Accessing the China Cloud Service Market

China is now the world’s second-largest cloud computing market after the United States, and the market is expected to continue growing.[1]  According to the 14th Five‑Year Plan for Developing Digital Economy released by the People’s Republic of China (“PRC”) State Council[2], China is to build a digital economy in full expansion mode by 2025, with the value added by core industries of such an economy accounting for 10% of GDP and significant progress having been made in the integration of digital technologies with the “real economy”.  Against this background, there is a huge demand from Chinese enterprises for digital transformation. Moreover, the Covid-19 pandemic served as a catalyst for even more enterprises to embrace online productivity and collaboration services – variations of the cloud technology.  While leading foreign cloud companies have already entered into the China market, many more are planning to come and take advantage of the massive market demands especially when the local government in many Chinese cities are now attracting foreign cloud companies to invest in their cities with preferential treatment.[3]

While there are obviously many market opportunities, many foreign companies with plans to expand in mainland of China are concerned with the complex regulatory landscape, and are sometimes held back by the difficult question of how to establish a compliant commercial presence while generating a positive return from their investments in mainland of China.  This article provides a brief introduction on the regulatory landscape and identifies major obstacles that foreign companies may be faced with when entering into the China market, and concludes with a summary of business models commonly adopted by foreign cloud companies.

I.Entering the China market – regulatory framework and compliance requirements

Many services provided on the cloud are deemed as a type of “telecommunication service”, which is a highly regulated sector in mainland of China. One of the most frequently asked questions by our clients is whether our company could provide the cloud-based services either directly from offshore or onshore in mainland of China. 

(i)Cross-border provision of cloud-based services

Many foreign cloud companies wish to leverage their global infrastructure and system for providing services to Chinese clients.  However, given that the Chinese government implements a “data cross-border security gateway” in between the networks of mainland of China and that of the rest of the world, cross-border internet traffic and access to the global internet and offshore servers may be slowed down to fail the desirable service level.  In addition, the offering of a cloud-based solution inevitably involves the storage of customer data and sometimes even personal information.  The PRC Data Security Law and Personal Information Protection Law as well as other sector-specific data regulations certainly add a layer of uncertainty to the viability of data transfer activities associated with the use of an offshore cloud-based solution by a Chinese customer.

Commercially speaking, if a cloud-based service or solution is provided on a cross-border basis, such a service or solution is usually deemed as less competitive by Chinese customers compared to other offerings that are provided onshore, especially if the customers that are being targeted in China are state-owned enterprises. Therefore, for foreign companies that eye the China market as one of the main targets, the cross-border provision model is not a commercially viable option.

(ii)Providing cloud-based services onshore

a. Licensing requirements to operate cloud-based services in mainland of China

Cloud-based services, by their nature, involve the use of internet resources, and China regulates a variety of services that use internet resources as a type of telecom business.  To the extent that a service falls within the Telecom Service Classification Catalogue (“Catalogue”) issued by the Ministry of Industry and Information Technology (“MIIT”), a licensing requirement will be triggered. 

According to the Catalogue, if a cloud-based service involves “the provision of data storage, internet application development environment, internet application deployment, operation and management services to users by virtue of the equipment and resources deployed in data centers, with the feature of accessibility on demand, usage as needed, capacity of expansion on demand and collaborative sharing through internet or other networks”, such a service constitutes the “internet resource collaboration (IRC) service”, which is a type of value-added telecom (“VAT”) service.  The service provider of the IRC service is obligated to obtain a VAT Service License prior to providing such services.

In this respect, the concept such as “IaaS”, “PaaS” or “SaaS” used by a service provider does not by itself determine the specific classification of the service under the Catalogue.  Generally speaking, IaaS and PaaS services are likely covered by the scope of the IRC service.  As for SaaS, what matters when determining the applicability of a particular licensing requirement is whether the essential character of the service is captured by the description of the Catalogue.  Based on our prior experience, it is possible that some SaaS services are captured by the Catalogue and become subject to a VAT Service License.

b. Restrictions on foreign-invested companies to obtain the VAT Service License

The biggest legal hurdle for foreign-invested companies to provide cloud-based services in mainland of China lies with the restriction and prohibition imposed by PRC laws and regulations on the application of the VAT Service License by foreign-invested companies.  Take the IRC service as an example, pursuant to China’s WTO Accession Protocol and the Negative List for the Access of Foreign Investment, foreign investors are not allowed to invest in and provide IRC services within mainland of China, and therefore not allowed to obtain the VAT Service License for IRC services.

A limited exception is provided for investors from China's special administrative regions of Hong Kong and Macau, which are deemed as "foreign investors" for purposes of investment management. The Closer Economic Partnership Arrangement ("CEPA") and relevant agreements and notices[4] do not prohibit "eligible service providers" from Hong Kong and Macau from establishing a foreign invested enterprise ("FIE") to provide IRC services in mainland of China, provided that the equity ratio of the eligible service provider from Hong Kong and Macau does not exceed 50%. It is noteworthy that CEPA also sets forth a number of requirements for what qualifies as an eligible service provider. For example, not only shall the scope and business nature of the Hong Kong/Macao entity cover IRC services, such an entity shall also be registered and engaged in substantial business operation for a certain period of time.

II.Potential service offering models

To the extent that a cloud-based service cannot be provided directly by the FIE and that the foreign company is not qualified to take advantage of the market access channel provided by CEPA, the first key decision to be made is how to structure the service offering model so that it complies with PRC law. From our past experience in advising cloud-based companies, we found that even though the models on which they operate in mainland of China vary depending on the scope and nature of their offerings, they have all taken actions to comply with applicable restrictions under PRC law one way or another. Despite there are pros and cons of each model, what matters most is to evaluate which one best achieves the company's business goals.

(i)Wholly Foreign-Owned Enterprise (“WFOE”) Model

If upon legal evaluation from local counsel, the services of the foreign company will not trigger any licensing requirements, the foreign company may set up a WFOE in mainland of China and offer the service/solution directly.  That said, even though there may not be market entry barriers for the foreign company, there may be other regulatory requirements (such as those relating to advertising, data, network security (i.e. Multi-Level Protection Scheme), domain name, encryption and content) applicable to its operation in mainland of China.

(ii)Local Partner Model

In mainland of China, jointly operating with a licensed local partner is a common practice and is widely adopted by some of the technology giants to provide cloud-based services that require a VAT Service License.  This offering model is also considered as the most accepted approach from the Chinese regulator’s perspective.  Under this model, the foreign company enters into a cooperation agreement with the local partner who is a licensed telecom service provider, and grants licenses of relevant technologies to the local partner. In turn, the local partner contracts with end-users in mainland of China and operates, provides, manages the delivery of the services and pays the foreign company a royalty/service fee.

(iii)VIE Model

The variable interest entity ("VIE") structure used to be commonly accepted as a business structure for foreign entities to invest in fields where PRC regulations restrict direct foreign investment. Under the VIE structure, the foreign entity may establish a WFOE or a partially controlled Chinese entity to control another operating entity that holds necessary license to provide the relevant service that requires a license. However, in light of the tightening of regulation over the telecom and internet sectors over the past few years, the VIE Model has become less popular given its compliance risks.

(iv)Distribution Model

While some foreign companies choose to adopt measures by restructuring organization or seeking cooperation with local partners, others eventually modify their services and operate a localized business in mainland of China that is slightly different from their global offering. There is a number of foreign companies that have disabled the cloud-based feature and offer their product or services as an on premise software via authorized distributors in China, so as to comply with applicable PRC law. Under this model, the Chinese end users will be granted a license to the solution directly from the foreign company, and then choose to deploy the solution on a China domestic cloud by itself.

III.Things to consider if your company is preparing

Undoubtedly, if the cloud-based service/solution provided by a foreign company triggers the licensing requirement under PRC law, the most compliant way to enter the China market is to find an eligible local partner. Such a cooperation is not easy by all standards

1) strategically, the foreign company shall find the right local partner upon comprehensively considering factors such as the partner's size, equity structure, market position, government resources and etc.;

2) commercially, the foreign company needs to consider the branding and pricing strategy, fees, charges and profit sharing structure and etc.;

3) legally, the foreign company and its local partner must divide clearly the respective roles and responsibilities assumed by each party.

The bottom line when designing these arrangements is to ensure that the cooperation would not cross any red lines set by applicable laws and regulations, otherwise the cooperation may be viewed as "illegally leasing or transferring the telecomm licenses in a disguised way" and could be ordered to shut down entirely. Given the rapidly developing regulatory framework in China, the foreign company should also stay tuned for relevant legislative updates and best market practices, so as to make an informed decision on its investment in China.