A Primer on Foreign Investments, Investment Structures & Special Development Zones in China

June 2011 Chinas economic strength continues to attract a growing number of first-time China investors. This memorandum presents a general introduction to: investments by foreign investors in China; the various investment structures that may be utilized by such foreign investors; and Chinas special development zones and their significance for foreign investors.

If foreign investors want to invest in China, it is important that they conduct extensive due diligence beforehand and become more familiar with the contents of this memorandum. This memorandum is not intended to address all the possible issues in connection with foreign investments in China and is meant only to be a general exposition of the contents herein. Should you have any questions in connection with this memorandum, please contact us. I. FOREIGN INVESTMENTS A. LIMITATIONS ON FOREIGN INVESTMENTS

The nature of a foreign companys investment activities in China will largely dictate its options for an appropriate investment structure, the level of government scrutiny, and whether it may or may not be subject to preferential treatment. The Foreign Investments Industrial Guidance Catalogue (the Foreign Investment Catalogue) published by the Ministry of Commerce (MOFCOM) and the National Development and Reform Commission (the NDRC) categorizes foreign investment into specific sectors as either encouraged, permitted, restricted, or prohibited.

This memorandum has been prepared by Cadwalader, Wickersham & Taft LLP for informational purposes only and does not constitute advertising or solicitation and should not be used or taken as legal advice. Those seeking legal advice should contact a member of the Firm or legal counsel licensed in their state. Transmission of this information is not intended to create, and receipt does not constitute, an attorney-client relationship. Confidential information should not be sent to Cadwalader, Wickersham & Taft LLP without first communicating directly with a member of the Firm about establishing an attorney-client relationship.

Foreign investments in encouraged sectors are normally eligible for various incentives and investors are permitted to utilize various investment structures. In general, sectors that involve advanced or new technologies are encouraged. Foreign investment in restricted sectors, however, are subject to strict examination by government authorities, and the investment structure options may be limited such that a majority Chinese partner may be required. Restricted investment sectors commonly include banking, insurance, securities services, certain manufacturing sectors, and investments in areas that are technologically undeveloped, or belong to certain sectors that are gradually opening up in China. Prohibited sectors are not open to foreign investors and include industries that may threaten the public interest and/or national security, or may cause serious environmental damage. If a sector is not mentioned in the Foreign Investment Catalogue, then foreign investment in that sector is generally permitted. B. APPROVAL AUTHORITIES

All foreign investments in China are subject to the approvals of various governmental agencies, even where the foreign-invested enterprise (FIE) will not engage in a regulated business sector. A number of factors determine which government authority has jurisdiction to grant approval. MOFCOM must approve the establishment of a FIE. When the total investment amount of a FIE reaches certain thresholds, the approval of the NDRC will also be required. Usually, MOFCOM will work with the NDRC to ensure compliance with the Foreign Investment Catalogue and consider other policy considerations. The investment amount may also dictate whether provincial, municipal, or district-level approvals will apply. For foreign exchange issues, the approval of the State Administration of Foreign Exchange (SAFE), or its local counterpart, is required. For land use and real property matters, the approval of the State Land Administration Bureau or its local counterpart is necessary. For joint ventures (JV) where a Chinese state-owned enterprise (SOE) contributes tangible assets as its capital contribution to a JV, the State Administration of State-Owned Assets Commission will be involved in approving the asset appraisal and contribution. Specific and preferential tax treatment is approved by the State Administration of Taxation along with Chinas State Council.

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In certain sectors, special approvals may be necessary in connection with the FIEs scope of business. Chinese enterprises are required to have a narrowly defined business scope, and if the business described falls under the supervision of a particular government agency, approval from that body in addition to general approval from MOFCOM may be required. II. FOREIGN INVESTMENT STRUCTURES

Foreign investors in most sectors have various foreign investment structure options. As each structure presents relative advantages and disadvantages, investors must carefully select a suitable structure based on both legal and commercial considerations. Having the correct legal structure at the beginning and receiving the right legal advice regarding the same is crucial and can save a lot of complications and wasted effort and time down the line. Foreign investment in China always begins with an offshore corporate holding structure in a taxfavorable jurisdiction like the Cayman Islands or the British Virgin Islands, commonly followed by a second-layer offshore holding company established in Hong Kong to take advantage of the favorable withholding tax arrangements between Hong Kong and China. Discussions on these offshore structures is outside the scope of this memorandum, but, basically, these offshore holding structures allow for two things: (1) they permit indirect ownership changes in the Chinese onshore investment without requiring Chinese regulatory approval; and (2) they permit a future listing in an international stock exchange. We will now discuss the various onshore structure options below. A. TRADITIONAL ONSHORE INVESTMENT STRUCTURES 1. Joint Ventures Chinese law provides for two different types of JVs: (1) an equity joint venture (EJV); and (2) a cooperative joint venture (CJV). The foreign investor(s) co-invest(s) with one or more local Chinese entities to form a new JV entity. EJVs are independent legal persons with limited liability, and CJVs are generally in this form as well. The Foreign Investment Catalogue lists various sectors in which the foreign investment must be in the form of a JV. JVs may be preferable where the foreign company needs a partner to share the initial capital investment. Moreover, Chinese companies may have certain technologies, distribution capabilities, or other attributes that make them attractive foreign JV partners. This may be particularly true in industries where a SOE may be the principal customer. The challenges

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associated with JVs include unanimous board approval requirements and the integration of corporate cultures. EJVs are established on the principle of strict proportionality, such that dividends and shares in the residual assets of the JV after dissolution are distributed strictly in proportion to the parties' contributions to the JV's registered capital. Representation on the JV's board of directors and board of supervisors also tends to be allocated in proportion to the registered capital contributions. CJVs are more flexible, allowing one or more parties to contribute cooperative conditions instead ofor in addition tocash or readily appraisable in-kind assets. Such terms of cooperation may consist of access to or use of certain assets and/or rights that cannot be, or are not, assigned formally to the CJV. These include market access rights or undertakings to supply certain services that will promote the business prospects of the CJV. In the most common scenario, the Chinese party provides non-equity cooperative conditions in exchange for an agreed share of the profits while the foreign party contributes all of the traditional registered capital in the form of cash or other permitted contributions. The distribution of dividends, residual asset shares, and participation in the governance of a CJV reflect the terms of cooperation by contract rather than the proportion of registered capital contributions. 2. Wholly Foreign-Owned Enterprises The wholly foreign-owned enterprise (WFOE) structure provides a foreign investor full control of the business and entitlement to any profits that are not taxed by the PRC government. However, the foreign investor also bears all the risks within the context of limited liability. One of the main attractions of the WFOE is that it takes less time to establish than a JV because the foreign investor does not need to select a suitable local partner or negotiate a JV contract. Furthermore, many foreign investors find it much easier to recruit, train, and retain employees when the foreign investor is in full control. The autonomy to manage employees also reduces the likelihood of intellectual property erosion, a key issue for many foreign companies investing in China. It should be noted that WFOEs do not eliminate the need to work with non-equity Chinese partners. For most foreign companies, local managers and personnel are essential to navigating local market conditions and customer relationships, understanding rules and regulations, establishing distribution channels, and managing governmental regulatory affairs. Not all sectors are open to investment by means of a WFOE. Foreign investors in sectors subject to particular foreign investment constraints, such as telecom and publishing, may consider investing

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through WFOEs established as consulting companies. Such WFOEs contractually control most business aspects of the licensed business but are formally owned by Chinese investors. 3. Foreign-Invested Partnerships The foreign-invested partnership (FIP) is a new investment structure and is particularly attractive in the private equity and venture capital industries for establishing Renminbi (RMB)-denominated funds. A FIP may be established without the approval of MOFCOM and may be directly registered with the State Administration of Industry and Commerce (AIC). FIPs are not subject to dual taxation and may receive limited liability. Non-Chinese enterprises and individuals may both be partners of the partnership. There are no statutory governance structures and the operation of a FIP is largely based on the partners contractual terms. Partners may make contributions to a FIP in freely convertible non-Chinese currencies or in RMB obtained legally in China. Non-currency contributions are also permitted and there is no ceiling on non-cash contributions by FIP partners. Moreover, the timing of capital contributions is not subject to statutory time limits. FIPs are new and many of the legal issues of this investment structure remain unclear. B. COMMON ALTERNATIVE INVESTMENT STRUCTURES 1. Representative Office A representative office is not recognized under Chinese law as an independent legal entity. Therefore, it does not have the legal standing to enter into contracts with other entities on behalf of its parent company. The parent company will be legally responsible for the activities of the representative office. A representative office has no capital contribution requirement. Representative offices are prohibited from engaging in direct business activities and are restricted only to liaison activities, market research, and preliminary investigations on behalf of the parent company. Finally, representative offices are not permitted to directly hire local staff. It may only do so through an official employment services company such as Foreign Enterprise Human Resources Service Co., Ltd.

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2. Foreign-Invested Venture Capital Enterprises Venture capital investors may establish a foreign-invested venture capital enterprise fund (FIVCE) with one or more Chinese partners. The fund is a Chinese entity and its investments are denominated in RMB. The principle advantage to the FIVCE investment vehicle is that it can deploy funds directly and quickly to Chinese portfolio companies without establishing an offshore structure. The FIVCE can invest in Chinese portfolio companies listed on Chinese stock exchanges but not on an offshore stock exchange such as the NASDAQ or the Hong Kong Stock Exchange. There remain uncertainties regarding the tax treatment of the foreign fund upon exit from a FIVCE. 3. Foreign-Invested Companies Limited By Shares A foreign-invested company limited by shares (FICLS) is a FIE with its capital divided into shares of equal value and equal voting rights. The FICLS structure allows Chinese partners to invest through companies or as individuals. This structure may facilitate capital formation by allowing the issuance of additional shares to existing or new shareholders which can promote employee retention by creating an employee stock-ownership arrangement. Board and shareholder unanimity is not required; however, a twothirds majority is required. A FICLS is subject to higher capital requirements and its founders are restricted to a three-year lock-up period during which they cannot dispose of their shares. A FICLS may be newly established or converted from an existing FIE. In the case of conversion, the company must satisfy several requirements, including demonstrating that the existing Chinese company has been profitable for at least three consecutive years. In practice, a FICLS is better suited as a vehicle to acquire less than 100 percent interest in a profitable existing business rather than as a greenfield investment. 4. Foreign-Invested Holding Companies A foreign-invested holding company (FIHC) is a EJV or a WFOE that is expressly permitted to hold interests in other FIEs in China. Foreign investors with multiple projects and large capital investments may utilize a FIHC to centralize operations and be a regional headquarters. A FIHC can engage in only a limited number of activities such as providing support services like the consolidation of sales, research and development, and back office functions (but not the filing of consolidated tax returns).

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This structure allows the words "holding company" and "China" to be included in the FIHC's name, whereas Chinese law generally restricts other structures from using these terms in their names. 5. Compensation Trades Activity in compensation trades has been rapidly developing in recent years and commonly involves natural resources, chemicals, light textiles and electronics. It essentially consists of a barter transaction. The Chinese party produces a product, processes materials or assembles parts with foreign machinery, equipment, or technology provided by the foreign party. Typically, the foreign party provides manufacturing equipment and retains title to all imported materials and the final processed product while the Chinese party receives a fee or a portion of the finished goods for its work. The parties can negotiate which party retains the manufacturing equipment at the end of the term of the arrangement. Foreign investors are attracted to this structures tax advantages, contractual flexibility, and the absence of having to manage Chinese labor issues. III. SPECIAL DEVELOPMENT ZONES

Chinas various special development zones enjoy unique economic policies and more flexible governmental measures. Such policies and measures allow these zones to offer more flexible economic arrangements and lower tax rates than in other areas of mainland China. Today, these special development zones include Special Economic Zones, Coastal Development Zones, Free Trade Zones, Economic and Technological Development Zones, High Technology Industrial Development Zones, and Chinas Great Western Development Area. The Chinese government, at the central, provincial and local levels, accords these special development zones with very high priority, and began to establish and promote these zones in the 1980s. The preferential policies of these special development zones serve two primary purposes. First, such zones develop a foreign-oriented economy, generating foreign exchange through exporting products and importing advanced technologies. Second, such zones serve to accelerate inland economic development. There are many benefits for foreign investors considering the establishment of operations in such special development zones. For example, foreign companies may receive preferential treatment by foreign exchange bodies for remitting foreign-invested corporate income and foreign employees personal income overseas. Furthermore, import tariffs may be exempted if a FIE purchases equipment, spare parts, raw materials, transportation facilities, and other means of production from overseas. Moreover, foreign experts, employees, and their families can be provided with certain privileges when applying for entry-exit permits through local immigration bureaus.

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Many foreign investors choose to invest in these special development zones largely as a result of special tax incentives and greater independence on international trade activities. Manufacturing companies operating in these zones may be granted a reduced tax rate of 15% with a full tax exemption during the first two (2) years and a 50% reduction in taxes during the following three (3) years. Foreign-invested service companies and banks may also benefit from tax concessions but are subject to special regulations when operating in these zones. Like many foreign investments in China, the common investment vehicles utilized by foreign investors in these special development zones are JVs and WFOEs. Many of these special zones are geared toward exporting processed goods and serve to integrate science and industry with trade. Key industries include automotive, bio-pharmaceutical, food and beverage, new energy and materials, equipment manufacturing, petro-chemical, aviation, and outsourced services. IV. CONCLUSION

Foreign investors interested in making an onshore investment in China must conduct careful due diligence. This involves planning their onshore structuring needs very carefully, understanding how government agencies such as MOFCOM and the NDRC regulate various facets of the investment process, being cognizant of the Foreign Investment Catalogue and how certain fields of investment are restricted in China, and understanding the advantages and disadvantages of investing in special development zones.

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If you have any questions about the foregoing, please contact:

Rocky T. Lee
Asia Managing Partner and Head of the China Corporate Practice

+86 10 6599 7200 rocky.lee@cwt.com

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