Speech: Legal Issues on Investment in Food & Beverage Industry in China

On December 11, 2001, the 15-year campaign for China to join the World Trade Organization (“WTO”) came to an end when China became a full member of the WTO. The immediate effect of China’s entry was that, as a WTO member, China was obliged to open its domestic market further. In addition to a schedule of tariff reductions China has agreed to certain market access undertakings in key service sectors, including telecommunications, insurance, banking, trade, distribution and logistics, etc. In the majority of these sectors, foreign investment and participation is to follow a schedule whereby initial investment caps and business scope and geographic scope limitations are gradually liberalized over a period of several years. China is currently becoming one of the most promising jurisdictions in the world for foreign investment. More than 28,000 foreign invested enterprises have been set up in Shanghai in 2005.

China's WTO commitments are reflected in the Foreign Investment Guidance Catalogue ("Catalogue"), which lists various types of foreign investment projects under the following category heads: encouraged, restricted and prohibited. All foreign investment projects not included in the Catalogue are considered to be permitted. Different approval requirements apply depending on the classification of the project. The Catalogue which is updated from time to time is the initial starting point for analysis of foreign investment projects in China. The most recent edition of the Catalogue took effect on 1 January 2005. The Catalogue also indicates whether there are limitations on the foreign ownership percentage in a project, e.g. projects in which 100% or majority foreign ownership are not permitted.

According to the Catalogue, most of the food processing industry is listed as “encouraged”, including storage and processing of food, vegetables, fruits, fowl, and livestock products; aquatic products processing, seashell products cleaning and processing, and development of function food made from seaweed; development and production of drinks of fruits, vegetables, albumen, teas and coffees; development and production of food for babies and agedness, as well as function food; production of dairy products; and development and production of biology feeds and albumen feeds. However, the following are in the list of “restricted”: production of millet wine and spirits of famous brands; production of soda beverage of foreign brand; production of synthetic sweet agent such as saccharin; processing of fat or oil.

In the past, a foreigner is required to set up a joint venture in case he wants to invest in the retailing. However, the promulgation of Measures for the Administration on Foreign Investment in Commercial Fields (“Measure”) changes the situation. According to the Measures, foreign-funded commercial enterprises are allowed to be established from Dec. 11, 2004. The foreign-funded commercial enterprises refer to the enterprises with foreign investment which undertake the following business activities:

1.              Commission Agency: selling agents, brokers, auctioneers or other wholesalers for goods, who sell goods of other people and provide relevant attaching services through collecting fees on the basis of contract;

2.              Wholesale: selling goods to retailers, customers of industry, commerce and organizations, or to other wholesalers or providing relevant attaching services;

3.              Retail: providing goods for consumption and use of individuals or groups or offering relevant attaching services in the fixed places or through television, telephone, mail order, internet, and automats;

4.              Franchising: authorizing other people with using its trademark, trade firm, or mode of management through signing contract for gaining remunerations or franchising fees.

That’s to say, the retailing and distribution sector is open not only to joint ventures but also to other foreign invested companies including wholly foreign owned companies (WFOE). Therefore, let’s take a look at the common investing vehicles in China.

1. JV (Joint Venture)

A JV is typically a non-share-issuing limited liability company formed between one or more non-PRC entities with one or more Chinese entities. JVs are popular investment vehicles either for foreign investors less familiar with investment in China that would prefer a local partner with connections to help handle local issues, or for those investing in certain industries that require the participation of a Chinese partner under the current PRC legal regime.

A JV can be set up in the form of an equity joint venture (“EJV”) or a cooperative joint venture (“CJV”), which are structurally similar in most respects. Principal Differences between an EJV and a CJV can be simply summarized as follows:

(i) For an EJV:

• each party must make cash or permitted in–kind contributions in proportion to its subscribed percentage of the EJV’s registered capital.

• profit must be distributed strictly in accordance with the parties’ respective percentage shareholding of the registered capital of the EJV.

• upon dissolution of the EJV at the expiry of the term of operation, the EJV’s net assets are to be distributed to each party in accordance with its respective shareholding of the EJV’s registered capital.

(ii) For a CJV:

• a party (typically, but not always, the Chinese party) may contribute non-cash intangibles in the form of “cooperative conditions”. Such “cooperative conditions” may consist of market access rights, rights to use buildings or office space owned or leased by the party that are not subject to clear valuation. In exchange for such “cooperative conditions”, the party is entitled to participate in the distributable earnings of the CJV.

• profit sharing in a CJV need not be made strictly in accordance with the parties’ respective percentage shareholding of the registered capital of the CJV but can be made in accordance with the agreement of the parties (e.g. the Chinese party may be entitled to a fixed profit share with the balance to be distributed to the foreign party, or the parties may agree on a multi-tiered profit-sharing arrangement that permits the foreign party to recover an amount equal to its capital investment on a priority basis, following which the profit split will be changed, etc.).

• upon dissolution of the CJV at the expiry of the term of operation, the CJV’s net assets may be transferred to the Chinese party without compensation (thus operating in many respects as a BOT project) so long as the foreign party has been able to recoup its capital contribution during the term of the CJV. Such recoupment typically is funded by excess cash flow generated by accelerated depreciation of the CJV’s assets. Such arrangement requires approval of relevant finance and tax authorities in China. Note that this capital recoupment is separate and distinct from possible priority rights to receive after-tax net profit distributions as outlined in the bullet point above.

(2)   WFOE (Wholly Foreign-Owned Enterprise)

A wholly foreign-owned enterprise (“WFOE”) is a limited liability company 100% owned by one or more foreign entities, although currently most WFOEs only have one investor. During the past several years, WFOEs have become popular investment vehicles especially favored by foreign investors that are more familiar with investment in China because they are totally owned by foreign parties. This usually means that there will be greater flexibility in terms of management and control, and less complexities arising from having to deal with Chinese partners. However, because it is wholly foreign-owned, a WFOE may be subject to more stringent investment restrictions with respect to the types of activities in which it may engage, especially in certain sensitive industries.

(3)   M & A

Under tentative rules jointly issued in March 2003 by Ministry of Commerce (MOFCOM) and other authorities and which became effective in April 2003, a foreign investor may directly acquire an equity interest in an existing domestic enterprise (share deal), and if the resulting foreign ownership share is more than 25% and the investment otherwise complies with the other laws, rules and regulations applicable to FIEs, then the target domestic company can be converted into a new FIE. Alternatively the foreign investor can also acquire assets of a domestic enterprise and inject these into an existing FIE or use such assets to establish a new FIE (asset deal).

The requirements of investing in retailing and distribution by domestic investors and foreign investors used to be different. The threshold for the foreigners to invest in the retailing used to be much higher than that of a domestic investor. However, the Measure states the same threshold to foreigners as domestic investors. Now a foreign-funded commercial enterprise shall meet the following requirements:

1.      The minimum registered capital shall confirm to the relevant provisions of the Company Law, which is only RMB 500,000 now and will be much lower according to the new Company Law taking effect from Jan. 1, 2005.

2.      The company shall confirm to the relevant provisions on the registered capital and total investment of the enterprises with foreign investment;

3.      The term of operation of a foreign-funded commercial enterprise shall not exceed 30 years in general, and the term of operation of a foreign-funded commercial enterprise that is established in the middle and western areas shall not exceed 40 years in general.

Although the threshold for foreign investment in retailing and distribution has become much lower, the establishment of such a foreign funded commercial enterprise still requires examination and approval by the concerned authority. Upon approval, these enterprises may operate the following business:

1.      For the foreign-funded commercial enterprises that undertake retailing business:

(1)   retailing of commodities;

(2)   importing of self-managed commodities;

(3)   purchasing domestic products for export;

(4)   other relevant matching businesses.

The establishment of such enterprises shall be applied to the commercial authority at the provincial level for examination and approval.

2.      For the foreign-funded commercial enterprises that undertake wholesaling business:

(1)   wholesaling of commodities;

(2)   commission agency (excluding auction);

(3)   importing and exporting of foods;

(4)   other relevant matching businesses.

The establishment of such enterprises shall be applied to the Ministry of Commerce and the commercial authority at the provincial level for examination and approval.

The commercial authority will make decision on whether to approve the application within 3 to 4 months from the date of receiving all the application documents. The Certificate of Approval for Foreign-funded Enterprises will be issued if the establishment is approved. The investors shall, within 1 month after receiving the Certificate, go through the registration formalities at the administrative department for industry and commerce. 

However, it shall be noticed that foreign investors cannot take majority ownership of a Chain-store that has over 30 branch stores and engages in the distribution of grain, vegetable oil, sugar.

In order to establish a foreign-funded manufacturing enterprise, it shall apply to commercial authorities at different levels according to its registered capitals:

1.      Less than USD 10,000,000: commercial authorities at county level

2.      More than USD 10,000,000 (including USD 10,000,000 ) and less than USD 50,000,000: commercial authorities at provincial level

3.      More than USD 50,000,000 (including USD 50,000,000 ): the Ministry of Commerce

Notice of the Ministry of Commerce on Matters Relating to Additions to Distribution Business Scope of Foreign Invested Non-commercial Enterprises

In the case of additions to the distribution business scope of a non-commercial foreign invested enterprise, all investing parties in the enterprise shall make changes to the enterprise’s contract and articles of association pursuant to relevant laws, fill out the application forms, notify in accordance with the legal procedures for applying expanded business scope and exchange for the approval certificate for FIEs.  The specific distribution method (wholesaling, retailing or commissioning) shall be identified in the application forms, accompanied with a catalogue of commodities operated by the FIE.

You may have found out that the foreign-funded commercial enterprises are entitled to trading (import-export) rights. However, for Foreign-funded manufacturing enterprises, application shall be filed to the Ministry of Commerce for the trading rights.

The following laws and regulations concern food and drink import and export:

Food Hygiene Law of the People’s Republic of China

Law of the People’s Republic of China on Import and Export Commodity Inspection

Implementing Regulations of the People’s Republic of China on Import and Export Commodity Inspection

Administration Measures on Import and Export Food Label

The Health Department of the State Council is responsible for the nationwide supervision and administration of food hygiene. The General Administration of Quality Supervision, Inspection and Quarantine take the responsibility for the inspection of import and export commodities. Furthermore, the food import and export operator or agent is required to file an application for examination of the food label to designated inspection and quarantine organizations. The import and export food label examination certificate will be issued if all the requirements have been met. It shall be noticed that all imported food label must be in Chinese. Names, the producing place, the factory name, the producing date, the batch number/code number, the specification, the prescription/chief ingredient, the eating/using method of the fixed packaging food and food additive, shall be indicated on the package symbols or instructions for products.

With the above introduction, I would like to leave you with the following idea:

It’s just the right time to invest in China now, not only because you may get preferential treatment since foreign investment is encouraged in China now, but also because China’s re-entry into WTO helps to improve a lot on the market and regulatory environment. However, never be blindly optimistic about the present situation which may lead to unexpected failure, nor ignore the chance before you during such rapidly developing period.

(This speach was delivered on China Food & Beverage Industy Summit on December 2, 2005)