General framework

Business climate and recent developments

What is the extent of franchise business in your jurisdiction, including any particular franchise-heavy sectors and notable recent developments?

Franchising as a business model is relatively new in China. The first pilot franchise regulations in the People’s Republic of China (PRC) were adopted in 1997. Since then, domestic franchises have taken off, particularly as Chinese consumers gained more purchasing power. As of the end of 2016, the top 100 franchise systems in China operated more than 110,000 franchise units – 22% more than in 2015 (the 2017 statistics have not yet been released).

The sectors where international franchises are particularly successful in China include various types of academic and personal development services, such as adult education, early childhood education, language classes, fitness and skills development; elderly care and hospitality services are also in demand. Western brands are often viewed favourably by consumers and are associated with high quality and superior customer service.

Regulation

Are there any franchising-specific laws in your jurisdiction? What other legal regimes apply?

PRC (excluding Hong Kong) is a civil law jurisdiction, heavily based on the German model. All contracts in the PRC must conform to the general principles set out in the Contract Law of the PRC (合同法, Hetong Fa). In addition, franchise relationships are governed by the following regulations and administrative measures (ie, instruments issued by the government which are subordinate to and must be interpreted in accordance with the general principles expressed in the legislation and the doctrine):

  • the Commercial Franchise Administration Regulation (商业特许经营管理条例, Shangye Texujingying Guanli Tiaoli) Ordinance of the State Council 485 of January 31 2007 (the franchise regulations);
  • the Commercial Franchise Registration Administrative Measures (商业特许经营备案管理办法, Shangye Texujingying Bei’an Guanli Banfa), MOFCOM Decree 5 of 2011;
  • the Commercial Franchise Information Disclosure Administrative Measures (商业特许经营信息披露管理办法, Shangye Texujingying Xinxi Pilu Guanli Banfa), Decree 2 of 2012; and
  • the Administrative Measures for Foreign Investment in Commercial Fields (2004) (外商投资商业领域管理办法, Waishang Touzi Shangye Lingyu Guanli Banfa) MOFCOM Decree 8 of 2004.

Other laws that may affect franchisors in the PRC include:

  • the Labour Contract Law (劳动合同法, Lao Dong He Tong Fa);
  • the Anti-unfair Competition Law (反不正当竞争法, Fan Bu Zhengdang Jingzheng Fa);
  • the Anti-monopoly Law (中华人民共和国反垄断法, Zhonghua Renmin Gongheguo Fan Longduan Fa);
  • the Trademark Law (商标法, Shangbiao Fa); and
  • the Copyright Law (著作权法, Zhuzuoquan Fa).

Is there a legal definition of ‘franchise’?

The franchise regulations define a ‘franchise’ as an arrangement in which:

  • the franchisor through an agreement grants a franchisee the right to use the franchisor’s business operating resources, including registered trademarks, logos, patents and proprietary technologies;
  • the franchisee conducts business under a uniform mode of operation; and
  • the franchisee pays franchise fees according to the agreement.

The Chinese definition of a franchise is considerably broader than the one implemented by other jurisdictions. The Chinese term for franchising, 特许经营 (texujingying), includes both business format franchises (as in the United States) and product distribution arrangements. Further, licensing of non-trademark IP rights such as a trade secret or patented technology can also fall under the definition of a franchise if a fee is paid and the licensee conducts business under “a uniform mode of operation”.

Are there any specific regulatory implications for foreign franchisors seeking to expand into your jurisdiction?

While Chinese regulation of foreign investment has been significantly liberalised since the 1990s, certain industries, including banking, telecommunications and compulsory school education, remain closed to foreign investment. Most franchising activities are not restricted.

Foreign investors should consult the Catalogue of Industries for the Guidance of Foreign Investment, published by the National Development and Reform Commission and the Ministry of Commerce in June 2017. The catalogue categorises industries either as ‘restricted’, ‘prohibited’ or ‘encouraged’:

  • The restricted list outlines the industries where foreign investment is subject to certain restrictions.
  • The prohibited list includes sectors where no foreign investment is allowed.
  • The encouraged list contains sectors that are fully accessible to foreign investors.

Are any regulatory reforms envisaged or underway that affect franchises?

At this time, no significant reforms of the franchise regulations have been announced by the government. However, in March 2018 the National People’s Congress adopted an institutional reform which may result in the reshuffling of responsibilities for the regulation of franchising between state agencies.

Franchise models

Which models and company forms are commonly used for franchises in your jurisdiction? Are there any restrictions or requirements as to which models and forms may be used?

International franchisors need not establish a local entity in China to offer direct unit or master franchises, or area development rights.

Equity and contractual joint ventures (available in a form of either a Sino-foreign equity joint venture or Sino-foreign cooperative joint venture) are regulated by special laws and are not considered franchises. A proposal from a Chinese partner to form a joint venture should generally be treated with caution. Joint venture structures should be avoided unless there is no other way to establish a franchise in China.

Franchisors who decide to incorporate in China usually establish a wholly foreign-owned enterprise (ie, a limited liability company that can be owned and controlled by a foreign corporation). The formation of a wholly foreign-owned enterprise is necessary if the foreign franchisor wishes to own or lease premises in China or engage in other commercial activities, particularly if the franchisor wishes to exercise the right to take over the franchisee’s location in China.

Industry associations

Are there any national or regional franchising associations? If so, is membership mandatory and what operational codes and guidelines apply?

The Chinese business association for the franchise industry is the China Chain Store and Franchise Association. Membership is not mandatory. Members of this association must abide by the Code of Ethics.

Franchise agreements

Common features and contractual requirements

What are the common elements of franchise agreements in your jurisdiction? Do any requirements or restrictions on contractual provisions apply?

Franchise agreements must be in writing and must include a number of provisions under the franchise regulations, including:

  • the nature of the franchise business;
  • the term of the agreement;
  • the type, amount and payment method for franchise fees;
  • standards of operation for the franchised business, including the technical support and training to be provided by the franchisor;
  • the quality standards for the products or services;
  • allocation of responsibility for the promotion and advertising of the business; 
  • allocation of responsibilities and liabilities for the protection of consumer rights;
  • provisions regarding amendment, cancellation and termination of the franchise agreement;
  • default provisions and liability for breach; and
  • dispute settlement mechanisms.

Further, franchise agreements must contain a cooling-off period in which the franchisee may unilaterally terminate the agreement. The length of the cooling-off period is not prescribed by the franchise regulations and should be negotiated by the parties in good faith.

International franchisors should follow certain formalities of executing a contract in the People’s Republic of China (PRC)  to ensure that it can be enforced against the franchisee. The franchisee’s official name in Chinese must be used. Neither companies nor individuals in China have official English names. As pinyin (ie, English) versions of names are not reversible into Chinese characters, it is impossible to identify a company or individual by their English name alone. If the franchisee is a legal entity, the contract must be signed by 法定代表人 (often translated as ‘a legal representative’ or a person with a valid power of attorney from the legal representative. The contract must be sealed with the company’s official seal and parties should initial each page of the document.

Are parties to a franchise agreement subject to an implied or explicit duty of good faith?

Yes, the law in the PRC is based on the principle of good faith in negotiating and performing contracts, which is the opposite of the common law doctrine of caveat emptor (‘buyer beware’). Article 4 of the General Principles of the Civil Law, Article 6 of the Contract Law and Article 4 of the franchise regulations require the parties to act fairly, honestly and in good faith.

Are franchise agreements subject to any formal or documentary requirements, including registration?

There is no requirement to register a franchise agreement or franchise disclosure document; however, franchisors should register with the Ministry of Commerce (MOFCOM) within 15 days of the first franchise agreement being signed.  The list of documents required for registration with MOFCOM includes:

  • franchisor’s standard form of franchise agreement;
  • the franchise agreement signed with the first franchisee in China;
  • the corporate registration certificate;
  • registration certificates for trademarks or copyright (eg, logo) used in the franchise system; and
  • evidence of compliance with the 2+1 Rule.

All franchisors in China must have a mature business model and demonstrate compliance with the requirements of Article 7 of the franchise regulations. Article 7(2) of the franchise regulations (the 2+1 Rule) requires that a franchisor must have owned and operated at least two outlets for at least a year. According to the practice developed by MOFCOM officials, the outlets may be owned and operated by the franchisor’s subsidiaries or, in some cases, other affiliates; the outlets may also be located outside China if they are operated under the same franchise brand. If the outlets are located outside China, franchisors may use statements issued by trade organisations (eg, the International Franchise Association) to show compliance with the 2+1 Rule. Chinese courts generally agree that it is possible to have a mature system without complying with the 2+1 Rule, which in practice means that the franchise agreement will be valid (assuming non-compliance with the 2+1 Rule is properly disclosed), but registering with MOFCOM will be problematic.

All documents must be translated into Chinese. Documents that are prepared abroad must be notarised and either legalised at the Chinese embassy in the country of origin or certified according to the Hague Convention on Abolishing the Requirement of Legalisation for Foreign Public Documents.

International franchisors should register with MOFCOM’s head office in Beijing, rather than with local MOFCOM departments. The franchisor should register any changes in the information submitted to MOFCOM within 30 days.

Trademark licence agreements should be registered against the respective trademark registration with the China Trademark Office.

Due diligence

What due diligence should both parties undertake before entering into a franchising agreement?

Conducting due diligence on a prospective franchisee is an essential step in a franchise transaction in China. In major urban centres, a lot of information about a corporation can be obtained online (in Chinese), including:

  • shareholders;
  • registered capital;
  • management;
  • affiliates; and
  • past litigation.

At the very least, a franchisor should start by obtaining a copy of the individual’s passport or identity card. If the prospective franchisee is a PRC company, the franchisor’s lawyers should obtain a copy of 营业执照 (business licence). Business licences disclose the Chinese character name of the corporation which must be used in the contract – even if the contract is in English – to ensure that the contract may be enforced against the franchisee. The business licence will also disclose the name of 法定代表人 (often translated as ‘the legal representative’, who is the only person who can sign for the company unless he or she issues a power of attorney to another person to sign the agreement.

Pre-contractual disclosure

Are franchisors subject to pre-contractual disclosure requirements? If so, do any exemptions apply? What remedies are available to franchisees in the event of breach of these requirements?

Article 22 of the franchise regulations and Article 5 of the information disclosure measures require the franchisor to disclose certain information to the franchisee in writing at least 30 days before signing the franchise agreement. Information that must be disclosed includes:

  • the franchisor's registered trademarks, business logos, patents, proprietary technology and operational or business format model;
  • the type, amount and payment method for franchise fees, any required security deposits and the conditions and method of refunding a security deposit;
  • the terms and conditions for supplying products, services and equipment by the franchisor;
  • a description of the continuous services to be provided to the franchisee, including operating guidance, technical support and training; 
  • the investment budget for a franchise location;
  • the list of existing franchise outlets within the PRC and an assessment of their business performance (an earnings claim);
  • summaries of the financial statements and audit reports (audited by an accounting firm) for the past two years; and
  • a description of franchisor’s franchise-related lawsuits and arbitrated matters for the past five years, and information about bankruptcies for the past two years.

Article 23 of the franchise regulations prohibits franchisors from concealing any relevant information, even if not specifically listed. Further, Article 42 of the Contract Law prohibits a party from intentionally concealing key facts relating to the making of the contract. These provisions can be interpreted as a requirement to disclose all material facts, even if such information is not listed in the regulations.

Choice of law

May the parties freely choose the governing law of the franchise agreement?

Parties in a foreign-related transaction may select foreign law to govern the franchise agreement; however, parties cannot contract out of the application of the franchise regulations and choosing foreign law is not always recommended.

When choosing governing law and dispute resolution forum, international franchisors should consider where they would need to enforce a judgment or arbitral award. If the franchisee’s or guarantor’s assets are in the PRC, enforcing a foreign judgment may be either difficult or impossible, as China enforces foreign court decisions only if there is a treaty with the respective jurisdiction or if this jurisdiction enforces Chinese judgments. There is currently no such treaty or reciprocity with the United States, Canada, Australia or the United Kingdom – in such cases, litigation in China is a preferred route.

PRC is a party to the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (New York, 1958). While Western companies overwhelmingly prefer arbitration to litigation in Chinese courts, arbitral awards must still be approved by a local court for enforcement – this process is as expensive and time consuming as a trial. Further, certain issues (eg, ownership of a Chinese-registered trademark) are unlikely to be eligible for arbitration. Arbitration tends to be more expensive and time consuming than litigating directly in a Chinese court.

Contrary to popular belief, Chinese courts are efficient and generally friendly to foreign parties. The World Bank Group’s enforcing contracts indicator ranks China fifth in the world for cost and time required to enforce a commercial contract in court and quality of judicial process (for comparison, the United States is ranked 16th, Hong Kong 28th and Canada 114th). Parties litigating in Chinese courts should choose PRC law to govern the franchise agreement in order to avoid costs and delays in adducing evidence of foreign law.

Fees

What fees are typically charged under a franchise agreement?

Fees charged by international franchisors in China may include:

  • royalties;
  • initial franchise fees;
  • development fees;
  • advertising fund fees; and
  • interest on late payments.

The type, amount and method of payment of franchise fees are not prescribed by the franchise regulations and must be negotiated between the parties. However, international franchisors should consider some practical aspects when negotiating franchise fees:

  • Due to foreign currency exchange regulations, weekly or biweekly payments by a local franchisee to an overseas recipient are difficult to administer. For example, a domestic entity needs State Administration for Foreign Exchange approval to purchase foreign currency exceeding the $50,000 annual limit. Chinese payors transferring money overseas must submit certain paperwork to the bank, including a tax authority-issued tax recordal form. Therefore, royalty and other regular payments are usually charged on a monthly or quarterly basis.
  • As English is not commonly spoken in mainland China, adverts targeting Chinese consumers must be in Chinese and adapted to local customs and culture. If an international franchisor charges advertising fund fees, a separate fund for Chinese advertising should be considered.
  • If the franchisor charges a pre-contractual deposit, the purpose of this payment and conditions of refund (if the deposit is refundable) must be evidenced in writing.
  • Chinese parties are rarely comfortable providing personal guarantees. Instead, domestic franchisors charge a security deposit, which may be returned to the franchisee on the expiration of the franchise agreement if the franchisee complied with the obligations under the agreement.

Renewal

Do franchisees have a right of renewal?

There is no prescribed right of renewal. The minimum term of the franchise agreement is three years (unless the franchisee agrees to a shorter term); many domestic franchise agreements in China have a term of three to five years.

On what grounds may a franchisor refuse to renew?

A franchisor is not obliged to comply with a request for renewal.

How are renewals of franchise agreements usually effected? Do any formal or substantive requirements apply?

Renewal of the franchise agreement must be evidenced in writing. A new disclosure is not required if the franchise agreement is renewed on the same terms and conditions. Renewal of a trademark licence must be recorded with the China Trademark Office.

Termination

On what grounds may a franchisor terminate a franchise agreement? Are any remedies available to franchisees in this regard?

The grounds for terminating a franchise agreement must be set out in the franchise agreement. Except for the cooling-off period set out in Article 12 of the franchise regulations, there are no prescribed grounds of termination. However, any termination provisions of the franchise agreement must comply with the duty of good faith and Chapter VI of the Contract Law. 

Ongoing franchisor/franchisee relationship

Operational compliance

What mechanisms (formal and informal) are commonly used by franchisors to ensure franchisee compliance with the operational terms and standards of the agreement?

Franchisors typically reserve inspection and audit rights to monitor compliance with the franchise agreement. International franchisors should factor in the costs of site visits to the franchisee’s location when determining royalty or other fees. In addition to the audit rights, franchisors should require franchisees to provide copies of tax returns. Monitoring franchisees’ Chinese websites is also important.

While having access to the franchisee’s computer systems and point-of-sale data is useful to monitor compliance with financial obligations, complete access to franchisees’ computers and data is difficult to achieve in the People’s Republic of China (PRC), including for privacy law reasons.

Amendment of operational terms

Can the franchisor unilaterally change operational terms and standards during the course of the agreement?

Chinese contract law and business practices are based on the principle of reciprocity and mutual consent. Article 77 of the Contract Law provides that parties can modify an agreement “upon consensus through consultation”. A unilateral right of amendment will likely be pushed back by a Chinese party.

Applicable laws

Do any specific laws affect the ongoing franchisor/franchisee relationship after they enter into the franchise agreement?

After entering into the franchise agreement, the parties must perform their contractual obligations in good faith (Article 60 of the Contract Law). The franchise regulations require the franchisor to provide ongoing operational guidance, technical support and business training in accordance with the franchise agreement, and to disclose to the franchisee any promotional and marketing expenses.

Further, the parties to a franchise contract must comply with the laws on:

  • advertising;
  • product liability;
  • consumer rights;
  • privacy; and
  • cybersecurity.

Ongoing disclosure

Do any ongoing disclosure requirements apply during the course of the agreement?

Our interpretation of Article 23 of the franchise regulations is that there is no continuing obligation to disclose after the franchise agreement is signed.

Transfer and sale

Transfer and sale

What rules and procedures apply to the transfer and sale of a franchise business?

Franchisees may transfer or sell their franchise only with the franchisor’s consent (Article 18 the franchise regulations). The relationship between the parties to a franchise contract regarding the transfer and sale of the business are also governed by the principle of good faith under the Contract Law.

Competition issues

Applicable laws

What competition laws apply to franchises, with particular regard to:

(a) Non-competes and other restrictive covenants?

Subject to the duty of good faith set out in the Contract Law and the General Principles of the Civil Law, which does not support overbroad restrictive clauses, non-compete and non-solicitation covenants are enforceable in the People’s Republic of China (PRC).

A post-term non-compete covenant with an employee is limited to two years and requires compensation to be paid to the employee, according to the Labour Contract Law. If the level of compensation is not specified by the parties, the amount will be determined by the local authorities.

(b) Exclusive geographical areas?

Article 17(4) of the Anti-monopoly Law prohibits establishing exclusive geographical areas without justifiable cause for players with a dominant market position. Franchisors in China rarely have a significant market share that could constitute a dominant market position.

(c) Price fixing and mandatory product purchases?

Price fixing and minimum resale prices are prohibited in vertical agreements or horizontal monopoly agreements between competitors; however, the Anti-monopoly Law provides some exceptions for horizontal agreements. The practice of setting ‘recommended prices’ may attract scrutiny from the anti-monopoly authorities if the franchisor enforces the recommendation.

Franchisors should observe the price fixing restrictions under the Anti-monopoly Law. The authorities actively enforce the law, including against certain industries such as car dealerships.

The courts and government authorities are debating whether a negative effect on competition is required to secure conviction for a resale price maintenance offence. While the government considers resale price maintenance as a per se offence, which does not require proof of intent or a negative effect on competition, the courts would consider whether the price fixing has lessened or restricted competition.

Article 17 of the Anti-monopoly Law prohibits tie-in sales clauses imposed by parties with a dominant market position without justification.

(d) Online trading?

Chinese law does not prohibit franchisors from imposing online trading restrictions on their franchisees.

(e) Other?

China’s Anti-unfair Competition Law – the new version of which came into force in January 2018 – aims to protect businesses from unfair competition, including:

  • fraudulent or misleading use of trademarks;
  • fraudulent advertisement;
  • unauthorised use of domain names;
  • commercial bribery; and
  • trade secrets infringement.

Intellectual property

IP rights

How can franchisors protect their intellectual property (eg, trademarks and copyright)?

Franchisors should consider registering their trademarks in the People’s Republic of China (PRC)  as soon as possible and before entering the Chinese market. In addition to any English or other non-Chinese language marks and logos, franchisors should create and register a trademark in Chinese characters before a squatter can register it. Having a Chinese language trademark also mitigates the risk of a franchisee registering the mark in its own name and ‘breaking away’ from the franchise system. Localising a foreign brand is important to increase the recognition and reputation of the brand among Chinese customers, as English is rarely spoken in mainland China.

China is a first-to-file jurisdiction and trademarks registered abroad are generally not protected. Trademark registration with the China Trademark Office takes between one and two years (assuming that there are no oppositions or complications). The registration is valid for 10 years with an option to renew.

Copyright is protected under the Copyright Law. While registration with the Copyright Protection Centre of China is optional, it may be useful as a record of ownership in copyright infringement claims.

The Anti-unfair Competition Law protects ‘protected commercial marks’ (eg, name, packaging, domain name and website name used for a particular product) by prohibiting acts of confusion intended to mislead customers into believing that a product or service is a branded one or is connected with a brand.

Must IP licences be registered?

If the franchisor licenses the Chinese trademarks (eg, from the group’s IP holding company), the licence must be recorded with the China Trademark Office. Otherwise, registration of a licence agreement is optional.

Know-how

How can franchisors protect their know-how and trade secrets?

Although the Anti-unfair Competition Law contains provisions aimed at protecting trade secrets, contracts remain the most important means of protecting the trade secrets. Franchisors should ensure that their non-disclosure agreements with Chinese franchisees are properly initialled, signed and sealed, and reference the franchisee’s legal name in Chinese. Franchisors should collect evidence of the information that has been disclosed and the time of disclosure. Identifying a clear scope of information in the non-disclosure agreement also enhances the chances of enforcement.

Breach

What are the consequences of a franchisee’s breach of the franchisor’s IP, know-how or trade secret rights and what remedies are available to the franchisor in this regard?

Franchisors should monitor the market and their franchisees to identify possible infringement as soon as possible. Franchise agreements should allow the franchisor to terminate the agreement if the franchisee infringes on the franchisor’s IP rights. Franchisors should bear in mind that the PRC is a civil law jurisdiction, so there is no discovery. Therefore, franchisors should endeavour to collect or secure the evidence that they need for infringement proceedings before sending cease and desist letters or launching lawsuits.

In addition to termination rights under the franchise agreement, franchisors may seek recourse in the courts and launch administrative proceedings.

Infringement lawsuits can be based on either the Trademarks Law or the Anti-unfair Competition Law. Franchisees may seek orders to stop infringing activities and award damages. Historically, damages awarded in IP infringement cases have been low; however, there seems to be a trend towards raising the damages awarded to IP rights holders. 

Administrative proceedings before the State Administration for Industry and Commerce can be useful to seek orders to:

  • seize counterfeit goods;
  • impose fines on infringers; and
  • conduct raids.

Real estate

Laws and considerations

What real estate laws and considerations should franchisors bear in mind where:

(a) The franchisor owns the premises on which the franchisee operates?

The land in urban centres belongs to the state and can be leased only for a certain period. Businesses can own commercial units in buildings, but not the land on which the building is built. As foreign entities are prohibited from purchasing or leasing real estate, international franchisors must incorporate a foreign-invested real estate corporation and obtain various permits from the government agencies to conduct real estate business.

Further, the commercial real estate market in major urban centres is highly competitive; therefore, purchasing a good commercial unit may be expensive. Franchisors may consider entering real estate market in second-tier cities, where competition for prime real estate is less fierce.

(b) The franchisor sub-leases the premises to the franchisee?

To sub-lease the premises to the franchisees, an international franchisor must first:

  • incorporate a foreign-invested real estate corporation with appropriate scope of business licence;
  • obtain all required permits from the government agencies; and
  • enter into the head lease.

The maximum term of a lease is 20 years; however, many domestic real estate lease agreements are entered for a term of three to five years. The franchisor will not be able to sub-lease the premises for a term longer than the head lease.

(c) The franchisee leases the premises from a third-party landlord?

As domestic leases of commercial property are relatively short – between three and five years – a franchisee’s lease may expire before the end of the franchise agreement term. This scenario should be addressed in the franchise agreement to avoid disputes as to the parties’ obligations should the franchisee fail to secure a new location before the current lease expires or is not renewed.  

International franchisors should also note that while conditional lease assignment is enforceable in the People’s Republic of China (PRC), a foreign legal entity cannot be a tenant; therefore, it must incorporate in the PRC to enforce these types of provision.

(d) The franchisee owns the premises?

Even if the franchisee owns the premises, the land under the building belongs to the state and is leased to the developer, usually for a term of 40 years. The franchisee may be required to vacate the premises if the lease is not renewed by the government.

Employment issues

Liability

Can franchisees or their employees be regarded as employees of the franchisor for liability purposes? If so, how can franchisors mitigate this risk?

The franchisor is not liable for the franchisee’s employees.

Tax and currency controls

Tax implications

What tax regimes apply to the franchisor/franchisee relationship?

If the foreign franchisor sells franchises in the People’s Republic of China (PRC) without establishing a local entity, all remittances of royalties by a Chinese franchisee to the overseas franchisor will be subject to the withholding tax. The rate of withholding tax on royalties is 10%, unless reduced by a treaty. Management fees and other active income sourced in China is also taxable.

Chinese tax authorities may consider service fees and other payments to be subject to withholding tax if they suspect that these payments are designed to reduce royalties. As Chinese franchisees are better suited to liaise with Chinese tax authorities, franchisors should consider gross-up clauses to shift the burden of dealing with tax authorities to the local franchisees.

If there is no gross-up clause, the franchisor may be able to credit withholding taxes paid in China against income tax of the franchisor in its home country.

Franchisors selling franchises via a local subsidiary will be charged an enterprise income tax at the rate of 25%.

Currency controls

Do any currency controls apply with respect to foreign franchisors?

Yes, Chinese currency, known as the ‘renminbi’ or ‘yuan’, is still not freely exchangeable, although controls have loosened over the last decade.

Chinese residents must obtain State Administration of Foreign Exchange approval to purchase foreign currency above the annual quota of $50,000. The foreign exchange controls are primarily enforced by the banks, which monitor all overseas payments made by customers. Chinese franchisees should submit documents evidencing their payment obligations (eg, a franchise agreement) to make the overseas payment. To facilitate payments, franchisors should ensure that all registration requirements (eg, registration with the Ministry of Commerce and recording trademark licences with the China Trademark Office) are timely completed.

Further, banks require payors to submit a tax recordal form issued by the tax authorities. Many tax departments will not issue tax recordal forms until all withholding taxes are paid.

Dispute resolution

Common disputes

What issues are typically the subject of disputes arising in the franchisor/franchisee relationship?

Due to the franchise regulations’ broad definition of ‘franchise’, which includes not only business franchises but also product distribution arrangements, there is a fair amount of litigation focused on whether a distribution or agency agreement was a franchise. 

Other common disputes include:

  • non-payment of royalties;
  • encroachment on exclusive territory; and
  • failure of the franchisor to provide support and assistance to the franchisees.

Venue

Which venues are empowered to hear franchising disputes in your jurisdiction? What considerations should be borne in mind when choosing a venue?

Franchising disputes usually fall under the jurisdiction of either the basic or intermediate people’s courts. Specialised IP courts in some major cities also have jurisdiction over major franchise cases. The level of court that will hear a dispute is determined by the amount of the claim and the status of the party (ie, a domestic litigant or foreigner). The monetary thresholds differ between provinces. Generally, foreign-related disputes have a lower monetary threshold to be heard by an intermediary people’s court or specialised IP court. In other words, it is easier for a foreign party to obtain more sophisticated judges at the trial level; therefore, appeals are heard by higher people’s courts.

For example, in Beijing, a franchise dispute involving a foreign franchisor with a monetary claim between Rmb50 million and Rmb100 million (approximately $7.8 million and $15.8 million) will likely be heard by the IP Court, while a domestic franchise dispute with the same monetary claim would go to the lower level basic people’s court. Basic people’s courts in major economic centres such as Beijing and Shanghai are highly reputable and their judges are fairly sophisticated.

Domestic franchise disputes are typically heard by local courts. There are few reported court decisions that involve international franchisors, even though international claimants have a good track record of prevailing in local courts. For example, Michelin’s Chinese subsidiary Chijia (Shanghai) Automobile Products Trading LLC recently won a case in the Court of Intellectual Property in Shanghai (Zhao Kewen v Chijia (Shanghai) Automobile Products Trading LLC, 赵克文与驰加(上海)汽车用品贸易有限公司特许经营合同纠纷, (2017) 沪73民终333号, 上海知识产权法院) against a franchisee which failed to pay the initial franchise fee and royalties, and tried to pull out of the franchise agreement by alleging:

  • disclosure deficiencies;
  • lack of franchisor’s authority to sign the franchise agreement; and
  • lack of assistance from the franchisor.

The appellate court upheld the trial court’s decision in favour of the franchisor, in part because of the adequate disclosure provided to the franchisee.

Alternative dispute resolution

Is alternative dispute resolution (ADR) commonly used for franchising disputes in your jurisdiction? What considerations should be borne in mind when opting for ADR?

Arbitration is regularly used in China-related franchise disputes, arguably because of a lack of understanding of the Chinese court system rather than the benefits of arbitration as a dispute resolution mechanism in the People’s Republic of China (PRC). Arbitration is expensive and more time consuming than litigation in local courts because arbitral awards must be approved by local courts for enforcement.

However, arbitration may be an effective tool if the franchisee has assets outside China, as arbitral awards are more ‘portable’ across borders than court judgments. The PRC is a party to the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (New York, 1958) and recognises both domestic and international arbitral awards. If opting for arbitration, franchisors should consider drafting an exception for IP-related disputes, as disputes regarding IP rights registered in China are unlikely to be eligible for arbitration.

Foreign judgments and awards

What regulations and procedures apply to the recognition of foreign judgments and arbitral awards where international franchising networks are concerned?

Enforcement of a foreign judgment in the PRC is often difficult. The PRC enforces foreign court decisions only where there is a treaty with the respective jurisdiction or where this jurisdiction enforces Chinese judgments based on reciprocity. No such treaty or reciprocity exists with the United States, Canada, Australia or the United Kingdom.

As the PRC is a party to the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (New York, 1958), arbitral awards are enforceable in China. However, arbitral awards must still be approved by a local court for enforcement – this process is as expensive and time consuming as a trial. Further, certain issues (eg, ownership of a Chinese-registered trademark) are unlikely to be eligible for arbitration. Arbitration tends to be more expensive and time consuming than litigating directly in a Chinese court.

Contrary to popular belief, Chinese courts are efficient and generally friendly to foreign parties. The World Bank Group’s enforcing contracts indicator ranks China fifth in the world for cost and time required to enforce a commercial contract in court and quality of judicial process (for comparison, the United States is ranked 16th, Hong Kong 28th and Canada 114th). International franchisors should consider opting for litigation in Chinese courts if enforcement against assets of a franchisee located in China is anticipated.