The Third Road to China: Foreign-invested Partnerships

By Dezan Shira & Associates
Editor: Steven Elsinga

Most foreign investors in China are familiar with the two main vehicles of investing in the country: the joint venture (JV) and the wholly foreign-owned enterprise (WFOE).

An often overlooked third option is the foreign-invested partnership, which was introduced in 2010. As the name suggests, this entity requires two or more investors to conduct business together. The option would therefore not work for foreign investors looking to set up an entity over which to have 100 percent control.

Foreign-invested partnerships can consist of several foreign partners, or foreign and Chinese partners. The partners may be natural persons or legal entities.

Introduction: WFOEs and JVs

Separate legal entity

When investors set up a company in China, they create a separate legal entity with its own name, assets and liabilities. Being distinct from the individual investors, it pays its own taxes on the profits it makes. When these profits are distributed to investors, the investors pay dividend tax. This has been termed as double taxation, as tax needs to be paid twice on the investment. First when the company makes a profit, and second when the investor receives dividends.

A country’s company laws strictly manages the internal management and external dealings of a company in order to protect its creditors. Since the investors and the corporate entity are two separate beings, the creditors cannot seek recourse with the investors if the company cannot repay its debts: it is a company debt, not the investor’s debt. One of the remedies against this lack of protection is the requirement to have a minimum amount of registered capital so that there are some funds available for creditors to claim.

As a way to solidify the independence of a company, the investors may not directly run the company themselves. When they set up a company, they become shareholders, and need to appoint a board of directors to conduct the company’s daily activities. The interests of those who own the company (shareholders) and those that run it (board of directors) can give rise to problems of corporate governance. Again, these relations are regulated in a country’s company laws.

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How a partnership is different

A partnership is a contractual arrangement

A partnership is not a separate legal entity, but a contractual arrangement between two or more parties to do business together under a common name, that is registered as such with the government. Instead of having to stay within the boundaries of the Company law, a partnership affords investors broad freedoms to make internal arrangements as they see fit. For example, the profit shares and voting rights need not be aligned with the investor’s capital contribution.

While the Partnership Enterprise Law says that in principle, the unanimous approval of all other partners is needed when a partner sells their share in the partnership, investors are free to stipulate otherwise in the agreement. It can therefore be much easier to transfer one’s participation in a venture that way.

While it’s not an independent entity in the full sense of the term, by law, agreements that meet the criteria of a partnership have features that strongly resemble a separate legal personality.

For instance, in a sense partnerships do have the capacity to own property. This partnership property consists of the partners’ contributions, profits and assets it purchased, and is jointly owned by the partners. The partners cannot sell partnership property without the consent of the other partners.

External liability

For debts of the partnership, the creditors must first turn to the partnership’s property. If the partnership property is not sufficient to repay the debts, the partners are jointly liable for the debts. This means any creditor can sue any partner for the full amount of the partnership debt. That partner can then seek recourse with the other partners for compensation according to the share of each.

If a company has insufficient funds to repay its debts, the creditors are left with nothing. If a partnership is in the same situation, the creditor can sue any of the partners for its debts. Since the creditor is in a better position here, there is less need to have measures in the law to protect creditors. As such, foreign invested partnerships have no minimum registered capital requirements.

Contributions

Investors are free to stipulate the terms of capital contributions, such as who contributes what amount and what the time frames are. Unlike with a WFOE or JV, the amount of resources an investor contributes need not be linked to its share in profits or voting rights. Similarly, the partners have much more leeway in determining when and how to distribute partnership profits. Repatriating profits is not as challenging as would be the case with a JV or WFOE.

Contributions may consist of cash, intellectual property, land use rights, labor or services, assets in kind or other property rights. Unlike with the JV and the WFOE, cash contributions may be done in RMB as well.

As there are no government requirements on contributions, a foreign company can become active in China without having to commit too many resources. It can negotiate a certain level of voting or profit rights, irrespective of how much capital it contributes. 

If a partner leaves the partnership, its contribution should be returned, its share of the profits paid out, and deducted by its share of the losses. 

The foreign invested partnership is particularly interesting for foreign companies that want to cooperate with a Chinese partner without having to shed too much control, or surrender intellectual property. As said, intellectual property contributions are returned to the partner if it decides to leave. 

External relations

In a partnership, the partners own the company, but they also run it. Each partner individually is authorized to represent the partnership, and bind it contractually.

However, the partners are free to provide further rules in the partnership agreement, such as that decisions need a majority vote, the consent of at least two partners, the consent of a third party or even unanimity.

These rules only bind the partners internally. If one of the partners signs a contract without following the internal rules, it still binds the partnership. The counterparty has no way of knowing what a partnership’s internal rules are, and may assume the partner is representing the partnership. Investors should note that this is even the case when a partner sells an asset belonging to the partnership, provided the counterparty is acting in good faith. The risk of abuse here is obvious, and should be closely paid attention to.

The other partners do have the right to seek recourse on the partner that violated the internal agreement. If there is unanimous approval among the remaining partners, there may even be grounds to remove that partner.

Tax

Since the partnership is not an entity of its own, it does not pay income tax. Instead, the partners pay tax on the share of the profits they receive. Where the partner is a corporation, it pays Corporate Income Tax. Partners that are natural persons pay Individual Income Tax. This essentially eliminates the double taxation that is otherwise present when investing through a limited liability company, such as a WFOE or JV. Using a Foreign-invested Partnership allows investors to reap significant tax savings.

The partnership does need to pay turnover tax (VAT and Business Tax) and Customs Duties like other companies.

RELATED: Setting Up a Wholly Foreign-Owned Enterprise in China

Restrictions

The Chinese government maintains a list of industries where foreign investors may not invest. Some sectors are completely off-limits; others require a Chinese equity partner or be its majority shareholder.

Foreign-invested partnerships may only invest in industries that are not in any way catalogued as restricted. The rationale of the Catalogue is to prevent foreign entities from having too much control over sensitive sectors of the Chinese economy. The flexibility that the foreign-invested partnership affords would defeat that purpose, as the partnership agreement could circumvent the control requirements laid down in the Catalogue.

Set-up requirements

The procedure for setting up a partnership is faster than that of the WFOE or JV. It does not require approval from the Ministry of Commerce.

Conclusion

Foreign-invested partnerships offer a lot of flexibility to investors unhappy with the restrictions imposed on other vehicles. The partnership agreement gives parties more freedom to determine internal decision-making arrangements, as well as contributions.

The partnership can be set up more quickly than a company, and allows a foreign business to become active in China without locking in too many resources. Chinese legislators created the foreign-invested partnership in 2010 with the express purpose of attracting foreign know-how and management experience, not capital.

It is often beneficial from a fiscal perspective as well. However, there are potential risks involved in the relationship with the other partners in the partnership. If no proper safeguards are in place, a partner might dispose of partnership assets without approval. Unauthorized debts may exceed the partnerships assets, leaving the foreign investor exposed to liability. Proper due diligence and a well-designed partnership agreement are crucial.

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