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Internet Business Law in China for US Companies

Author/s: Lothar Determann
Good news first: The People’s Republic of China (PRC) provides more than a billion potential consumer customers and has a rapidly growing population of Internet users exceeding 250 million and broadband subscribers exceeding 70 million. No U.S. company with aspirations for international expansion can afford to ignore the opportunities in China. And, Chinese regulators largely ignore U.S. companies in the sense that the Chinese authorities do not usually apply or enforce Chinese laws extra-territorially to companies that run their Internet businesses from locations outside the PRC unlike, say, the European Community and its member states’ regulators. Thus, a US company can create a Chinese-language version of its global Web sites with relative ease and disregard for the Chinese regulatory regime.

So, anything goes? Well, not so fast.

The need to go onshore

Yes, anything goes for U.S. companies that can successfully operate their Internet businesses entirely off-shore, that is, outside of the PRC. Due to exchange control restrictions, China’s grip on Internet gateways and also a perceived need for local sales and marketing representation, many U.S. companies feel a need to go onshore and establish presences in China.
  • The vast majority of potential customers in China cannot or will not pay in US dollars and the Chinese currency, the Renminbi, is not freely tradable. This means that a US company cannot charge in Renminbi, and only companies based in China can obtain blank official invoices from the government and process Renminbi payments.
  • Internet users in China experience delays and slow speeds when they access Web sites that are hosted on servers outside China, because all foreign Internet traffic is routed  through government-controlled gateways. To compete effectively, US companies with complex Web sites are forced to create at least mirror sites on servers in China or establish local servers to host content and e-commerce applications for the Chinese market.
  • Many US companies experience a need for up-to-date information on the very different and constantly evolving market conditions. Thus, they want to send employees to China and hire local representatives, also, to make and take calls at a local phone number, demonstrate a commitment to the market, provide a face to potential partners and customers, and pursue business opportunities in the same time zone with local talent.

The Perils of Going Onshore into the Heavily Regulated PRC Environment

With the drive to go onshore and set up shop in China comes the bad news: The People’s Republic of China has heavily regulated Internet, e-commerce, telecom, and content publishing businesses on top of an already strict general regulatory regime that applies to all business activities, in particular foreign-controlled investment.
  •  Basic telecom services in practice are off-limits to foreign companies and many Internet services (classified as “value added services”) cannot be offered by majority-foreign-owned enterprises.
  • Joint ventures with Chinese companies are difficult to establish and control due to regulatory restrictions and mandatory corporate governance requirements that have the effect of protecting Chinese shareholders.
  • The establishment of subsidiary corporations and representative offices takes more time and investment than in most other jurisdictions.
  • The PRC government requires service providers to censor all content offerings and actively pursues dissidents who publish critical views via email or bulletin boards (which puts US-based Internet service providers and social networking operators in conflict with public policy and public opinion in the United States).
  • Multiple agencies have jurisdiction over various aspects of Internet business activities.
  • Although applicable laws and regulations are largely consistent, official guidelines and practice vary from province to province and town to town, and the reality in the marketplace often differs greatly from statutory wording, which makes planning and implementation difficult, costly, and time-consuming.
  • The PRC tax environment is complex and tax rates are relatively high.
  • Employment laws have been tightened and have increased the cost of labor significantly in recent years.
  • Legal translation costs are also high.

Details of the Chinese internet and business law

The Ministry of Industry and Information Technology (MIIT) has overall responsibility in China for regulating the Internet. It recently underwent a change of name and is probably better known to U.S. companies familiar with China by its former name, the Ministry of Information Industry. Governmental authorities with jurisdiction over imports, tax, foreign exchange, and online payments also play important roles. In addition, Internet transactions are subject to industry sector authorities, such as those that administer pharmaceuticals, securities, audiovisual products and news reporting.

The State Administration for Industry and Commerce, which is familiar to many foreigners as the agency in China that issues business licenses, also regulates all kinds of commerce. It has not taken an active role in regulating the Internet, but uncertainty prevails about the potential impact of its policies.

All telecommunications into and out of China are routed through four international communication gateways controlled by the MIIT, which can, and frequently does, take steps to firewall offending Web sites by blocking Internet protocol addresses, filtering and redirecting domain name systems, filtering uniform reference locations, and packet filtering.

Under the Regulations for the Administration of Internet Information Services, effective from 25 September 2000, and subsequent legislation, vendors located within China are additionally subject to monitoring of their Web sites by Internet content providers and Internet service providers, which are required to keep records of site or service use for 60 days.

Another tool that has been used to regulate the supply of foreign goods and services over the Internet is China’s foreign exchange control regime. Payments for items for the capital account (e.g. investment, purchase of securities) are subject to approval by the State Administration of Foreign Exchange, and all payments for the current account (e.g. purchases of goods and services, royalties) are subject to documentation requirements, in some cases quite detailed. Each remittance to a foreign vendor is channeled through an authorized foreign exchange bank in China that examines any required supporting documents. If the documents are not complete or the payment is for a restricted purpose, the bank will refuse to remit the payment or will refer the matter to the local counterpart of the State Administration for Foreign Exchange.

If the remittance is refused, the customer in China often has no legal alternative means to pay the foreign vendor. China thus effectively restricts the sales of certain goods and services from offshore by prohibiting payment for them.

The documentary requirements for remittances were quite burdensome, and purchasers often were unwilling to deal with them, putting foreign vendors at a competitive disadvantage vis-à-vis local vendors that accepted payment in local currency (Renminbi). Either the customer or the foreign vendor could retain the services of an agent in China to assist with remittances, but such assistance added to the cost of goods and services to the purchaser. Although the foreign exchange control regime remains in place, fortunately for foreign vendors and Chinese purchasers, China has gradually relaxed foreign exchange limits on both individuals and businesses.

Under the Detailed Implementing Rules of the Measures for the Control of Foreign Exchange of Individuals, effective 1 February 2007, individuals may now purchase up to USD50,000 of foreign currency each year and remit up to USD10,000 or USD50,000 (depending on the source of the funds being remitted) of foreign currency each day for current account payments on the basis of a valid identification document. Capital account payments still require approval by the State Administration for Foreign Exchange.

Companies are not subject to any general monetary limits on remittances as long as they are made for permitted business purposes, but must provide supporting documentation.

Although small as a percentage of the total Chinese population, debit card and, to a lesser extent, credit card usage is rapidly increasing in China. Cross-border payment in Renminbi is not permitted, and the purchaser must have a foreign exchange debit or credit card to make a cross-border purchase. Foreign exchange cardholders must deposit foreign exchange with the card-issuing bank or give a pledge over their savings deposits. Total charges using the card generally may not exceed 80 percent over the secured amount. Separate limits apply to credit card purchases by companies for business purposes.

A word of caution is warranted regarding offshore Web sites. China can clearly extend its jurisdiction to them, if it wishes, even if enforcement of a judgment or administrative decision may be difficult. Foreign vendors should anticipate that China will try to exert some control over offshore Web sites that have a direct effect in China as Chinese Internet regulations develop and foreign exchange controls are loosened. For example, Chinese privacy laws could be applied to protect the interests of Chinese customers if an offshore Web site collects and uses the customers’ personal information.

When goods are imported from offshore, the purchaser or an agent must pay import duty, import level value-added tax, and consumption tax, if any. The duty and taxes are paid when the goods are cleared through customs. Although foreign vendors generally do not bear any Chinese tax burden on such goods, import duty and taxes add to the cost of the goods to the purchaser. Cross-border trade is now facilitated by the services of FedEx, UPS, and other international courier services, which may provide assistance with customs clearance.

Software purchased from offshore is a special case because it may be treated as an import of a good or provision of a service (i.e. a license) or both. If shipped on a CD through customs, the Chinese purchaser or the agent pays the duty and applicable import-level taxes. China does not impose import duty on software, but does impose import-level value-added tax at the rate of 17 percent on the total of software media and qualifying royalties. In practice, software purchased over the Internet is often imported through customs (sometimes by sending a blank CD through customs if the customer has already downloaded the software), and the purchaser pays value-added tax in China on the full value of the media and software in order to generate documents to support payment to the vendor.

If software is sold and delivered over the Internet without clearing Chinese customs, the transaction will not generate any customs documents to support payment through an authorized foreign exchange bank; however, the vendor and purchaser can often generate payment documents by treating the sales as a nontrade transaction. Non-trade transactions under China’s foreign exchange regime include licensing of technology and trademarks (e.g. software downloaded over the Internet) and provision of services in person or over the Internet.

A sale of software over the Internet can be treated as a software license that generates royalty payments. It must be supported by a license agreement between the vendor and purchaser. Under Chinese tax laws and treaties, royalties to licensors that have no establishment in China are passive income subject to withholding, typically at the rate of 10 percent of the gross amount of the payment. Royalties for certain intangible rights, such as a license of software, are also subject to withholding of business tax at the rate of 5 percent of the gross amount of the payment. The taxes are now added together, resulting in a combined rate of 15 percent, which the purchaser deducts from remittances sent to the foreign vendor.

Non-trade remittances by Chinese consumers are subject to the foreign limits described above. In addition, all non-trade remittances must be supported by a Tax Clearance Certificate if the remittance amount exceeds USD50,000. As part of the liberalization of foreign exchange controls in China, however, the Circular of the State Administration of Taxation on Relevant Issues of the Trial Tax Filling System for Remittances Offshore for the Foreign Service Trade, issued 6 March 2008, allows companies in certain trial areas, including Shanghai, Tianjin, and Fujian Province, to remit payments in excess of USD50,000 and settle withholding taxes later.

Because software may be treated as either a product or a service, software vendors are well advised to plan sales to China to minimize the risk of duplicative taxation. In most cities, the value-added, passive income, and business taxes are paid to two tax bureaus (i.e. state and local tax bureaus) or departments and are allocated to different government coffers, creating a substantial risk that value-added, passive income, and business tax will all be levied on the same purchase of software.

Turning to sales and services supplied from within China, Chinese foreign exchange regulations require sales to Chinese customers to be denominated and paid in the local currency, Renminbi. Customers typically prefer paying local currency because they do not have to deal with China’s foreign exchange control regime and business customers receive a value-added tax (VAT) invoice, which they require to credit the input tax against the tax received from their customers, which must otherwise be paid to the tax bureau.

Under the Foreign Invested Commercial Enterprise Regulations, effective from 1 June 2004, a foreign vendor that wishes to sell goods within China can establish a subsidiary in China. The subsidiary may deal only in classes of products listed in its business scope, which is subject to approval by the Ministry of Commerce (MOFCOM) or its local counterpart. Certain activities and classes of goods (such as publication of books, newspapers, and magazines) are prohibited to foreign investment, but most are either fully open, or foreign investment is permitted subject to certain restrictions.

A subsidiary of a foreign vendor can import and sell goods within its business scope. The subsidiary can record a Web site to market its products under the Regulations for the Administration of Internet Information Services, effective from 25 September 2000. If the Web site is used to market and sell the subsidiary’s own products, it is generally considered a “non-commercial Internet information service” and requires only recordal with the telecommunications authorities to operate.

On the other hand, supplying services from within China raises thorny issues of law and practice. China restricts foreign investment in certain industries. The Catalogue for Guiding Foreign Investment in Industry, which was last amended and took effect on 1 December 2007, classifies industries and assigns them to the category of prohibited, restricted, or encouraged. All industries not listed are permitted.

Most Internet services fall under the Telecommunications Regulations of the People’s Republic of China, promulgated on 20 September 2000, and, along with most telecommunications services, fall in the restricted category.

Internet services are subject to differing treatment according to their classification as “basic telecoms” or “value-added telecom services.” The Regulations for the Administration of Foreign-Invested Telecommunications Services, promulgated 5 December 2001, limit foreign ownership to 49 percent of a Chinese-foreign joint venture providing basic telecoms services and 50 percent of a Chinese-foreign joint venture providing those value-added services listed in the Schedule of Specific Commitments on Services, which China agreed to upon accession to the World Trade Organization. Value-added services not listed in the Schedule are subject to further restriction or prohibited.

The dividing line between basic and value-added telecoms services is not always clear, but basic telecoms mainly include services requiring telecom infrastructure, such as fixed-network telephone services and mobile cellular communications services, as well as voice-over Internet protocol (VOIP). In practice, no direct foreign investment in basic telecoms is currently permitted.

Value-added telecoms include services of potential interest to Internet vendors, such as (1) online data processing (e.g. online banking, auctions, payment processing, and back-office functions), (2) data storage services, (3) Internet information services (e.g. Internet content providers (ICPs)), (4) data hosting, (5) Internet access services (e.g. Internet service providers (ISPs)), and (6) call centers (e.g. centers providing technical or training assistance online or by telephone). Items 1 to 3 are open to 50 percent Chinese-foreign joint ventures, although we are not aware of any foreign-invested joint venture that has been granted an online data processing permit (item 3).

Items 4 to 6 are not in the World Trade Organization Schedule and are subject to tighter restrictions than other value-added services or are prohibited to foreign investment. Under the Mainland-Hong Kong Closer Economic Partnership Arrangement, however, signed 29 June 2003, Hong Kong companies (including those with foreign investment that meet certain criteria) are permitted to establish joint ventures to provide Internet data center, data storage, call center, and Internet information services (i.e. ICPs).

Although many more foreign investors have applied, only about 19 Chinese foreign joint ventures have received permits from the MIIT to provide value-added services, and the majority are authorized as Internet content providers. Some delay in approving further value-added permits to foreign-invested joint ventures was experienced because of a 2008 reorganization of the MIIT, but the MIIT began operating in June and its new Web site is now online.

Given the restrictions on foreign investment in value added services, foreign companies have found several creative workarounds to provide Internet services. A common strategy, relying on the recent provenance and ambiguity of many of China’s commercial laws and regulations, is to establish a subsidiary with a business scope to provide permitted services, such as consulting services or technology development, but additionally use the subsidiary to engage in related services falling in a so-called grey-area of the regulatory regime. For example, some foreign subsidiaries offering portal-like functions have been established with a business scope that includes development of software or research into new technologies.

Other strategies include contracting with a licensed, third-party local company to which a foreign subsidiary leases equipment. The local company provides value-added services on behalf of the subsidiary. Some foreign subsidiaries have “rented the license” of a local company by assuming operational control and/or sharing revenue of that company through a mix of service, license, loan, stock option, and other contracts. This last arrangement is sometimes called the China-China-foreign (CCF) structure, as it typically involves a local company with the appropriate license, either a wholly owned foreign subsidiary or a joint venture between a Chinese and a foreign company and a foreign parent company. The foreign company or subsidiary supplies the capital and technology required by the local company.

The CCF structure has been used for many years, but it can be risky. It was created when China Unicom built out its mobile telecoms infrastructure in the 1990s. Despite a prohibition on foreign investment in telecoms that was in effect at the time, many foreign companies sought ways to participate in the build out and subsequent operation of the network (classified as basic telecoms). With the tacit approval of the regulatory authorities, those companies and China Unicom used the CCF structure to channel more than USD1 billion into the build out. In 1999, however, the Ministry of Information Industry (now Ministry of Industry and Information Technology (MIIT)) ordered the foreign investors to divest their interests. In addition to being excluded from future operational profits, some investors were not able to recoup their full capital.

Despite the implosion of this arrangement, many companies have subsequently used variations of the CCF structures to invest in value-added services in China. The CCF structures used by high-profile players, including Sina.com and Sohu.com, are ongoing and information about them is publicly available.

It is clear, however, that the MIIT is not comfortable with the structure. In its Notice concerning Strengthening the Administration of Foreign Invested Value-Added Telecom Business Operations, issued on 13 July 2006, the MIIT expressly cracked down on cooperation between foreign and local telecoms companies by requiring local companies to own the domain names and trademark registrations used for value-added services operations. Foreign companies typically are reluctant to transfer established intellectual property assets to China for organizational and control reasons. In addition, transfer of an established mark or domain name may result in substantial tax costs to the transferor. The Notice additionally prohibits local companies from covertly renting, lending, or transferring their value-added licenses to any party.

China tends to target high-profile players, and in 2006 it was widely reported in the Chinese press that the MIIT was scrutinizing Google for allegedly using the license of Ganji.com, a local company, to provide value-added services in China. Google subsequently applied through a joint venture subsidiary and received an Internet Content Provider permit. Despite such cases, variations of the CCF structure and other workarounds are reportedly still widely used in the value-added space in China by both experienced and new players.

What will the future bring for Internet services in China? Currently, a significant issue is the rapidly evolving nature of Internet services and the difficulty of fitting them within the Chinese telecom regulatory regime. China is clearly determined to develop Internet commerce, however, as evidenced by a slew of regulations and notices in the past several years, such as the Several Opinions of the General Office of the State Council on Accelerating the Development of E-Commerce, issued on 28 January 2005. While there is still no easy way for foreign Internet vendors to participate, the enormous potential of China will no doubt continue to stimulate creative efforts to enter the Chinese Internet market.

What to do? Planning and execution on the PRC internet business plan

U.S. companies going to China should carefully assess which of their activities require a local presence and consider tailored strategies for individual business lines.

Sophisticated services targeted at large companies may be better offered from offshore, ideally under a slightly different brand and with clearly divided organizational structures to separate these offerings from onshore activities. The same applies to advertising-financed business models that target multinationals that are also outside of China and want to use an Internet forum to promote products sold through different channels. To support such business lines from a market perspective, the U.S. company could deploy a representative office with a limited business scope.

U.S. companies that want to successfully target consumers or small to mid-sized companies in China, however, will have to go onshore. They have to evaluate the PROs and CONs of partnering with Chinese companies that hold necessary licenses, or work with independent intermediaries, with the obvious disadvantages regarding margins and control. Tax and customs planning is also vital.

A final word on joint ventures: Equity joint ventures are costly and timeconsuming to set up and dissolve for any jurisdiction, but China’s regulatory regime takes the pains to an extreme, especially when U.S. companies try to structure off-shore joint ventures to minimize the impact of local corporate law inflexibilities. Most perceived advantages of equity joint ventures can be simulated and achieved through carefully crafted contractual cooperations, except the exit options of a public listing and third-party sale. But, these are often not realistic options anyhow for U.S. companies that enter China to promote their global brand.

So, be wary when you enter the land of the dragon. You cannot afford to stay away, but you need to prepare all stakeholders in your business for an adventurous journey.

This article was first published in Computer & Internet Lawyer, April 2009, and is one of several that appear in China Legal Developments Bulletin, July-September 2009.
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