Legal Protections to an Equity Joint Venture in China: Incentives and Problems - Research Paper Example

Legal Protections to an Equity Joint Venture in China: Incentives and Problems Name University Tutor Course Date Legal Protections to an Equity Joint Venture in China: Incentives and Problems Introduction The following paper will discuss legal protections for equity joint ventures in China. The paper also discusses the incentives and problems associated with equity joint ventures in China. By definition, an equity joint venture is a form of business which consists of at least two investors: one Chinese and the other foreigner. This form of business has become common in China and is the entry strategy of choice for many foreign companies wishing to explore the Chinese market. Since China joined the World Trade Organization, it has drastically relaxed its legal barriers so as to encourage open competition from foreign firms. Accordingly, many foreign owned companies have expressed interest in the vast, untapped Chinese market. The well established regulatory and legal regimes that govern equity joint ventures in China have loosened restrictions on foreign owned enterprises. As a result, several equity joint ventures are being formed and have shown immense potentials to change the country’s economic prospects and the financial objectives of the foreign investors. Characteristics and Benefits of Equity Joint Ventures in China Chinese laws define an equity joint venture as a business partnership between an overseas and a Chinese individual, enterprise or financial organization approved by the government. All equity joint ventures operating in China are considered independent legal entities (persons) with limited liability (Huang, 2003). Although there are many modes of entry to the Chinese market, equity joint ventures are the most common method used by foreign companies to establish businesses in China. There are specific requirements for formation and management structures of equity joint ventures in China. The laws governing operations of equity joint ventures in China stipulate that profits, losses and risks associated with the business should be shared according to the partner’s respective registered capital contributions. Moreover, the foreign investor’s equity interest in the equity joint ventures must amount to at least 25% of the corporation’s registered capital. There are no minimum investment restrictions for the Chinese partners (Li & Parket, 2001). Setting up equity joint ventures in China requires approval from the Ministry of Commerce, which issues a decision within 90 days of receiving application materials. If the application is approved, the Ministry issues an approval certificate, which gives a green light to the concerned parties to go ahead with their investment plans. The Ministry of Commerce may occasionally fail to approve an equity joint venture application if it could be detrimental to the sovereignty of the country or if its intended purpose may not be in line with the requirements for developing the country’s national economy. In matters of corporate governance, Chinese equity joint ventures are led by a board of directors consisting of at least three people. The board’s composition should be determined collectively by the parties to the venture. Each director in the board serves a renewable four year term. Any amendments to the article of association, mergers and acquisitions, suspension and termination of the joint venture and changes to the registered capital must be agreed unanimously by all board members. Shareholdings in joint ventures are generally non-negotiable and cannot be transferred without the consent of the government. The laws prohibit investors from withdrawing registered capital during the life of the venture’s contract (Huang, 2005). In China, as in many other countries, equity joint ventures operating in certain industries are required to operate for a specific duration. Some of these industries include: service industries; exploration and exploitation of natural resources; land development and industries in which the government restricts foreign investment. However, equity joint ventures may extend their term if both parties agree and obtain approval from relevant authorities (Huang, 2003). In accordance with China’s company laws, all foreign owned enterprises, including equity joint ventures must establish a board of supervisors to inspect company finances. The supervisors also monitor the conduct of supervisors and manage on behalf of the shareholders. Chinese laws are generally less strict on human resource issues pertaining to equity joint ventures hence these businesses can hire and compensate employees directly. However, the compensation of high-ranking board managers must be determined by the board of directors. An important consideration is that Chinese laws allow equity joint ventures employees to form trade unions in accordance with the country’s labor laws and regulations. Such unions have the authority to sign important labor contracts and negotiate terms of service with equity joint ventures on behalf of employees (Li & Parket, 2001). The maximum permissible equity to debt ratio of equity joint ventures is regulated by the ministry of commerce depending on the size of the joint venture. Currently, in situations where the sum of debt ad equity is less than US$3 million, equity must constitute 70% of the total investment. If total equity exceeds US$30 million, then at least a third of the sum of equity and debt must be equity. Equity includes not only cash but also equipment, buildings, materials, intellectual property rights and land use rights (Prasad & Wei, 2005). Equity joint ventures operating in China are required to pay taxes according to existing laws. However, preferred tax rates, refunds or holidays are available depending on the equity joint venture’s industry and location. Most importantly, China’s custom regulations provide for exemption of duty on imported machinery and equipments for certain projects. This measure encourages investment in certain important sectors of the economy such as infrastructural development (Huang, 2005). As the most common preferred vehicle for foreign capital investment in China, equity joint ventures have many advantages which include: i. Equity joint ventures are very flexible such that business relationships can be arranged in a way that both parties benefit. This applies especially to the management of joint ventures and their financing. ii. Unlike whole owned enterprises, equity joint ventures requires little capital investment and manpower. Therefore, it is easier for the foreign investors to obtain capital, the necessary technology as well as the support of the local community and the government. iii. Joint ventures in China allow investors to enjoy a high degree of marketing control which greatly shortens the time required to conduct market research. iv. Foreign investors do not need to establish new corporations in China under the joint venture provisions. Both the foreign investor and the Chinese partner participate in managing the affairs of the joint venture by doing businesses using a common license under a co-operative and contractual agreement. This allows each partner to focus on their own specialty. v. Equity joint ventures also bring the opportunities for the foreign investor to capitalize on the established reputation of the local partner. vi. The sharing of risks and resources between the venture partners is a major incentive for foreign investors. vii. Considering China’s large population (about 1.4 billion people) equity joint ventures are a good entry strategy for foreign firms to reach a large market base through pooled resources.   Major Disadvantages Associated With Equity Joint Ventures in China Although Chinese laws on joint ventures are relatively more favorable to foreign investors, there are considerable disadvantages associated with joint ventures as a means of entry into the Chinese market. One such disadvantage is that compared to license and contractual manufacturing in China, equity joint ventures require the foreign investor to commit more funds than their Chinese counter parts which may result in higher risks for the foreign investor (Sun, Tong & Qiao, 2002). Another disadvantage is that because of cultural differences and profit sharing issues, a lot of valuable time can be wasted in settling agreements. Therefore, it is essential that both parties to the joint venture embrace correct communication techniques. Moreover, because of issues of differences in business culture between the Chinese partner and foreign investor, there results consequent divergence in objectives and expectations. As a matter of fact, most foreign investors generally seek toehold in their investments and can forego profits to build a stable market share. On the other hand, Chinese partners will usually be looking for quick cash to finance their expansion programs or pay of debt. Chinese investors are also known to use equity joint ventures as an outlet for dumping excess workers. Inevitably, this exacerbates normal operational and managerial difficulties and results in project failure (Prasad & Wei, 2005). Even when interest between the foreign investors and their Chinese partners coincide, battles over management control and strategy implementation are very frequent. It is therefore important for the foreign investors to search for the most suitable Chinese partner. However, the scale of dynamism and diversity in the Chinese market can either result in an overwhelming number of potential partners or make it extremely difficult to find the right potential partners. Essentially, unless the Chinese partners are a perfect match, the disadvantages of an equity joint venture may outweigh its benefits (Sun, Tong & Qiao, 2002). Huang (2003) has cited undesirable income tax and liability implications as a major risk if joint venture businesses are construed as partnerships. Most importantly, parties involved do not enjoy the autonomy of sole proprietorship in information searching and decision making processes. Necessity and difficulties of due diligence are another major disadvantage associated with equity joint ventures in China. Even when the Chinese partner is deemed desirable, the foreign investor must conduct a serious due diligence investigation on the potential partner. Major areas that are investigated when conducting due diligence include under-reporting of tax, security arrangements, under-funding of employee’s social welfare programs and complications in debt-equity structures. Due diligence analysis will have an impact on the ongoing valuation of equity joint ventures and can be used as negotiation during price negotiations. If the equity joint ventures partners set unclear objectives for their business, the end result may be unmet expectations as well as hard feelings on both sides. Most importantly, different objectives in the joint venture may compel each partner to work against one another using valuable resources without necessarily bringing desired outcomes. In cases where there is mutual mistrust between joint venture partners, the partners may not be sufficiently committed to the joint venture. This may leave, one partner (in most cases the foreign investor) shouldering the bulk of the responsibility with decreased benefits (Prasad & Wei, 2005). It has however been realized that certain problems are encountered during due diligence investigations. These problems include inadequate documentation and poor transparency. This problems can however be circumvented by coordinating the various due diligence teams so as to ensure that any suspicious discoveries are properly investigated. Additionally, a more hands-on approach to due diligence is necessary to get effect results including focus on commercial aspects besides financial and legal matters (Huang, 2003). Risks and Problems Associated with Equity Joint Ventures in China and How to Resolve Them The foreign investor’s level of control is a major risk associated equity joint ventures in China. More often than not, it is the case that Chinese partners will exercise management control over the joint venture regardless of the equity share or contractual arrangement. This happens because the joint venture staff transferred from the partners retains their original objectives, loyalties and objectives. Foreign investors can deal with this problem through continual communication and by structuring the joint venture properly in the first place (Prasad & Wei, 2005). The authoritarian nature of the Chinese government system is another major risks associated with equity joint ventures in the country. The autocratic nature of government means that potentially-adverse rules and business regulations can be implemented. Another major risk is that China’s regulatory system for securities has not developed fully. This means that there are several cases of fraud than in other countries. A good way to avoid this risk is to hire foreign auditors and to double check financial statements (Sun, Tong & Qiao, 2002). The rapid growth of China’s economy has spawned potential problems with inflation. This has compelled the government to increase interest rates so as to slow growth. If these problems persist, Chinese joint ventures that export goods may be faced with downward pressures. Other major risks associated with investing in China include a rudimentary monetary policy system and too many privileges for state-owned enterprises. These risks together with high labor costs, increased strain on natural resources and tight labor supply make China less attractive to foreign investors (Park & Sehrt, 2001). There are various ways in which foreign investors can avoid risks associated with equity joint ventures in China. One way is to explore all possible alternatives before entering into an equity joint venture. Because there are numerous risks associated with equity joint ventures, they should only be entered into only if necessary. Some of the alternative investment arrangements which can be explored include creating wholly foreign owned enterprises. This alternative investment strategy can be a good entry strategy especially into unrestricted sectors (Huang, 2005). Another equally important way in which foreign investors can avoid the risks of equity joint ventures in China is by focusing on long term competition. It is often the case that foreign investors lose considerable shares of product markets to previous joint venture partners. Therefore, one of the greatest long term risks for foreigners in Chinese joint ventures is the risks of establishing competitors. It is also important for the foreign investor to understand their Chinese partner’s motives (Prasad & Wei, 2005). Unless the participation of the Chinese partner is necessary for operational purposes, they can better work as dormant partners. Unfortunately, this is very rare since the Chinese motives for entering into the joint venture are not necessarily based on profits. In addition to profits, Chinese investors seek joint venture partnerships with foreign firms for the strategic purposes of gaining technology, know-how and new products. In this case, their motives tend to be as much competitive as they can be collaborative. However, if the Chinese partner continues producing related products or is affiliated to a state owned group, then the competitive risks can be much higher (Li & Parket, 2001). The risks inherent in the Chinese equity joint ventures can also be avoided by properly defining products and markets. Such a move can strategically help both parties avoid possible overlaps with each other’s markets and products and hence reduce unnecessary competition. It is also essential for the foreign investor to demand non-competitive commitments from the Chinese partner. This will prevent the Chinese venture from producing joint venture products once the contract is ended (Buckley, 2010). To some extents, the control of joint ventures can be shared and hence the business’s management functions and structures can be the focus of collaboration and contention between the parties. To overcome this challenge, it is important that both the executive and board positions are allocated equally among the partners and that their functions are carefully specified in order to establish the right balance of power (Prasad & Wei, 2005). If any of the partners has substantial majority in equity share, it is important to clearly determine the board management control. In addition, provisions should be made for critical negotiation issues relating to minority protection such as veto rights. In case foreign managers and employees are needed, due consideration should be given to the costs involved and the fact that most foreign expatriates may be unwilling to work outside China’s developed urban centers (Huang, 2003). Another important strategy for avoiding the risks associated with Chinese joint ventures is to have an exit strategy. According to Chinese rules, joint ventures cannot be terminated unilaterally by either party except by agreement from both parties and on special grounds. Therefore, the parties should agree on the range of grounds that can potentially trigger a premature termination of the joint venture contract. Termination of Equity Joint Ventures due to deadlocks is common in China. Terminations can also be triggered if the joint venture fails to meet expected sales and market share thresholds. The foreign partners should ensure that there are provisions for cross-terminations in the joint contact and technology transfers (Huang, 2005). Incentives for Equity Joint Ventures in China Following its admission into the World Trade Organization, China has significantly opened up its domestic markets to foreign investments and competition. Although there are still some areas of resistance to foreign investment, this will certainly change with time. As is common in other countries, strategic industries will remain restricted in line with the government policies. A major incentive for equity joint ventures in China is the stability and development of infrastructure for export manufacturing. It can be shown that despite considerable regional hiccups, China’s export manufacturing remains excellent in terms of cost of labor, infrastructure development and availability of skilled labor. In addition, quality control issues are improving and China is well placed strategically to take advantage of developing regional markets (Chantasasawat, Fung & Alan, 2004). Another important incentive is the ever increasing number of consumer driven middle class. China’s economy is progressively moving to the point where more and more people will have more money and hence the necessary purchasing power to spend on international brands. These brands are still considered superior in the country. Because of rapid increase in wealth, an estimated a quarter a billion Chinese can afford real estate properties and luxury cars. The massive growth in spending power is an ideal incentive for setting up equity joint ventures in China and selling to the Chinese market (Huang, 2005). Another important incentive is that China’s tax base is very favorable to foreign investors. Currently, China does not offer wholesale tax incentives as it had done in the past. Instead, nationally implemented tax incentives are made available through occasional rebates and discounts. However, these are usually arranged as commercial transactions rather than as pure tax holidays. The Chinese government also offers rental and purchase discounts on state-owned properties. These incentives are largely driven by the government’s desire to encourage investments in specific areas of the economy. The policy of using government-owned property to offer incentives to foreign investors is expected to increase into the foreseeable future (Li & Parket, 2001). In order to encourage more high level equity joint ventures, the Chinese government is offering a re-investment scheme to foreign investors who reach a certain level of declared individual income tax. This re-investment scheme includes discounts on purchase of local real estate properties and even for automobile purchasing. Although most of these incentives are dependent on the target property, they can play a significant role in encouraging foreign investment into the country (Buckley, 2010). In the recent past, the Chinese government has indicated the availability of tax incentives for foreign investment in certain industries. Some of these industries include information technology, the health sector and insurance. As from 2010, imports for technological and scientific developments by foreign companies are subject to exemptions from tariffs, value added tax and goods and services tax. In addition to encouraged industries, the government also provides what is known as Western and Central Regions investment incentives (Park & Sehrt, 2001). These incentives are meant to encourage investments in the country’s western regions majority of which are poorly developed due to harsh climate and distance from coastal region. Equity joint ventures are particularly encouraged in China’s central and western areas more especially in labor intensive and eco-friendly businesses. Although existing tax incentives will continue for new investments in the western and central regions, the government has promised support for foreign investments in China’s coastal regions which relocate to the west (Chantasasawat, Fung & Alan, 2004). Another major incentive that exists for equity joint ventures in China is that the government has since joining the World Trade Organization pledged to upgrade the country’s manufacturing capacity by vigorously promoting high-end manufacturing industries. Resultantly, the government has improved the production capacity of traditional industries besides curbing sectors that were previously overcapacity. In addition, the government is aggressively fostering strategic emerging industries by incorporating them into the list of encouraged industries. In particular, these industries are related to energy conservation, biotechnology, environmental protection, generation of information technology and new energy resources. The government also encourages foreign investments in developing service industries. These industries are related to intellectual property rights, vehicle charging stations, vocational skills training and offshore oil pollution cleanup. Foreign investments in financial leasing and medical institutions are also encouraged greatly (Huang, 2005). In an attempt to encourage foreign companies to create more jobs for the local people, municipal governments in China offers special tax subsidies to equity joint ventures that employ large numbers of laid-off workers. Moreover, all foreign enterprises are exempted from city maintenance and construction fees as well as extra education fees (Buckley, 2010). Conclusion Equity joint ventures are still the most popular mode of entry to the Chinese market for foreign investors. Over the last ten years, the government has considerably relaxed legal barriers against foreign investment in most sectors of the country’s economy. As a result of relaxation of legal barriers, potential foreign investors have the necessary legal protection to exploit opportunities in the Chinese market. However, because of the authoritarian nature of China’s government system, care should be taken when deliberating on investment negotiations with Chinese firms. References Buckley, P 2010, Foreign Direct Investment, China and the World Economy, Basingstoke and New York, Palgrave Macmillan. Chantasasawat, B., Fung, K. C. and Alan, S 2004, ”Foreign direct investment in China and East Asia”. Paper presented at the Third Annual Conference on China Economic Policy Reform, Stanford Center for International Development. Huang, Y 2003, Selling China: Foreign Direct Investment During the Reform Era, New York, Cambridge University Press. 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