FUNDING AND INVESTMENT
Opportunities for Foreign Investment in the Distribution Sector in China
January 24, 2007
Franki Cheung, Deacons

China traditionally restricted foreign investment in the retail and wholesale sectors with the aim of nurturing strong domestic players before their foreign counterparts were allowed into the country. Since becoming a member of the World Trade Organisation, China has gradually opened up its distribution sector to foreign investment. The revised policy is implemented through a number of regulations of which the key ones are the Measures for the Administration of Foreign Investment in the Commercial Sector (Commercial Measures), effective from 1 June 2004, and the Notice of the Ministry of Commerce on Entrusting Local Authorities with the Examination and Approval of Commercial Enterprises with Foreign Investment, effective from 1 March 2006. These developments in the distribution sector go hand in hand with other policy changes that have given foreign investors greater access to foreign trade rights.

Commercial Foreign-invested Enterprises (FIEs)

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 foreign-invested commercial enterprise if it wishes to engage in these distribution activities. The investors in commercial FIEs can be foreign companies, enterprises or other economic organisations as well as foreign individuals.

Foreign investors may establish a commercial FIE in partnership with a Chinese counterpart in a joint venture or on their own in a wholly foreign-owned enterprise. A restriction, which was lifted on 11 December 2006, prohibited some commercial FIEs from being wholly owned by a foreign investor. Previously, a commercial FIE with more than 30 outlets dealing in specified products of various brands that are sourced from multiple suppliers needed to take the form of a joint venture in which the maximum share of the foreign investor was limited to 49%. The specified products are books, magazines, motor vehicles, newspapers, pharmaceuticals, pesticides, mulching film, chemical fertilizer, processed oil, grain, vegetable oil, sugar, cotton, etc.

Conditions

The foreign investor is required to have a good reputation and be law-abiding. Whereas the statutory requirement is that a commercial FIE engaging in wholesale or retail activities has a minimum registered capital of only RMB30,000 (about US$3,730), the authority in charge of approving the establishment may impose a higher registered capital requirement to match the proposed scale of the business activities of the commercial FIE. The investment must comply with the minimum debt to equity (registered capital) ratios imposed under PRC law unless the commercial FIE deals in agricultural by-products and agricultural production materials. The term of operations should normally not be longer than 30 years but may be as long as 40 years in the central and western regions of China.

Permitted Business Activities

A retail commercial FIE may engage in the following business activities:

• commodity retailing
• commodity import for its own account
• sourcing of domestic products for export
• other relevant ancillary activities

A wholesale commercial FIE may engage in the following business activities:

• commodity wholesale
• commission agents' services (except for auctions)
• commodity import-export
• other relevant ancillary activities

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

Franchising

The Commercial Measures do not contain detailed guidelines regarding the operation of franchising business. According to the Measures for the Administration of Commercial Franchising Operations (Franchising Measures), effective from 1 February 2005, a franchisor must have operated two directly owned stores in the PRC for at least one year before it may lawfully grant franchises. The Franchising Measures are silent on the principles governing the grant of franchises by overseas franchisors to franchisees inside the PRC. It is expected that relevant regulations will be issued in due course.

Range of Products

A commercial FIE must specify the range of products it distributes in the business scope of its corporate establishment documents. A commercial FIE 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 commercial FIE deals are products subject to special State regulations or are import-export products, which are subject to quota or licensing control, the commercial FIE must comply with the relevant licensing requirements.

Establishment Procedure'

While the Ministry of Commerce (MOFCOM) is the principal approval authority for commercial FIEs, it has delegated its approval powers with respect to most types of commercial FIEs to the provincial commerce authorities. Within the scope of these delegated powers, the provincial commerce authorities can autonomously approve the establishment of commercial FIEs and they are only required to report the matter for the record to MOFCOM. MOFCOM has reserved the right to approve itself the establishment of a commercial FIE in either of the following circumstances:

• Its mode of operations involves sales through television, telephone, mail order, Internet or automatic vending machines, etc.
• 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, pharmaceuticals, motor vehicles, pesticides, mulching film, salt, tobacco, grain, vegetable oils, edible sugar or cotton

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

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

Establishment of Outlets

Commercial FIEs may set up shops or outlets on condition that their establishment complies with regulations regarding urban development and urban commercial development. An already established commercial FIE 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 commercial FIEs. Provincial commerce authorities are authorized, 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 commercial FIEs
• 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 commercial FIEs
• The area of a single outlet does not exceed 300 square meters
• The provincial commerce authorities are only required to report the approval of such 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 that Mainland China has concluded with Hong Kong and Macau. SAR suppliers are permitted to establish wholly-owned car retailers without any restrictions.

Hong Kong service suppliers are permitted to operate commission agents' services in respect of chemical fertilizer, processed oil and crude oil, and wholesale and retail services in respect of chemical fertilizer, on a wholly-owned, equity joint venture, or contractual joint venture basis.

There are also preferential treatment for a Hong Kong service supplier who opens more than 30 stores on the Mainland to retail books, newspapers, magazines, motor vehicles, pharmaceuticals, pesticides, mulching film, chemical fertilizers, staple food, vegetable oil, edible sugar and cotton. If those goods are of different brands and come from different suppliers, the Hong Kong service supplier may be the controlling shareholder in the commercial FIE, with a maximum shareholding of 51%.

Looking Ahead

China's continuing rapid economic growth is generating an urban middle class of increasingly sophisticated consumers who are demanding higher quality products, better access to those products and an improved retail shopping experience.

With a majority of the global top 50 retailers now in China, foreign invested retail operations only accounted for a mere 2.6% of total retail sales in 2004. There are still many opportunities for foreign investors to get a seat at the table in one of the most exciting distribution sectors in the global economy, but determining the right strategy and finding the right investment vehicle remain important considerations.

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