When you are all set to start a manufacturing company/business in China, you must be prepared to get acquainted with the different laws and legalities involved in the custom manufacturing business which is much different from what is traditional; be it in America or any other country. Chinese laws and the Communist governance are a whole different animal to deal with. Here is a simple overview of what you need to know in terms of legalities and make sure your OEM business operation in China is purely constitutional.
Before you can start OEM business operations in China, you need to work alongside business partners and clients who will support and assist you of your operations. In doing so, you need to have a contract with a China-based company to make your business in the country purely legal. To start off, let us discuss contract situations for businesses in China.
Contract Negotiations in China
I continually praise the advantages of foreign enterprises having proper contracts in China. Yesterday I saw a distinct situation that support getting one.
Our client bought a huge quantity of wholesale clothing for US$120k from a clothing manufacturer in China. Before the purchase, they received the spec sheet which matched their requirements and the Texas compliance laws. Unfortunately, they were unable to use the custom clothing product because they did not meet the standards, and, as a result, they lost tons of cash and clients.
When they asked if we can help them get reimbursed for the custom clothing and repaid for the damages to their enterprise. We sent them a response not to their liking. Our first question was: “Did you have a contract with the Shenzhen based firm?” Our next questions were, “Is your OEM contract in Chinese? Does it have the Chinese enterprise’s seal on it? Does it have amendments for failing quality assurance? Is it applicable in China?”
Unfortunately, they answered NO to all these questions. In fact, if you want to enforce your contract, you must answer YES to all the comments above. Contracts scare the hell out of Chinese manufacturing companies so those who engage in one are the real deal (usually).
Usually though, issues pertaining to Chinese products come in three:
- Selecting the correct partner
- Asking for a China-specific contract.
- Checking quality control
Once you have an issue, the contract is the only thing that can rescue you, but to avoid having an issue, all three are required.
Constructing a Contract in China
Our clients always ask, which contracts are the best to have. We usually recommend the following three (in English and Chinese from a Chinese law firm):
- NNN/NDA Agreements: NNN Agreements aim to protect the confidentiality of your product and to prevent your Chinese contract manufacturing from competing with you or circumventing you.
- OEM Agreements: You need an OEM Agreement after you chose a Chinese manufacturing company, it contains all the substantive provisions of the NNN Agreements.
- China Trademarks: You should register your brand name and/or your product names and logos as trademark(s) in China, even if you will not be selling your product in China.
In addition, when you create the OEM, adding a paragraph that states the factory will be doing new product development for the company, but such company will own all the IPs. Also, you will need language about mold ownership, and you absolutely must pay for the molds.
Company Laws in China
Now you have a brief idea of contract negotiations in China, let us move on to company laws involving business organizations. For starters, there is a book called “Company Law in China: Regulation of Business Organizations in a Socialist Market Economy” becoming popular to Chinese lawyers of this day.
This understandable book provides a comprehensive and important introduction to business laws in China and covers the most recent legislative and regulatory developments of Chinese business law. This book covers topics such as shareholder litigation, mergers, acquisitions, among others and is a must-read if you are a newbie with business in China. It is important to get acquainted to existing company laws before submerging deep into Chinese business. However, there are also changes to China’s investment laws that you should also be aware of. Here are a few of them;
Changes in China’s Investment Laws
The Chinese Ministry of Commerce released the draft of the proposed new Foreign Investment Law to solicit public opinions. The proposed law will significantly reduce barriers to foreign investment, whilst at the same time increase scrutiny of foreigners trying to evade regulations on investing in restricted industries.
The new law introduces 5 major changes:
- Foreign-invested company laws repealed: WFOEs, foreign-invested equity JVs and contractual JVs will no longer have separate legal regimes.
- Broader definition of foreign investment: the new Foreign Investment Law creates a new definition for the term Foreign Investment.
- Annual report replaces pre-approval: all foreign investors need to submit a report upon making an investment. This report needs to be submitted to the local department tasked with handling foreign investment.
- Pre-approval only for negative list: The State Council will publish a negative list of industries in which foreign investment is restricted or prohibited. It will also set limits on the investment amount.
- National Security Review: China will assess whether foreign investment poses or may pose a threat to national security.
Investing in China is only going to get more difficult, but, if paperwork is done right, the business plan becomes more flexible.
How to Avoid IP Theft in China?
Intellectual property (IP) issues have always been an issue with contract manufacturing companies in China. Therefore, a lot of foreign investors are skeptical in starting an OEM business in their shores due to fear of IP theft. When you develop a product, three types of agreements are necessary: an NDA, new product development and OEM agreement. A typical IP theft goes this way:
- The foreign party approaches a Chinese firm with new concept, but no engineering. Therefore, it is still not ready for production. The industrial design may not even have a sample.
- The foreign party asks the Chinese side to engineer the product.
- The Chinese manufacturing company agrees if the product owner agrees to purchase later.
- Both sides are happy: the foreigner for the “free work”, the Chinese side for the new client. No one documents the development of the product.
- If the foreigner likes the new product design, they buy it. If not, they simply move along to the next factory and look for a product they like.
First and foremost, since the factory isn’t being paid, why should they care? Little attention is often paid to new product development. Delays will be common. Moreover, quality management is not specified. Even if the product’s finished IP issues still exist because the product has changed so much from the original manufacturing design, this could lead to a point where the factory decides to produce the product for its own use rather than to sell to you.
Tax Holes in China: Beware of the Gray Area
Taxes are a dominant figure in custom manufacturing: taxes act as a direct trade inhibitor and causes friction regardless of industry. In China, taxes rates both vary by province and are interpreted differently in each jurisdiction. Too much information exists and can either be ignored or overlooked (or both) when starting a business. Such tax compliance can benefit you, but often it may not.
For example, many foreigners buy from China (in fact, China is the largest exporter, so this is an understatement). However, both export and importation taxes exist; the material simply isn’t in English. Eventually, though it could become a problem which merits more compliance penalties than repayment of past taxes. One problem foreigners are often “caught up” in is payment of foreigners in China on the hush. This means, paying them directly to foreign bank accounts while they operate in China.
Such a method works while working on a small scale but will lead to larger penalties later. Having a permanent establishment in China-legally-is extremely tricky, but governments do not care. If you are hiring in the gray area, your custom manufacturing business will be subject to double taxation rules (i.e. you pay both your government and China). Such a problem is particularly risky because you face both legal repercussions for non-compliance with business registration laws and tax laws. Simply beware of the gray area.
Getting to Know the Fapiao: China’s Official Receipt
The fapiao is one of the most unique features of China: it is the official invoice collected by the government. A fapiao—unlike a “dan”—is printed on special paper that must be purchased from the tax authorities and allows a business to use the expense for tax deductions or refunds. Likewise, this government receipt is used for reimbursements from an employer.
Why does a company need to have a fapiao? The fapiao system enforces companies to stay within their business scope. If customers are unable to receive a fapiao, they will be unable to declare their purchases as expenses. Overall, there are three types of fapiao: VAT, business (BT) and consumption. The consumption fapiao is typically a 17% receipt associated with dining. The VAT is more complicated. Transactions included in the VAT system must be printed on a different type of fapiao. More importantly, there are two VAT fapiao: 1) to businesses and 2) to consumers.
Here’s one oddity: the government will estimate how many Fapiao a business can issue from the company size. Overall, taxpayers are categorized into General Taxpayers and small-scale taxpayers. Small firms typically pay a lower VAT which does not vary. However, they cannot separate input from output VAT, they are not entitled export exemptions and reimbursements. The output VAT state the sales amount and output VAT of the transaction. The buyer may then use output VAT fapiao to offset his or her VAT liability. Since small-scale taxpayers cannot issue the Special VAT fapiao larger businesses are reluctant to do business with these entities.
How does one get General Taxpayer status? Since the government sets a tax threshold, a small-scale taxpayer must first exceed the threshold. The threshold is an annual taxable turnover exceeding RMB 500,000 (for manufacturing companies), RMB 800,000 (for trading enterprises) or RMB 5 million. Other regulations such as such as office size and number of employees are applied.
New companies typically have a quota of 25 fapiao, each with a limit of RMB 10,000. When the firm runs out, it must purchase new ones. This would lead to an eventually increase in the firm’s overall fapiao quantity (after some temporary increases). To purchase fapiao, a staff member needs to go to the tax office with the previous fapiao booklet, their employee ID card, the company fapiao seal and the tax certificate; within five days the company will be issued a fapiao booklet.
Getting more Special VAT is a bit more complicated and requires a VAT fapiao authentication device; it contains all the company information and transactions. More importantly, it contains the number of fapiao printers registered to that company. To get a printer, the company must bring a Notice on the Use of a Fapiao Printer to special firms which sell the item.
Arbitration in China
Presently, the International Arbitration in China went through a period of uncertainty in 2012. For many years, the CIETAC controlled international arbitration in China. In addition, CIETAC established sub-commissions in both Shanghai and Shenzhen in order to expand its scope.
Eventually, the Shanghai and Shenzhen Sub-Commissions separated from the main branch in Beijing. To cement their new-found independence, each sub-commission changed their name: The Shanghai International Arbitration Center (SHIAC). This newly named arbitration center carried on new rules and engaged a new panel of arbitrators.
However, for a contract that specified arbitration at the Shanghai CIETAC sub-commision, does the newly renamed SHIAC have jurisdiction? In China this is not the case. Beijing issued a notice on August 1, 2012 that the former sub-commissions had no jurisdiction and contracts referring to the CIETAC Shanghai sub-commission should be submitted to Beijing CIETAC for resolution.
The situation was caused by the CIETAC notice issued on December 31, 2014 announcing that it had formed new sub-commissions in both Shanghai and Shenzhen. Based on this notice, all contracts referring to the CIETAC Shanghai sub-commission should be heard in the newly formed, Beijing CIETAC controlled sub-commissions.
In the event of this decision, Shanghai has two competing international arbitration centers at present: the SHIAC and the Beijing CIETAC-Shanghai sub-commission. However, the Shanghai Number 2 Intermediate Court brought some semblance of order to this situation: A decision announced on December 31, 2014, the court concluded that a contract stipulates arbitration before the CIETAC Shanghai sub-commission, SHIAC has exclusive jurisdiction in the matter—not Beijing. (in other words, Beijing has no legal force)—since the name change was procedural in nature rather than substantive.
In the future, careful designation of the arbitration location in your China contract is required. Presently, there are two competing international arbitration commissions operating in Shanghai: SHIAC and the CIETAC Shanghai sub-commission. Choose one. Chinese lawyers are masters at delay. Therefore, it is essential that your China contract be clear on threshold decisions such as dispute resolution, governing language and governing law.
The most important is that foreign parties should carefully think about whether it even makes sense for them to use arbitration in China at all. CIETAC arbitrators are excellent, and the decisions are well crafted; however, arbitration is usually slow and expensive, and their powers are limited.
Think carefully about which method is best for you: litigation, international arbitration in China or arbitration in a neutral foreign country?
Conclusion
Investing in an OEM custom manufacturing business in China is much more complicated compared to other countries. The combination of the Communism rule, good manufacturing practices along with their company laws and business rules make it hard for a fresh OEM business to have a head start in their shores. However, it is understandable Chinese people have all these laws and rules in place to protect the interest of their country and make sure they don’t get taken advantage of. As a foreign investor, it would be up to you to adjust to these laws or take your business elsewhere if you can’t abide to them.
