Twelve risks SMEs face when doing business with China and how to address them
Estimated reading time: 10 minutes
It is cliché to say China is a huge market with great potential; however, doing business there can still be tricky. According to opinions shared at the U.S.-China Business Forum held by Forbes in August 2022 – most American businesses operating in China have noticed that it’s getting harder to do business in China. For various reasons, companies are looking to diversify their supply chain due to China risks.
… most American businesses operating in China have noticed that it’s getting harder to do business in China.Forbes, U.S.-China Business Forum, Aug 2022
With this background in mind, we have come up with the top 12 most common legal risks that foreign businesses nowadays face in China.
Twelve Legal Risks of Doing Business in China
- Wrong form of business structure in China
- Missing or incorrect licensing and certification
- Conducting business outside of the allowed scope
- Theft of intellectual property
- Breaking foreign exchange regulations
- Not taking into account local taxes and duties
- Missing an arbitration clause in your contract
- Failing to comply with labour laws
- Lack of regulatory transparency
- Bad business partners, or local agents with conflicting interests
- Protectionism for local competitors
- Data storage and transportation restrictions
1. The wrong form of business structure in China
Establishing a local presence for a foreign firm in China can be done in several ways.
The type of activity the foreign company wishes to carry out will determine the best type of business structure. Using the wrong structure to carry out unauthorized activities may entail serious legal consequences. Representative offices (often shorted to Rep Office) may engage in any sales activities, for example, although they are substantially easier to establish than a separate legal entity would be.
2. Missing or incorrect licensing and certification
Registration, certification, and licensing are necessary for many kinds of products before they can be sold in China. Certification and registration are usually required for potentially hazardous products or products related to human health.
Our blog post China’s regulations on imports: what business owners need to know in 2022 will help you understand China’s customs regulations on importing products from international markets.
3. Conducting business outside of the allowed scope
Every company operating in China has a specific and legally-defined business scope, described in its business license and related documents.
Refer to our blog post “China Business License explained” to get a better understanding of business licenses.
4. Theft of Intellectual property in China
On paper, Chinese law offers comprehensive protection of patents, trademarks, trade secrets and copyrights. However, there is a widespread violation and ineffective enforcement of the law. So, the key for any company seeking to sell products in China is to create and implement a practical and effective action plan.
Action items include:
- Evaluate what intellectual property is important to the company
- Review the company’s product portfolio and take action to register the patents and marks that have not been properly registered in China (subject to eligibility standards under Chinese law)
- Register both the English and Chinese versions of the marks
- Register its domain name in China (.cn) if the company anticipates online business.
More importantly, a company should take precautionary measures within its organization and that of its Chinese business partner to protect its intellectual property.
For example, restrict access to sensitive information and develop protocols to protect it from unintended disclosure or misappropriation.
Utilize confidential agreements when appropriate, and properly train employees who will come into contact with sensitive information.
Please subscribe to get our upcoming whitepaper How to Successfully Protect Your IP in China (Whitepaper). The whitepaper provides a comprehensive and practical guide for international SMEs to protect their intellectual property rights when doing business with the Chinese market.
5. Breaking foreign exchange regulations
The Chinese regulatory regime includes strict foreign exchange regulations. This means that transferring funds out of or into the country can often require settlement, registration or approval, depending on the transaction type.
Approval must be acquired by the State Administration of Foreign Exchange or its local branch for any loan agreement between a foreign lender and a Chinese borrower, to be legally effective. For the local Chinese distributor to acquire foreign currency to pay its foreign seller in a distributorship arrangement, certain documents have to be sent to a bank designated for the purpose of certification that the foreign currency is actually necessary to fulfill a valid contractual obligation.
6. Not taking local taxes and duties into consideration
A foreign company may incur tax liability under Chinese law, depending on the structure of the transaction that it undertakes.
A foreign company, for example, might be liable for corporate income tax for some types of China-sourced income. These include interest, royalties, and capital gains.
As well, revenue coming from a licensing agreement will be subject to business tax in China.
It is important to be familiar with both Chinese tax law and your home country’s tax laws. This is because income tax that is paid in China may often be eligible for a foreign tax credit in your home jurisdiction, as provided for under your country’s tax laws, but business tax might not be eligible in the same way.
Value-added taxes (usually 13%) and import duties generally apply to all imported goods.
Issues with local tax and import duties can be quite complicated, with the results varying depending on the specific business arrangement created, so it is important to get sound legal advice.
7. Missing arbitration clauses in your contract
When considering a contractual relationship with a Chinese company, an arbitration clause is often the best and most effective way to give clarity and certainty to the process of dispute resolution.
The arbitration clause must be properly drafted in order to be enforceable in both China and foreign jurisdiction.
Careful consideration should also be given as to what kind of arbitral rules and institutions choose in the contract, the location of the arbitration, the language to be used in proceedings, and what the governing law around the arbitration is.
In many business contracts, the details of the arbitration clause are often the most heavily negotiated provisions. Compromise may be required by both parties in order to come to a position that is equitable and tolerable to both.
For other aspects of a commercial contract with a Chinese company, we recommend our previous blog post “The Importance of contract review and legal document drafting services for international SMEs”.
8. Failing to comply with labour laws in China
China’s labour laws are apply to both domestic and foreign-owned firms hiring employees in China.
A foreign company with employees in China, whether through its Chinese subsidiary or not, should make sure to be particularly careful in understanding the mandatory requirements of Chinese labour law, which can be very different than what a foreign employer might be used to.
Chinese law requires that all employers enter into a written employment contract with their employees, and significant penalties can be brought against employers that do not do so.
The concept of “at-will” employment, which is often used in the United States, does not exist in China. This means that employers may not terminate an employee without specific and limited grounds to do so.
There are only three types of employment contracts in China: open-ended, fixed-term and project-based:
- Open-ended contract
An open-ended contract has no termination date and the employer can only terminate the employee under the specific grounds enumerated in the law.
- A fixed-term contract
A fixed-term contract has an agreed-upon termination date, but an employee retained after two fixed-term contracts have expired is deemed to have an open-ended contract (mandatory after working for the same employer for ten or more years).
- A project-based contract
A project-based contract’s term is based on the project’s length.
A non-competition clause is only valid if it meets certain statutory requirements and compensation is required to be paid to the employee during the non-competition term.
9. Lack of regulatory transparency
China’s legal system is still developing, and one of the major differences between it and developed nation jurisdictions is the general lack of transparency in the system.
This can mean that regulations and rules can be seemingly arbitrarily passed without much warning, and it is essential to have locally-connected legal assistance to guide you through this.
In addition, it can be confusing for western companies that the scope of the law in China is broader and such things as central government “notices”, “opinions” or “guides” are also considered as “law” as a matter of practice.
10. Bad business partners, or local agents with conflicting interests
As of August 2022, there are over 7 million people in China listed by Chinese courts as “untrustworthy” individuals or people with bad credit records. It is prudent for international SMEs to conduct due diligence and find out whether a new business partner is reliable and whether a long-term business partner can still be trusted.
In addition, it is also important to be confident that a local partner or agent does not have conflicting interests. As mentioned in our previous blog post “Managing your supply chain in China”, it is critical for you to know your local partner – for example, the OEM – very well for you to control your supply chain.
11. Protectionism for local competitors
As the growth rate of the Chinese economy slows, there has been an increasing trend for authorities to favour local companies in certain industries.
Some of the areas where this protectionism is particularly strong are:
- Project bidding
- Being considered for receiving incentives
- Being allowed the same scope of business as domestic firms
- Indigenous innovation preferences
- The ability to open branches at the same pace as domestic companies
It is particularly important for western companies to consult China lawyers with local experience to understand the business practice in the region before signing a long-term contract or bidding for a big project.
12. Data storage and transportation restrictions
In the past 5 years, China has been tightening up its regulations on data security and personal information protection.
Among other things, international businesses located outside of China that sell products or services to the Chinese market are subject to the regulations governing the collection, storage and transportation of data of individuals in China.
Businesses located in China that need to transfer data to an overseas entity for processing, such as SaaS (Software as a Service) business with customers in China, are subject to a complicated compliance review.
This blog can be regarded as a follow-up piece to our high-level overview of “Tips for doing business in China”. Besides your awareness of the potential legal risks your business may face in China, it is important to make sure that you have access to experienced China lawyers in order to minimize these risks and make sure your business can succeed.
Mr. Zheng is a partner lawyer at a leading Intellectual Property law firm in China, with 20 years of experience advising international businesses in protecting their Intellectual Property Rights in China. Mr. Zheng is considered one of the best IP lawyers helping international businesses protect their trademarks, domain names and patents in China.
Mr. Deng is a partner at a leading Chinese law firm with over 15 years of experience advising international companies in China. His expertise covers a broad range of areas: foreign direct investment in China, mergers and acquisitions, capital markets, and corporate governance. He is fluent in English and qualified to practise in China and the State of New York.
Ms. Sun is a partner lawyer at a leading Chinese law firm. She has over 10 years of experience in advising international businesses in commercial contracts, international trade, and dispute resolution.