China's Service Sector Will Reign, Part VI -- Form Of Business (WFOE, JV, Or Rep. Office)

             By:  Steve Dickinson

In Part IV of this series, we talked about the growth in foreign service businesses in China and their continued opportunities.  In Part V, I talked about the legal framework of foreign service businesses in China.  This Part VI post is on the forming of a Chinese entity for a foreign service business.  Part VII will very briefly address other legal issues typically faced by foreign service businesses in China and Part VIII will be a case study of a foreign service business (academic editing) in Beijing. 

Foreign invested service businesses are formed according to the rules for formation of all foreign businesses in China. There are no special forms of business unique to service businesses.  A 100% foreign owned service business will be formed as a wholly foreign owned enterprise (WFOE). Where the foreign service business is formed together with a Chinese partner, the business will be formed as an equity joint venture (JV).  Both WFOE and JV entities are formed as limited liability companies under Chinese law.  Such companies are Chinese citizens, and are subject to Chinese law regulatory and tax provisions.  As foreign invested enterprises, such businesses are eligible for tax and other benefits granted to foreign invested enterprises under Chinese national and local law.

Where a domestic partner is required by the regulations, a JV is the only choice.  Where not required, the foreign investor has the option to form a WFOE or a JV.  Given the choice, most foreign investors in the service fields choose to operate as a WFOE and when they find it necessary to work with a Chinese partner, they do so through a contractual arrangement.  Such contractual cooperation is more flexible than the equity arrangement required by a formal JV. 

Though formation of service industry businesses follow the normal procedure of foreign invested companies in China, there are some issues that often arise and should be taken into account in the company formation process:

• By their nature, service industry businesses do not usually involve a large capital investment.  Chinese officials in the foreign investment area, however, are rated and promoted based on the gross dollar volume of investment they bring to their region.  Since service businesses are not capital intensive, this means that even where the regulations provide that the business is encouraged, the reality on the ground is that local officials will tend to give lower priority to such investments.  This can result in delays in approval and a lack of flexibility on the part of the local official charged with approval authority.
• As part of the approval process, the local authorities have the power to require a certain minimum investment (registered capital) for businesses they approve.  In many regions, the minimum capital required for small service businesses is often higher than such businesses really require to operate effectively.  This artificially high minimum capital requirement can be a barrier to smaller service businesses that simply do not require a large amount of capital to start operations.  This requirement for a large minimum capitalization is most likely to be encountered in the major, first tier cities.  The minimum capitalization in these cities is usually well established and should be determined before deciding whether to form a service business in any particular location.
• The opening of the service sector has been dramatic and reverses many years of prior Chinese practice.  Large cities such as Shanghai, Shenzhen, and Beijing understand the change and do not pose a problem.  However, in second tier and smaller cities, the local officials occasionally have not fully understood the changes in policy.  In these areas, the local officials may oppose registration of a service business that is clearly acceptable under the regulations.  It is usually possible to determine whether such problems will arise by consulting with the local authorities in advance.

Bottom Line:  It is usually essential to communicate with the key local officials; just thrusting a completed company formation application into some clerk's hands usually does not presage success.