Many clients have their products made in China under a contract manufacturing arrangement with a Chinese manufacturer. At the start of this relationship, the foreign company’s goal is only to sell its products in western markets. But as China continues to grow, to get wealthier and more sophisticated, it often happens that the Chinese company, or person, will actively approach the foreign company about selling the foreign company’s products in China, to Chinese customers.
Typically, selling products into China will be complex. Sometimes the foreign company does not own the China produced product until after it is shipped outside of China, so selling the product within China will necessarily involve a complex process of exporting out of China and then selling back into China. This results in potentially having to pay VAT twice, once on the export and again on the import. As a result of this, foreign buyers of contract manufactured products will often be approached by a Chinese company with elaborate schemes designed to avoid such taxation.
Different business models
The Chinese company often will try to convince the foreign company to enter into a complex “partnership” or joint venture that will “allow” the foreign company to participate in the product distribution business in China. Entering into such a partnership is virtually always a mistake and the sensible foreign company should not want to have anything to do with this kind of business in China, particularly when tax avoidance and “incentives” for making sales are the major objective.
The foreign company might instead insist on operating under a standard distribution model used throughout the world. The foreign company would then purchase its product from its Chinese manufacturer, receive that product outside of China, in an export processing zone or when shipped, and then sell that product back into China to a qualified PRC distributor. The distributor could be located in China, or in a PRC export-processing zone or in Hong Kong.
The foreign company should set up that distribution relationship so that it earns its profits from that initial sale, freeing the foreign company from any concerns with the financial side of the Chinese operations. On the other hand, the foreign company should strictly monitor the operations of the Chinese distributor through a standard distribution agreement which enables the books of the Chinese distributor to be made available.
If the foreign company wishes to support its PRC distributor, it is free to offer incentives. There are many ways to do this, including by:
- not charging the Chinese distributor for product that will be used as samples;
- giving the Chinese distributor reduced pricing for a certain number of products;
- providing the Chinese distributor with cash-incentive payments for advertising and seminars; and/or
- partially or completely covering the cost of government registrations.
However, such incentives should be offered to a distributor operating under a standard distribution agreement that allows the foreign company to terminate the agreement if the distributor does not perform, which unfortunately is common, that allows the foreign company the absolute right to audit the distributor’s performance, and that allows the foreign company to immediately terminate the Chinese distributor if it engages in irregular conduct such as bribery or kickbacks, which unfortunately is also common.
Complications in the business relationship
One major defect in any kind of partnership/joint venture approach is that it is difficult to hold the Chinese side to a tight performance standard when there is a business ownership relationship. It is like a marriage: easy to get into, but hard to get out of.
Due to the need to export product from China and then import it back into China, the distributor often will establish an entity in Hong Kong to handle these operations. The foreign company can take an ownership interest in the Hong Kong distributor, but the basic rules remain the same:
- the Hong Kong distributor should be treated as an arm’s length third party, operating under a standard distribution agreement and
- the foreign company should earn its profits from sales to the distributor – taking the profits NOW – and not from the very uncertain and tax disadvantaged distribution of profits from the distributor at some unknown inherently uncertain later date.
The foreign company should understand that it is a myth that it will be able to exercise more control in joint venture than via the above sort of distributor relationship. It is very difficult for a foreign company to control a joint venture thousands of miles away and with no right to make a quick and decisive contract termination decisions but when that joint venture is actually a JVCO set up in Hong Kong, which could then own an operating and/or trading Wholly Foreign-Owned Enterprise (WFOE, or sometimes WOFE 外商獨資企業) in China that is a lot easier.
It is rare for foreign companies, particularly SMEs, to want to get intensely involved in the business of product distribution in a vast and complex market like the PRC.
This is why major multi-nationals often contract with Chinese distributors to do the work. It is virtually unheard of for foreign SMEs that understand the issues to even consider taking on this difficult burden. But inexperienced SMEs and start-up companies seem constantly to get approached with this kind of ill-conceived concept, for obvious reasons.
Our take
So if you are having product made in China, and/or you are approached with a proposal to “joint venture” on selling product into China, then the following rules should apply:
- If the proposal is complex, don’t do it. You should be able to understand every word of the proposal in a first reading.
- If the proposal involves an equity joint venture business, don’t do it. Do not get into any business relationship with an entity in China that you cannot terminate by a simple contract termination notice.
- If the proposal is not supported with a detailed set of financial projections, don’t do it. A “business plan” full of jargon that no one really understands does not count. You need a standard set of financial projections hard numbers, not jargon, with each assumption clearly spelled out and supported with facts.
Following the above, you will save yourself time and money in dealing with China projects.
Our team at Hugill & Ip has extensive experience in dealing with cross-border commercial issues – so if you need further advice on these subject and other topics discussed, get in touch with us to find out how we can help.
This article is for information purposes only. Its contents do not constitute legal advice and readers should not regard this article as a substitute for detailed advice in individual instances.
