By Sidney Qin King & Wood Mallesons’ FDI Group

Deloitte predicts the private education sector will reach a market size of RMB640bn (US$102bn) by 2015. This growth is likely a response to rising income levels, which fosters the demand for high-quality private education. In 2013, China relaxed its decades-long one-child policy, allowing couples to have two children if one of the parents is an only child, which greatly bolsters the potential demand for private education like pre-school education and after-school tutoring. Up to now, education has been a valuable hot land of investment, but it is not easy for private investors to enter into the market, particularly foreign investors, because of legislation that treats education as a form of public welfare. But recent legislative developments look set to change this. Although no new national laws or regulations have yet been promulgated, recently-released draft legislation and newly promulgated local regulations suggest that the dawn of private educational institutions is approaching.

1.   From “not-for-profit” to “for-Profit” Private Educational Institutions

The Chinese government opposed marketization of the education sector. Under the Chinese laws, traditional educational institutions are not structured as a limited liability company. Rather, they are generally structured as not-for-profit organizations. Implementing Measures on Regulations on Sino-foreign Cooperative Education prohibit sino-foreign joint venture schools from carrying out for-profit activities.[1] Further, according to Non-State Education Promotion Law(《民办教育促进法》), a private investor in a non-state educational institution can only get a “reasonable return”(合理回报) from the institution which is still quite different from dividend distribution if such a return is provided for in the institution’s Articles of Association. However, both the Draft of a Package of Amendments to Education Law (“Draft Amendment”)(《教育法律一揽子修订草案》), released for public comment and several recent local regulations (see table below) make for-profit education a possibility.

Allowing for a “reasonable return” in existing law enables foreign investors to get some of their investment back in the education area.  However, for the following reasons, articles allowing a “reasonable return” are rarely used in practice: (1) there is no explicit definition of a “reasonable return”; (2) such an article increases the difficulty of obtaining a permit from relevant authorities; and (3) a “reasonable return” is required to come from the after-tax revenue and go through the foreign exchange regulations for capital if it is remitted overseas.  In this context, investors usually choose not to include “reasonable return” language in the Articles of Association of an educational institution.  Instead, they opt to obtain payments through a series of commercial arrangements such as IP license contracts or consulting services contracts.  However, if the Draft Amendment is finally passed, for-profit educational institutions will be explicitly recognized at the national level, and investors will be able to realize a profit from their investment in the educational sector without any policy barriers.

2. From Non-enterprise Legal Person to Limited Liability Company

Theoretically, an investor who wants to invest in private education and training in China can choose between two paths.  He can register with the Civil Affairs Authorities as a private non-enterprise legal person to be qualified as a school or quasi-school entity,  or he can register as a for-profit limited liability company with the Administration for Industry and Commerce (“AIC”) to be a commercial training company.  The main difference between these choices is that the former is a non-enterprise legal person which requires approval from the relevant Education Administrative Authorities or Human Resource and Social Security Authorities and the latter is a “for-profit” company which requires the local AIC to issue a business license (in deciding whether to issue the license, the local AIC will consult with the local Education Administrative Authorities or Human Resource and Social Security Authorities).  The approval and registration process for each path is listed below:

Although the Non-State Education Promotion Law(《民办教育促进法》) provides that “the administrative measures concerning operational non-state training institutions registered in the AIC shall be separately formulated by the State Council,” no such measures have been formulated after almost 11 years.  Therefore, the only option for education investors is the redundant traditional paths (see the left column of the above chart).  Recently, local AICs in certain cities have allowed the registration of a commercial training institution as an enterprise legal person (or limited liability company) if certain conditions are met.  For example, a domestic investor can register a training company with the AIC in several districts of Beijing and Shenzhen without prior approval from the Education Administrative Authorities.  In other cities like Hangzhou and Guangzhou, the local AIC allows a domestic investor to register a training company if the training is only provided to adults.  Shanghai has been a pioneer in passing the first Interim Measures of Private Commercial Training Institutions in 2013, allowing the registration of a commercial training limited liability company with the AIC after consultation with the local Education Administrative Authorities or Human Resource and Social Security Authorities.  Such commercial training institutions are able to provide “non-public welfare cultural education or vocational skills training services for the society.”  The shift from a non-enterprise legal person to a limited liability company not only adopts a simplified registration process, but also involves a completely different system of internal governance.

3.  A Previously Closed Door Gradually Opens to Foreign Investment

Given the difficulties in investing in the educational sector, foreign investors who see the abundant potential for private commercial education and training businesses usually adopt one of two investment models.  The first is the “variable interest entities” (“VIE”) model, where a foreign investor retains final control over the domestic operating entities through a series of contractual arrangements rather than direct shareholding.  Examples of this model include TAL Education Group and New Oriental.  The second model is that of a joint venture (“JV”) based on the Sino-foreign Cooperative Education Law.  However, in the JV model, the foreign partner must be a qualified educational institution that meets certain standards set by the China Education Administrative Authorities.  Given the risks associated with the VIE model and the narrow scope of the JV model, foreign investors are still looking for a more direct and fully compliant way to invest in the private education market in China.

The above-mentioned Interim Administrative Measures of China (Shanghai) Pilot Free Trade Zone for Sino-foreign Corporative Commercial Training Institutions (《中国(上海)自由贸易试验区中外合作经营性培训机构管理暂行办法》) promulgated in November 2013, provide a small opening for Sino-foreign commercial educational institutions to register as limited liability companies in Shanghai Pilot Free Trade Zone.

4.  Reflections/ Summary

In cities like Beijing, Shenzhen, Hangzhou and Guangzhou, it is practically possible to register a training company with the AIC to provide commercial educational training. While in Shanghai Pilot Free Trade Zone, it opens the door for foreign investment to register such a company in the education sector. Although we are still awaiting an indication that this area will eventually open up to all enterprises in areas other than the Shanghai Pilot Free Trade Zone, the changes detailed above demonstrate: (1) a gradually relaxing regulation in foreign investment in education area; (2) an increasingly open and practical attitude towards private commercial educational and training institutions. The education sector which is formally significantly shaped by regulations now might face a ripe surge encouraged by step-by-step loosen regulations.

[1] Article 28 of “Implementing Measures on Regulations of Sino-foreign Cooperative Education”(《中外合作办学条例实施办法》)

[2] Article 25 states that “no organization or individual may establish or run a school or any other institution of education for profit-making purposes.” The draft amendment to Article 25 states that “schools and other educational institutions using state financial funds and charity funds cannot be set up as a for-profit organization.”

[3] Article 24 states that “the Higher education institutions shall be established in accordance with State plans for the development of higher education and in keeping with the interests of the State and the public; they may not be established for purposes of making profits. The draft amendment to Article 24 deletes the expression of “not for the purpose of making profits.”

[4] The draft amendment to Article 18 adds the following language: “[a] non-state school can choose to register as a not-for-profit legal person or for-profit legal person.”

[5] Article 51 states that “after a non-state school has deducted its costs, has reserved development funds and has drawn other necessary expenses in accordance with relevant regulations of the state; the contributors may obtain reasonable returns from the balance of the school. Concrete measures for reasonable returns shall be formulated by the State Council.” The draft amendment to Non-State Education Promotion Law deletes Article 51.