China Law Blog

Excellent post over at the Briefing Blog on a topic that makes my blood boil. Forming a company in China. It makes my blood boil because, quite frankly, there are a number of consultants out there who are essentially lying to their clients about what it takes to form a company in China. They make it sound easy and cheap and so when I tell them it is difficult and expensive, they often think I am trying to put one over on them.

Part of the problem is that in many countries it is easy and cheap to form a company. In China it is not easy and if it is cheap, something is wrong and something will go wrong. One large part of the problem is minimum registered capital. Chinese law says it must be at least 100,000 RMB, which equals roughly $13,000. So the fly by night company formation consultants use this to claim that the minimum capital requirement is $13,000 and so when we tell prospective clients we expect their minimum capital requirement to be around $240,000, some of them are thinking we just must not be very connected.

Here's that post's take on this whole thing:

It’s the time of year when everyone starts to filter back to China again after the summer breaks, and also the time when new to China “consultants,” “lawyers” and generally enthusiastic new-to-China small investors start to emerge. Having a glass of ASC’s very fine imported Beringer Shiraz at Centro last night, it amazed me to hear several comments from other expats about the “great deals” and “cheap investments” that one can make in China. One bloke had tapped up his parents for a few dollars to set up a coffee shop. “The registered capital is only RMB100,000 (about US$13,000),” he stated.

Here’s the real deal with registered capital.

Registered capital is supposed to be a guideline, it is not enshrined in Chinese FIE regulations. It was originally in place to ensure FIEs indeed had enough capital to sustain a business, not to be a type of “sales pitch” to show how cheap it is to invest in China, which is what it has now become.

The post then goes on to explain why even if it is possible to get away with the absolute minimum in registered capital (and oftentimes it is not) it is not necessarily a good idea:

It [registered capital] should actually be calculated on the amount the new business needs to inject to sustain it until it can generate enough revenues from its own cash flow in China. If you do not do this, this is what happens:

You run out of money. That requires a cash injection, and cannot be put in from China generated funds (it’s a foreign investment, remember). If you transfer money if from overseas but do not go through the process of re-registering your registered capital, through the correct processes, (which take about 6 weeks and involves a new business license being issued) then that amount counts as income and is subjected to business and profits tax (which registered capital is not).
Many businesses underestimate the amount required up front in their operational cash flow. Take for example just two scenarios:
Imported equipment for use in the facility. Duty is now payable on full on this upon importation, and then repaid back at 20 percent per annum for five years. But you need to have the amount ready up front as a cash flow expense. It’s often missed meaning you have to go back to your head office and ask for additional money.
VAT payer status. Depending upon your first year expected turnover, and especially for a small business (small VAT payer status), customs now expect you to remit the entire VAT bill on your 1st years imports in one go, up front. Again, if you haven’t expected that you’ll have to go back to HO and ask for it.
The under appreciation of upfront cash flow needs has seen many a business go very quickly to the wall when if they had known about it possibly they would have thought twice about the investment or would ensured additional funding was available. I also wonder how many businesses are aware that registered capital is equal to their limited liability status in China and that there are issues to address with this also?

I particularly love the part when the post talks about how prospective clients tell them how “so and so told us we only need RMB100,000.” The post rightfully attributes this to "cheap consultants" who do not understand the implications of their clients' registered capital status and then concludes with this:

Cheap lawyers and China consultants, recommending RMB100,000 investments, are interested in securing their fees to stay in business, not the clients' long term well-being. There is a huge difference in professionalism. Because even in China, you cannot escape basic economics. You either have the money to run your business, or you do not.

For those of you out there looking at opening businesses in China on the cheap - please look beyond the ‘minimum registered capital amount’. Business is a professional occupation and you need to look at it in a professional light - and truly work out the amount of cashflow you require. Basic economics always has a habit of winning out over investor naivety.

The Briefing has it right. Earlier this year, I did a similar post, entitled, "China Company Formation Law Is Clear -- WFOEs Are Easy." In that post, I discussed three companies we were in the midst of forming for two lawyers working on behalf of their American clients and for an American lawyer with his own, non-law related business. I noted that China's minimum registered capital requirement was the biggest source of confusion for these lawyers in talking to company formation consultants and laid out the rules. I blamed the consultants for the confusion, insisting that the law itself is clear:

The law on minimum registered capital is clear, but the amount of capital that will be required does vary, depending mostly on the nature of the business of the company to be formed and on the city in which it is going to be registered.

Every company in China must have a stated registered capital. The registered capital includes all of the components of the initial investment in the company, including its start up cash, contributed property, and transferred intellectual property. Where the registered capital is small, the entire amount must be contributed immediately upon formation of the company. If the amount is large, it may be contributed in installments. There are a number of schedules for the percentage and timing of large amounts of registered capital. It is a crime to state a registered capital amount and then fail to contribute. It is also a crime to withdraw registered capital after it has been contributed. The purpose of registered capital is to provide some notice to creditors of the capital adequacy of the company. Because of this, Chinese regulators take very seriously the rules regarding registered capital.

Registered capital is an initial investment that is intended to be immediately used in the operation of the company. It is not a deposit that must just sit in a bank and never be touched. It can be used to pay salaries and rent, to purchase product, or for any other normal start up operating expense. Registered capital may include contributed real and personal property used in operating the business. Many foreign investors think registered capital is some sort of security deposit that they can never utilize. This is not true. On the other hand, some foreign enterprises believe they can simply withdraw their registered capital after the Chinese company begins normal business operations. This also is not true. Once the capital is contributed to the Chinese company, it can never be withdrawn. The only way to get funds from the Chinese company out of China is by repatriating profits or by liquidating the Chinese company. Both of these methods will work, but they both require paying Chinese taxes and meeting other requirements under Chinese law. Investors should also note that the RMB is not a freely convertible currency. For companies that will earn RMB income, the issue of conversion to U.S. dollars or other foreign currency should be carefully considered.

Chinese law is quite clear regarding minimum capital requirements for a WFOE but the statue's prescriptions on this are essentially meaningless in actual practice. Under Chinese Company Law, the minimum capital requirement is either 30,000 RMB (less than $4,000 US) or 100,000 RMB (a bit over $12,000 US) depending on whether it is a multiple or single shareholder company. However, these numbers have no real meaning for the formation of a WFOE in China.

The real question is what the Chinese authorities will consider as adequate capitalization for the specific project and that always depends on the type of business and its location. For example, it is very expensive to operate a business in Shanghai. On the other hand, it can be very inexpensive to operate the same business in a rural part of China. It is expensive to operate a capital intensive business like manufacturing, but relatively inexpensive to operate a knowledge based consulting business. Finally, some Chinese cities just seem to want WFOEs more than others.

The Chinese regulators usually consider all of these issues. To complicate matters, each local regulator has its own basic standards on what constitutes adequate capital for certain types of business activities. These numbers are not published, but when asked they will almost always be provided. They can only be determined through direct contact with the regulator and only after providing a clear explanation of the project. The local regulator virtually never considers the statutory minimum in making a determination regarding adequacy of capital. Rather, the local regulator will determine what it believes is an adequate amount of capital based on all the circumstances. Once the investor has a clear idea of the outlines of a project, it is usually a good idea to engage an attorney to contact the local regulator to see what their response will be to the proposed amount of investment. This initial screening can save a lot of time if the investor's idea of the proper amount of capitalization is dramatically different from that of the local regulator.

We always go to the local regulators to get this amount before we get very far along in the application process. Almost without exception, our experience has been that after we explain the nature of our client's business to the regulator, the regulator's decision on the minimum capital required has been a very workable one for our clients.

In determining what constitutes adequate capital, one needs to consider the peculiar situation in China that all rents are paid in advance, that payment for products for sale are paid in advance, and that a reasonable advance reserve for salaries is also required. Thus, the initial start up cost is going to be higher than for a comparable company in the United States, where credit and time payments are much more common. Chinese regulators will not approve a project that looks risky or under-funded.

Are we clear?

For more on forming a wholly foreign owned entity in China and the minimum capital required to do so, check out "Chinese Company Formation, Part II -- WFOE Minimum Capital Requirements" and "Chinese Company Formation -- Forming a Wholly Foreign Owned Entity (WFOE) in China."

Oh, and remember what your mamma told you, you get what you pay for.