Hong Kong Obtains Preferential Status with China in New Free Trade Agreement


September 15, 2003

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By Peter Bullock and Hew Kian Heong
Pinsent Masons

Ever since the United Kingdom returned sovereignty over Hong Kong to the People's Republic of China (PRC) on July 1, 1997, Hong Kong has been seeking to redefine itself. Over the previous 30 years, it had benefited first from a strong manufacturing base (long since migrated over the border to China); then from its excellence as a center for finance, shipping and freight (for which it is still well known); and more recently as a center for management and knowledge-based services.

However, the territory has a reputation as a costly place to do business, and it faces significant regional competition (primarily from neighboring Shenzhen, across the border with China, and Shanghai but also from Singapore, Taiwan, and Kuala Lumpur, Malaysia.)

The recent economic problems caused by SARS, which hit Hong Kong when it was showing only weak signs of recovery from a long period of economic malaise, would seem to have dealt a body-blow to the region's prospects.

However, Hong Kong received a shot in the arm with the signing on June 29, 2003, of its Closer Economic Partnership Arrangement ("CEPA") with the PRC. This is the first free trade agreement to be signed by either the PRC or Hong Kong under World Trade Organisation (WTO) procedures.

What advantages does CEPA bring to Hong Kong's service sector? CEPA:

• Provides for liberalization of Hong Kong's access to PRC markets across 17 sectors, starting January 1, 2004.
  
  
• Grants advantages to Hong Kong enterprises that differ between the 17 sectors but that respond to very real barriers to entry complained about by lobbyists for the sectors. The advantages consist of a combination of the following:
  
  
  • Faster access to the PRC market than allowed by the PRC's main WTO Agreements.
    
    
  • Additional services opened up, beyond the PRC's WTO commitments.
    
    
  • Exemption from foreign investment restrictions.
    
    
  • Reduced entry requirements.
    
    
  • Greater parity of treatment for Hong Kong professionals alongside their PRC counterparts.
    
    
  • No anti-dumping measures to be used by either side against the other.

Clearly, many domestic Hong Kong enterprises stand to benefit from CEPA. Although companies in Hong Kong already are adept at pursuing trading opportunities in and with the PRC, the earlier dates for greater market access will help them capitalize further on their first mover advantage. For industries where CEPA liberalization will be greater than PRC's WTO commitments ever will be, Hong Kong's market players will be better-placed than anyone outside the PRC to sell their products and expertise into the PRC.

However, Hong Kong's biggest benefit from CEPA may have little to do with its effect on pre-existing Hong Kong enterprises, as explained below.

Advantages for Those Selling Goods Into China

Zero import tariffs will apply from January 1, 2004, to 273 categories of products "Made in Hong Kong" and exported into the PRC. This will replace existing tariffs that can be as high as 35 percent.

Light industries that were not economically viable in past years if established in Hong Kong may find that their business case re-written by CEPA, allowing them to resume operations in Hong Kong. In addition, once established in Hong Kong, they will benefit from better protection of intellectual property rights and the branding advantage associated with "Made in Hong Kong."

Advantages to Companies Outside Hong Kong

Hong Kong historically has played the role of êntrepot, providing trade routes into the once-closed China market. That role in recent years has been at best diluted and at worst significantly marginalized by the PRC's emergence as a more open trading nation and by the services offered by PRC's cost effective "windows" to the world along its eastern seaboard. Until CEPA, it seemed that Hong Kong was destined to play on a level playing field and that Hong Kong necessarily would participate in a much smaller proportion of China trade, with the only consolation being the greater overall amount of China trade being conducted.

CEPA, though, reinserts Hong Kong into the China trade equation for a high proportion of overseas investors. This is because CEPA adopts a particularly liberal definition of "Hong Kong company." This is no accident or mistake. Henry Tang, Hong Kong's Financial Secretary, has stressed that questions of ownership, shareholder structure, ethnicity or nationality are of no relevance to qualification as a "Hong Kong company." So, overseas investors can avoid compliance with WTO timetables and entry barriers if they can qualify as a "Hong Kong company." At the same time, they may pay Hong Kong profits tax at the straightforward rate of 17.5 percent rather than the much higher, and more complex, rates charged in the PRC.

Subject to eventual wording of CEPA terms, there is excitement that goods finished in Hong Kong may attract "Made in Hong Kong" status, which will allow taxation at the low Hong Kong rates rather than PRC rates, and, with CEPA, avoid PRC tariffs upon export into the PRC. This could make Hong Kong a staging post for re-imports of semi-completed products originating in the PRC. These possibilities have ensured that Chinese, especially from the neighbouring Pearl River Delta, are as enthusiastic about CEPA as are Hong Kong business people.

What Is a 'Hong Kong Company'?

While different rules apply to banks, insurance companies and law firms seeking CEPA advantages, the majority of the other kinds of businesses must:

• Register under the Companies Ordinance or an equivalent law.
  
  
• Engage in substantive business operations in Hong Kong.
  
  
• Engage in the same nature of business in the PRC as in Hong Kong.
  
  
• Be liable to pay profits tax in Hong Kong.
  
  
• Have three years of substantive operation in Hong Kong or five years of operation in construction and related engineering services. But, there is no such requirement for real estate services.
  
  
• Own or rent substantive premises in Hong Kong.
  
  
• Employ in Hong Kong 50 percent or more of its total staff.

Overseas Businesses That Could Benefit from Structuring China Trade or Investment Through a Hong Kong Company

Construction and Related Engineering Services

Hong Kong-invested construction and related engineering services will have the following competitive advantages when doing business in the PRC compared with other overseas companies:

• Under the new PRC Foreign Investor Construction Enterprises scheme (Ministry of Construction Decrees 113 and 114), foreign-invested construction enterprises must obtain a Construction Skills Qualification Certificate ("SQC"). SQCs are granted based on the contractor's track record of projects undertaken in the PRC. CEPA will make it easier for Hong Kong construction companies to obtain SQCs compared with other foreign companies because PRC authorities now will take into account Hong Kong company projects in Hong Kong when considering SQCs. For overseas companies, only PRC experience will be considered. (However, requirements in Decrees 113 and 114 regarding the minimum number of managerial and technical staff that a construction enterprise must have in the PRC have not been relaxed for Hong Kong companies.)
  
  
• Under Decree 113, there are restrictions on the types of projects that a wholly foreign owned construction enterprise can undertake. For example, it can bid only on projects for which 50 percent or more of the project funding is from foreign sources. These restrictions are lifted for wholly Hong Kong-invested construction companies. Hong Kong construction companies will be able to undertake all Chinese-foreign joint construction projects.
  
  
• CEPA permits Hong Kong-invested enterprises that have obtained construction quality certification to bid for construction projects in all parts of the PRC. However, it is not entirely clear whether this will be of significant practical value. Current indications are that when actually undertaking construction projects, Hong Kong-invested enterprises still will be subject to the same qualification and licensing requirements as other overseas companies.

CEPA also has re-confirmed that:

• Hong Kong consultancy firms are permitted to set up wholly-owned enterprises in the PRC. The Ministry of Construction has indicated that this generally is limited to consultancy firms primarily involved in design work.
  
  
• Hong Kong-invested construction enterprises may partner with PRC construction enterprises to jointly bid for PRC construction projects that are technically difficult for PRC construction enterprises to undertake on their own.
  
  
• Hong Kong companies are permitted to wholly acquire construction enterprises in the PRC.

  
  Real Estate

Through wholly-owned operations, Hong Kong companies are permitted to engage in activities relating to self-owned or leased properties for high-standard real estate projects. Through wholly-owned operations, Hong Kong companies are permitted to provide real estate services on a fee or contract basis in the PRC.

Retail

Hong Kong retailers are permitted to establish wholly-owned retail commercial enterprises in the PRC. The entry requirements are reduced as follows:

Distribution

Hong Kong enterprises are permitted to supply distribution services in the PRC on a wholly-owned basis and to set up wholly-owned external trading companies one year ahead of China's WTO timetable. Entry requirements for Hong Kong enterprises wishing to set up a wholesale commercial enterprise are reduced as follows:

Hong Kong companies are permitted to set up wholly-owned enterprises the PRC to provide logistics services and related consultancy services for ordinary road freight and to engage in management and operation of logistics services through electronic means.

      
      Other Favored Sectors

CEPA provides benefits to the following other business and service sectors:

Foreign companies investing in, manufacturing in, exporting from or selling services into the PRC should re-evaluate their current arrangements and strategy now.

Hong Kong and the PRC are working hard to deliver fully worded CEPA rules in time for the liberalization on January 1, 2004. While much will depend on the words used (their clarity and whether there is any dilution of either side's commitments), this is not a time to wait and see.

Given that much of the advantage offered by CEPA is by way of abridgement of the WTO timetable, the Hong Kong government is encouraging Hong Kong enterprises to galvanize themselves into action to maximize the benefits offered. This applies equally to overseas investors that find advantage under CEPA.

To the extent that CEPA provides considerable reduction in capital and turnover requirements, CEPA may have the effect (for both Hong Kong and overseas investors) of providing a route into the PRC that would not otherwise exist.

Overseas enterprises without an existing presence in Hong Kong may believe requirements for a track record of substantive operations in Hong Kong for three years negates the abridgement of the WTO timetable offered by CEPA. Such organizations might benefit from acquiring a suitable Hong Kong enterprise that meets the criteria of a "Hong Kong company." There are likely to be synergies between "Hong Kong companies" and overseas investors with the capital and expertise to make a success of a CEPA enterprise.

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For more information about the issues covered in this report, please contact Peter Bullock in Hong Kong at 852-2521-5621 or at peter.bullock@pinsentmasons.com or Hew Kian Heong in Shanghai at 86 21 6321 1166 or at hew.kheong@pinsentmasons.com. For more information about Howrey's Construction Practice Group, click here.

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