. But currently, a foreign company has no right to get such kind of license and in one case MOFCOM required the acquirer of such online platform to stop the service or transfer the license to a Chinese-controlled entity (Wal-mart Stores Inc.).

 

Another issue-limitation is that few Chinese e-commerce portals are able or willing to deal with the customs clearance and after-sales service issues associated with imported goods. Chinese portals rely heavily on the foreign companies whose products they sell or promote to handle import, customs, logistics and fulfillment issues. Thus the effectiveness of local distribution and a permanent presence are still crucial to a foreign company’s successful e-commerce sales in China.

 

Therefore the rules and procedures for customs and transportation related to internet sales by foreign companies are becoming increasingly restrictive. In April 2012, China introduced new customs rules for online purchases of overseas goods and imposed restrictions on collaborations between Chinese domestic logistics and postal companies and their overseas counterparts. Under the new rules, logistics providers are required to go through a special customs channel to monitor compliance and enforcement of the new rules. In addition, goods for personal use that are valued at more than RMB 5,000 carry a 10 percent import duty in addition to VAT.

 

Foreign Company Structures for Distribution in China: Representative Office, Branch Office, Wholly Foreign-owned Enterprise, Cooperative Joint Venture, Equity Joint Venture, Foreign-Invested Partnership

 

Foreign suppliers can sell directly to distributors in China or can establish subsidiaries, representative offices, branch offices or partnerships in order to operate their business in China.

 

Representative Office

 

The Representative Office is a non-legal entity operating in China, which represents its parental company located overseas. ROs are not allowed to:

 

  • conduct business directly
  • collect money or issue invoices within China for services or products
  • represent any firm other than their headquarters
  • buy property or import production equipment
  • sign contracts or deals on the behalf of the parental company.

 

A RO is only permitted to:

 

  • carry out market research
  • perform presentation and promotional activities in relation to its parent company’s products or services
  • undertake liaison activities in relation to product sale
  • service provision
  • domestic procurement and domestic investment.

 

In order to operate as permanent presence in China, a RO can also:

 

  • rent commercial and residential premises
  • obtain work permits and residence permits for expatriate employees of the representative office
  • use company logos at the business premises of the representative office
  • use business cards referring to the representative office
  • open bank accounts in the PRC on behalf of the representative office
  • make travel arrangements for parent enterprise representatives and potential Chinese clients

 

Branch Office

 

A foreign company can set up a branch office in China. However, for distribution activities, this option is only available to foreign companies in a very limited scope of industries, such as commercial banking or oil exploration.

 

If a foreign entity has established a Chinese subsidiary, such as an EJV or WFOE, the subsidiary may set up its own branch office within China, which will allow the subsidiary to conduct activities in different Chinese locations. The Chinese subsidiary and its branch office are not separate legal entity and the subsidiary will be responsible for the branch office. However, in contrast to representative offices, branch offices are permitted to engage in revenue-generating activities.

 

Wholly Foreign-owned Enterprise

 

The Wholly Foreign Owned Enterprise (WFOE) is a limited liability company owned and managed by a foreign investor or combination of foreign investors in China. Currently it is possible to set up in China the following types of WFOEs:

 

  • Manufacturing WFOE. Foreign manufacturing companies, especially high-tech enterprises, have always been encouraged by the Chinese government with advantages of tax incentives, low labor costs and efficient infrastructures and transportation. Manufacturing WFOEs in China usually refer to companies engaged in industries such as machine manufacturing and electronics, building materials and construction, medical equipment and transportation. The procedure for establishing a manufacturing WFOE is the most complex. In fact the local Administration of Industry and Commerce (AIC) will perform several inspections (on the rented space for the factory, factory, equipment, materials etc.). In addition, Manufacturing WFOEs are required to obtain approval from the Environmental Protection Bureau. For some activities, a full report on the estimated environmental impact of the factory issued by an appointed agent is required, which is intended to ensure that manufacturing production processes comply with specified environmental norms. The Bureau will require information about the raw materials, the machinery and equipment, consumption and safe disposal of toxic products.
  • Service or Consulting WFOE. A consulting WFOE is a company that provides professional consulting services on matters as legal, accounting, insurance, tourism, education and management consultation. A service WFOEs is a company that provides technical services or consulting services to third parties on matters as technology, technology transfer and technology development. These types of WFOEs are the easiest to set up because they require a lower capital and a shorter establishment time frame compared to FICE or manufacturing WFOE.
  • Foreign-Invested Commercial Enterprise (FICE). A FICE is defined as a foreign-invested enterprise that engages in the following areas:

 

       - agency with commission: selling other owned goods and providing related services by sales agency of goods, broker, or auctioneer or other wholesaler on the basis of contractual relationship

      - wholesale business: selling goods and providing related services to retailers, industrial users, commercial users, organizational users and other wholesalers

      - retail business: selling goods and providing related services to individual or collective consumers in fixed locations or by means of television, telephone, internet and automat

     - franchise business: licensing of trademark, trade name and business mode by entering into a contract with others for the purpose of returns and licence fee

 

Equity Joint Venture and Cooperative Joint Venture

 

An Equity Joint Venture is an independent legal entity with limited liability. Investors contribute capital and enjoy rights to a percentage of the profits equal to their contributed capital. Capital contributions may be in cash or in kind, such as land use rights, buildings, intangible assets or equipment. In general, the ratio of equity interest held by the foreign investor(s) in an EJV is at least 25 percent. During the term of the EJV, the parties cannot withdraw their contributions to the registered capital or either transfer or assign their equity interests without prior government approval. Any transfer of equity interests is also subject to the consent of the other EJV partners. The board of directors is the highest authority in the management of an EJV. Either the chairman of the board, other board members or a general manager can be the EJV’s legal representative, who may be a Chinese or foreign national. Potential drawbacks of an EJV are that it can be time consuming to negotiate the establishment of an EJV and that there may be a risk of loss of control over IP and confidential information.

 

A Cooperative Joint Venture is often established as a company with its own independent legal identity and with limited liability. It can also be an entity with no separate legal personality and without the protection of limited liability. It should be noted that although it is legally possible to set up a CJV without establishing it as a separate legal entity, in practice it may be difficult to obtain government approval to do so. China’s legal regime allows a certain amount of flexibility in the structure of a CJV. The profit-sharing ratio does not necessarily have to reflect the ownership interest ratio of each investor and it may be decided by the investors based on their joint venture contracts. The parties may also provide “conditions of cooperation” instead of capital contributions to the CJV. The highest authority in the management of a limited liability CJV is the board of directors. If a CJV does not have a separate legal personality, its highest authority is a joint management committee. There must be at least three members on the board of directors or the joint management committee, each of which can be made up of Chinese citizens or foreign nationals.

 

Foreign-Invested Partnership Enterprise

 

A Foreign-Invested Partnership provides flexibility in terms of capital contribution and profit distribution. Partners can make capital contributions to the partnership in cash or in kind, such as labor, IP, land use rights, buildings or other property rights. Foreign investors may make their contributions either in exchangeable foreign currencies or in legally acquired RMB. Profit distribution can be arranged according to the partnership agreement, and the ratio of the distribution does not have to correspond to the partners’ respective capital contributions. Existing restrictions on foreign ownership in certain industries apply equally to FIPs.  It is possible to establish the following types of partnerships:

 

  • General partnership. A general partnership is formed by two or more general partners who bear unlimited joint and several liabilities for the debts of the partnership.
  • Limited partnership. A limited partnership is formed by a combination of general partners who bear unlimited joint and several liabilities for the debts of the partnership and limited partners who bear the liabilities for the partnership's debts to the extent of their capital contributions.
  • Special general partnership. The article 55 of PRC Partnership Enterprise Law introduces the special general partnership. A special general partnership resembles a general partnership except that it must be a professional service institution offering services requiring professional knowledge and special skills. It is intended as the preferred form of organization for law and accounting firms. The structure shields co-partners from liabilities due to the willful misconduct or gross negligence of one partner or a group of partners.


Applicable Taxes and typical tax consequences of different business strategies in China

 

On 1 January 2008, the new income tax system went into effect, applying to all foreign investment enterprises within China and all domestic Chinese enterprises as well. This new tax system has simplified tax procedures and it applies to both domestic and foreign-invested enterprises. Any applicable taxes will be assessed against the party legally responsible for paying the tax concerned and that party may be either the supplier or distributor. Therefore, while there is no requirement on parties to include any contractual provisions in a distribution agreement concerning tax payments, the inclusion of such provisions can be useful for avoiding misunderstanding. The most relevant taxes for the distribution are:

 

  • Customs Duty. Customs duty is applied to the customs value or dutiable price of the goods or materials imported. The dutiable price is calculated on the basis of the transaction price of such goods and includes freight and related expenses, as well as insurance premiums incurred before the unloading of the goods at the entry point within China. Dutiable price is subject to examination and final determination by China Customs. Import duties are levied at both general and preferential rates. The preferential rates apply to imports originating from countries or regions that have signed agreements with China containing reciprocal preferential tariff clauses. The general tariff rates apply to imports originating from all other jurisdictions. However, if the State Council Customs Tariff Commission gives special approval, preferential tariff rates may be applied to imports that otherwise would be subject to the general rates. To encourage foreign investment, foreign investment enterprises that meet certain requirements may be exempt from custom duties on the imports of machinery and equipment for personal use. Royalty payments may also be subject to customs duties if the royalty fee is relevant to the goods imported (e.g., payment of royalty fees constitutes the conditions for sale of such goods).
  • Value-Added Tax. VAT is assessed on sales and importation of goods as well as on processing, repairs and replacement services normally related to goods. In some locations, including Shanghai and Beijing, the provision of certain services and logistics are also subject to VAT. VAT is collected on most goods imported into the customs territory of China (import VAT) and on most goods that are sold within China. There are two types of VAT payers - the general VAT payer and the small-scale VAT payer. Small-scale VAT payers are entities engaged in manufacturing or providing labor services with sales not exceeding RMB 0.5 million per year, and as firms engaged in wholesale or retail trade with sales not exceeding RMB 0.8 million per year. The standard rate for value added tax is 17%, but the rate for certain basic commodities such as books, food staples, running water, forage, fertilizer, pesticide and farming machinery is 13%. Small scale VAT payers are required to pay VAT at a rate of 3%. VAT incurred on the purchase or construction of fixed assets may be credited against output VAT. Input VAT incurred under the following conditions, however, are not deductible against output VAT: 1) The purchase of goods and services for the exclusive use for non-VAT taxable or VAT exempt projects, welfare activities or individual consumption; 2) The purchase of yachts, motorcycles and motor vehicles that are subject to the Consumption Tax and used for the taxpayer's self-use; 3) Goods and taxable services purchased that are lost in an unusual manner; 4) Goods and relevant taxable services purchased and consumed or used for products or finished goods that are lost in an unusual manner.
  • Business Tax. BT generally applies to the provision of services that are not subject to VAT, the assigning of intangible assets such as patents, trademarks, copyrights, land use rights and the sale of fixed assets. Services are subject to Business Tax where either the service provider or the recipient is located in China. Before 1 January 2009, only services performed within China were subject to Business Tax. The Business Tax does not cover processing, repair and replacement services, which are instead subject to the value-added tax. Business Tax rates are set at 3%-5% for most sectors, except for the entertainment business, which is taxed at a significantly higher 20%. Enterprises operating within the service sector and liable for Business Tax have no mechanism to claim a VAT credit for inputs of goods subject to VAT. Unlike VAT, no credit is granted for paying Business Tax the exception being that in some cases, Business Tax can be levied on the difference between the revenue and deductible costs. Tax paid on services received or property acquired may not be deducted from the Business Tax, although deductions of costs are allowed for designated activities. The Chinese State Council announced on 26 October 2011 the launch of the pilot VAT reform program on 1 January 2012. The pilot program initially will apply to transportation and modern service industries in Shanghai and will be rolled out nationwide when conditions permit. Under the framework of the pilot program, the taxation of specified sectors in Shanghai will transition to being subject to VAT rather than Business Tax. The sectors affected include transportation industry and certain modern service sectors (including R&D and technology service, information and technology service, creative cultural service, logistics and ancillary service, leasing of moveable and tangible goods, attestation and consulting service).
  • Consumption Tax. CT is solely aimed at prescribed non-essential and luxury goods, including alcohol, cosmetics, fuel oil, jewelry, tires, motorcycles, motor vehicles, petrol, yachts, golf products, luxury watches, disposable wood chopsticks and tobacco. The Consumption Tax mainly affects the distribution of these goods when they are imported, but exports are exempt. The tax is calculated based on the sales value of the goods, the sales volume, or a composite of the two. The proportional Consumption Tax rate is set from 3% to 45% on the sales revenue of the goods.
  • Enterprise Income Tax. EIT is imposed on enterprises and is similar to company taxes in other countries. Resident enterprises are taxed on their worldwide income while non-residents are taxed on China source income and income effectively connected with their establishments in China. A company is deemed to be resident in China if it is established in China or if its effective and overall management is in China. The taxable income of a company is the amount remaining from its gross income in a tax year after the deduction of allowable expenses and losses. Taxable income generally includes profits, capital gains and passive income, such as dividends, interest, royalties and rents. Under the new law, the general enterprise income tax is 25%. The other income tax rates are: a) For small scale enterprises which register an annual income less than RMB 300,000, the tax rate is 20% on their global income; b) For the preferential enterprises (hi-tech enterprises, aviation, electronic, cutting-edge pharmaceutical and computer software), the tax rate is 15% on their global income. These companies must obtain approval from the National Technical Department or local technical department in order to be classified as “preferential enterprises". Withholding EIT. On dividends: A 10% withholding tax on dividends paid to nonresident companies was introduced in 2008. The 10% withholding tax may be reduced under an applicable tax treaty. On Interest: Interest is generally subject to a 10% withholding tax unless the rate is reduced under an applicable tax treaty. Interest from certain loans made to the Chinese government or state banks is exempt. A 5% business tax also applies to interest payments. On Royalties and fees: The withholding tax rate on royalties and fees arising from the licensing of trademarks, copyrights, know-how intellectual property and technical service fees is generally 10%. Royalties are generally subject to a 5% business tax except for payments made in connection with the use of technology, for which an exemption may be allowed.
  • Stamp Duty. Stamp taxes are levied on contracts made in China in respect of purchases and sales, processing, contracting, engineering project, asset leasing, transportation, storage and warehouse, loan, asset insurance, technology contract, transfer of property rights, accounting ledger, royalty licence. Stump duty ranges from 0.005% (e.g. loan agreements) to 0.1% (for leases and agreements, warehousing and storage contracts). The rate on share transactions is 0.1% for shares listed on a domestic stock exchange.

 

Each business and legal structure chosen for distributing within China has different tax consequences, benefits and disadvantages. Typical example is the difference between the so-called "Subsidiary Model" and "Branch Model". A foreign company with a headquarter in China may operate in a jurisdiction different from that of the HQ by establishing a subsidiary company (Subsidiary Model) or a branch company (Branch Model) in the local jurisdiction where the business operations will be conducted.

 

For instance, under the subsidiary model, a subsidiary would pay EIT to its local-level tax authority independently from its HQ whilst, under the branch model, an HQ with one or more branch companies would follow a central (or consolidated) filing method for EIT, and the overall EIT payable may be split and paid among different local-level tax authorities in different local jurisdictions. Regarding the losses, if either the HQ or its subsidiaries sustain losses in the current year, the current loss may not be used to offset the current profit made by another entity in the same year (subsidiary model). In contrast, under the branch model, the total EIT payable is split and paid to different local-level tax authorities in different jurisdictions according to a preset calculation, and thus the branch company may be treated less favorably by the local government, as compared to a subsidiary.

 

In addition, a branch company can be established as a non-tax-paying branch company or a tax-paying branch company. If a branch conducts “primary business functions” (for example, manufacturing or sales activities) or pays VAT/BT for its activities in its local jurisdiction, the branch company would likely need to pay EIT to the local-level tax authority. Conversely, if a branch company engages in internal or auxiliary functions (e.g.,  R&D and logistical support) but does not conduct primary business functions and does not pay VAT/BT locally, the branch company would likely not be deemed a tax-paying entity. However, it must be noted that the above rule might not apply when an HQ and its branch company are both located in the same province. 

 

Regarding the VAT, if goods are internally transferred between an HQ to its branch company for sale, the internal transfer could be taxed immediately. When the branch eventually sells the goods to its end customers, the future sales would also be subject to output VAT, but the branch may be able to claim input VAT credits under the aforementioned VAT credit system.

 

Foreign Exchange Restrictions

 

Although China’s State Administration of Foreign Exchange (SAFE) has recently issued new regulations on cross-border banking transactions, there are still restrictions and procedure on transferring money out of the country and on exchanging foreign currency into and out of China’s currency, which should be considered by foreign companies engaged in distribution business.

 

These restrictions can result in cash being “trapped” in China when it might be more efficiently used elsewhere. Early planning of a distribution network and structure, such as the use of shareholder loans, can be crucial to reducing the risk of “trapped” cash.

 

The distribution Contract

 

Through a distribution contract, the foreign investor makes real its planned market entry strategy in order to achieve its goals. However, many foreign distributors have faced several issues due to mistakes such as lack of clarity of the contract terms, not inclusion of certain provisions, incorrect interpretation of Chinese legal system and Chinese litigation system.

 

For example, many distributors and franchisees use the so-called "Standard Form Contracts" or "Contracts of Adhesion" without paying attention to their provisions and their legal consequences in China. China’s Contract Law protects the parties from certain types of provisions which exclude the user from any liability, increase the liability of the other party or exclude important rights of the other party. Other types of provisions which limit or eliminate the liability of a party must be clearly highlight to the other party in order to be admissible. Another common mistake of foreign companies, especially USA companies, is related to negotiations started with a letter of intent or memorandum of understandings. Whilst in USA those documents has no value and parties are free to walk away from negotiations without any formality, in China, under some circumstances, a LOI or a MOU can be cause of action for a breach of pre-contract.

 

Here the most relevant clauses of a distribution contract:

 

  • Exclusivity, “Non-Compete” and Exclusive Purchase Clauses. One of the primary issues to be taken into account is whether or not to grant exclusivity to the Chinese distributor in order to avoid potential competition in a specific area. However, the exclusivity is not always the best solution for a foreign company. Sometimes a more efficient solution may be to make the grant of exclusivity conditional on the local Chinese company consistently meeting or exceeding agreed sales targets. If the Chinese company fails to meet such targets, the foreign company may terminate the distribution contract or, alternatively, continue with the contract but on a non-exclusive basis, allowing other distributors in the same area to be appointed.  A non-compete clause prevents the distributor from selling, reselling, manufacturing or purchasing products that compete with products of the supplier. A non-compete clause can have the same effect as an exclusive purchase clause. In effect, a non-compete clause means that the distributor can purchase and resell products only from the supplier. If the distributor buys or manufactures and then sells products that compete with those supplied by the supplier, the distributor will be in breach of the non-compete obligation. If the supplier is dominant it cannot require, without justification, that the distributor deal only with the dominant supplier or with others designated by the dominant supplier. SAIC  regulations  prohibit a dominant supplier, without justification, from requiring its distributors to trade exclusively with the dominant supplier or those designated by the dominant supplier, and from restricting its distributors from trading with the dominant supplier’s competitors.
  • Distributor's Obligations. It is standard practice to include, in the obligations assumed by the distributor, provisions on market development, advertising and marketing, as well as other matters. A particular concern for foreign companies is to ensure that no competing products are marketed by their Chinese distributors. It is quite common to include clauses regarding training of the distributor´s staff, with agreement reached on specific training schedules and allocation of expenses. In the advertising and promotional materials provided or approved by the foreign company.
  • Ownership of intellectual property rights. The difficulties encountered by foreign companies in protecting their ownership rights in China are well known. Chinese laws protect only IP rights registered in China (according to the first-to-file rule), hence, unregistered rights or a foreign registration have no legal effect in China. It is important that any distribution contract addresses this subject by the inclusion of common provisions designed to protect such rights, including an acknowledgment by the distributor that it has no interest in the supplier's trademarks, a limited license in favor of the distributor and a prohibition on interference with trademarks or other notices appearing on the products concerned. Trademark  licensing can help the parent company retain ownership of the mark and control the use of it. There are two models of exclusive trademark licensing. One is the traditional  “exclusive” license, under which only one licensee has the right to use the trademark under license within a certain scope of use and during a certain period. Another model is a “sole” license, under which both the licensee and the trademark owner have the right to use the trademark. The primary difference between an exclusive license and a sole license under China’s Trademark Law is whether the trademark owner will or might be deprived of the right to use the trademark. A trademark license may include also the right to sub-license. However, careful consideration should be given to the  scope  of  any  allowed  sub-license—for  example,  whether  the  right  is  limited  to granting  only  non-exclusive, non-assignable and non-transferable sub-licenses for limited purposes. Consideration should also be given to whether the trademark license should cover use of the trademark in any internet domain name. 
  • Confidentially, State and Trade Secrets. It is also important that the distribution contract includes a general duty of confidentiality in relation to information disclosed during the course of the business relationship between the parties. Occasionally, such a duty will be subject to certain exceptions, such as information already publicly available or an obligation to disclose information pursuant to, for example, a court order. However, where information is to be provided to employees of either party, disclosure should be strictly limited to those persons who require the confidential information to perform their duties. If a supplier or its distributors are dealing with an State-Owned Enterprise, particular care should be taken when either gathering what might be regarded in other countries as market information about an SOE, or transferring, disclosing or using commercial and technical information related to an SOE or the markets in which an SOE operates. China’s State-Owned Assets Supervision and Administration Commission and the State Council introduced new rules in 2010 that re-categorize a commercial secret of an SOE as a state secret. These new rules mean that the traditional trade secrets of an SOE, such as business and technical information, may now be considered state secrets and subject to China’s State Secrets Law and the Criminal Law. Disclosure or use of a state secret is potentially a criminal offense, so disclosure or use of information previously categorized as an SOE’s commercial secret can potentially lead to criminal liability. A distribution agreement might include in a confidentiality clause a guarantee from an SOE that no documents provided by the distributor will include any state secrets. The Anti-Unfair Competition Law protects against infringement of trade secrets. When drafting distribution, franchise or other arrangements that include the grant of an exclusive right to use trade secrets, consideration should be given as to whether the licensee/distributor should be able to act unilaterally when enforcing infringement of trade secrets in the Chinese courts. In 2007, the Supreme People’s Court issued an interpretation stating that if a distributor/franchisee has an exclusive license to use a trade secret, such distributor/franchisee may, without the intervention or knowledge of the owner of the trade secret, unilaterally bring an action for infringement of the trade secret. 
  • Term. The parties must decide whether or not the local Chinese company´s appointment as distributor will be for a fixed term or open-ended (subject to termination following agreed prior notice). Where the distributor is granted exclusivity, it may not be in the best interests of the foreign company to appoint the distributor for a fixed term, unless it has the power to bring the agreement to an end before the expiry of the fixed term due to a breach on the part of the distributor. 
  • Termination. The circumstances in which either party will have the right to terminate the distribution contract prior to the expiry of the fixed term, as well as the consequences involved, should be clearly stated. Typical provisions include the parties´ right to settle accounts, the foreign company´s option to cancel shipments of products and the distributor´s obligation to return or destroy all advertising and promotional materials while ceasing to present itself as the distributor of the foreign company´s products. It is also common for the distributor to be permitted to sell any remaining product stock, unless the foreign company agrees to repurchase the same.

 

Anti-Monopoly Law on distribution: Dominant Suppliers and Dominant Distributors, Retailers and Large Retailers, Suppliers to Large Retailers

 

China's Anti-Monopoly Law came into effect in August 2008 and it is equivalent substantially to the European Union’s competition law and U.S. antitrust laws.

 

According to the AML, monopolistic  conduct  are  defined  as  "including  agreements,  decisions  or  other  concerted behavior  that eliminates or restricts competition; abuse of a dominant market position; and concentrations such as mergers, acquisitions and joint ventures that may have the effect of eliminating or restricting competition".

 

A breach of the AML can result in fines of up to 10 percent of a company’s annual revenues, confiscation of illegal gains and private damage actions in the courts. There is also the possibility that an agreement contrary to the AML may be declared invalid and unenforceable.

 

Thus, a dominant supplier or distributor bears the AML legal duties because of its position as a dominant player in the Chinese market. According to the AML there is a presumption of dominance, and therefore additional legal duties, in the following situations:

 

  • The supplier or distributor’s market share is 10 percent or more, and the supplier and two other undertakings together have 75 percent or more of the market
  • The supplier or distributor’s market share is 10 percent or more, and the supplier and one other undertaking together have 66.6 percent (two-thirds) or more of the market
  • The supplier or distributor’s market share is 50 percent or more


In addition, if a supplier or distributor declares publicly that it is dominant or has a market share in which the presumption of dominance arises, China courts will assume that the supplier or distributor is in fact dominant. In such cases, the burden shifts to the supplier or distributor to prove that it is not dominant. Examples of additional legal duties imposed by the AML on a dominant supplier or distributor include the prohibition, without justification, of the dominant undertaking from refusing to trade with a trading party, restricting a trading party to trading only with the dominant supplier or dominant distributor, or discriminating in pricing or other treatment between customers.

 

The  Administrative  Measures  on  the  Sales  Promotions  of  Retailers (Retailer  Promotion Measures) and the Administrative Measures for Fair Transactions Between Retailers and Suppliers (Fair Retail Transaction Measures) regulate arrangements between retailers, large retailers and their suppliers. 

 

The Retailer  Promotion Measures, which are applicable to almost all retailers regardless of their size or revenue, contain strict rules on how sales promotions can be conducted. The Fair Retail Transaction Measures, which only apply to large retailers, impose strict requirements on the way large retailers deal with their suppliers. For example, a large retailer is severely limited as to what provisions it can agree with its suppliers, including with regard to fees, product returns, refunds, removal of products from displays and sales to other retailers. The supplier to a large retailer can refuse the latter’s return of a product that has been destroyed, expired or spoiled, even if the supplier bears no loss as a result of such return. At the same time, under the Fair Retail Transaction Measures, a supplier to a large retailer cannot restrict the large retailer’s sale of product supplied by other suppliers. 

 

Written by 常磊Pierluigi Damiano Lenge