China Joint Ventures: Moving Contractual Liabilities Out of China

November 24, 2009 Posted by China Briefing Reading Time: 5 minutes

Part Six in our “Joint Ventures as a Strategic Investment” series

By Chris Devonshire-Ellis and Richard Hoffmann

NOv. 24 – In this concluding part of our series on China joint ventures we discuss alternatives to the legal pitfalls that can befall a joint venture domiciled in China. On the premise that an investor has read our previous articles on the subject and has conducted due diligence on the partner, we now look at moving the liabilities a JV brings with it out of China, and in also being able to reward your potential partner for doing so. In this article we examine the shortfalls in Chinese law that may influence your decision as regards legal domicile, and make suggestions for following this through.

Ability to effect changes in ownership
One of the issues about Chinese commercial law as it affects businesses is that the decision to make changes to the company, such as equity repositioning or changes to the board composition; do not actually lie in the hands of the shareholders of directors. Government permission must be sought before effecting these changes. This is usually a formality, but has on occasion – mainly politically driven – lead to delays or even refusal by the government to endorse changes in ownership.

Ability to alter the business scope
Likewise, other alterations – such as changing the scope of the business activities, perhaps to domestic sales from an export driven model, or adding new business lines, services and so on must be endorsed by the government rather than the investors. Again, this may not be forthcoming. The Chinese government regulates investment, and licenses may be limited for certain new areas of business it may be prudent to apply for. Licenses may also be granted to preferred competitors rather than your business. In fact, nearly every aspect of an alteration to your company structure or activities in China requires government approval.

Arms length security
Depending upon the circumstances, it may be legally prudent to place an administrative corporate barrier between the China JV and the overseas investment. This provides an additional layer (or more, if really necessary) of security between any untoward events in China and direct exposure to those to the foreign partners holding company. Litigation, insolvency and bankruptcy can be dealt with via a holding company “special purpose vehicle” (SPV) rather than the foreign parent itself. This may help better manage any dispute and reduce liability risks. The costs of bankrupting an SPV under limited liability status provisions may be less than dealing with litigation or liabilities that are directly the responsibility of the foreign parent. Political risks too in sensitive trading areas may also be mitigated for by placing an SPV between the foreign investor and China.

Inability for the Chinese partner to realize dividends offshore
Although by their very nature JVs in China are involved extensively in foreign trade, the ability for the Chinese partner to realize dividends overseas is denied. Profits and dividends for the Chinese partner must be distributed in RMB.

Inability for the Chinese partner to realize royalty payments offshore
The same is also true of royalty payments. These could be many and varied, from technology or brand provision to sales commissions. If solely domiciled in China, these payments can only be made to the Chinese partner in RMB.

Partner disputes
With ownership offshore, disputes do not have to be settled under Chinese law or through the Chinese courts. They can be dealt with instead under (typically) the British-based legal system, which tends to be more impartial and fair to both sides. Having such an arrangement may also reduce the ease on the Chinese side through which disputes can be instigated.

If these or similar situations apply to you, and your Chinese partner is amenable, the structuring of the JV investment can take a different approach. Instead of incorporating the actual JV in China, the Chinese partner can join a joint venture incorporated externally from China’s borders. This could include Hong Kong, Singapore or other offshore jurisdictions. The offshore entity, in which both the foreign partner and Chinese partner invest in, is then used to establish a wholly foreign-owned enterprise in China. The benefits are as follows:

Changes in ownership or directorship do not require Chinese government approval
The business scope can be amended according to the wishes of the investors
Arms length security of China investment is achieved by the foreign investor
The Chinese partner can participate in any royalty / dividends in foreign currency
Disputes between partners can be settled externally from Chinese law (Hong Kong and Singapore for example both use a British-based legal structure)

Tax advantages
There may also be tax advantages in structuring the China investment as an offshore company and a WFOE rather than a JV directly. These may include the payment of royalties, licensing agreements and so on to the SPV at a reduced withholding tax rate as opposed to liabilities from China’s corporate income tax rate. Professional advice needs to be taken in these areas, however, as pointed out these can be beneficial for both parties and not just the preserve of the foreign investor. Attention to detail needs to be taken with this to maximize the tax benefits and to not fall foul of China’s recent policy of questioning the activities of an SPV. However, if the SPV is effectively invested, and directly owns assets in China (the WFOE), the chances of upsetting a WFOE in China for the purposes of challenging the legitimacy of the SPV are limited.

Professional advice
These are just some of the advantages that can be structured into an investment with a Chinese partner held offshore. However, these depend upon and vary from case to case. A good professional firm with international tax knowledge will be able to discuss all the issues with you, assess what needs to be checked through, and allocate dedicated on-the-ground staff to look into the specific tax and legal implications, assess these against available jurisdictions and report back. Successful foreign investors understand this and get it right. We also do not recommend using any services firm that subcontracts out such legal and advisory work and only recommend using firms with a proven track record in handling joint ventures and with applicable resources and offices in China and in pertinent offshore jurisdictions, such as Hong Kong.

Chris Devonshire-Ellis is the founding partner of Dezan Shira & Associates and lived in China for 21 years. He has over 17 years of experience in establishing JVs in China. He is now based in Mumbai.

Richard Hoffmann is a senior associate of Dezan Shira & Associates and has seven years experience of foreign direct investment in China. Richard also writes for the Legal Ease column on the Beijing Review, China’s only English national news magazine. He is based in Beijing.

Sabrina Zhang is the national tax partner at Dezan Shira & Associates and provides domestic and international tax advice to companies wishing to establish operations in China or to hold assets in China via SPVs. She can be reached at tax@dezshira.com.

To contact Dezan Shira & Associates’ business advisory services division for JV advice and other corporate establishment issues email info@dezshira.com.

China Joint Ventures Part Two: Legal Due Diligence

China Joint Ventures Part Three: Financial Due Diligence

China Joint Ventures Part Four: Understanding the Intangibles

China Joint Ventures Part Five: Negotiating the Contract

China Briefing Books:

Setting Up Joint Ventures in China (available in hard copy and PDF)