Legal Risks for SMEs in China: Navigate Compliance Issues (2024)

Given the pace of these regulatory developments, it is not surprising that executives increasingly harbor anxieties. In PwC’s 2021 China Business Climate Survey Report, 83% of surveyed multinational companies in China expressed concerns about the regulatory environment and its impact on their operations.”

— PwC, 2023

With this background in mind, we have come up with the most common legal risks that foreign businesses nowadays face in China.

1. 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 shortened to Rep Office) may not 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 on China’s regulations on imports 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 glossary “China Business License”to get a better understanding of business licenses.

4. Theft of intellectual property (IP)

On paper, Chinese law offers comprehensive protection of patents, trademarks, trade secrets, and copyrights. However, there is widespread violation and ineffective enforcement of the law. Companies seeking to sell products in China should create and implement a practical and effective action plan. Key steps include:

– Evaluate what intellectual property is important to the company.

– Review the company’s product portfolio and take action to register 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 the domain name in China (.cn) if the company anticipates online business.

More importantly, companies should take precautionary measures within their organization and that of their Chinese business partners to protect intellectual property. This includes restricting access to sensitive information, developing protocols to protect it from unintended disclosure or misappropriation, and using confidential agreements when appropriate. Properly train employees who will come into contact with sensitive information. Get our whitepaper “How to Successfully Protect Your IP in China” today, which provides a comprehensive and practical guide for international SMEs to protect their intellectual property rights from some of the top IP lawyers in China.

5. Breaking foreign exchange regulations

The Chinese regulatory regime includes strict foreign exchange regulations, meaning 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 a 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 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. For example, a foreign company might be liable for corporate income tax for some types of China-sourced income, including interest, royalties, and capital gains. Revenue 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. 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 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 to be enforceable in both China and a foreign jurisdiction. Careful consideration should also be given to what kind of arbitral rules and institutions to choose in the contract, the location of the arbitration, the language to be used in proceedings, and what the governing law around 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 to come to a position that is equitable and tolerable to both. For other aspects of a commercial contract with a Chinese company,refer to ourblog 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 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 ensure compliance with mandatory Chinese labour laws. These laws can be very different from those a foreign employer might be used to. Chinese law requires all employers to enter written employment contracts with their employees, and significant penalties can be imposed on employers that do not do so. The concept of “at-will” employment does not exist in China, meaning employers may not terminate an employee without specific and limited grounds. There are only three types of employment contracts in China: open-ended, fixed-term, and project-based.

9. Lack of regulatory transparency

China’s legal system is still developing, and one major difference between it and developed nation jurisdictions is the general lack of transparency in the system. Regulations and rules can be seemingly arbitrarily passed without much warning, making it essential to have locally-connected legal assistance to guide you. Additionally, it can be confusing for western companies that central government “notices,” “opinions,” or “guides” are also considered “law” as a matter of practice.

China’s legal system is still developing, and one major difference between it and developed nation jurisdictions is the general lack of transparency in the system. This lack of transparency can lead to sudden regulatory changes and enforcement actions that can catch businesses off guard. The Heritage Foundation’s 2024 China Transparency Report highlights that the Chinese government has a history of withholding, manipulating, and falsifying data for its own purposes, exacerbating the lack of transparency (The Heritage Foundation). This makes it essential for foreign businesses to have locally connected legal assistance to navigate these challenges effectively.

10. Bad business partners, or local agents with conflicting interests

As of August 2022, over 7 million people in China are listed by Chinese courts as “untrustworthy” individuals or people with bad credit records. It is prudent for international SMEs to conduct due diligence to determine whether a new business partner is reliable and whether a long-term business partner can still be trusted. It is also important to ensure that a local partner or agent does not have conflicting interests. Our previous blog post “Managing your supply chain in China”discusses the importance of knowing your local partner, such as the OEM, to control your supply chain

11. Data storage and transportation restrictions

In the past five years, China has tightened its regulations on data security and personal information protection. International businesses located outside of China that sell products or services to the Chinese market are subject to 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 businesses with customers in China, are subject to a complicated compliance review

Conclusion

Navigating the complex legal landscape in China requires careful planning and an in-depth understanding of local regulations and practices. The 11 key legal risks outlined in this blog highlight the critical areas where North American SMEs must exercise caution and seek appropriate legal guidance. From choosing the correct business structure and obtaining the necessary licenses to protecting intellectual property and complying with strict foreign exchange regulations, each step of the process presents unique challenges. The lack of regulatory transparency and sudden changes in rules further complicate the business environment, making local legal assistance invaluable. By staying informed and proactive, businesses can mitigate these risks and enhance their chances of success in the dynamic Chinese market.