Recently, China’s e-commerce industry has begun growing at an exceedingly fast pace and the Chinese government it is embracing it. One of the goals listed in China’s 12th Five Year Plan (2011 – 2015) was to develop e-business and e-commerce. The Ministry of Industry and Information Technology’s (“MIIT”) detailed five year plan included plans to boost e-commerce by improving the legal regime around it. Earlier this year the MIIT announced that e-commerce companies in the Shanghai Free Trade Zone would no longer be subject to restrictions on foreign ownership. More recently, on March 12, 2015 the State Council approved the creation of a cross-border e-commerce pilot zone in Hangzhou, the capital of Zhejiang and home to Chinese e-commerce giant Alibaba.
On March 10, 2015 the National Development and Reform Commission (“NDRC”) and Ministry of Commerce (“MOFCOM”) issued “Catalogue for the Guidance of Foreign Investment Industries (Revised in 2015)” (“2015 Catalogue”) through which they announced numerous changes that, among other things, remove significant restrictions on foreign investment in the e-commerce industry. This change, which comes into force on April 10, 2015 , removes the restriction that e-commerce enterprises must be at least half Chinese owned. In addition, depending on how approval authorities interpret the amendment, approval of foreign invested e-commerce enterprises might also be significantly easier.
Although there is currently no official definition for e-commerce (electronic commerce, also called “EC”) in Chinese law it is usually defined narrowly as “trade and business activities, both local and global, conducted through the internet and other electronic means including, but not limited to, telephone, television, fax, and mobile technology.
This paper describes the certain changes in the new Catalogue, raises an important interpretive difficulty with them, and discusses the effects of these changes.
I. The Amendment of the Catalogue
The amendment to the Catalogue was a significant change to the previous version promulgated in 2011 (“2011 Catalogue”) and affected a number of industries. In general (but not entirely) the amendment liberalized restrictions on foreign investment. This section gives an overview of the catalogue and describes the parts of the amendment relevant to e-commerce.
The Catalogue is a key document in the Chinese foreign investment legal regime. It categorizes all industries into one of four categories: (1) encouraged; (2) permitted; (3) restricted; and (4) prohibited. The catalogue explicitly lists industries in the encouraged, restricted, and prohibited categories. Industries not listed default to the permitted category. The category an industry falls into determines what hurdles, in terms of filing and approvals, must be cleared in order for a foreign party to invest in it. In addition, the Catalogue will state if foreign investment in a certain industry is limited in other ways such as by which type of entity can invest in it, what percentage (if any) must be held by Chinese parties, etc…
As stated above, the amendment affected many industries. As relevant to e-commerce, however, the amendment is as follows. The 2011 Catalogue listed the following in the restricted category:
Telecommunication companies: value-added telecommunications services (with the proportion of foreign capital not exceeding 50%), basic telecommunication services (with the proportion of foreign investment not exceeding 49%)
The 2015 Catalogue also lists telecommunication companies as restricted, however, it makes an exception for e-commerce:
Telecommunications companies: value-added telecommunications services (with the proportion of foreign investment not exceeding 50%, excluding e-commerce); basic telecommunications services (with the proportion of foreign investment not exceeding 49%)
II. Interpreting The Amendment
The amendment discussed above leads to an interpretive question. On the one hand, it is clear that e-commerce commerce enterprises are no longer subject to the restriction that they must be 50% foreign owned. On the other hand, it is unclear if the e-commerce industry is still a restricted industry.
Under one interpretation (the more liberal interpretation) the words “excluding e-commerce” modifies “value-added telecommunications services.” Under this interpretation, the e-commerce industry is removed from the restricted category (and because it is not listed anywhere else, defaults to the permitted category) and e-commerce industries need no longer be 50% or more Chinese owned.
In contrast, under another interpretation, the more conservative interpretation, the words “excluding e-commerce” modifies “with the proportion of foreign investment not exceeding 50%.” Under this interpretation, e-commerce is still a restricted industry but e-commerce industries need no longer be 50% or more Chinese owned.
As of the time when this paper is published, no clarifying documents have been promulgated. As such, it is unclear which interpretation will be adopted by the approval agencies.
III. Company Approval
If the more liberal interpretation discussed above is correct i.e. if e-commerce is no longer in the restricted category, this will make it significantly easier to obtain approval for an e-commerce company. Establishing any company in China requires approval from MOFCOM or a local commerce authority. Obtaining approval from a local authority is both easier and faster. As per the Circular of the Ministry of Commerce on Delegating Approval Authority over Foreign Investment to Local Counterparts, approval for the establishment of a company is delegated to the lower local counterparts if the total investment amount is below the following thresholds:
USD 300 million
USD 300 million
USD 50 million
If the e-commerce industry has been moved from the restricted to the permitted category, e-commerce companies of up to USD 300 million can, as of April 10, be established with local approval.
Note that the exact level of authority from which approval will be needed will depend on the way in which each province, autonomous region, and city directly under the central government delegates the authority granted to it.
IV. Restrictions on Ownership Removed
Under the 2011 Catalogue, e-commerce companies could not be more than 50% foreign owned. As such, they were limited to Equity Joint Ventures (EJVs) and Cooperative Joint Ventures (CJVs). Now that the cap on foreign ownership has been removed, foreign investors can own up to 100% of an e-commerce company. This section discusses some of the results that flow from this change.
A. Flexible Ownership and Profit Sharing
The most obvious benefit of this change is that enterprises are now free to choose their ownership structure in a way that makes the most sense for the company and the investors. This also leads to more flexibility with respect to profit sharing. Although e-commerce enterprises set up prior to the amendment could use the CJV form which allowed for some flexibility in profit sharing schemes, there are still limits as to what can be done with a CJV. The removal of this restriction in the 2015 Catalogue will give investors more options.
B. Wholly Foreign Owned E-Commerce Enterprises
Under the 2015 Catalogue, e-commerce companies can be Wholly Foreign-Owned Enterprises (WFOEs). WFOEs offer foreign investors a number of advantages, such as:
- The foreign partner(s) enjoy full managerial and operational control
- Greater flexibility with respect to the board of directors and management body
- No need to share profits with a local partner
- The intellectual property is under the control of the foreign investor
These advantages are significant and as a result WFOEs are, by an extremely wide margin, the preferred form of Foreign Invested Enterprise (“FIE”).
In particular, the protection of intellectual property will be of great interest to foreign investors in e-commerce as intellectual property with respect to code is notoriously hard to enforce. As a result, an e-commerce company with an innovative algorithm (for example, for recommending purchases) or website design might find it easier to protect these if there is no need for a local partner.
It is worth noting that a local partner can often bring advantages to a company such as local knowledge and experience in dealing with local employees. Thus, even though a WFOE is now possible, a company should carefully consider advantages and disadvantages of having a local partner.
C. Use of the VIE Stucture
Even prior to the 2015 Catalogue, foreign investors have wanted to invest in industries forbidden to them or be able to realize the entirety of the profits of companies where this was not possible. Investors often utilize the Variable Interest Equity (“VIE”) structure to do.
Briefly, the VIE structure generally has an offshore company creating a WFOE which has contractual arrangements (in the form of consulting fees, technical assistance, etc…) with PRC individual(s) and/or a domestic company. These contractual arrangements are designed such that the WFOE (and therefore the offshore company) is able to effectively realize (often imperfectly) all of the profits of the PRC individual(s)/company. This allows foreign investors to, for example, effectively invest in prohibited industries by using a company without any foreign investors as an intermediary.
However, under the 2015 Catalogue, the VIE structure need no longer be used as a way to “work around” Chinese law. Investors can simply setup a WFOE, or a joint-venture with whatever proportion of share holdings they desire, and run their business in this way avoiding unnecessarily complex contractual arrangements and the related overhead costs. Those investors who wish to use a VIE for other purposes, such as those who wish to engage in an offshore IPO, can continue to do so without risking the ire of the Chinese government.
V. Other Issues
Despite the relaxation of restrictions on foreign investment in e-commerce, there are other hurdles and difficulties that must be considered:
- Because e-commerce involves telecommunications, companies may need to obtain certain licenses with the government before starting their business.
- Some other related industries such as online publishing services and online audio-visual program services, which are not considered e-commerce, are still in the forbidden category.
In addition to the amendment discussed above, two other related amendments are worth noting:
- The online shopping industry, a sub-industry of e-commerce, was removed from the restricted category and is now a permitted industry.
- Development and application of IoT (internet of things) technology has been moved to the encouraged category.
Although a small change in the text of Catalogue, the change discussed here has significant ramifications for existing foreign owned e-commerce enterprises as well as foreign individuals and companies considering starting an e-commerce enterprise in China. The (potentially) easier registration process and removal of ownership restrictions make foreign investment in an e-commerce enterprise a more attractive option than it was before.