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Business> Legal-Ease
UPDATED: December 21, 2009 NO. 51 DECEMBER 24, 2009
Choosing Your China Structure: Joint Ventures

Forming a joint venture (JV) in China can be a successful endeavor as long as each side's goals, contributions and responsibilities are mutual and understood. Unfortunately, this is not always the case, as evidenced by the fall in percentage of total foreign investment allocated to JV establishment from 32.2 percent in 2004 to 22.8 percent in 2007. This does not mean the JV is a deadweight entity, however. It has its purposes, and it's crucial for foreign investors to understand those purposes and whether their Chinese partner is capable of fulfilling them.

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

There are significant operational differences between the contracts and laws governing EJVs and CJVs. EJVs and CJVs are respectively governed by the Sino-Foreign Equity Joint Venture Law of 1979, the Sino-Foreign Cooperative Joint Venture Law of 1988, and their related post-hoc amendments. The China Company Law of 2006 is also partially applicable to JVs. There are several key differences between the two.

Liability status

EJVs must be established as limited liability companies, while CJVs can operate either as a limited liability company or as a non-legal person (though this option is becoming less popular). In the latter case, liability will be defined within the business contract. 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 the 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 of 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

Payment to any JV can either be in cash or in kind, taking the form of 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, such as advertising, telecom, real estate and transportation, the foreign partner is required to own less. Profits in CJVs can also be taken "in kind," whereby the Chinese party would undertake processing and the foreign party would realize profits through sale of finished goods.

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 CJV's 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.

Land use rights

Often, the Chinese party's equity contribution to any JV will be in the form of land use rights. It is important to remember that in China there are two forms, "granted rights" and "allocated rights."

Granted rights are ones in which the state has approved the rights to the specific JV itself, and that it thus holds title to the land for the period specified in the land use rights certificate. Allocated rights are ones in which the title to the land lies with the Chinese partner who holds the land. In practical terms, land in the cities and suburban areas is owned directly by the state. The land may be collectively owned in some rural areas, and if so would need to be transferred back to the state before being reallocated or granted. In both cases, this means any value attached to buildings essentially lies with the Chinese party, not the foreign investor, so be cautious when financing for buildings that are on allocated land, as it is the Chinese side who stands to benefit.

The author is Senior Legal Associate of Dezan Shira & Associates Beijing Office (www.dezshira.com)

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