Investing in Shenzhen Special Economic Zone - Math Problem Example

MEMORANDUM TO: CEO, JR International, Inc. FROM: General Counsel, JR International, Inc. DATE: 27 April 2012 SUBJECT: Investing in Shenzhen Special Economic Zone (SEZ) STATEMENT OF FACTS The government of Shenzhen, a city located in the southern province of Guangdong, China, has invited JR International, Inc. to invest in its Special Economic Zone (SEZ). Two areas of investments are being considered: a hotel project, and; a manufacturing project. JR is a multinational with main headquarters located in Texas and is engaged in the hotel industry as well as in semiconductor manufacturing. After conducting a feasibility study, JR is ready to invest in both projects for a total of $125 million only, instead of the $250 million required including the supporting infrastructures to both projects. ISSUES 1. Given the limit on the total investment is $125 million, what are the alternative forms for the structure, financing and management of the hotel project, the manufacturing project, and the advantages and disadvantages of each alternative? What is your recommended alternative for the projects and why? 2. What other concerns/issues should JR be aware in bringing this alternative into operation, including legal measures to protect its intellectual property interests in the projects? 3. What kind of incentives could the SEZ provide to JR for the hotel and manufacturing projects? 4. If a controversy arises in respect of all the alternatives considered in question (1), what dispute resolution mechanisms would be available to JR to resolve the matter? DISCUSSION A. The Hotel Project Structure. The alternative forms of structure for a hotel project in Shenzhen’s Special Economic Zone are Wholly Foreign-Owned Enterprise (WFOE hereafter), Joint Venture (JV hereafter), Partnership Enterprise (PE hereafter), and Representative Office (RO). The WFOE is governed by the Law of the PRC on Wholly Foreign-Owned Enterprises 2000 (LPROC-WOFE hereafter), JV both by the Law of the People’s Republic of China on Chinese-Foreign Equity on Joint Ventures (LPROC-CFEJV hereafter) and the Law of the People’s Republic of China on Sino-Foreign Corporation Enterprises 2000 (LPROC-SFCE), PE by Partnership Enterprise Law (amended in 2007) and RO by Regulations on Administration of Registration of Resident Representative Offices of Foreign Enterprises (Regulations), which came into effect on 1 March 2011. The RO is not applicable here because it is limited to business liaison activities geared for small-scale operations. Before considering the various types of business structures that a foreign investor may form in China, it is practical to note that various industries are categorized as encouraged, restricted, and prohibited with respect to foreign investments. According to the 2007 Catalogue for the Guidance of Foreign Investment Industries, which has been recently amended, the construction and operation of high-end hotels are restricted. Industries that are categorized as restricted may be imposed limits in ownership percentage or by increased difficulty in obtaining operating licenses and permits. Moreover, lands in the special zones in Guangdong are owned by the People’s Republic of China and it will be the government that will determine preference as to which industries will be allowed any land use, according to Article 12 of the Regulations on the Special Economic Zones in Guangdong Province. Each type of business structure in the Chinese law context has advantages and disadvantages. The WFOE is a limited liability entity and is accorded a Chinese legal personality under China law. The obvious advantage of this kind of structure is that it is independent from any kind of influence from local counterparts and the consequent cumbersome processes attached to having to deal with another entity in pursuing a project. It is therefore, easier to enter as well as exit into the Chinese market with this kind of structure. As earlier stated, however, the WFOE is restricted and prohibited in certain areas of the Chinese business. Considering the categorization of high-end hotels and the land ownership system in the SEZ, the WFOE is not advisable for JR’s hotel project in Shenzhen’s SEZ. The amended law on PE allows a foreign entity or entities to form a partnership with Chinese individuals or Chinese companies. A PE may take any of the following form: a general partnership, where the partners have unlimited and joint liabilities; limited partnership, which must be constituted by at least one limited partner and at least one general partner and where liabilities are shared in accordance with the agreement of the parties and in proportion to their contributed capital, and; special general partnership, which is allowed only in the cases of professional service providers and consultation firms. The advantages of a PE are: it entails fewer processes for approval than the other types of business structures; it has no requisite minimum registered capital requirement; it does not entail the payment of corporate income tax, and; currency conversion is available for repatriation of profits. On the other hand the disadvantages of putting up a PE in China are: unless the PE is a limited partnership, the liability for all partners is unlimited; there is no bankruptcy protection because under the Enterprise Bankruptcy Law of the PROC as only enterprise legal persons are entitled to file for a bankruptcy proceeding, and; it cannot enter into a general partnership with state-owned public service, or listed companies. This is not an advisable type of business structure for JR to use in its hotel project because of the kind of limitations it imposes. In a JV, a foreign entity and its Chinese counterpart both contribute capital. A JV may either be an equity joint venture (EJV) or a cooperative joint venture (CJV). Both forms are considered legal entities with limited and separate liabilities from the entities composing them although in the past, a form of CJV did not necessarily take the form of a juridical entity. In an EJV, capital contributions take the form of cash, technology, materials, equipment and other property rights and profits and losses are shared in accordance to the proportion of their contributions to the venture. On the other hand, the more flexible CJV allows the contributions to be in the form of “cooperative conditions.” This may constitute access to or use of certain assets that are not within the official ambit of the CJV, but nevertheless are important in the promotion and conduct of its business. In practical terms, a foreign entity may contribute cash to the venture while its Chinese counterpart may contribute “cooperative conditions.” The flexibility of the CJV is also reflected in the sharing of profits and losses, which are not necessarily pegged to the parties’ contribution ratio. JVs as a whole have the following advantages: easier entry of foreign entity into areas or industries that are mostly accessible only to Chinese companies; sharing of costs and losses, and; terms are longer and fixed and are extendible. On the other hand, the disadvantages of this type of business structure are: complicated tax system; flexibility is not as that of PE, and; intellectual property protection is weak because of the Chinese component. Both forms of JV require the creation of a Board of Directors. In an EJV, the directors are selected by the parties in accordance with their respective contributions and a management team operates the day-to-day business of the venture, but under the supervision of the former. The CJV, on the other hand, also has a BOD, but management can be delegated only to non-parties to the venture upon the approval of the government. Considering all of the above, it is advisable for JR to adopt the JV type of structure, particularly the CJV, in its hotel project in the city of Shenzhen. First, it will allow JR to bypass the restrictions imposed by China laws on high-end hotels. Second, it is more secure than the PE because of the sharing of costs and liabilities that may not be available in the latter and it allows going into a venture with the local government of Shenzhen. Third, a JV, being a legal entity, is protected by the bankruptcy law of China in the event something goes wrong with the business. Fourth, by forming a CJV, JR can resolve its problem of sharing in the costs of the infrastructure because it can just stipulate with Shenzhen that the latter provides for the infrastructures and allows the hotel to access them under a “cooperative condition” agreement. Although intellectual property protection is weaker in this type of business structure, this is not much of a concern in the hotel industry as much as in the manufacturing industry. Financing/Management. Under the Chinese law on joint ventures, a foreign investor is required to contribute at least 25% of the capital. JR can contribute three-fourths of the cost of the hotel or the amount of $75 million, which forms 75% of the cost and let the Shenzhen Tourism Industry contribute 25%. Also, JR should negotiate for Shenzhen to shoulder the cost of the infrastructures and enter into a “cooperative condition” agreement in exchange for an equivalent increase in the share of profits. As to management, JR can agree with Shenzhen to take over the management of the hotel considering its extensive experience in the hotel industry. B. Manufacturing Project Structure. In venturing into manufacturing in Shenzhen, the most important issue is the protection of intellectual property. Of the four types of business structures allowed in China, i.e. WFOE, JV, PE, and RO, the WFOE gives the best protection of intellectual property and is therefore, the most suited form for JR’s manufacturing investment. A WFOE, in the Chinese law context, is a limited liability company whose capital is owned 100% by a foreign entity or entities. This means that JR should shoulder the entire investment cost of $50 million on its own without pairing up with any Chinese business entity. There are advantages in choosing a WFOE over a JV in setting up the manufacturing project in China. Under Article 1 of the LPROC-CFEJV, a foreign entity or entities is allowed to jointly establish and operate “equity joint ventures” with Chinese companies, enterprises and other economic organizations. This means that JR will have to enter into an agreement with at least one Chinese business entity, which is a cumbersome process although this aspect is overridden by the fact that the foreign entity has to come up with only at least 25% of the capital of the joint venture as held under and liabilities are shared proportionately in accordance with their respective investments. However, the government may pry into the business of the entity such as in the case contemplated by Article 5 where the government may determine whether an investment in the form of technology and equipment is advanced and really suited to China’s needs. Then there is the other complicated business of setting up the BOD as well as the officers of the corporation, which must be agreed to by the parties subject to the law provided under Article 6. In another article, it is provided that the raw materials for the venture should be purchased in China or in the international market, but subject to the vague phrase “pursuant to the principles of fairness,” which the law does not expound on. On the other hand, the WFOE, being wholly owned is not subject to the aforestated cumbersome processes of negotiating with local counterparts on investment shares, BOD composition and other important matters as well as going through arbitration processes in the event of conflicts. Notable provisions that can be found in the LPRC-WOFE, which have no counterparts in the LPROC-CFEJV are Articles 8 and 11. Article 8 states that “A wholly foreign-owned enterprise that meets the requirements regarding legal persons as stipulated by the laws of China shall obtain the status of a Chinese legal person according to law,” while Article 11 provides “No interference shall be allowed in the operation and management activities of a wholly-owned enterprise conducted according to its approved articles of association. The same arguments against JV as a vehicle for setting up a manufacturing business in Shenzhen applies to the PE and the RO. The PE, being a consortium of a foreign entity and a local individual or entity, also makes protection of intellectual property more difficult. Moreover, the lack of bankruptcy protection, unlimited liability and the uncertainty brought about by the fact that the law on the PE is new and therefore relatively untested militate against making it a suitable vehicle for JR in its planned manufacturing investment in China. The RO, on the other hand, is prohibited under the Chinese law to engage in direct business operations that results in profit-making and is certainly not the kind being contemplated by JR in its proposed business venture in China. Finance/Management. To put up a WFOE in the manufacturing business implies that JR should shoulder all expenses in constructing and operating the plant. It must therefore, be ready to put up $50 million for the project. As to management, JR has complete jurisdiction over its operation with guaranteed non-interference from the government so long as it conducts business only in accordance with its articles of association. C. Investment Incentives The hotel and manufacturing projects, which will be built within the SEZ, is governed by the Regulations on Special Economic Zones in Guangdong Province. Under this law, many incentives are granted to foreign investors such as ease and facility in entry and exit, employment of foreign personnel for technical and managerial work, preferential treatment in land use, exemption from import duties, enterprise income tax rate is lower, ease in the remittance of profits abroad, reduction or exemption from income tax in certain cases, preferential prices for machinery and equipment, raw and semi-processed materials made in China, and; simplified entry and exit to foreign personnel. The Shenzhen government also gives incentives in the form of tax subsidies in the case of high-technology investments, which JR can take advantage of when it pursues its plan to put up a manufacturing project in Shenzhen. D. Dispute Resolution Mechanism The CJV, which is the determined vehicle structure for the hotel project, will be governed by Article 15 of the LPROC-CFEJV in the event of disputes by the parties to a JV. This article provides that the BOD shall try to settle the controversy or conflict, but if it remains unresolved then the conflict will be elevated to an arbitral institution of China, which will then conduct the arbitration or conciliation. If the parties, however, had written into their contract a specific conflict resolution process or agency, the same will govern. If resolution does not succeed at the arbitration level, either of the parties may elevate the matter to the people’s court. This provision has no counterpart under the law on WFOE perhaps because the entire project is owned by a foreign entity without the participation of any domestic entities. E. Other Issues/Concerns Taxes. Under Chinese law, taxes are imposed and collected in the national and local levels. A Foreign Investment Enterprise (FIE) is imposed an enterprise income tax at the rate of 33% on their worldwide income, but as earlier stated an enterprise within the SEZ is taxed at a lower 15%. There are also available tax incentives offered in certain industries, especially in the so-called encouraged industries. Export-oriented FIEs may also receive tax breaks SEZs. China also imposes VAT or the value added tax at the rate of 17%, but this may be lowered to 13% in case of the sale or import of certain goods or even to 6% if annual sales do not exceed certain limits. Exports are not imposed with VAT. If a business is not covered by VAT, then it is imposed a business tax on the basis of provision of labor services, sales of immovable property and assignment of intangible assets. FOREX and Profit Repatriation. China’s accession into the WTO has liberalized its FOREX, which is now following a floating rate. Nonetheless, it still exerts control over it depending on the nature of the transaction involved. If it involves capital expenditures, the FOREX will be subjected to stricter control and needs to be placed in a controlled bank account and transactions involving therewith must secure approval from the State Administration of Foreign Exchange. If it involves transaction in the course of ordinary cross-border expenditures, such FOREX transaction will be subjected to lesser control. On the other hand, remittances required confirmation of authenticity and the underlying transaction while profit repatriation are relatively unrestricted, but must comply with certain procedural requirements. Technology Transfer. Under the PRC Technology Import-Export Management Regulations technology is classified as prohibited, restricted or permitted. Prohibited technology cannot be moved in or out of the country; restricted technology can be brought in or out of the country, but subject to government approval, and; permitted technology can freely move in or out of China even without approval, but registration is required. Exit from China. Exit from China by FIE can be made through sale of equity interest, termination and liquidation. The disposition or assignment of a property right however, requires the consent of the other parties in a CJV, for example, as provided under Article 10 of the LPROC-CFCJV or waivers of preemptive rights. These requirements, however, are not applicable in WFOE, which gives this structure type the easiest exit from the country. The process of termination and liquidation, on the other hand, are usually set out in the agreement of the parties themselves in JVs or PEs, but are usually time consuming and costly and hence, not a preferable exit strategy for FIEs. References 2007 Catalogue for the Guidance of Foreign Investment Industries. Enterprise Bankruptcy Law of the PROC. Law of the People’s Republic of China on Chinese-Foreign Equity on Joint Ventures. Law of the People’s Republic of China on Sino-Foreign Corporation Enterprises 2000. Law of the PRC on Wholly Foreign-Owned Enterprises 2000. Partnership Enterprise Law (amended in 2007). Regulations on Administration of Registration of Resident Representative Offices of Foreign Enterprises (Regulations) Regulations on the Special Economic Zones in Guangdong Province Read More