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Direct distribution

Ownership structures

May a foreign supplier establish its own entity to import and distribute its products in your jurisdiction?

Under the current regulatory environment, a foreign supplier may establish its own entity (wholly owned) to import and distribute its products in China, subject to some exceptions such as certain audi0visual work, agricultural products and gasoline where joint venture arrangements remain as the requisite structure to attain approval. There are some product categories that are still not open to foreign investors such as genetic testing equipment and military products, and local importers and distributors have to be engaged for importing these products.

May a foreign supplier be a partial owner with a local company of the importer of its products?

As mentioned, a foreign supplier may enter into a joint ownership arrangement with a local company or importer for the importation of its products, except products that are still not open to local trading by foreign investors. There are two major joint ownership structures: joint ventures in China and limited liability companies invested by the parties in China. For a joint venture in China, there is a choice of two types: equity joint ventures and contractual joint ventures. For an equity joint venture, each party must make a cash or permitted contribution and share the profits in proportion to its subscribed percentage of the venture’s registered capital. For a contractual joint venture, the parties may agree in the joint venture contract that profits will not be distributed in proportion to the subscribed percentage of the venture’s registered capital. Parties can invest in limited liability companies with a direct shareholding structure to set up holding companies outside China (using locations such as Hong Kong owing to certain tax considerations) and then the Chinese entity can be placed under such offshore holding structure.

What types of business entities are best suited for an importer owned by a foreign supplier? How are they formed? What laws govern them?

Unless it is required by law that a joint venture be established, from a corporate management perspective, a wholly foreign-owned enterprise (WFOE) is generally the preferred type of business vehicle for a foreign supplier to import and distribute its own products. A WFOE will be incorporated as a limited liability company in which the foreign supplier is the only shareholder. The establishment, operation and termination of the WFOE is governed by the Company Law of the People’s Republic of China (PRC) and the Law of the PRC on Foreign-invested Enterprises. There are different local approval procedures for certain businesses.

Restrictions

Does your jurisdiction restrict foreign businesses from operating in the jurisdiction, or limit foreign investment in or ownership of domestic business entities?

The Chinese regulatory environment is more focused on the regulation of business than on the ownership of business entities, and the scope of business of a business entity is specifically defined in the corporate formation documents. In essence, conducting any business beyond the approved scope of business is illegal. Foreign investors are required to follow the Catalogue of Industries for Guiding Foreign Investment (Catalogue) to verify whether the proposed business is restricted under national and local regulations. In the Catalogue all industries are divided into three groups:

  • encouraged industries;
  • restricted industries; and
  • prohibited industries.

Foreign investors are not allowed to conduct business, or invest, in prohibited industries and are subject to several restrictions for investing in restricted industries. The Catalogue may be subject to changes by the government from time to time.

Equity interests

May the foreign supplier own an equity interest in the local entity that distributes its products?

See question 3.

Tax considerations

What are the tax considerations for foreign suppliers and for the formation of an importer owned by a foreign supplier? What taxes are applicable to foreign businesses and individuals that operate in your jurisdiction or own interests in local businesses?

The major relevant taxes are corporate income tax, value added tax and customs duties. China also follows the Organisation for Economic Co-operation and Development model on the issue of transfer pricing. The tax authority in China has been using the industrial average profit margin generated from its database to determine whether the assessable income should be adjusted due to certain transfer pricing arrangements between related companies.

Local distributors and commercial agents

Distribution structures

What distribution structures are available to a supplier?

Various distribution structures are available in China, including the typical structures of distributorship, commission agency, franchise, trademark licence and joint ventures. Apart from the usual business considerations such as whether the model can achieve better penetration into the market and serve the objectives of the brand owner, tax issues and actual logistic arrangements are also crucial in determining whether a certain structure is preferred. For example, it is common to use local agencies for importing cosmetic products due to certain testing procedures of the China Food and Drug Administration, and the distributors are supplied through such local agencies.

Legislation and regulators

What laws and government agencies regulate the relationship between a supplier and its distributor, agent or other representative? Are there industry self-regulatory constraints or other restrictions that may govern the distribution relationship?

Generally, the Contract Law of the PRC governs the relationship. There is no specific government agency regulating the distribution aspect, provided that in the context of franchising, the Ministry of Commerce is the regulatory authority that oversees compliance pursuant to the franchise laws and regulations such as the Regulations of Administration of Commercial Franchising. Recently, the government released a series of national standards for different sectors stipulating the necessary standards for management of different contractual relationships. However, the legal position of these national standards has not yet been defined.

Contract termination

Are there any restrictions on a supplier’s right to terminate a distribution relationship without cause if permitted by contract? Is any specific cause required to terminate a distribution relationship? Do the answers differ for a decision not to renew the distribution relationship when the contract term expires?

The Contract Law of the PRC does not restrict the supplier’s contractual rights to terminate a distribution relationship without cause. The contractual provisions regarding termination are usually descriptive and elaborate in contracts with Chinese parties, because some common concepts in other jurisdictions, such as time sensitivity, do not exist under Chinese law.

Is any mandatory compensation or indemnity required to be paid in the event of a termination without cause or otherwise?

The Contract Law of the PRC does not require the brand owner to provide a mandatory compensation or an indemnity at the termination of the distribution or similar relationship. There is no requirement under the law to compensate the distributor for the goodwill established by the distributor.

Transfer of rights or ownership

Will your jurisdiction enforce a distribution contract provision prohibiting the transfer of the distribution rights to the supplier’s products, all or part of the ownership of the distributor or agent, or the distributor or agent’s business to a third party?

It is common to have change of control provisions in distribution or agency contracts enabling termination of the agreement in the event of transfer of ownership of the distributor or agent to a third party, and so far there is no specific judicial precedent prohibiting the enforcement of such contractual provisions.

Regulation of the distribution relationship

Confidentiality agreements

Are there limitations on the extent to which your jurisdiction will enforce confidentiality provisions in distribution agreements?

Confidentiality provisions in distribution agreements are generally enforced contractually and there are also statutory protections under the Anti-Unfair Competition Law of the PRC. However, the usual challenges relate to the mechanism implemented to protect the confidential nature of the information involved (eg, document marking, restrictions to access, etc) and it is necessary to devise a system to protect the confidential information. The Anti-Unfair Competition Law of the PRC (2017 Revision) abolished the previous requirement that confidential information should be of practical value, and the coverage of confidential information has expanded.

Competing products

Are restrictions on the distribution of competing products in distribution agreements enforceable, either during the term of the relationship or afterwards?

So far the judicial precedents have not shown a very systematic approach towards the determination of enforceability of non-compete provisions. Non-compete provisions are generally enforceable during the term of the distribution relationship. It is generally agreed that non-compete provisions are enforceable if the restricted period is not excessively long (eg, after two years for the original distribution territory is generally acceptable). In determination of the reasonableness of certain restrictions, the general ‘fair and reasonable’ test, which is relatively vague, is adopted.

Prices

May a supplier control the prices at which its distribution partner resells its products? If not, how are these restrictions enforced?

Generally, distributors can be required to follow the supplier’s pricing policy. However, under the Anti-Monopoly Law of the PRC, price-fixing arrangements, to monopolise the market, between the supplier and distributors are prohibited, and there are other restrictions mentioned below.

May a supplier influence resale prices in other ways, such as suggesting resale prices, establishing a minimum advertised price policy, announcing it will not deal with customers who do not follow its pricing policy, or otherwise?

Minimum advertised price policies that only regulate the advertised resale prices without restricting the actual resale prices to be negotiated by the distributors and the customers are common nowadays, but such provisions remain relatively untested. It is necessary to mention that a supplier may violate the Anti-Monopoly Law of the PRC if it enters into an arrangement with a distributor to fix resale prices or set minimum resale prices to achieve market monopoly. It is advisable to make the termination provisions related to violation of the pricing policy and minimum advertised price policy more detailed.

May a distribution contract specify that the supplier’s price to the distributor will be no higher than its lowest price to other customers?

The general belief is that this type of ‘most-favoured customer’ provision is enforceable. However, the Anti-Monopoly Law of the PRC prohibits a distributor from abusing its dominant position in the market to secure certain trading conditions that restrict market entry by other parties.

Are there restrictions on a seller’s ability to charge different prices to different customers, based on location, type of customer, quantities purchased, or otherwise?

The law generally does not intervene in the freedom of dealings between the parties on pricing issues. The exception is that under the Anti-Monopoly Law of the PRC, a supplier who is in a dominant position in the market is not allowed to offer different transactional terms and conditions (eg, sale prices) to customers (which means the distributor in the present context) with the same background without proper reason. There is no statutory definition of ‘customers who are of the same background’, and the court has wide discretion to determine who may be in breach of this law.

Geographic and customer restrictions

May a supplier restrict the geographic areas or categories of customers to which its distribution partner resells? Are exclusive territories permitted? May a supplier reserve certain customers to itself? If not, how are the limitations on such conduct enforced? Is there a distinction between active sales efforts and passive sales that are not actively solicited, and how are those terms defined?

It is common to agree on exclusive territory for a particular distributor, and the contractual provisions remain decisive in determining how to define the territories and markets. The law so far has not provided sufficient guidance on construing the contractual provisions of active sales and passive sales that are not actively solicited, but which are heavily litigated in other jurisdictions.

Online sales

May a supplier restrict or prohibit e-commerce sales by its distribution partners?

It is common that a supplier restricts or prohibits e-commerce sales by its distribution partners in China, as e-commerce distribution rights are normally separately granted. Whether restrictions as to the use of e-commerce intermediaries exist is a matter of negotiation between the parties but the engagement of e-commerce intermediaries is a growing phenomenon in the past few years. The provisions on territorial limitation as to distribution activities with enhanced technological requirements are seen in most of the distribution agreements. A supplier may require that its distribution partners, or e-commerce intermediaries, do not sell products outside the assigned territory. Under the highly computerised environment of e-commerce, it is usual for suppliers to request their distribution partners to provide more reports as to sales by territory, and some distribution systems have a specific fee or ‘invasion fee’ for sales out of its authorised territory.

Refusal to deal

Under what circumstances may a supplier refuse to deal with particular customers? May a supplier restrict its distributor’s ability to deal with particular customers?

The Anti-Monopoly Law of the PRC prohibits businesses that are in a dominant position in the market from refusing to deal with particular customers, or from restricting their distributors from dealing with certain parties, without proper reason. There is no statutory definition for ‘proper reason’, which is subject to the determination by the courts at their discretion on a case-by-case basis. However, if there is no abuse of a dominant position, the prohibition should not be relevant, and the supplier is free to devise a policy on selection of customers.

Competition concerns

Under which circumstances might a distribution or agency agreement be deemed a reportable transaction under merger control rules and require clearance by the competition authority? What standards would be used to evaluate such a transaction?

Under the Anti-Monopoly Law of the PRC, a merger or common control of shareholdings of different competitors, entering into arrangements for control of different competitors, may lead to a concentration situation, and such a situation is subject to reporting and approval requirements. There are further rules defining what reportable situations are, some examples of which are as follows:

  • if the annual global sales figure for the concentration is more than 10 billion yuan, when annual sales figures of two operators in China exceed 400 million yuan; or
  • if the annual Chinese sales figure for the concentration is more than 2 billion yuan, when annual sales figures of two operators in China exceed 400 million yuan.

There are a number of relevant standards to be examined, such as:

  • the market share and the relative power of control by the operators in such an environment;
  • the level of concentration of the market;
  • the level of influence of the operator on the entry by others into the market and on technological development;
  • the level of influence of the operator on customers and other competitors; and
  • the level of influence of the operator on national economic development.

The above is not an exhaustive list.

Do your jurisdiction’s antitrust or competition laws constrain the relationship between suppliers and their distribution partners in any other ways? How are any such laws enforced and by which agencies? Can private parties bring actions under antitrust or competition laws? What remedies are available?

The Anti-Unfair Competition Law of the PRC and the Anti-Monopoly Law of the PRC are the primary relevant legislation in this respect. Apart from the points discussed in other questions, under the Anti-Monopoly Law, a supplier abusing its dominant position in the market and requiring its distributors to purchase products from the suppliers designated by it for the purpose of excluding fair competition is prohibited.

The regulatory authority under the Anti-Unfair Competition Law is the administration for industry and commerce and the regulatory authority under the Anti-Monopoly Law is the Anti-Monopoly Commission. Both authorities have the necessary powers to investigate and impose administrative penalties.

Affected parties are entitled to bring actions under the Anti-Unfair Competition Law or the Anti-Monopoly Law for damages, loss of profits and reasonable investigation costs.

Parallel imports

Are there ways in which a distributor or agent can prevent parallel or ‘grey market’ imports into its territory of the supplier’s products?

At present, Chinese law only allows parallel imports of patented products. The law does not specify whether parallel import of products under registered trademarks is prohibited, but there are cases where the parallel import of products under registered trademarks is regarded as an infringement of trademark rights. It is common to include contractual provisions to restrict parallel import, but instead of simply relying on the contractual arrangements, brand owners may record their registered trademarks with customs, and as a result, customs will monitor the shipments and seize any infringing products that bear the trademark. A registered patent is also recordable, but generally customs has difficulty in monitoring this due to lack of technical capability.

Advertising

What restrictions exist on the ability of a supplier or distributor to advertise and market the products it sells? May a supplier pass all or part of its cost of advertising on to its distribution partners or share in its cost of advertising?

A supplier may advertise and market its products pursuant to the Advertisement Law of the PRC at its own cost, or pass all or part of its costs on to its distributors, or share in its costs upon mutual agreement.

Intellectual property

How may a supplier safeguard its intellectual property from infringement by its distribution partners and by third parties? Are technology-transfer agreements common?

China is party to major international conventions on intellectual property protection. Following international practice, patents and trademarks should be registered in China in order to secure protection under local laws. Although a copyright work created overseas is automatically protected under local laws, in practice, a separate copyright record should be filed before the judicial and administrative authorities will recognise such rights. Trade secrets and confidential information are protected under the Anti-Unfair Competition Law of the PRC. Information that is not a trade secret or confidential relies heavily on the protection as stipulated in the relevant contractual documents between the parties. It is common for owners of intellectual property to enter into different kinds of agreements such as licensing and technology-transfer agreements with local parties.

It is prudent to conduct an audit to review the portfolio before entering into any negotiation with a local party, as there are usually some additional issues to be resolved (eg, Chinese transliteration of the brand should be registered).

Consumer protection

What consumer protection laws are relevant to a supplier or distributor?

A distributor is not protected by the Consumer Interests Protection Law of the PRC, as, defined by this law, a distributor is not a consumer. However, under chapter 3 of the law, the supplier or distributor shall fulfil its statutory obligations as a business. For example, when selling its products to a consumer, the supplier or distributor cannot impose unfair or unreasonable transactional conditions on the consumer (eg, a tie-in sale). Apart from the Consumer Interests Protection Law of the PRC, the Tort Law and the Product Liability Law of the PRC set out the general obligations and liabilities of suppliers and distributors.

Product recalls

Briefly describe any legal requirements regarding recalls of distributed products. May the distribution agreement delineate which party is responsible for carrying out and absorbing the cost of a recall?

China does not have a general law regulating product recalls, but there are several regulations concerning the product recall of specific categories of products, including automobiles, drugs, children’s tools and foods. The requirements and procedures for product recalls are basically the same. Generally, manufacturers are responsible for product recalls and distributors or retailers are obliged to cooperate. A detailed action plan of the product recall must be filed with the authority.

Except in product recalls of automobiles where the relevant regulations stipulate that the manufacturer has to bear the cost thereof, other regulations are silent on which party is responsible for the cost. The parties in cases other than automobiles can negotiate the apportionment of liability and financial exposure in such product recall situations.

Warranties

To what extent may a supplier limit the warranties it provides to its distribution partners and to what extent can both limit the warranties provided to their downstream customers?

Except for the mandatory warranties as set out in the Product Quality Law of the PRC, which covers the basic requirements on safety, use, and written descriptions and instructions of use, the supplier and distributors are free to negotiate additional warranties in their contractual arrangements, and to agree on the warranties to be offered to their downstream customers.

Data transfers

Are there restrictions on the exchange of information between a supplier and its distribution partners about the customers and end users of their products? Who owns such information and what data protection or privacy regulations are applicable?

Although the law is silent on the ownership of personal data of customers and end users, according to the Consumer Interests Protection Law of the PRC, business operators that collect the personal data of their consumers (including end users) are required to keep such information strictly confidential. Consent has to be obtained from the consumers before the exchange of personal data between a supplier and its distributor. The provisions on protecting the personal information of telecommunications and internet users, which is a general set of rules for the internet environment, further regulates the collection and use of personal data on the internet by dividing personal data into different categories. Different protection is offered for each category.

The first Cyber Security Law of the PRC was passed in 2016, and has been implemented from 1 June 2017. Under the Cyber Security Law, critical infrastructure providers (ie, companies running infrastructure critical to the economy such as public communications, energy, traffic, finance, etc) shall store all users’ data on Chinese servers and undergo a security check if they want to transfer data out of the country.

Employment issues

May a supplier approve or reject the individuals who manage the distribution partner’s business, or terminate the relationship if not satisfied with the management?

Chinese laws do not restrict these kinds of provisions, but it is advisable to have detailed provisions in this respect, as the court normally adopts a relatively restrictive interpretation for these types of clauses.

Are there circumstances under which a distributor or agent would be treated as an employee of the supplier, and what are the consequences of such treatment? How can a supplier protect against responsibility for potential violations of labour and employment laws by its distribution partners?

In general, each business in China has to secure a business licence. From the administrative point of view, contracting with a business that has a business licence effectively designates a commercial relationship between two separate businesses. Furthermore, it is common to adopt provisions in the distribution agreement stating that the distributor is an independent contractor rather than employee of the supplier, and the distributor shall be responsible for its own actions.

In the event that the distributor or agent is an individual and a dispute arises on whether there has been an employment relationship, the PRC courts will consider the following aspects to determine whether there has been an employment relationship (‘Notice on determining whether an employment relationship exists’ Lao She Bu Fa [2005] No. 12):

  • written agreement between the parties;
  • whether the distributor is on the payroll and whether the supplier has paid any statutory social insurance for the distributor;
  • whether the distributor has acquired any corporate identification, uniform from the supplier and made any authorised representation as the supplier’s representative to the public; and
  • whether the distributor completed any job application forms.

Having said that, practically, a properly set up distribution network should not give rise to such concern. As mentioned above, the existence of a business licence is the crucial factor in the determination in practice, as once such business relationship has been established, a distributor or agent with a business licence would not be deemed an employee of the supplier.

Commission payments

Is the payment of commission to a commercial agent regulated?

There are no specific laws or regulations governing payment of commission to a commercial agent. The general contractual law principles apply.

Good faith and fair dealing

What good faith and fair dealing requirements apply to distribution relationships?

There are no good faith and fair dealing requirements applicable to distribution relationships in Chinese law. There is a ‘fair and reasonable’ principle under the Contract Law of the PRC, but this principle is not frequently applied. If applied, it is usually used to determine whether certain contractual provisions are oppressive instead of examining the course of dealing between the parties.

Registration of agreements

Are there laws requiring that distribution agreements or intellectual property licence agreements be registered with or approved by any government agency?

There is no specific requirement governing distribution agreements to be registered with any government agencies. Instead, there are recordal requirements for intellectual property licence agreements. A trademark licence agreement should be recorded with the Trademark Office. Although such recordal is not mandatory, without it the licensing arrangement will not bind other third parties. A patent licence agreement should be recorded with the State Intellectual Property Office and is mandatory, otherwise the licensing arrangement will not bind other third parties. A copyright licence agreement should be recorded with the Copyright Protection Centre and is voluntary.

Anti-corruption rules

To what extent are anti-bribery or anti-corruption laws applicable to relationships between suppliers and their distribution partners?

The Criminal Law of the PRC provides two categories of corruptive practices offences. The first is against bribes offered to civil servants, and the other is against commercial bribery. There are different thresholds under the current prosecution policy, for example, in individual bribery situations, for bribes offered to non-public officials, the threshold of prosecution is 10,000 yuan. On the other hand, under the PRC Anti-unfair Competition Law (2017 Revision), as long as gifts or invitations may give the subject company or employees an advantage which is unfair to other competitors, any amount (whether provided in cash or in any other form) offered to non-public officials in exchange for business opportunities or interests will be subject to confiscation of illegal gains and a fine up to 3 million yuan, and if the circumstances are serious, the business licence of the subject company may be revoked.

Prohibited and mandatory contractual provisions

Are there any other restrictions on provisions in distribution contracts or limitations on their enforceability? Are there any mandatory provisions? Are there any provisions that local law will deem included even if absent?

Apart from the issues covered above, the Contract Law of the PRC does not impose any specific restrictions or mandatory provisions on distribution contracts. The general contractual principles apply.

Governing law and choice of forum

Choice of law

Are there restrictions on the parties’ contractual choice of a country’s law to govern a distribution contract?

Chinese laws do not impose any restrictions on the governing law of distribution contracts. However, in practice, if a local party files a lawsuit at the local court and the court proceeds with the case, it is unlikely that the local court will apply the governing law as set out in the distribution contract. Instead, the Chinese laws are likely to be applied.

Choice of forum

Are there restrictions on the parties’ contractual choice of courts or arbitration tribunals, whether within or outside your jurisdiction, to resolve contractual disputes?

Chinese laws do not impose any restrictions as to the choice of courts or arbitration tribunals. However, since the performance of the distribution contract takes place within China, it is possible for the Chinese courts to assume jurisdiction over the case despite the choice of venue provisions.

Dispute resolution procedures

What courts, procedures and remedies are available to suppliers and distribution partners to resolve disputes? Are foreign businesses restricted in their ability to make use of these courts and procedures? Can they expect fair treatment? To what extent can a litigant require disclosure of documents or testimony from an adverse party? What are the advantages and disadvantages to a foreign business of resolving disputes in your country’s courts?

The procedures of the Chinese courts are relatively simple and normally a case can be closed within approximately a year. Under the present court rules, remedies are limited and certain relief such as injunctions and specific performance are not generally available.

Foreign parties’ participation in Chinese court proceedings are common nowadays. Quality or predictable judgments can be seen in the courts of major coastal cities, although sometimes foreign parties may elect to have the disputes resolved in alternative venues such as arbitration in Hong Kong owing to the language barrier, and Hong Kong arbitral awards are enforceable in China. Under Chinese court and arbitration rules, there are no general disclosure obligations and evidence rules are less flexible (eg, electronic records and evidence should be notarised, evidence outside China should be legalised or authenticated by a Chinese Embassy or Consulate, and special attention should be paid at the preparation stage).

Alternative dispute resolution

Will an agreement to mediate or arbitrate disputes be enforced in your jurisdiction? Are there any limitations on the terms of an agreement to arbitrate? What are the advantages and disadvantages for a foreign business of resolving disputes by arbitration in a dispute with a business partner in your country?

There is no formal mediation process under the rules, but judges and arbitrators usually suggest ad hoc mediation before the conclusion of the case.

Arbitration clauses are generally enforced, and the choices of the parties such as language, number of arbitrators and venue are generally respected. There are now several arbitration commissions within China, such as the China International Economic and Trade Arbitration Centre (CIETAC) in Beijing, the Shanghai International Arbitration Centre and the Shenzhen Court of International Arbitration. The second and third institutions were formerly sub-commissions of the CIETAC, in Shanghai and Shenzhen. Since both sub-commissions are now independent, an arbitration clause previously designating them as CIETAC sub-commissions should be revised, otherwise there may be an issue regarding the identity of the institution.

Arbitration is gaining popularity in cross-border commercial disputes because arbitrators are usually practitioners with substantial experience in the relevant areas and arbitration proceedings are more flexible in terms of the procedure.

Update and trends

Recent developments

Updates and trends

China’s first E-commerce Law was adopted on 31 August 2018 and became effective on 1 January 2019. The E-commerce Law governs e-commerce platforms, individual merchants of these platforms and people who operate the business on their independent websites or other online service (eg, social networks). Under the E-commerce Law, an e-commerce operator shall register with competent authorities.