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UPDATED: November 6, 2007 NO.45 NOV.8, 2007
The JV Is Back
 
By RICHARD HOFFMANN
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With the upsurge in foreign investors wanting to set up joint ventures (JVs) in China, we examine the points to consider when taking this investment route.

Contractual JVs vs. Equity JVs

There are two types of JVs in China, the equity JV (EJV) and the cooperative JV, sometimes known as the contractual JV (CJV). They may appear similar on the surface but have different implications for the structuring of your entity in China. Here we explore the differences, and provide practical advice on structuring and tips on investment drawbacks, land use rights and profit distribution.

An EJV is a JV between Chinese and foreign partners where the profits and losses are distributed between the parties in proportion to their respective equity interests in the EJV, but the foreign partner shall hold more than 25 percent of the equity interest in the registered capital of the EJV. The company enjoys limited liability is a "Chinese legal person."

A CJV is a very flexible foreign-invested enterprise where Chinese and foreign investors have more contractual freedom to structure cooperation. It is a JV between Chinese and foreign investors where the profits and losses are distributed between the parties in accordance with the specific provisions in the CJV contract, not necessarily in proportion to their respective equity interests in the CJV.

In the past, CJVs took one of two different forms-a true CJV that did not involve the creation of a legal person that was separate and distinct from the contracting parties; and a legal person CJV in which a separate business entity was established and the parties' liability was generally limited to their capital contributions.

In the case of a true CJV, each party was responsible for making its own contributions to the venture, paying its own taxes on profit derived from the venture and bearing its own liability for risks and losses. In contrast, a legal person CJV, the more prevalent form today, shares more of the characteristics of an EJV. The true CJV is rare today as few investors are willing to entertain the prospect of unlimited liability and the rest of this discussion only refers to legal person CJVs.

In practice EJVs are more common-10,223 EJVs were created in 2006, compared to only 1,036 CJVs-although the latter are still used in some specialized fields such as oil exploration.

There are significant operational differences between the contracts and laws governing the two types. The key differences and practical issues are discussed below.

- Liability status-EJVs must be established as limited liability companies, while CJVs have the option to operate either as a limited liability company or as a non-legal person. In the latter case, liability is unlimited, but split between the parties in a ratio according to their equity investment. Such entities are run by a "management committee" rather than by a board of directors. They are typically operated in the event of the foreign party making capital contributions to a Chinese manufacturer to upgrade facilities, but then wanting some degree of control as to how that investment is managed.

- Management structure-EJVs must have a two-tier structure, consisting of a board of directors and a contractually appointed management team, usually defined as the "general manager and two deputies" (although precise number of deputies varies), who have legal responsibility for the daily operations of the business. This is to ensure that the specific management functions of a larger operation are clearly defined. CJVs can operate solely as a board of directors (or management committee if non-legal status), but they must have a general manager as well. For smaller concerns, decision-making responsibility can then rest solely with the board.

- Contractual obligations-In real operational terms, EJVs tend to be far more rigid in their contractual structure, thus lending greater security to the larger amounts of equity that such structures are typically used for, albeit that such security is defined more by state regulations. CJVs allow greater contractual flexibility for the investors to define the obligations of the interested parties.

- Capital contributions-Contributions to any JV can be in the form of either cash, or in kind, such as buildings, machinery, materials and know-how. With EJVs, this process and the value attached to contributions are highly scrutinized. Independent valuers are often used to ensure that "items thus identified are not higher than the prevailing international market prices," as they form an inalienable part of the contractual agreement. CJVs, however, need not have their "investment conditions for cooperation" priced or evaluated, meaning that the JV parties may decide how the value of their contributions should be determined.

- Profit sharing and equity ratios-EJVs are defined contractually as each investor being entitled to profit-sharing based upon the proportion of equity owned. Foreign investors may have a minimum of 25 percent of equity. CJVs differ fundamentally, in that the profit-sharing ratio does not have to be tied to the equity stake. Thus, a foreign partner can own less of the equity than the Chinese partner, but take out more in profit. In some restricted industries the foreign partner must own less, such as advertising, telecoms, real estate and transportation. Profits in CJVs can also be taken "in kind," whereby the Chinese party would undertake processing, with the foreign party realizing profits through sale of finished goods. This is common in real estate CJVs, where the Chinese side provides land use rights as their equity and the foreign side provides the finance, and finished units then distributed on a contractually agreed ratio as profits.

- Reclaiming capital investment-CJVs, but not EJVs, can theoretically allow for the original capital injected by the foreign party (but not the Chinese) to be recovered in an accelerated repayment structure during the term of the venture. This is of great assistance when the foreign party is using loan capital to finance the venture. The trade off, however, is that the Chinese side then has title to the CJVs assets after the expiration of the JV term. However, the State Council did issue a circular in 2002 to deal with such accelerated repayment structures. This now makes it very difficult to obtain approval for such arrangements.

This concludes our series of articles on JVs in China.

The author is with Dezan Shira & Associates www.dezshira.com

 



 
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