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How To Form a China WFOE. Scope Really Really Matters, Part II.

Posted in Basics of China Business Law, Legal News

Every few months we get an email from someone seeking our help to prevent the Chinese government (broadly defined) from shutting down their business. Something is definitely afoot in China right now as we received three such emails just this week.  The following is a composite of these three emails:

We set up a WFOE and started a small XYZ business inside a residential compound in ______. The local authorities came knocking the other day, pointing out that it is impossible to license our venue for any sort of business — “our company legal address is necessarily elsewhere.” Apparently there is only a title deed for the entire complex, which was built some 5 years ago. We have the property management company fully on our side, but they seem unable to do anything, or don’t know what to do. They have said that they intend to close us down. Just so you know, we are registered as a consulting company, not an XYZ business.

We would really like to have this resolved asap, as we will otherwise need to lay off our staff. Is there anything you can do?

We write back suggesting they retain local Chinese counsel. But what we really want to say is the following:

Dude, you have a big, probably insurmountable problem. And it is entirely of your own making. You no doubt used a cheap entity formation company to form your WFOE and, unfortunately, they went along with what you knew was illegal. Your business is illegal in four ways and there is no way a bunch of American lawyers can solve a problem like that.

Not that I need to tell you this, but just to be clear, your business is illegal for the following four reasons (and this is just what I am able to glean from your five sentence email:

  1. You registered your business as a consulting company but you are operating as an XYZ business. I’m guessing you did this because you wanted to keep your required minimum registered capital low.
  2. Your registered address is “necessarily elsewhere” because to register as a consulting business, you needed an office and your XYZ business is not an office.
  3. Your XYZ business location can never qualify as a legitimate WFOE because to do so you need your own separate space and where it is located (as you point out by saying there is only one title for the entire complex) constitutes just one business location.
  4. Your lease is illegal and that is why your landlord cannot help you. It sounds like your landlord is not authorized to lease out a part of the property for a business. The area in which the building is located is almost certainly not zoned for business.

I really don’t know what else to tell you other than that you had better get to a good local Chinese attorney and fast.

In “How To Form a China WFOE. Scope Really Really Matters,” we talked of how the scope you describe in your initial WFOE application matters even after your WFOE is approved:

BUT — and this is why I am writing this post now — if you under or overreach on the description of your business scope, you might find yourselves in big trouble.  We are getting an increasing number of calls from American companies in trouble with the Chinese government for doing things in their business that were not mentioned in the business scope section of their initial WFOE.

In some cases, the companies have admitted to us that they were never “really comfortable” with the business scope mentioned in their applications, but that the company they had used to form their WFOE had “pushed” them into it as it would “make things much easier.” In some cases, the scope of the business changed after the application was submitted and the company had failed to secure approval in advance for the change. And in some cases, the company probably would never have been approved at all had it been upfront and honest in its application. In nearly all instances, the companies had managed to secure local approval but were now in trouble with Beijing, which constantly is auditing these applications. In one instance, the local government went back and changed its mind, probably after conducting an audit of its own.

I cannot go into any more detail on these matters, but I can give this advice: applying for a WFOE in China involves a heck of a lot more than just filling out a form and getting approval. It does matter for what you get approved and you (or whomever you are using for your WFOE application) need to know China’s foreign investment catalog inside and out before applying. You then must tailor your application to meet both the requirements of the foreign investment catalog AND the reality of what you will be doing in China. A failure to comply on both fronts will lead to, at best, a rejection of your application and, at worst, being shut down months or years later.

If you take away nothing from this post, please at least understand that your getting local government approval for your WFOE does not mean you are out of the woods. There is little to no benefit in getting approval for a non-conforming WFOE.

In Leasing Requirements For A China WFOE To Be, Part II, we talked about the importance of having a valid lease for your WFOE and we even went so far as to say that without such a lease, you shouldnt’ even bother having a WFOE at all:

If you are not going to get the right space for a WFOE, you are probably better off not getting a WFOE at all. Registering a WFOE and then not complying with ALL of the requirements for having a legally operating WFOE is a classic example of trying to operate quasi-legally in China. For why this is a bad idea, check out “Quasi-Legal In China. Not The Place You Want To Be” and “Forming A Company in China. Do It Right Or Do It ALL Wrong, But Don’t Do A Rep Office.

The Bottom Line: We have said it before and we will no doubt say it again. Form your WFOE correctly or don’t bother forming one at all. China’s economy is on the decline and that means it will be looking to get rid of foreign companies operating illegally. If your WFOE is not living up to its registration requirements/promises, you are at risk.

What are you seeing out there?

  • http://twitter.com/SteveLaudig SteveLaudig

    Duty, breach, causation, hmmm. This sentence got my nose twitching: “In some cases, the companies have admitted to us that they were never “really comfortable” with the business scope mentioned in their applications, but that the company they had used to form their WFOE had “pushed” them into it as it would “make things much easier.”” The market opportunity may be for clever lawyers to litigate against those companies providing faulty [indeed apparently lethal] ‘registration services.’ Caution/disclaimer to save critics time. I know not quite nothing about Chinese law. But if you round down to the nearest integer I do know nothing about civil liability under China’s law.

  • Chris

    There is nothing new in what you are describing. As far as I can remember (the last 13 years anyway), these have always been the regulations. For even longer than that, there has always been a law that says you cannot have a legal business entity in a residential complex. Period.

  • Guest

    Your usual fly by night small time WFOE operators with no money who bend the rules then whinge when they get found out. Why are you giving these people the time of day?

  • Twofish

    One problem here is I don’t think it’s *possible* for a foreign small business to be completely in compliance with Chinese regulations.  There are so many conflicting regulations that you will inevitably trip over something, and the government likes it that way that way they can shut you down if they want to.  If you avoid getting shut down, then you will likely owe someone something, and that keeps businesses in line.

    The big thing that you need to figure out and quickly, is what does the government want.  If the local government really wants to shut you down, then you are hosed.  However, often they don’t, and if someone in the local government wants to keep you in business, you can work something out.

    They may be getting pressure from Beijing to do something, but Beijing has a habit of losing interest in things quickly.

    Harris: Form your WFOE correctly or don’t bother forming one at all. China’s
    economy is on the decline and that means it will be looking to get rid
    of foreign companies operating illegally.

    Or maybe not.  If you are creating jobs, being shut down is usually the last thing that the government wants to have happen.  One thing about China is that illegal/legal is not black and white.  I don’t believe that there is any business in China that is fully in compliance with Chinese law.  But there is more illegal and less illegal.

    Harris: If your WFOE is not living up
    to its registration requirements/promises, you are at risk.

    Sure, but if you wanted to play things totally safe, you wouldn’t be in China in the first place. 

  • Brad Finkler

    OK Dan, a question if you can share your wisdom here – surely it better to leave the business scope as loose as possible to try and get maximum operational benefits? I’d like your answer please we’re going through this right now and need some guidance.  

  • Twofish

    Q: Surely it better
    to leave the business scope as loose as possible to try and get maximum
    operational benefits? I’d like your answer please we’re going through
    this right now and need some guidance.

    Chinese corporations don’t work like US corporations.  In the US, the papers that get filed with the Secretary of State typically state that the corporation is allowed to do any legal business and typically the registered agent is a attorney’s office.  The issue with China is that the company registration bureaus will not approve articles of association or issue a business license unless it specifically states the nature of the business and if it lists the principal location of business.  So in order to file the company documents in China, you have to list a specific business purpose and principal business location, and it’s not like the United States where forming a corporation is something you can do in an hour.  The problem is that SAIC doesn’t have the people (and it’s not clear to me whether they have the legal authority) to deal with changes *after* you file the papers.

    The legal authority for the regulations is a quite messy which is usual for Chinese law.  You have some laws and regulations that come from extremely high authority (i.e. NPC Law on WFOE’s and SAIC/MofComm regulations) but those tend to be vague and abstract.  You have extremely detailed regulations and practices from local officials, but the legal foundation for those regulations can often be very shaky (not that it matters).  For these sorts of things, the letter of the law won’t help you, so if you can figure out why officials are knocking at your door now, and try convince them that it’s not in their interest to bother you.  If you are hiring local people and paying local taxes, then that’s usually enough to convince them to work something out.

    Also, “didn’t you know it was illegal?” doesn’t quite work, because there are a ton of laws that aren’t enforced, and just because a law or requirement doesn’t exist, doesn’t mean that people can’t make them up on the fly if they want to.  There is very little that keeps a local government from issuing a regulation that all WFOE’s must have offices painted with pink elephants.

    There are also enough situations where the rules were flagrantly violated enough so that the government threw in the towel and ended up explicitly legalizing things in the end.  (i.e. all of the Chinese market economy).  If you wait for Beijing to approve everything nothing will get done, and the fact that the risks are huge also means that the rewards can be also.  For that matter, the reason the corporate filings in the US are so easy is that states spent much of the 19th century trying to restrict corporate files in the same way China is doing now, and they gave up around the 1920′s. 

    One reason I think Chinese authorities are so picky about business location is they what to avoid what happened in the US, as companies just moved to the states with the easiest corporation formation laws (i.e. Delaware).  For that matter, I know people in the United States that have gotten phone calls from corporate filing divisions asking them to pay fees and file papers that have been ignored for years.

    SteveLaudig: The market opportunity may be for clever lawyers to litigate against
    those companies providing faulty [indeed apparently lethal]
    ‘registration services.’

    Having very no money means that you are litigation proof.  Also to file a court case in China, you need to have a legal entity, and if the government shuts down your WFOE, you have no legal entity that you can use to sue anyone.  Chicken meet egg.

  • Tim

    Twofish: Or maybe not.  If you are creating jobs, being shut down is usually the
    last thing that the government wants to have happen.  One thing about
    China is that illegal/legal is not black and white.  I don’t believe
    that there is any business in China that is fully in compliance with
    Chinese law.  But there is more illegal and less illegal. 

    This would depend on what government you are talking about. If you are running a large operation in a CBD that does not enjoy your tax revenues because you have registered in an outlying county using a virtual address you at least one bureau I am aware may be interested in your activities. (this is also why certain government bureaus will be picky about location).

    I do agree with your assessment, however, that it is nearly impossible for a company to be completely in compliance with all laws in China and that if an official or government bureau wants you shut down then as a Foreign invested SME your likely going to be shut down. However, as you have already mentioned there are laws that are tons of laws that are not enforced; by that very logic then there are at least some laws that are enforced and these are the ones I suspect Dan is referring to when he suggests either go legal or not at all.

    It’s a risk as you so rightly pointed out and one that for most FIE’s that abide by the rules that are generally enforced, have yet to be slapped for violating the more obscure or vague ones.

    • Twofish

      Sure.  One rule in China is that any regulation which is critical for the local government getting more money and power tends to get rather strictly enforced.  However even in those situations there is the cost of enforcement and the side-effects of enforcement that do get considered.  There is also a matter of “turf.”  Once you register as business type X, you are subject to regulation by agencies Y, and so the Chinese government usually doesn’t like people circumventing the system by registering as X to avoid regulations Y. 

      There’s also WTO and trade policy.  Often foreign companies are allowed to do something only because of some long and painful negotiation with WTO.  If China has agreed to let a business do X, then they then set things up so that the business can *only* do X, and not move a millimeter beyond X.

      The trouble with enforcement is that the rules do change, and people have found unenforced rules suddenly become enforced.  It also works the other way.  I don’t know of any non-trivial business in China that *hasn’t* had to deal with rule changes.  However, in the end what keeps the system working is more politics rather than law.  In the end, the Chinese government wants businesses (including foreign businesses) to generate wealth so that the government can stay in power, and so in the end, usually more or less reasonable things end up happening.

      The important thing for the OP is to figure out why exactly the local government is trying to enforce those regulations.  One thought that occurs to me is that the local government has probably invested a large amount of money in building office space that may be empty, in which case, they just want you to move into a business district and start paying rent to a development company owned by the local government, and they couldn’t care less what your business scope is.  Or maybe someone has just decided that they don’t want your type of business in China, in which case they do care about business scope, but not where your business is located.

      Whatever it is, your main goal at this point is to figure out fast what’s going on.  It’s unlikely that someone that is unfamiliar with the local politics can help you, so you’ll need to find someone that does know what is going on.  One place to start is to just ask the people that are saying that they will shut you down, why are you doing this and what can be done to make you stop?  One thing that is case for hope is that if they really wanted to kill your business, they would have done it already.

      Another source of information are people in the same business as you since they are likely going through the same thing, and can get you information.

  • http://www.foreignentrepreneursinchina.com/ Clara Muriel Ruano

    I think we will never emphasize enough how important “business scope” is when you set up your WFOE in China. I wrote more than a year back a post entitled “Choosing the wrong company formation agent could kill your business” and the key lesson was that you need to get good advisors. Some times people try to use shortcuts, but in a lot of cases they fully rely on advisors that help them navigate an unknown business environment.
    In the case I was writing about, the agent had set up the company with a business scope that did not cover the main activity their business was about and it all came as a surprise to the unexperienced entrepreneurs that they were out of legality.
    In case you want to read it:
    http://www.foreignentrepreneursinchina.com/2010/10/china-stories-choosing-the-wrong-company-formation-agent-could-kill-your-business/ 

    • http://www.chinalawblog.com/ Dan Harris

      So here’s the question. Do you think that the company that set up the company you mention did it the way they did intentionally? In other words, did they pick an easy scope so that the company could be registered, without concern for what this would mean for the foreign company down the road, or did they just not know what they were doing?  I ask this because I think there are a number of unscrupulous entity formation companies out there that put everything into the “consulting” box because it is fast and easy and they get paid and nobody notices until they get shut down a year or so later. 

      • Clara Muriel Ruano

        I think the agent was bad and unexperienced (a Chinese agent). When confronted he claimed ““It is not my mistake, it is yours, because you chose me to do this job and I have never done food & beverage”.
        I must say that the entrepreneurs who hired him were also very inexperienced. They were investing all their savings on this project and I think their biggest mistake was trying to “save money” where they should have spent it- getting a good agent or advisor to make sure the business was legal.

  • Klement

    Let’s say you are operating a WFOE and later identify a complimentary business that falls outside the scope of your current WFOE. What’s stopping you from creating a new WFOE then operating the two businesses simultaneously? Given that an adjustment to your business scope is almost like doing the entire registration process over again, wouldn’t this be the optimal way to go so that you’re not restricted to the scope of your initial WFOE?

    Are there any restrictions on owning more than one business as a foreign investor in China?