Special Report: Retail & Distribution

Moving Forward on Distribution

After nearly a year's delay, China opens the way for the expansion of foreign retail and wholesale operations

by Research staff of the US-China Business Council's Beijing and Shanghai offices

December 11, 2004 was supposed to mark the date by which China would fully implement a system to grant trading and distribution rights to foreign investors, in accordance with its World Trade Organization (WTO) accession protocol. But it was not until mid-2005 that the PRC government fully clarified the application procedures for foreign investors to obtain such rights, thereby paving the way for an increase in the rate and number of approvals issued to foreign companies.

Trading rights refer to the ability to import into and export products out of China. Distribution rights denote the ability to sell—either retail or wholesale—products within China. Previously, companies were required to use domestic import-export agents and distributors for their imported products.

Early delays

Although the PRC Ministry of Commerce (MOFCOM) issued regulations in April 2004 regarding foreign distribution operations, the measures did not clearly define the process by which noncommercial foreign-invested enterprises (FIEs) could expand their business scopes to include distribution. Moreover, various local authorities offered different interpretations of the Measures on the Management of Foreign Investment in the Commercial Sector. This, combined with insufficient interagency preparatory work and coordination, led to confusion and delay.

A survey by the US-China Business Council (USCBC) in March 2005 revealed that none of the surveyed companies had been able to secure trading and distribution rights unless the approvals were obtained under the Closer Economic Partnership Arrangement between the mainland and Hong Kong. Most companies, moreover, had withheld their applications pending clarifications from MOFCOM. Some local governments, including those in Beijing, Shanghai, and Shenzhen, had forwarded to MOFCOM applications to expand business scopes, but none of the local authorities had received responses from the central government. Other localities, meanwhile, were unable or unwilling to accept applications from companies because of the lack of guidance on the process from MOFCOM.

In April, MOFCOM clarified application procedures for noncommercial FIEs and holding companies to expand their business scopes. Shortly thereafter, MOFCOM officials and US companies indicated that the distribution rights application and approval channels seemed to be opening up.

There were several issues that still remained unresolved, however. At the top of the obstacle list was the question of whether FIEs in free-trade zones (FTZs), such as Waigaoqiao in Shanghai, could apply for distribution rights. The April 2004 measures made no specific mention of companies within FTZs. As a result, local foreign trade bureaus refused to forward distribution rights applications from companies with operations in bonded zones to MOFCOM, citing either a lack of regulatory authority to do so or the absence of appropriate channels.

In late July, the PRC government issued a notice indicating that foreign companies with operations in bonded zones may apply for distribution rights. And in August, MOFCOM issued three documents that fully clarified the application procedures for investors to establish new foreign-invested commercial enterprises (FICEs), for existing FICEs to open new stores, and for existing FIEs to expand their business scopes. The documents give provincial-level agencies the authority to review and approve applications and—if an FIE is registered in a province other than where it operates—to coordinate with other provincial authorities in the review process.

Thus, almost one year after the WTO implementation date, the process by which FIEs can obtain distribution rights finally came into place. The delay was not necessarily because of the desire to protect domestic companies, as has often been the case with delays in WTO implementation in other sectors. Rather, it appears to have resulted from the need for MOFCOM to coordinate with other ministries and departments, such as the General Administration of Customs and the State Administration of Taxation, to resolve various technical issues. For example, the distribution rights applications of bonded-zone companies were left in limbo in part because MOFCOM and Customs were still in the process of reaching an agreement on whether to treat goods that enter China from the bonded zones as imports or as domestically distributed products.

The options

Foreign companies may choose one of two ways to acquire trading and distribution rights. They can set up a new, standalone FICE or apply to expand the business scope of an existing FIE.

Foreign companies may choose one of two ways to acquire trading and distribution rights. They can set up a new, standalone FICE or apply to expand the business scope of an existing FIE. Existing manufacturing FIEs, free-trade zone trading FIEs, investment companies, and regional headquarters FIEs may all apply to expand their business scopes. Companies must specify in their applications the product categories they wish to trade in, based on Customs' Product Catalogue. Manufacturing FIEs may only deal in products that either they or their parent companies produce; trading companies are generally limited to three product categories; investment companies may acquire up to five categories; and firms with regional headquarters status, as issued by the central government, have no category limitations on the products they may import and sell. Currently, companies with whom USCBC has consulted are generally satisfied with their new business scopes. Some, however, have expressed dissatisfaction with the narrowness of their product scope. There are also concerns that the product category restrictions are inconsistent with China's WTO commitments.

Quicker approvals

Until the release of final clarifications, applying to set up a new FICE was the quickest method by which to acquire trading and distribution rights. In early fall, however, there was an across-the-board increase in the speed and number of both FICE and expanded-scope FIE application approvals. Manufacturing FIEs, FTZ companies based in Shanghai's Waigaoqiao, and regional headquarters or investment firms have all reported securing approval to expand their business scopes to include trading and distribution rights. Some companies applying to expand their business scopes have reported requests for additional increases in registered capital from local authorities; some firms have found that they can forestall this requirement by clearly explaining in their application's feasibility study report how they expect to finance distribution activities from existing cash flows.

Many of the companies acquiring approvals have used service companies affiliated with local or municipal government bodies, such as the Foreign Enterprise Service Center set up by the Shanghai Municipal Foreign Economic Relations and Trade Commission, to assist in preparing applications. These entities are close to the approval bodies and know what is needed in the application to gain approval quickly. Companies that have submitted applications prepared on their own are also getting approvals, however. As the application process becomes clearer, it is likely that approvals will continue to accelerate; waiting times are now estimated at around three months.

And now for the hard part

As FIEs acquire approval for trading and distribution within China, their focus is shifting to actually selling imported and third-party goods in China. Because relevant government bodies, particularly the customs and tax authorities, have yet to issue regulations governing the import and sale of products by foreign companies, it will likely take some time to develop routine processes and procedures. Firms trying to use trading and distribution rights will probably face new situations that cause uncertainty among local officials. As a result, municipal and local government bodies may delay processing transactions from FIEs with trading and distribution rights until receiving explicit clarification from their superiors—and until the regulations catch up. Ideally, under WTO national treatment principles, FIEs would follow the same procedures as domestic companies.

It also remains unclear how authorities will enforce the stipulation that manufacturers must earn no more than 30 percent of their revenue from sales of third-party produced goods, including imports, if they are to retain the various tax incentives enjoyed by foreign-invested manufacturers. Whether the loss of tax benefits would be permanent or temporary, and whether the new tax rate would be levied starting the next year or retroactively, remain unknown. The regulations also do not specify how the 30 percent would be calculated, an issue of particular concern to manufacturing FIEs that assemble products using a significant amount of imported components. At least one firm is keeping sales of such products to well below that level until this issue is clarified.

In short, China has come a long way in implementing distribution rights, but on several fronts, questions and uncertainties will be resolved only as companies start to exercise their new rights.

Implementation of Select China WTO Distribution Commitments
Commitment	Implementation Status
Allow wholly foreign-owned enterprises (WFOEs) in wholesale, retail, and commission agents' service	Done, late. In April and again in July 2005, the Ministry of Commerce (MOFCOM) issued clarifications on combining distribution and manufacturing activity. Manufacturing companies in China are eligible for distribution rights, but are expected to keep revenue from distribution below 30 percent of total revenue to continue to enjoy current preferential tax policies for manufacturing enterprises, although it is unclear how authorities will enforce this requirement. In July, MOFCOM issued a notice allowing foreign-invested enterprises (FIEs) in free-trade zones to apply for distribution rights. In August, MOFCOM clarified the application procedures for distribution rights.
Allow franchising	Done. FIEs can apply to franchise in China, although high capitalization and local presence requirements curtail new entrants.
Allow direct sales	Done, late. Regulations were issued in September 2005 and take effect December 1, nearly a year after the commitment due date.
Allow retailing and wholesaling of pharmaceuticals	Done, late. After initially saying that it would draft separate rules for foreign participation, MOFCOM now approves foreign pharmaceutical retail and wholesale WFOEs using the Measures on the Management of Foreign Investment in the Commercial Sector and the State Food and Drug Administration's Rules on the Management of Drug Business Licenses.
Allow retailing of refined fuel	Regulations allow WFOEs (Interim Measures on the Administration of the Oil Products Market), but as currently interpreted, the cap of 30 outlets permitted nationwide limits the value of this commitment.
Allow wholesaling of printed matter	Unclear. The 2003 Rule on Management of Foreign-Invested Book, Magazine, and Newspaper Distribution Enterprises opened up the sector early, but the 2005 Opinions on Attracting Foreign Investment in the Media Sector appear to roll back this commitment.
Source: The US-China Business Council

At Last, Progress on Direct Selling

The PRC State Council issued the long-awaited direct selling rules in early September, reinstating the legitimacy of a business model that it had banned since 1998. Because of the large number of unscrupulous enterprises that used fraudulent pyramid schemes in the late 1990s to defraud hundreds, if not thousands, of Chinese, the PRC government banned all forms of direct selling and permitted only 10 foreign-invested direct selling companies to operate in China through retail outlets that employed sales representatives. Under its World Trade Organization (WTO) commitments, China agreed to reopen the market to legitimate direct sales firms by December 11, 2004. The regulations do so, but entry requirements are stringent. As with many PRC regulations, difficulties will lie in the interpretation, implementation, and enforcement of the rules.

The Administrative Measures on Direct Sales, which take effect December 1, 2005, indicate that direct sales companies may sell products of their parent and holding companies and may obtain foreign trade and distribution rights. Thus, foreign direct selling companies will be able to sell products without setting up production facilities in China, though they must establish local service networks with fixed locations. The measures impose various other requirements on direct sales companies, including rules for the recruitment and training of salespeople and direct sales trainers.

The Regulations on Prohibition of Pyramid Sales, which took effect November 1, attempt to eradicate illegal pyramid schemes. The regulations define pyramid sales and stipulate severe punishments for such activities. Companies and individuals that violate the rules may be fined up to Yen2 million ($247,179) or face criminal charges, depending on the type and seriousness of the transgression.

As the CBR went to press, MOFCOM was soliciting comments on a series of implementing measures that addressed issues including reporting requirements for direct sales companies; remittance and use of bank deposit required of direct sales companies; training for direct sellers; and product scope for the direct sales regulations. The draft measures left many questions unanswered. For example, they did not indicate how the 30 percent cap on commissions for direct sellers will be calculated or whether the multitiered marketing system will be permitted. Companies were hoping that their suggestions would be reflected in the final regulations.

—Lin Jun and Rebecca Karnak

Lin Jun and Rebecca Karnak are, respectively, manager of Government Affairs and manager of Business Advisory Services at the US-China Business Council in Beijing.

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