Guide to China's New Laws Governing Foreign Contractors and Design Professionals


January 19, 2004

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By Hew Kian Heong
Pinsent Masons

INTRODUCTION

On 27 September 2002, China’s Ministry of Construction ("MOC") and Ministry of Foreign Trade and Economic Co-operation (“MOFTEC”), now the Ministry of Commerce (“MOFCOM”), jointly issued Regulations on Administration of Foreign Investment Construction Enterprises ("Construction Regulations") and Regulations on Administration of Foreign Investment Construction and Engineering Design Enterprises ("Design Regulations"). These regulations came into force on 1 December 2002. The implementation measures (“Implementation Measures”) for the Construction Regulations were issued by MOC on 8 April 2003. Implementation measures for the Design Regulations have not been issued.

The regulations have significant implications for the way foreign contractors and designers carry out business in China. This paper outlines some of the more important features of the regulations. Click here to view the English translation (non-official) of the regulations and the Implementation Measures.

OVERVIEW

• The regulations were drafted based on commitments made by China to open the Chinese construction market to foreign participation as part of China’s entry into the World Trade Organization.
  
  
• The regulations for the first time allow wholly foreign owned construction enterprises ("WFOCE") and wholly foreign owned construction and engineering design enterprises to be set up in China (although there still are restrictions on the types of work that a WFOCE may undertake).
  
  
• Foreign contractors and designers may set up Sino-foreign equity or co-operative joint ventures, and those already set up may continue to operate subject to certain conditions.
  
  
• After 1 April 2004, foreign contractors may not undertake projects in China by applying for approval on a project-to-project basis. Rather, a foreign contractor may carry on business in China only through a Chinese corporate entity after that date.
  
  
• WFOCEs and Sino-foreign construction joint ventures (collectively, "foreign investment construction enterprises" or "FICEs") in their applications for skill qualification certificates (“SQC”) must comply with the same requirements as domestic counterparts. Foreign investment construction and engineering design enterprises ("FIDEs") are subject to more onerous requirements than their domestic counterparts under the Design Regulations, as will be discussed below.

CONSTRUCTION REGULATIONS

The Construction Regulations comprise 27 articles in 5 chapters. They provide for repeal on 1 October 2003 of the system under which foreign contractors are allowed to undertake projects in China without setting up a Chinese corporate entity (the “Registered Foreign Contractor System”). The Construction Regulations also specify the requirements for setting up FICEs. On 28 September 2003, the 1 October 2003 deadline was extended to 1 April 2004. The Implementation Measures give more detail about the requirements for setting up these FICEs, including the types of enterprise entitled to obtain a SQC, the classes of SQC available, track record requirements, and management and technical staff qualification requirements.

1.    The Registered Foreign Contractor System

In 1994, MOC issued Tentative Measures on Administration of Foreign Enterprise Skill Qualification for Contracting Construction Works Within the Territory of China ("Decree No. 32"). Under it, a foreign contractor that intended to undertake construction work on a project in China had to obtain approval to carry out the work, which involved an assessment of its skill and experience. The types of work that a foreign contractor was allowed to undertake in China was limited to:

• Projects entirely funded by foreign investment or grants.
  
  
• Projects funded by loans provided by international financial institutions, such as the World Bank, and awarded through international open tenders.
  
  
• Sino-foreign joint venture projects requiring technical expertise that Chinese contractors were unable to provide.
  
  
• Projects funded by domestic sources but difficult for Chinese contractors to undertake independently. Foreign contractors were allowed to undertake these projects jointly with Chinese contractors with approval of construction authorities.

The approval process required the foreign contractor to apply for a skill qualification certificate, a project-specific business license and a project permit to undertake the project.

The Registered Foreign Contractor System has some advantages. The main one is flexibility. A foreign contractor is not required to maintain a significant presence in China unless it has a project there. The system is favored by foreign contractors that came to China because clients in their home countries set up businesses in China and engaged the contractors to carry out one-off projects, such as construction of a manufacturing plant or facility. Over the years, many foreign contractors have become familiar with the workings of this system, and the application process has become part and parcel of the paperwork needed to carry out a project in China.

But. promulgation of the Construction Regulations means that as of 1 April 2004, foreign contractors no longer will be able to obtain approval to carry out business in China on a project-to-project basis. (There is one limited exception provided in the PRC Bidding Law for projects funded by foreign financial institutions such as the World Bank. If the terms of the loan require work to be carried out by foreign parties, these foreign parties may do so without setting up a FICE.) Any project awarded to a foreign contractor before 1 April 2004 and for which approval has been given may be completed, even if after April 1. (We understand from MOC that during the WTO negotiations, the governments of some countries, particularly Japan, lobbied strongly for the Registered Foreign Contractor System to be retained. This was not accepted by the Chinese government.)

Under the Construction Regulations, WFOCEs are restricted to contracting for the following types of work:

• Projects financed or funded entirely by foreign investment or grants.
  
  
• Projects funded by international financial organizations and awarded through international tendering in accordance with provisions of the funding documents.
  
  
• Sino-foreign joint venture projects in which the foreign investment is 50 percent or more or in which the foreign investment is less than 50 percent but, because of technical difficulties, Chinese contractors are unable to undertake the projects independently.
  
  
• Domestically financed projects that, because of technical difficulties, Chinese contractors are unable to undertake independently and so long as such projects are jointly undertaken with WFOCEs.

There is one difference in the restrictions on the WFOCEs and Registered Foreign Contractors: WFOCEs can undertake Sino-foreign joint venture projects when the foreign investment is 50 percent or more, but Registered Foreign Contractors can undertake Sino-foreign joint venture projects only if Chinese contractors are unable to undertake the projects independently because of technical difficulties.

The Construction Regulations require WFOCEs to satisfy all the requirements that Chinese contractors of the same class must satisfy, including minimum amounts of registered capital, management and technical personnel requirements, number of projects to be carried out each year and the like, but their market is limited to the four categories of projects described above. These restrictions are likely to make WFOCEs unattractive to foreign contractors as vehicles for long-term investment although most foreign contractors now are interested only in tendering for the four permitted types of projects.

3.    Sino-Foreign Joint Ventures

Foreign contractors have been allowed to participate in the Chinese construction market by way of Sino-foreign equity or co-operative joint ventures since 1995. The requirements for setting up these joint ventures were, however, quite stringent. For example, a Class 1 Sino-foreign joint venture must have registered capital of at least $10 million, and the Chinese joint venturer must have at least a Class 2 skill qualification certificate.

Under the Construction Regulations, these requirements no longer apply. If a foreign construction company wishes to form a construction joint venture with a Chinese party, the Chinese party may be an enterprise of any class, and the required registered capital for the joint venture is similar to that for Chinese contractors of the same class. The Chinese venturer’s interest must be at least 25 percent. There is no requirement that the Chinese venturer be a Chinese construction company.

The restriction on the types of work that WFOCEs can undertake do not apply to Sino-foreign construction joint ventures. They can undertake the same projects as domestic Chinese contractors so long as the projects are within the scope of their SQCs. Joint ventures, therefore, appear to be better long-term investments for foreign contractors than WFOCEs.

The Construction Regulations do not spell out the detailed requirements that a FICE must satisfy to apply for a skill qualification. The Construction Regulations are intended to be read together with other laws and regulations relating to foreign investment and setting up construction enterprises in China. When deciding on the type of enterprise to set up and the class of skill qualification to seek, a foreign contractor should consider pertinent implementation measures and the following other regulations:

• Regulations on Administration of Construction Enterprise Skill Qualifications ("Decree No. 87") issued by MOC on 18 April 2001, which set out the requirements and procedures for application of skill qualifications to construction enterprises.
  
  
• Implementation Opinion on the Regulations on Administration of Construction Enterprise Skill Qualifications issued by MOC on 28 May 2001, which explains how Decree No. 87 is to be implemented.
  
  
• Construction Enterprise Skill Qualification Classification ("Skill Qualification Classifications") issued by MOC on 20 April 2001, which sets out the qualifying standards for different classes of skill qualification.
  

Under Decree No. 87, a construction enterprise applying for an SQC for the first time could obtain one in only the lowest class in the industry or discipline for which it was applying, and the applicant had to carry on business in that class for at least a year before it could apply for a higher skill qualification.

But, under the first paragraph of Article 22 of the Construction Regulations, a foreign contractor need not necessarily start with the lowest class of SQC. Rather, it can apply for an SQC based on its track record of projects in China as a properly registered foreign contractor under Decree No. 32. However, such a track record may be used only once to support an application to set up a FICE. The track record may not be used for subsequent applications.

For Sino-foreign joint ventures, the Implementation Measures expressly provide that the track records of both the foreign and Chinese parties be considered. However, it is unclear whether a Sino-foreign joint venture can qualify solely on the track record of the Chinese party if the foreign party has not performed projects in China. We are of the view that the answer should be yes, but the authorities probably will consider the extent of the interest of the foreign party in the joint venture.

The skill qualifications of existing Sino-foreign joint ventures will be subject to reassessment to ensure that they comply with the requirements of the Skill Qualification Classifications. This process started in 2001 before the Construction Regulations were issued.

In applying for an SQC, all contractors must employ a minimum number of qualified management, financial and technical personnel. The Implementation Measures provide that a FICE may employ “foreign service providers” (for example, by “importing” staff from other offices) to satisfy these requirements. However, they must satisfy conditions in the Skill Qualification Classifications and Implementation Measures, including educational qualifications, experience and residency requirements.

The Construction Regulations set out three steps for applying to establish a FICE:

• Application for a certificate of approval from the local MOFTEC office or MOFCOM in Beijing.
  
  
• Application for a business license from the State Industry Administration Commission (“SIAC”).
  
  
• Application for a SQC from the relevant construction authority.

The third step is the most critical. If an applicant is unable to obtain an SQC, it is not allowed to undertake any work, even if it has obtained a business license. The Construction Regulations, therefore, provide for a preliminary examination of the application by the relevant construction authority before approval is given by the local MOFTEC office (or MOFCOM). If the applicant is unable to satisfy the construction authority at the preliminary examination, the local MOFTEC office or MOFCOM will not issue a certificate of approval.

We understand that even if the applicant is able to satisfy the construction authority at the preliminary examination stage, there is no guarantee that the SQC will be issued. Further conditions may be imposed before the SQC is issued. We understand that one of these conditions may be that the applicant pay in full its registered capital before issuance of the SQC. Foreign investment laws and regulations generally allow foreign investment enterprises to pay their registered capital in installments.

Besides WFOCEs and Sino-foreign joint ventures, there are other options available to foreign contractors wishing to enter the Chinese market. One is to acquire an equity interest in an existing Chinese construction company. This approach, if properly executed, would enable a foreign contractor to obtain the benefit of the skill qualifications of the Chinese construction company that it acquired. Careful consideration, however, must be given to matters like the financial health of the company being acquired, percentage of foreign investment, amount of registered capital, and management and control of the enterprise. Another option is to use an existing joint venture to invest in a new joint venture. There are requirements as to the level of foreign interest in such joint ventures that differ from place to place.

DESIGN REGULATIONS

The Design Regulations contain 21 Articles, and their content and structure generally are similar to the Construction Regulations. The Design Regulations cover the following matters:

PROJECT CONSULTANCY

One of the questions most commonly asked by foreign contractors and designers is: Do the Construction and Design Regulations apply to companies that provide only “project consultancy” or “engineering consultancy” services. One of the perceived advantages that foreign contractors and consultants have over Chinese contractors and design institutes is their expertise and experience in project management and ability to bring in new technology. Many foreign contractors and consultants are looking to enter the Chinese construction market by setting up project or engineering consultancy companies. This is particularly true for those that are not prepared or are unable to make the substantial investment required to set up a construction or design company.

The short answer is that the Construction and Design Regulations do not apply to project and engineering consultancy companies. However, this is not to say that when authorities approve setting up a project management or engineering consultancy company, they do not consider the experience and track record of the foreign applicant. For example, in Shanghai, because there is no SQC requirement or specified standard to assess the qualifications of such applicants, the authorities tend to scrutinize in some detail the applicant’s expertise and track record against the nature of the business (as described in the Articles of Association) that the company wishes to conduct.

We have seen some of these foreign-owned project and engineering consultancy companies enter into EPC contracts in joint venture with Chinese contractors. The consultants provide project management services or transfer technology, and their Chinese partners carry out the “physical” work, such as detailed design and actual construction. These sorts of joint ventures are quite common, particularly on major infrastructure and petrochemical projects. However, there is some uncertainty, created by provisions in the PRC Construction Law and Bidding Law, as to whether such joint venture arrangements are permissible. We are of the view that such arrangements are permissible and consistent with recent efforts by MOC to promote different models of EPC contracting in China. Such arrangements also are a good vehicle to promote co-operation between foreign and Chinese contractors.

CLOSER ECONOMIC PARTNERSHIP ARRANGEMENT

On 29 June 2003, MOFCOM and the government of the Hong Kong SAR signed the Mainland/Hong Kong Closer Economic Partnership Arrangement, which provides beneficial treatment for Hong Kong-invested construction and engineering services companies.

The main benefits are:

• Under Decree No. 113, a wholly foreign-owned construction enterprise can undertake only projects with foreign investment of 50 percent or more. However, Hong Kong-invested construction companies can undertake projects with any level of foreign investment; there is no minimum foreign investment.
  
  
• Hong Kong companies can count projects that they performed in Hong Kong as part of their track record when applying for SQCs for their PRC companies. For other foreign investors, only their PRC projects can be counted.
  
  
• Hong Kong companies may set up wholly owned “engineering consultancy” companies in the PRC effective 1 January 2004. Based on our unofficial discussions with MOC, we understand that these “engineering consultancy” companies refer to design companies. We understand that implementation rules on how to set up these “engineering consultancy” companies are being drafted.

In view of these benefits, foreign contractors and consultants that have companies in Hong Kong may consider using their Hong Kong companies to invest in the PRC.

CONCLUSION

The Construction and Design Regulations, while purporting to open the construction market in China to foreign participation, appear to have made it more difficult for foreign contractors and consultants to undertake projects in China. The regulations clearly require foreign contractors and consultants to change the way they do business and, possibly, to restructure their existing corporate entities in China.

We are aware that a number of foreign contractors already have taken steps to set up FICEs in China, and we understand that some applications have been approved and that a few have obtained their SQCs to carry out business. There are, however, many foreign contractors that have yet to submit their applications. We understand that the main obstacles for most companies are the substantial minimum registered capital requirement for the higher classes of skill qualifications and personnel requirements. For contractors that choose not to set up the proper Chinese corporate entities to carry on business, either as a construction or project management or engineering consultancy company, it is likely that they will face difficulties contracting for new projects in China after 1 April 2004.


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For more information about the issues covered in this report, please contact Hew Kian Heong at Pinsent Masons' Shanghai office at 86 21 6321 1166 or at hew.kheong@pinsentmasons.com.

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