SUMMARY OF CONTENTS

GOVERNMENT RESTRUCTURING

The First Meeting of the Tenth National People's Congress adopted the State Council’s Plan for the Reform of the Organs of the State Council 国务院机构改革方案on 10 March 2003. The Plan marks the third major reform of the State Council in a decade.

MOFTEC becomes MOFCOM

One of the main reforms under the Plan is the abolition of the Ministry of Foreign Trade and Economic Cooperation (“MOFTEC”) and the State Economic and Trade Commission (“SETC”) which were previously responsible for foreign trade and domestic trade respectively and the creation of a new Ministry of Commerce (“MOFCOM”) which will be responsible for both foreign and domestic trade.

Key reforms

Other key points of the Plan include: 

• the establishment of a State Asset Management Commission to intensify the reform of state-owned asset administration;

• the establishment of a China Banking Regulatory Commission which will assume part of the People's Bank of China’s dual function completing the separation of regulatory and commercial functions;

• the reorganisation of the State Development and Planning Commission into the State Development and Reform Commission which shall be in charge of macro-economic control mechanisms;

• to reorganisation of the State Drug Administration into the new State Food and Drug Administration which shall improve supervision over the safety of food, health products and cosmetics;

• the promotion of the State Administration of Work Safety formerly under the SETC into an organ directly under the State Council.

As a result of the reforms, the total number of organs of the State Council has been reduced to 28 from 29.

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HOLDING COMPANY REGULATIONS AMENDED

The Ministry of Foreign Trade and Economic Cooperation promulgated the Decision on Amending the “Provisional Regulations Concerning Investment in and Establishment of Investment-type Companies by Foreign Business Entities and the Supplementary Regulations” 关于修改《关于外商投资举办投资性公司的暂行规定》及补充规定的决定 on 7 March 2003. The Decision, which entered into effect 30 days after its promulgation, amended the key regulations governing the establishment and operation of holding companies in China by foreign investors. The Decision amended the Provisional Regulations Concerning Investment in and Establishment of Investment-type Companies by Foreign Business Entities 关于外商投资举办投资性公司的暂行规定 (the “Provisional Regulations”)and other ancillary regulations regarding holding companies such as the Supplementary Regulations for the Provisional Regulations Concerning Investment in and Establishment of Holding Companies by Foreign Business Entities,《关于外商投资举办投资性公司的暂行规定》的补充规定 (the “Supplementary Regulations”) (as discussed in the March 2000 issue of China Legal Update) and the Supplementary Regulations No. 2 for the Provisional Regulations Concerning Investment in and Establishment of Holding Companies by Foreign Business Entities 《关于外商投资举办投资性公司的暂行规定》的补充规定（二）(the “Supplementary Regulations No. 2”) (as discussed in the September 2001 issue of China Legal Update). The Decision did not change the fundamental requirements which investors must satisfy in order to establish a holding company in the PRC. 

The new Ministry of Commerce subsequently issued a new statute which consolidates both the earlier regulations regarding holding companies and the amendments introduced by the Decision. The Regulations on the Investment in and Establishment of Investment-type Companies by Foreign Business Entities 关于外商投资举办投资性公司的规定 (the “Regulations”) were issued on 10 June 2003 and will enter into effect on 10 July 2003. All previous regulations regarding holding companies will be repealed once the Regulations enter into effect.

Expanded business scope

The Decision expands the permissible range of holding company business activities. Holding companies can now invest in any area in which foreign investment is permitted. Previously, holding companies were only allowed to invest in “encouraged” or “permitted” projects. This means that holding companies may now also invest in "restricted" projects. 

The services that a holding company can provide to enterprises that it has invested in (“invested enterprises”) have been slightly redefined in the Decision to include services such as technical support, staff training, internal personnel management etc. The Regulations specifically permit the establishment of research and development centres by holding companies. These research and development centres may assign the results of their research and provide related technical services. A holding company may now also provide its affiliates with services related to market information and investment policy advice.

A holding company which operates lawfully, has no record of breaking the law, has paid its capital contributions on schedule and has actually paid up registered capital of not less than US$30 million may also operate the following types of business:

• act as a distributor for the products of its invested enterprises in China and abroad;

• provide its invested enterprises with comprehensive services such as transportation, warehousing, etc.; 

• export domestic commodities which are not subject to quota or licensing as an agent, distributor or through the establishment of an export purchasing organisation; 

• perform systems integration of products manufactured by its invested enterprises and then sell these products in China and abroad; 

• provide relevant technical training to the domestic distributors and agents for the products of its invested enterprises and to domestic companies and enterprises that have concluded technology transfer agreements with the holding company and its parent company; 

• test the market for a product by importing a limited quantity of identical or similar products from its parent company before its subsidiary commences production of its product;

• provide operational leasing services to its invested enterprises in respect of machinery and office equipment;

• provide after-sales services for the products of its parent company; and

• participate in overseas contracting projects carried out by Chinese contractors.

Renminbi capital contributions

Foreign investors are now also permitted to contribute lawfully obtained Renminbi revenue to the capital of the holding company provided the investor can provide the relevant supporting documents and evidence of tax payment. This means that Renminbi proceeds from activities in the PRC such as equity transfers or liquidation may be used as part of the capital contribution of a holding company.

Borrowings

Under the Supplementary Regulations, a holding company with registered capital of not less than US$30 million was permitted to borrow no more than four times the amount of paid up registered capital. The Decision makes a further provision for holding companies with registered capital of at least US$100 million. Such holding companies may borrow up to six times the amount of the paid up registered capital. 

Acting as a promotor

The Supplementary Regulations permit holding companies to act as the promoters of companies limited by shares with foreign investment and to hold the unlisted legal person shares of companies limited by shares with foreign investment. The Decision extends this further to the unlisted legal person shares of other companies limited by shares in China.

Market testing

An important innovation under the Supplementary Regulations No. 2 was to permit a holding company to test the market for a product by importing a limited quantity from its parent company before making a decision to invest in the production of such product. In any given year, the total amount of such imports was not allowed to exceed 20% of the portion of the company’s registered capital contributed in cash foreign exchange. The Decision raises this limit to 35%.

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MAINLAND AND HONG KONG CONCLUDE FREE TRADE PACT

The Central Government of the People's Republic of China and the Government of the Hong Kong Special Administrative Region reached agreement on the principal aspects of the Closer Economic Partnership Arrangement (“CEPA”) between the Mainland and Hong Kong on 29 June 2003. Under the CEPA tariffs and other barriers on trade in goods and services will be gradually phased out and measures will be implemented to promote trade and investment between the Mainland and Hong Kong starting from 1 January 2004. Further negotiations and concessions are expected pursuant to CEPA.

Trade in goods

The Mainland will allow the duty free import from Hong Kong of 270 product groups which meet the rules of origin requirements starting from 1 January 2004. The products include electrical and electronic products, plastic goods, paper articles, textiles and clothing, chemical products, pharmaceutical products, clocks and watches, jewellery, cosmetics, metal products and other products.

The Mainland will also permit the duty free import from Hong Kong of a second batch of products which meet the rules of origin at the latest by 1 January 2006. The products in this second batch will be based on a consolidated list drawn up by the HKSAR government following applications made by Hong Kong manufacturers. 

The HKSAR agrees to maintain its existing zero import tariff regime with respect to all goods of Mainland origin and not to impose restrictive regulations on trade in these goods.

The two sides have agreed not to adopt any anti-dumping, countervailing duty and specific safeguard measures against the other side’s goods. The Mainland has undertaken not to impose tariff rate quotas on goods of Hong Kong origin.

Rules of origin

The rules of origin for the first batch of duty free products are subject to further negotiations between the two sides with a view to reaching an agreement before 1 January 2004. The rules for the second batch of products will be determined at a later stage. The two sides have undertaken to adopt measures to prevent illegal circumvention of the agreed rules of origin.

Trade in services

The CEPA provides for liberalisation of market access in 17 services sectors ahead of the liberalisation schedule under the Protocol on the Accession of the People's Republic of China to the World Trade Organisation (the “WTO Protocol”). In some sectors the concessions surpass China's WTO commitments. Larger concessions have been made for construction and real estate services, logistics services, transport services, distribution services, legal services, and audio-visual services. Unless otherwise provided in CEPA, China's WTO commitments regarding the various service sectors will also continue to apply to Hong Kong companies. 

Qualifying criteria for Hong Kong companies

CEPA contains various qualification criteria for what constitutes a Hong Kong company for the purpose of enjoying beneficial treatment under the arrangement. With respect to convention services, management consulting services, advertising services, transport services, distribution services, freight forwarding agency services, storage and warehousing services, logistics services, tourism services, audio-visual services, real estate services, and construction and related engineering services, the criteria for qualifying as a “Hong Kong company” are:

1. the enterprise is registered and established pursuant to the Companies Ordinance or other relevant ordinances of the Hong Kong Special Administrative Region. 
   

2. the enterprise engages in substantive business operations in Hong Kong, which is determined on the basis of the following factors:

• the nature and scope of business of the enterprise in Hong Kong;

• the payment of profits tax in Hong Kong;

• the number of years of substantive operations in Hong Kong;

• the ownership or rental of business premises in Hong Kong to engage in substantive operations; and

• the employment in Hong Kong of 50 % of its total staff.

Trade and investment facilitation

The two sides have agreed to further strengthen economic and trade cooperation through trade promotion and investment facilitation in seven areas: customs clearance, quarantine and inspection of commodities, quality assurance and food safety. The two sides have also agreed to foster cooperation with respect to small and medium-sized enterprises, Chinese medicine and medical products, electronic commerce, trade and investment promotion and transparency in laws and regulations.

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The Press and Publication Administration and the Ministry of Foreign Trade and Economic Cooperation jointly issued the Measures for the Administration of Book, Newspaper and Periodical Distribution Enterprises with Foreign Investment 外商投资图书、报纸、期刊分销企业管理办法 on 17 March 2003. The Measures, which entered into effect on 1 May 2003, are the first regulations to permit foreign participation in the distribution of books, newspapers and magazines (“publications”) inside of China. The portion of the Measures that deals with foreign investment in the wholesaling of publications will only enter into effect on 1 December 2004.

The Ministry of Construction (“MOC”) and the Ministry of Foreign Trade and Economic Cooperation jointly promulgated the Regulations for the Administration of Urban Planning Service Enterprises with Foreign Investment外商投资城市规划服务企业管理规定 on 13 February 2003. The Regulations, which entered into effect on 1 May 2003, open up the urban planning services sector to foreign investment. The MOC also published on 9 May 2003 the Notice of the Ministry of Construction on Relevant Matters in Applications for an Urban Planning Services Qualification Certificate by Foreign Investment Enterprises 建设部关于外商投资企业办理城市规划服务资格证书有关事项的通知 (the “Notice”), which imposes some additional requirements. Under the Protocol on the Accession of the People's Republic of China to the World Trade Organisation (the “WTO Protocol”), China has committed to permitting joint ventures with foreign majority investment in the urban planning services sector. Wholly foreign-owned investment will be permitted within five years of China’s accession, i.e. commencing from 11 December 2006. 

The State Administration of Taxation (“SAT”) recently issued the Notice of the State Administration of Taxation on Relevant Issues in the Administration of the Taxation of Resident Representative Offices of Foreign Enterprises 国家税务总局关于外国企业常驻代表机构有关税收管理问题的通知to clarify certain issues in the taxation of representative offices in China. The Notice, which entered into effect on 1 July 2003 explains certain issues raised by an earlier notice of the SAT, the Notice of the State General Administration of Taxation on Strengthening the Management of Taxation on Resident Representative Offices of Foreign Enterprises 国家税务总局关于加强外国企业常驻代表机构税收征管有关问题的通知 issued on 13 September 1996 (the “1996 Notice”). The 1996 Notice sets forth the types of activities of representative offices of foreign enterprises (“representative offices”) that are taxable and how tax is to be assessed on representative offices.

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EQUITY ACQUISITION TAX ISSUES EXPLAINED

The State Administration of Taxation issued the Notice on Relevant Taxation Issues in the Acquisition by Foreign Investors of Equity in Domestic Enterprises 关于外国投资者并购境内企业股权有关税收问题的通知 on 28 May 2003. The Notice, which became effective on 1 January 2003, explains the tax impact of an equity acquisition under the Provisional Regulations Regarding the Acquisition of Domestic Enterprises by Foreign Investors 外国投资者并购境内企业暂行规定 (the “Provisional Regulations”)(as discussed in the April 2003 issue of China Legal Update). The Provisional Regulations provide for two forms of acquisition of domestic enterprises by foreign investors: an equity acquisition and an asset acquisition. In an equity acquisition, a domestic company is converted into a foreign investment enterprise (“FIE”) after a foreign investor has either purchased the shareholder’s interest in the domestic company or subscribed to the capital increase of the domestic company. The Notice deals solely with issues related to equity acquisitions.

Tax treatment and preferences

The Notice provides that if the foreign party holds more than 25% of the equity in the new FIE, the tax laws and regulations applicable to FIEs shall be applicable. If the FIE satisfies the relevant provisions of the Income Tax Law of the People's Republic of China for Foreign Investment Enterprises and Foreign Enterprises 中华人民共和国外商投资企业和外国企业所得税法 (“Foreign Tax Law”) and its detailed implementing rules, the FIE is eligible for the various forms of preferential tax treatment available under the Foreign Tax Law. 

The Notice explains that accumulated losses of the acquired domestic enterprise which have not been set off may continue to be set off by the FIE in subsequent years for the remainder of the period during which losses may be set-off pursuant to Article 11 of the Foreign Tax Law. The maximum time limit for setting off losses under this Article is five years from the year in which the losses were incurred.

Under the Foreign Tax Law, tax benefits are enjoyed for a fixed number of years commencing from the first year of profit. The Notice provides that the first year of profit is the year in which an FIE formed upon the equity acquisition of a domestic enterprise still has a profit after setting off the allowable losses of previous years against that year’s income. If the FIE has not completed a six-month term of actual production and operation in that year of profit, the FIE is permitted to start reckoning the period during which the tax benefits are enjoyed from the next tax year. In that case, the FIE must pay normal taxes on the profit earned during the first profit year.

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FOREX RULES GOVERNING FOREIGN DIRECT INVESTMENT

The State Administration of Foreign Exchange (“SAFE”) issued the Notice on Relevant Issues in Improving the Administration Work Regarding Direct Foreign Exchange Investment of Foreign Investors 关于完善外商直接投资外汇管理工作有关问题的通知 on 3 March 2003. The Notice which entered into effect on 1 April 2003 creates for foreign investors new possibilities for the opening of bank accounts and payment of capital contributions.

Special foreign exchange account

The Notice permits foreign corporate investors who have not established a foreign investment enterprise but are engaged in direct investment or related activities to open special foreign exchange accounts in their name. For this purpose they must make an application to the local branch of SAFE in the place where their investment projects are located. Each foreign investor is permitted to open a single special multiple currency foreign exchange account, which can be used for four different purposes: 

• investment account: an investor engaging in contracted projects, cooperative extraction, development and exploration of resources and venture capital investment may apply to open such account after having secured a non-legal person business licence;

• acquisition account: an investor who plans to establish a foreign investment enterprise (“FIE”) in China and in the initial phase needs to purchase land use rights and ancillary immovable property, machinery, equipment or other assets, may apply to open such account after the asset purchase contract has entered into force;

• expense account: an investor who plans to establish a foreign investment enterprise (“FIE”) in China and in the initial phase needs to conduct market research, planning and work preparatory to the establishment, may apply to open such account after the company name has been approved;

• security account: an investor, who prior to making the investment is required to provide financial security to a Chinese entity in accordance with relevant regulations or the contract, may apply to establish such account for the term specified in the contract.

Following the establishment of the FIE, the balance remaining in an acquisition, expense and security account may be transferred to the FIE’s account and serve as the foreign party’s investment provided that a relevant SAFE approval document can be produced. If no FIE is established the balance may be remitted overseas on the strength of a relevant SAFE approval document.

Alternative cash contributions

Whereas in the past, cash funds injected into FIEs were almost invariably directly remitted from overseas for this purpose, the Notice sets forth alternative methods for injecting funds into an FIE. A foreign investor may use the foreign exchange funds held in a non-resident personal cash foreign exchange account to invest in an FIE. An FIE may use its expansion fund, reserve fund (or capital common reserve fund, surplus common reserve fund) for a capital increase of the enterprise. Undistributed profits, dividends payable or interest payable thereon, registered foreign loans and interests thereon by the foreign investor may also be used for this purpose.

Other issues

The Notice provides that no funds should be transferred between FIEs which are not holding companies and enterprises in which they have invested or between such invested enterprises except upon special approval of SAFE.

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ARBITRATION RULES FOR FINANCIAL DISPUTES

The China International Economic and Trade Arbitration Commission (“CIETAC”) recently issued the Arbitration Rules for Financial Disputes 金融争议仲裁规则. The Rules are formulated to provide an avenue for the quick resolution of disputes regarding financial transactions. This goal is mainly achieved by providing for a shorter time frame and allowing more flexibility in the proceedings than are provided under the ordinary arbitration rules of CIETAC (the “CIETAC Arbitration Rules”). A financial arbitration under the Rules can be completed within 45 days as opposed to the nine months usually required to complete an arbitration under the CIETAC Arbitration Rules. This is a significant advantage as financial disputes typically benefit from a quick resolution. Implementation of the Rules commenced on 8 May 2003.