An Update On The Opportunities For Foreign Investment In The Distribution Sector In Mainland China

Tuesday, March 31, 2009 - 00:00

China has traditionally restricted foreign investment in the retail and wholesale sectors with the aim of nurturing strong domestic players before their foreign counterparts would be allowed to enter the country. Since becoming a member of the World Trade Organisation on 11 December 2001, China has gradually opened up its distribution sector to foreign investment.The revised policy has been implemented through a number of regulations of which the key one is the Measures for the Administration of Foreign Investment in the Commercial Sector ("2004 Commercial Measures"), effective from 1 June 2004.

Major Changes Introduced By The 2004 Commercial Measures

Before the 2004 Commercial Measures, foreign investors could not set up wholly-foreign-owned enterprises to engage in retail or wholesale activities in China.In order to engage in retail or wholesale activities in China, foreign investors' only option was to set up a joint venture company with a Chinese party and the foreign investor's share in the joint venture company was subject to a maximum cap.In addition, the proposed joint venture companies should at least have a registered capital of RMB50,000,000 (for retail companies) or RMB80,000,000 (for wholesale companies).Both thresholds would be reduced by RMB20,000,000 if the joint venture companies were to be set up in the central or western regions of China.The granting of a franchise for the purpose of setting up new retail outlets was also prohibited.

Pursuant to the 2004 Commercial Measures, foreign investors can set up wholly-foreign-owned enterprises to engage in retail and/ or wholesale activities in China (except for a number of specified products) since 11 December 2004.The 2004 Commercial Measures has also removed the abovementioned minimum registered capital requirements and the restriction on franchise operation.

A major supplement to the 2004 Commercial Measures is the Notice of the Ministry of Commerce on Entrusting Local Authorities with the Examination and Approval of Commercial Enterprises with Foreign Investment ("2006 Approval Notice"), effective from 1 March 2006, by which the Ministry of Commerce ("MOFCOM") has delegated some of its approval powers to the provincial level departments in charge of commerce ("provincial commerce authorities").

This article discusses the key elements of the regulatory framework for foreign investment in the distribution sector in China.

Foreign Investment Commercial Enterprise ("FICE")

In this article, FICE refers to foreign investment enterprises (whether in form of a wholly-foreign-owned enterprise or a joint venture) which are established pursuant to the 2004 Commercial Measures.

Foreign investors are permitted to engage in four forms of distribution activities:

• commission agents' services;

• wholesaling;

• retailing; and

• franchising.

A foreign investor is required to establish a FICE if it wishes to engage in these distribution activities. The investors in FICE can be foreign companies, enterprises or other economic organisations as well as foreign individuals.

Foreign investors may establish a FICE in partnership with a Chinese party as a joint venture or on their own as a wholly-foreign-owned enterprise. However, not all FICE may be wholly-owned by a foreign investor. A FICE with more than 30 outlets dealing in certain specified products of different brands that are sourced from different suppliers must take the form of a joint venture in which the maximum share of the foreign investor is limited to 49%. The specified products are pharmaceutical products, pesticides, mulching films, chemical fertilizers, processed oil, staple food, vegetable oil, edible sugar and cotton.

Also, FICE are prohibited from engaging in the wholesale sale of salt and tobacco and in the retail sales of tobacco.

Conditions

The foreign investor should have a good reputation and comply with PRC law.Whereas the statutory requirement is that a FICE has a minimum registered capital of only RMB30,000 (about US$4,390), the authority in charge of approving the establishment may impose a higher registered capital requirement to match the proposed scale of business of the FICE. The investment must comply with the minimum debt to equity (registered capital) ratios imposed under PRC law. The term of operation should not normally be longer than 30 years but may be extended to 40 years if the FICE is established in the central and western regions of China.

Permitted Business Activities

A retail FICE may engage in the following business activities:

• commodity retailing;

• commodity import for its own account;

• sourcing of domestic products for export; and

• other relevant ancillary activities.

A wholesale FICE may engage in the following business activities:

• commodity wholesale;

• commission agents' services (except for auctions);

• commodity import-export; and

• other relevant ancillary activities.

A FICE may engage in one or more of the business activities set forth above and may authorise third parties to open franchise shops.

Franchising

The 2004 Commercial Measures does not contain detailed guidelines regarding the operation of franchising business.According to the Regulations for the Administration of Commercial Franchising Operations ("2007 Franchising Regulations"), effective from 1 May 2007, a franchisor must have operated two directly owned stores for at least one year before it may lawfully grant franchises. The franchisor can be a foreign entity.

Franchising activities in China must be reported to MOFCOM or the provincial commerce authorities within 15 days from the signing of the first franchising agreement.The franchisor is also statutorily required to disclose certain specified information concerning the franchising arrangement to the franchisee at least 30 days before a franchising agreement is signed.

Range Of Products

A FICE must specify the range of products it distributes in the business scope of its corporate establishment documents. A FICE is only permitted to deal in those types of products listed in its business scope.

The import and distribution of certain categories of products in China are subject to various forms of state control. If the products in which a FICE deals are products subject to special state regulations or are import-export products that are subject to quota or licensing control, the FICE must comply with the relevant quota or licensing requirements.

Establishment Procedure

Whilst MOFCOM is the principal approval authority for FICE, it has delegated its approval powers with respect to most types of FICE to the provincial commerce authorities pursuant to the 2006 Approval Notice. Within the scope of these delegated powers, the provincial commerce authorities can autonomously approve the establishment of FICE and they are only required to report the matter to MOFCOM for record.A FICE is still subject to MOFCOM approval if:

• its mode of operations involves sales through television, telephone, mail order, internet or automatic vending machines, etc.; or

• it distributes important industrial raw materials such as steel, precious metals, ironstone, fuel oil, natural rubber or products such as books, newspapers, periodicals, processed oil, pharmaceutical products, motor vehicles, pesticides, mulching films, chemical fertilizers, staple food, vegetable oil, edible sugar and cotton.

In those instances where approval by MOFCOM is required, an application for the establishment of a FICE must be submitted first to the provincial commerce authority in the proposed investment location. After preliminary examination, the provincial commerce authority will forward the application to MOFCOM within one month. MOFCOM will then have three further months to decide whether or not to approve the application.

If an existing foreign investment enterprise intends to expand its business scope to include distribution rights and become a FICE, it must proceed in accordance with the approval procedure and principles for the establishment of a new FICE set forth above.

Establishment Of Outlets

FICE may set up shops (outlets) on condition that their establishment complies with the regulations regarding urban development and urban commercial development. An existing FICE may only set up a new outlet if it has passed the annual inspection and has paid up its registered capital in full.

MOFCOM is the approval authority for the opening of new outlets by FICE. Provincial commerce authorities are authorised, however, to approve new outlets in the following three situations:

• the area of a single outlet does not exceed 5,000 square meters and there are not more than three outlets in total, and the foreign investor has not opened more than 30 outlets in the same class in China through FICE; or

• the area of a single outlet does not exceed 3,000 square meters and there are not more than five outlets in total, and the foreign investor has not opened more than 50 outlets in the same class in China through FICE; or

• the area of a single outlet does not exceed 300 square meters.

Under the above circumstances, the provincial commerce authorities are only required to report the approval for the establishment of outlets to MOFCOM.

Special Provisions Regarding Hong Kong and Macau Service Suppliers

Qualified Hong Kong and Macau service suppliers (collectively referred to as "SAR suppliers") are granted greater access to the distribution sector than other service suppliers under the provisions of the Closer Economic Partnership Arrangements which Mainland China has concluded with Hong Kong and Macau. For example, SAR suppliers are permitted to establish wholly-owned car retailers.

As mentioned above, a FICE with more than 30 outlets dealing in certain specified products of different brands that are sourced from different suppliers must take the form of a joint venture in which the maximum share of the foreign investor is limited to 49%. However, there are preferential treatments for a Hong Kong service supplier who/which has opened more than 30 stores accumulatively inMainland China to engage in distribution of pharmaceutical products, pesticides, mulching films, chemical fertilizers, vegetable oil, edible sugar and cotton on a wholly owned basis if those goods are of different brands and come from different suppliers.

The Outlook For Foreign Investment In The Distribution Sector In China

Since the introduction of the 2004 Commercial Measures, a wholly-foreign-owned enterprise has been the most popular way by which foreign investors set up FICE notwithstanding the restriction on certain specified products.According to the latest available statistics published by MOFCOM, 90% of the new FICE set up in 2007 were wholly-foreign-owned enterprises and only 10% of them were joint venture enterprises.

6,338 FICE were established in 2007, which is a 79% increase from the 2006 figure of 3,548.The amount of foreign capital invested in FICE in 2007 was US$2.68 billion, being a 49.58% increase from the 2006 figure.

In terms of the amount of capital invested in FICE in 2007, the top five foreign investors were from Hong Kong (33.63%), British Virgin Islands (19.47%), Japan (8.91%), Cayman Islands (3.68%) and Korea (3.5%).In 2007, investors from ten Asian countries/ regions (i.e. Hong Kong, Macau, Taiwan, Japan, the Philippines, Thailand, Malaysia, Singapore, Indonesia and Korea) invested US$1.4 billion (85.03% increase compared with 2006), EU investors invested US$277 million (0.7% increase compared with 2006), and US investors invested US$81 million (18.15% reduction compared with 2006) in FICE.

According to the preliminary estimation of the National Bureau of Statistics of China, the total sale of the wholesale and retail businesses in China in 2008 was RMB9,120 billion, an increase of 21.5 % from the 2007 figure.

There has been a rapid consumption growth in China as a result of a rapid rise in the disposable income of the Chinese people and their increasing acceptance of new lifestyles and buying habits similar to those of their western counterparts. The gross domestic product (GDP) of China in 2008 was RMB30,067 billion, a 9% increase from the 2007 figure. The per capita disposable income of urban households in the first half-year of 2008 was RMB8,065, which represents a year-on-year increase of 14.4% and a real growth of 6.3% absent the inflation factor. However, the contribution of domestic household spending to China's GDP is still well below the average proportion in other countries.While the current global financial crisis is expected to have a negative impact on recent growth trends in China's distribution sector, in the short term at least, there are still plenty of business opportunities in the wholesale and retail sector of China for foreign investors to explore.

Peggy Chow is an Associate in the Deacons' China Practice Group. She specialises in matters relating to foreign direct investments in China. Franki Cheung is the Head of Deacons' China practice group. He has more than 20 years of experience in China trade and investment matters.

Please email the authors at franki.cheung@deacons.com.hk with questions about this article.