September 11-12, 2000
San Francisco, CA

A Legal Perspective: The Impact of WTO on Foreign Investment in China's Internet/E-commerce Sector

Jon Eichelberger
Partner
Perkins Coie LLP

Annabel Allen
Senior Consultant
Perkins Coie (Hong Kong) Limited

1.Introduction

The November 1999 signing of the US-China Bilateral Market Access Agreement (the "US-China Agreement") in relation to China's pending accession to the World Trade Organization marked China's official sanctioning of foreign investment in its Internet and e-commerce sector. The bilateral agreement signed between China and the European Union (the "EU-China Agreement") in May 2000 has not yet been publicly released, but certain of its provisions are reportedly even more favorable for foreign investors in China's Internet market. The WTO is now harmonizing the terms of these two agreements, as well as the terms of bilateral agreements between China and other countries, based on the principle that the most liberal terms of the agreements should be made available to all WTO members upon China's accession.

The provisions of the US-China Agreement and the EU-China Agreement contrast with the ban on foreign investment in China's Internet sector articulated in September 1999 by China's Ministry of Information Industry ("MII").¹ This reiteration of the ban on foreign investment in the Internet sector, coming in the final weeks before China's signing of the US-China Agreement, has been interpreted as a political move by MII to assert regulatory control over the Internet in the face of competing claims by other government agencies, as well as a tactic in the negotiations between China and the United States over WTO market access. But the MII's pronouncements also reflect a more fundamental concern within policy circles, and more broadly within Chinese society and culture, as to the appropriate direction of foreign investment and the acceptable degree of foreign influence in China. Tension over these issues remains acute, notwithstanding the Chinese government's decision to aggressively pursue WTO accession and to allow less restricted market access.

The roots of this tension extend deep into the history of China's interaction with the West. The predominant view for generations has been that in the effort to modernize, China should adopt foreign technology, and more recently that China should attract foreign capital, while limiting both the influence of Western cultural and political ideas and the ability of foreign business to dominant the economy. This ambivalence between admiration of Western technology and modernity and rejection of many aspects of Western thought and values is still widely shared by policy makers in China, as well as by many of the intelligentsia and the general populace. The protection of China from undue foreign influence and foreign economic domination is a key factor in the process by which the state legitimizes itself in the eyes of its people. These attitudes have informed policy formulation and legal development since China's opening to foreign investment in the late 1970's, and to a large extent they will shape the reforms in policy and law that China must adopt following WTO accession, particularly with respect to market access.

In the longer term, attitudes will continue to evolve, particularly as China becomes stronger economically, and as younger generations attuned to the information age acquire greater economic and political power. With respect to the nearer term implementation of WTO reforms, however, the area that is the primary concern of foreign investors today, the attitudes discussed above introduce a degree of uncertainty as to the significance of the market access provisions in the US-China Agreement and the EU-China Agreement.

Against this background, we examine below the current laws and practices applicable to foreign investment in Internet and e-commerce in China and the potential impact of WTO.

2.Existing Regulation of Foreign Investment in Internet and E-Commerce

Existing regulations governing foreign investment in China do not address the Internet and e-commerce in any detail. At present, foreign investment in this sector is regulated largely based on the rules prohibiting or restricting foreign investment in telecommunications and on other rules restricting foreign investment in various services, such as trading or advertising, that are vital to many Internet and e-commerce businesses.

Regulation of Foreign Investment Generally

Since the late 1970's when China started its "open door" policy toward foreign investment, the basic goals of the Chinese government have been to encourage the import of foreign capital and technology, but to limit the activities and influence of foreign investors. The government has sought to keep foreigners out of areas perceived as strategic to China and to inhibit foreign domination of the Chinese economy. Protecting the interests of local economic players has also been a priority, especially in the earlier years when most Chinese enterprises had little or no experience with international business transactions. The regulatory framework for foreign investment reflects these goals in a variety of ways, such as discretionary government approval of all investments, unanimous board consent and government approval for share transfers and major company actions, caps on ownership interests of the foreign shareholder in joint ventures, prohibition of wholly foreign-owned enterprises in certain sectors, and restrictions on the permitted business scopes of enterprises with foreign investment ("FIEs").

The key regulations concerning the allowable scope for foreign investment are the Provisional Regulations for Guiding the Direction of Foreign Investment² and its companion Catalog for Guiding Foreign Investment in Industry (the "Foreign Investment Catalog").³ These regulations divide industrial and commercial sectors into four categories for foreign investment: encouraged, permitted, restricted and prohibited. The Foreign Investment Catalog lists the sectors in which foreign investment is encouraged, restricted or prohibited. Foreign investment is deemed to be permitted in sectors that are not listed, except where other laws, regulations or industrial policies provide otherwise. Notably, foreign investment projects in the restricted category require higher-level government approvals, and many of them are subject to limits on the foreign shareholder's ownership.

An important aspect of these regulations with respect to market access is that many types of services, for example, domestic commerce, foreign trade, sales agency, advertising, transportation of goods, brokerage and publishing, are listed in the "restricted B" category. This means that central government approval is required for all foreign investment projects involving these services, regardless of the size of the project. In practice, the central government has rarely granted approval for such projects.

Regulation of Foreign Investment in Internet and E-commerce

The Chinese government's general policies toward the Internet and e-commerce are a blend of encouragement and control. E-commerce is viewed as means for China to remain competitive in foreign trade and to improve efficiency in the domestic economy. Government and business leaders appreciate the historical significance of the information revolution and do not want China to lag behind more developed countries in this area. There is also a belief that China has a competitive advantage in software development and other areas of technology related to the Internet because of its relatively advanced system of higher education. At the same time, the government is concerned about controlling the dissemination of information over the Internet, particularly with respect to classified information (referred to as "state secrets"), political dissent and undesirable foreign influences.

Government encouragement for the development of a legal framework for Internet and e-commerce has been expressed in numerous ways, such as the provisions on electronic contracts in the new contract law that took effect last year,⁴ the establishment of a domain name registration system,⁵ pilot projects in Beijing, Shanghai and Guangzhou for online advertising,⁶ and recent attempts to control cyber-squatting.⁷ The State Council and MII are reportedly formulating an overall framework for the development of e-commerce in China and other government agencies are working on e-commerce policies and regulations in areas such as foreign trade, online advertising and taxation.

Government control over use of the Internet and e-commerce is reflected in many regulations that have been promulgated in recent years. For example, the government has sought to control and monitor access to the Internet,⁸ to prevent the divulgence of state secrets over the Internet,⁹ to restrict the use of foreign-made encryption software,¹⁰ to control the online sale of audio-visual products,¹¹ and to control the online distribution of books.¹²

The emerging but as yet largely uncoordinated legal framework described above applies to both foreign-invested and domestic Internet and e-commerce businesses in China. In contrast, the legal issues related to Internet and e-commerce that are unique to foreign investment relate primarily to market access, i.e., to prohibitions and restrictions on the business scopes of FIEs. The Foreign Investment Catalog is one key regulation that addresses these issues, but for Internet and e-commerce, other regulations governing foreign investment in telecommunications are also relevant.

The Foreign Investment Catalog prohibits foreign investment in the operation and management of telecommunications business.¹³ This prohibition is more fully detailed in a series of older regulations, which disallow any form of foreign investment or participation in this sector.¹⁴ Based on these regulations and on the regulations referred to above regarding Internet access,¹⁵ it is generally accepted that foreign investment in Internet service providers ("ISPs") is prohibited today.

The situation is less clear for Internet content providers ("ICPs"), a term that has not been defined in Chinese legislation but is widely used in official discussions about the Internet. Since all online businesses provide some amount of information or content on their websites, the term is sometimes used to describe all online businesses other than ISPs. MII has interpreted the ban on foreign investment in telecommunications as applying to all ICPs, apparently based on an expansive definition of "value-added telecommunications services," which are included in the ban. More recently, however, MII has acknowledged that the situation is more complex and that foreign investment in some ICPs may be regulated under laws and regulations other than those governing telecommunications.¹⁶ It is possible that a distinction will emerge between ICPs whose core activity is to attract website traffic by disseminating general information or by providing e-mail, EDI or other types of communications services, and those whose core business is to distribute goods or to provide other types of application services over the Internet. However, whether such a distinction makes sense given the nature of the Internet or whether the regulators would embrace it remain open questions.

Foreign investment in ICPs that escape the telecommunications ban may still be subject to other restrictions under the Foreign Investment Catalog. Many services that are key to website-based businesses, such as commission sales, advertising, trade in goods, brokerage, publishing and distribution, are in the "restricted B" category, which means that all foreign investment must be approved by the central government. Since such approvals have not been forthcoming, many foreign investors in the Internet and e-commerce sector have had to choose between staying out of the market and adopting creative but sometimes irrational business structures that exploit gray areas in the regulations. In some instances, this is possible because it is not clear how foreign investment legislation adopted long before the Internet became significant in China applies to online businesses.

3.Effect of Existing Regulation on Internet/E-commerce Business Models

To illustrate how existing regulations affect foreign investment in Internet and e-commerce, we examine below several typical business models that we have encountered in this sector in China. We should emphasize, however, that these are simplified models for illustrative purposes only. Most actual businesses are more complex and often involve more than one of these simple models.

3.1Business Models

Internet software developer

One type of Internet-related business involves the development and sale (or licensing) of enabling software for e-commerce and other Internet applications. Under current regulations, foreign software companies can normally obtain approval to establish a wholly foreign-owned enterprise ("WFOE") or a Sino-foreign joint venture to develop and produce software and to sell and or license that software. In most cases, the WFOE or joint venture localizes the foreign company's software for use in the Chinese market, and provides software engineering services, such as customization, related to its own products. Software development has long been considered to be "production-oriented" and therefore has been treated for foreign investments purposes similarly to the manufacture of goods.

Manufacturing FIE with online sales

An FIE that manufactures products in China may decide to channel sales through its own website. Under existing law, FIEs that manufacture products are permitted to sell the products that they manufacture (but not any other products) in China or abroad. Therefore, adopting an online sales channel should be within the FIE's existing scope of business, so long as it promotes and sells only its own products. However, the FIE would be considered to exceed its authorized business scope if, for example, it advertised the products of other companies on its website or created links to other websites involving the payment of sales commissions to the FIE. Both activities would run afoul of restrictions in the Foreign Investment Catalog, and it is unlikely that the FIE would be able to obtain central government approval to amend its business scope.

B2C "catalog" sales

The main problem for a foreign company that wants to set up an FIE to operate online "catalog" sales is that foreign investment in foreign or domestic trading, whether retail or wholesale, is restricted under the Foreign Investment Catalog and requires central government approval. Central government approvals have been few, primarily limited to a small number of brick and mortar department stores in several major cities.

B2C portal

A B2C portal provides a wide selection of information aimed at attracting Chinese consumers to the site. The portal operator generates advertising revenue by designing advertisements for the products and services of other companies and publishing them on its website. The site also contains links to other websites, from which the portal operator earns commissions on the sale of goods or services. The portal operator may organize offline sales activities from which it earns commissions, as well as sell consumer information from its database.

Since information is provided on the website, the portal operator may be categorized as an ICP. As discussed above, it is presently unclear whether an ICP of this kind would fall within the ban on foreign investment in telecommunications, so at best this aspect of the business falls within a legal gray area.

Sales agency is a restricted sector under the Foreign Investment Catalog, and central government approval would not be forthcoming at this time. Consequently, for an FIE to receive commissions from the sales of another company's products made via a link from its website would likely be outside of its authorized scope of business.

Under China's advertising regulations, a distinction is made between companies that want to advertise, agents that design, create and place advertisements, and publishers of advertisements. Advertising agency and publishing are within the restricted category of the Foreign Investment Catalog requiring central government approval. Even if it were possible to obtain central government approval, a foreign-invested publisher must be in the form of a joint venture in which the foreign investor holds a minority stake. A recent notice issued in Beijing requires website enterprises there to obtain an advertising agency license or permission to publish advertisements before undertaking these activities online, a requirement that would be difficult for most FIEs to meet.

B2B trading portal

A B2B trading portal helps North American buyers find suppliers in China. The portal operator provides product information on its website, receives commissions from purchases by the foreign buyers, and generates revenue from publishing advertisements. It may also hold online auctions, from which it receives commissions. The B2B portal faces essentially the same restrictions on foreign investment as the B2C portal above, although it may have a lesser risk of being treated as an ICP in which foreign investment is banned if the information provided on the website pertains mainly to its own business.

3.2Actual Practice

From the above discussion, one might assume that foreign investors would be deterred from investing in Internet and e-commerce in China. In fact, foreign investment has poured into the sector over the past year. Investors, usually with the cooperation of Chinese partners or local government authorities, have adopted a number of strategies to circumvent the restrictions on foreign investment. Some common ones include:

• Avoiding the establishment of an FIE by entering into a contractual relationship with a local company, under which the local company handles the operation of the business and collects revenues, if any, from inside China. It then pays the foreign company under the rubric of a cross-border consultancy, technical services or similar contract. However, this structure may lead to foreign exchange control problems.
• Establishing a software development FIE, as described above. In addition to other software-related services, it is often possible to include website-related design, systems integration and other technical services in the scope of business. In reality, the FIE may operate an online business directly, or it may establish a contractual relationship with a local company as in the previous example. In both cases, the FIE's revenue is likely to be dressed up as technical services fees or licensing fees, although the FIE does no true software development.
• Convincing a local government to approve a scope of business worded in such a way as to encompass all or some of the restricted activities, without actually using the language of the Foreign Investment Catalog or other regulations to describe those activities. This creates the appearance that the project did not require central government approval.
• Variations on the Chinese-Chinese-Foreign ("CCF") investment structure that the State Council declared illegal at the end of 1998 continue to be adopted, particularly for ISPs and other businesses that are within the telecommunications ban.

That these strategies can work has much to do with flexible interpretations of the regulations by local governments (usually driven by a desire to increase foreign investment levels in their localities), lack of knowledge about Internet and e-commerce on the part of local officials, and the difficulty of policing the hundreds of Internet-related businesses that have sprung up in a short time.

But these strategies share at least two common problems. First, the business may run into problems raising funds in the venture capital or public markets, or in selling the business privately, because the foreign company does not own the business or because the legality of the structure is questionable. Second, the risk of a central government crackdown cannot be dismissed, as demonstrated by the well-publicized rectification last year of China Unicom's foreign investment projects using the CCF structure, or by the crackdown on foreign investment in the retail industry in 1997-98. Nonetheless, most investors seem to believe that with WTO accession pending, the risk of a crackdown in the Internet and e-commerce sector is low.

4.Potential Impact of WTO

The Foreign Investment Catalog and the US-China Agreement are compared in Table 1 for selected areas related to Internet and e-commerce. Based on the US-China Agreement, foreign investment in certain value-added telecommunications services will be permitted, subject to limits on foreign ownership that will increase to 49% one year after accession and 50% two years after accession. In advertising, retail, commission sales and wholesaling, geographical, quantitative and foreign ownership restrictions will be eliminated in stages.

Table 1. Comparison of selected e-commerce and Internet-related service sectors under the 1998 Foreign Investment Catalog and the US-China Agreement

We consider the impact of WTO, based on the provisions of the US-China Agreement, on the various business models discussed above in Section 3:

Internet software developer

For FIEs that actually engage in software development and sales, the impact of WTO will be less significant than in other sectors. However, it is not known if investors will continue to be able to use software development as a mask for other activities, such as technical services or online businesses. For example, the US-China Agreement provides that foreign investment in software implementation services, systems and software consulting services and systems analysis services must be in the form of joint ventures, rather than WFOEs. Also, foreign investment in certain Internet-related areas that today is often hidden in software development WFOEs or majority-owned joint ventures may be required post-WTO to be carried out in joint ventures with limits on foreign ownership.

Manufacturing FIE with online sales

Manufacturing FIEs that sell products online may gradually be able to expand their online activities to include advertising and distribution of the products of other companies, including but not limited to those of the foreign shareholder. However, this will depend on the requirements of the specific regulations adopted for advertising and distribution post-WTO. For example, the government may try to impose restrictions that are not expressly addressed in the WTO agreements, such as requiring that the foreign investor in an advertising FIE be in the advertising business itself outside of China.

B2C "catalog" sales

Retail and wholesale distribution will open up to foreign investment in accordance with the details set out in Table 1. For online wholesaling, investors should note that certain products that have been popular for e-commerce sites outside China, such as books, newspapers, magazines and pharmaceuticals, will become unrestricted three years after accession, whereas for most products it is only one year. Similarly, while foreign investment in the retailing of most products may begin upon accession, the retailing of books, newspapers and magazines will be delayed for one year and the retailing of pharmaceuticals for three years after accession.

B2C portal and B2B trading portal

If the portal operator's services are within the value-added telecommunications category in the US-China Agreement, the portal should be permitted to operate as a joint venture, and the foreign party's stake may increase from 30% upon WTO accession to 49% a year later and 50% two years later. The joint venture could be established only in Beijing, Shanghai or Guangzhou for one year after accession, but within two years after accession, the joint venture could locate anywhere in China.

Value-added telecommunications services are listed in the US-China Agreement as including e-mail, voice-mail, on-line information and database retrieval, electronic data interchange, enhanced fax services, code and protocol conversion, and on-line information and/or data processing. However, it is not clear if this list is exclusive. Under the draft regulations concerning the telecommunications industry that MII has recently submitted to the State Council,¹⁷ value-added telecommunications services and information and related services on the Internet and multimedia networks are treated in a similar way. Although the draft regulations do not stipulate an equity cap, MII, at least, may be seeking to impose the 50% limit on foreign ownership to all FIEs that are within the ICP category, rather than only to those engaged in value-added telecommunications as defined in the US-China Agreement. This could have a significant effect on foreign investment in portal sites.

Commission sales are treated under the US-China Agreement in the same manner as wholesale distribution (see comments above on catalog sales).

The US-China Agreement provides for the lifting of restrictions on foreign investment in advertising agency but does not specifically address the publishing of advertisements. Pilot projects and a government study for online advertising are currently underway. It appears that investors will have to wait until online advertising regulations are promulgated for clarification concerning the publishing of advertisements on foreign-invested websites.

5.Conclusion

Two broad concerns emerge from the discussion above. The first is how the large number of existing FIEs that operate in restricted Internet and e-commerce sectors under questionable business scopes approved by local governments will be handled after China accedes to WTO. The US-China Agreement purports to require "grandfather" treatment for foreign invested projects in existence at the date of China's accession. However, the language is vaguely worded, and past experience with similar provisions in Chinese regulations suggests that grandfather treatment will not be extended to FIEs set up in violation of regulations in effect at the time of establishment. From the central government's perspective, many FIEs in the Internet and e-commerce sector should not be eligible for grandfather treatment because they applied for an authorized business scope that did not reflect their intended business and/or because they were approved locally when central government approval was required.

While a general crackdown on these FIEs may be unlikely, there could be selective termination of some, while others are required to amend the terms of their projects to comply with the post-WTO regime. This would be similar to the approach taken in the rectification of the retail sector a few years ago. On the other hand, local governments may resist any attempt to rectify the Internet and e-commerce sector, and the central government may decide that it does not want to expend its resources in this area. In either case, questions about the legality of existing businesses may be exacerbated as the legal framework becomes clearer and as new players enter the market under the new framework, perhaps leading to disruption in the financing or sale of existing businesses.

The second concern is how the implementation of WTO reform in China will differ from the expectations of other member countries, particularly as reflected in the US-China Agreement and the EU-China Agreement. We have referred above to the draft telecommunications regulations prepared by MII in anticipation of WTO accession, and the seeming intention to apply restrictions on value-added telecommunications services to other ICPs. These draft regulations also suggest other ways in which restrictions could be introduced. For example, they provide that the foreign investor in a project involving value-added telecommunications or information and related services on the Internet must have annual revenue of at least US$500,000 and total assets of US$1 million in the year prior to application, as well as a solid performance record in the industry. These requirements, if enforced, would make it difficult for start-up enterprises with foreign investment to be established in China. In another example, several government officials have recently expressed the view privately that post-WTO, distribution of goods will be permitted only for those foreign companies who have already established manufacturing FIEs in China. Further examples of this kind will multiply rapidly as the implementation process gets underway.

China's accession to WTO will bring many long-term benefits to foreign investors in the Internet and e-commerce sector. At the same time, the deeply held protectionist sentiments of government regulators, the doubtful validity of the legal structures of many existing FIEs in the sector, and the ambiguities that will be found in applicable market access provisions after China's accession, all point to a difficult path for existing foreign investors during the implementation of WTO reforms.

Endnotes

1. Interview with Wu Jichuan, published in the Financial Times on September 14, 1999.

2. Provisional Regulations for Guiding the Direction of Foreign Investment, issued by the State Planning Commission on June 27, 1995.

3. Catalog for Guiding Foreign Investment in Industry (the "Foreign Investment Catalog"), revised by the State Council on December 29, 1997 and promulgated with effect from January 1, 1998 under Guo Han [1997] No. 117.

4. Contract Law of the People's Republic of China, adopted by the National People's Congress on March 15, 1999, and effective from October 1, 1999. Articles 11, 16, 26,and 33 contain specific provisions regarding electronic contracts.

5. Tentative Procedures for the Administration of the Registration of Domain Names for the Chinese Internet, promulgated by the State Council on May 30, 1997; Detailed Implementing Rules for the Registration of Domain Names for the Chinese Internet, promulgated by the State Council on June 3, 1997.

6. Urgent Notice of Guangdong Province Concerning Pilot Projects for Registering Network Advertising Business, issued by the Guangdong Province Administration for Industry and Commerce on February 28, 2000; see also Notice of the Beijing Municipal Administration for Industry and Commerce Concerning Standardization of Qualifications for Internet Advertising Business, issued on May 16, 2000.

7. "Beijing court adopts guidelines for cases involving cyber-squatting," reported on September 6, 2000, on www.chinaonline.com; originally reported in the September 1, 2000 issue of China Consumer Journal.

8. Provisional Regulations of the People's Republic of China for the Administration of International Connections to Computer Information Networks, promulgated by the State Council on February 1, 1996 and amended on May 20, 1997; Implementing Rules for the Provisional Regulations of the People's Republic of China for the Administration of International Connections to Computer Information Networks, promulgated by the State Council on February 13, 1998.

9. Administrative Regulations on the Maintenance of Secrets in the International Networking of Computer Information Systems, issued by the State Secrecy Bureau on January 25, 2000, and effective from January 1, 2000.

10. Regulations on the Administration of Commercial Encryption, promulgated by the State Council with effect on October 7, 1999.

11. Notice on Relevant Issues Concerning Online Business in Audio-visual Products, issued by the Ministry of Culture in April 2000.

12. "Read it and weep: Beijing cracks down on online book retailers," reported on July 5, 2000, on www.chinaonline.com; originally reported in the Press and Publishing News on June 29, 2000.

13. Foreign Investment Catalog, List of Industries in Which Foreign Investment is Prohibited, Section 7(1).

14. See Opinion of the Ministry of Post and Telecommunications on Further Strengthening Control of the Telecommunications Services Market, issued on June 30, 1993 and approved by the State Council on August 3, 1993; Provisional Measures for Administration of the Examination and Approval of Engagement in Previously Restricted Telecommunications Business, issued by the Ministry of Post and Telecommunications on October 11, 1993 with effect from November 1, 1993.

15. See note 8.

16. Interview with Wu Jichuan, published by Caijing Magazine in January 2000, on www.caijing.homeway.com.

17. Regulations of the People's Republic of China on the Administration of Telecommunications (draft); and Regulations on the Administration of Foreign Invested Telecommunications Enterprises (draft). Michael A. Aldrich and Jacqueline P.L. Teoh analyze these new regulations in A Preview of the Shape of Things to Come in PRC Telecoms, at www.perkinscoie.com/resources/intldocs/prc_tele.htm.