Despite the recent global economic slowdown, for many foreign companies China is still the land of opportunity. China's strong and steady growth has led to an increase in personal income, especially in larger cities. Since the country created a legal structure for the franchise business model, the demand for franchising has increased, opening the door to foreign franchisors.
Ever since the Franchise Regulations were approved, in 2007, foreign franchisors enjoy the same treatment as Chinese people and may engage in any industries that are not prohibited in The Catalogue for the Guidance of Foreign Investment Industries approved by the State Council.
The laws regulating franchising in China stipulate the way the parties must enter into a franchise agreement. The relevant laws are the Franchise Regulation (2007), Administrative Measures for Information Disclosure of Commercial Franchises (effective since 1 April 2012 - Disclosure Regulations) and Administrative Measures for the Record Filing of Commercial Franchises (2012).
Franchise agreements are also subject to the Contract Law, under which the parties must abide by the principle of fairness in prescribing their respective rights and obligations, and the principle of good faith in exercising their rights and performing their obligations.
The Ministry of Commerce is mainly responsible for enforcing franchising laws and requirements in China.
The relationship between franchisor and franchisee after the contract comes into effect is governed by the Franchise Regulation, which requires the franchisor to provide ongoing operational guidance, technical support, and business training in accordance with the franchise agreement, and to disclose to the franchisee any promotional and marketing expenses.
In China, the franchisor may incorporate mechanisms in agreements to ensure operational consistency and adherence to brand standards, such as inspection and audit rights, copies of tax returns and access to the computer system. This last one may be difficult in China due to the privacy law.
Foreign franchisors should consider the cost of onsite visits to the franchisee’s location when establishing royalty or other fees.
The franchisor may unilaterally change operational terms and standards during the franchise relationship if the agreement allows.
Except for the cooling-off period set out in article 12 of the Franchise Regulation, the law does not specify grounds of termination. The reasons for terminating a franchise agreement must be set out previously in the contract.
However, if a franchisor conceals relevant information, provides false information, or fails to provide a disclosure document, the franchisee may rescind the franchise agreement.
Franchisee must exercise its right of rescission within one year after they knew or ought to have known the cause for rescission unless the franchise agreement provides for a longer rescission period. Some Chinese courts have recently denied rescission claims where there was no substantial negative impact on the franchisee caused by failure to disclose, or where the franchisee failed to prove that the failure to disclose had substantially affected its decision to join the franchise system.
A franchise agreement may be renewed, while a new disclosure is not required if the contract is renewed on the same terms and conditions. Renewal of a trademark license must be recorded with the National Intellectual Property Administration.
A franchisor may refuse to renew the franchise agreement unless there are any contrary provisions in the contract. In a similar way, the franchisor must previously approve the transfer or sell of the franchise by the franchisee.
Some of the fees charged by international franchisors in China may include royalties; initial franchise fees; development fees; advertising fund fees; and interest on late payments, among others.
The parties involved should determine the type, amount, and method of payment of franchise fees. There are a few practical aspects that foreign franchisors can consider when negotiating fees, such as weekly or biweekly payments by a local franchisee due to foreign currency exchange regulations.
A local company needs State Administration for Foreign Exchange approval to purchase foreign currency exceeding the US$50,000 annual limit. Chinese payors transferring money overseas must submit certain paperwork to the bank, including a tax authority-issued tax recordal form. Therefore, royalty and other regular payments are usually charged on a monthly or quarterly basis.
When targeting Chinese consumers, advertising should be done in the local language and adapted to the culture of the region. If an international franchisor charges advertising fund fees, a separate fund for Chinese advertising should be evaluated.
If the franchisor charges a pre-contractual deposit, the purpose of this payment and conditions of refund (if the deposit is refundable) must be put in writing.
Chinese parties are rarely comfortable providing personal guarantees. Instead, domestic franchisors charge a security deposit, which may be returned to the franchisee on the expiration of the franchise agreement if the franchisee has complied with the obligations under the agreement.
In general, interest charged on overdue payments is considered liquidated damages. The Civil Code states that if the agreed-upon number of liquidated damages is excessively higher than the actual loss incurred by the creditor, parties (generally, the debtor) may request the court to make an appropriate abatement.
A Chinese franchisee’s ability to make payments to a foreign franchisor in the franchisor’s domestic currency is till limited. Though some restrictions have been lifted, the Chinese yuan is still not freely exchangeable.
Chinese citizens must obtain State Administration of Foreign Exchange approval to purchase foreign currency above the annual quota of US$50,000. Foreign exchange controls are primarily enforced by the banks, which monitor all overseas payments made by customers.
Chinese franchisees must submit documents evidencing their payment obligations (eg, a franchise agreement) to make the overseas payment. To facilitate payments, franchisors should ensure that all registration requirements are completed in a timely fashion.
A franchisor may enforce a confidentiality covenant in the franchise agreements, which should be properly signed and sealed, and include the franchisee’s legal name in Chinese. Franchisors should collect evidence of the information that has been disclosed and the time of disclosure, as well as identify the information subject to confidentiality.
When doing business in China, it is highly recommended to provide a Chinese language version of the agreement to avoid a franchisee’s claims that the English version was not understood. However, it is not a requirement.
In case of a franchising dispute, it will fall under the jurisdiction of either the basic or intermediate courts. Specialized intellectual property (IP) courts in some cities also have jurisdiction over major franchise cases.
Domestic franchise disputes are typically heard by local courts. There are few reported court decisions that involve international franchisors, even though international claimants have a good track record of prevailing in local courts. Chinese courts are efficient and generally friendly to foreign parties.
While Western companies overwhelmingly prefer arbitration to litigation in Chinese courts, arbitral awards must still be approved by a local court for enforcement. This process is as expensive and time consuming as a trial. Arbitration may be an effective tool if the franchisee has assets outside China, as arbitral awards are more portable across borders than court judgments.
To learn more about our services in China, contact our Head of Business Advisory - Ms. Kristina Koehler-Coluccia at firstname.lastname@example.org.
DISCLAIMER: All information in this article is verified to the best of our ability and is assumed to be correct at time of release; however, Woodburn Accountants & Advisors does not accept responsibility for any losses arising from reliance on the information provided within. The information provided is for general guidance and does not replace specialized advice.