Header graphic for print
China Law Blog China Law for Business

How To Form A China Company (WFOE or JV). Hong Kong Entities. They’re Baaaaack.

Posted in Legal News

By: Steve Dickinson

When making a WFOE (Wholly Foreign Owned Enterprise) or JV (Joint Venture) investment in China, the investor must consider: who will be the shareholder in the PRC entity? Will the investor invest directly, or will the investor create a special purpose subsidiary company  (an SPV or Special Purpose Vehicle/a/k/a SPE or Special Purpose Entity) to act as shareholder. If an SPV is used, where will it be formed?  In the U.S.? In a generally recognized tax haven such as the British Virgin Islands or the Cayman Islands? Or in Hong Kong in accordance with the favorable PRC/Hong Kong tax treaty?

From a tax standpoint, the decision is complex and requires careful analysis by the primary investor. Ignoring the tax issue, however, from the standpoint of company formation, the use of a Hong Kong entity offers the advantage that it solves many of the technical problems in forming a WFOE or JV in China.

It is relatively easy to prove the existence and organizational structure of a Hong Kong company. The process is straightforward and the Chinese investment authorities understand the documents and readily accept them. This is not true for corporate documents from other countries. The Chinese authorities want documents that are similar to their own. They do not understand foreign company systems, and will often challenge perfectly standard documents from foreign jurisdictions that do not accord with the way they think the world should work. For example, the Chinese authorities will often demand notarized documents. When the notary is from a common law jurisdiction like the United States or England, they will object to the form of the notarization because it does not look like a Chinese or civil law country notarization.

In other cases, we have had Chinese authorities object to United States limited liability company documents because the officers’ titles do not match the equivalent terms in Chinese. For example, in most U.S. jurisdictions, a limited liability company (LLC) does not have directors and officers. Instead, the LLC is either member managed or manager managed. We have had Chinese authorities object to both forms of management because they do not understand the U.S. system. Of course, the issues can be even worse when the investor company is based in a system even more different from China, such as the Middle East, Central Europe or Africa.

All of these sorts of problems are solved if the foreign investor sets up a Hong Kong company and specifies the Hong Kong company as the shareholder of the Chinese WFOE or Joint Venture. For this reason, many of our clients will almost automatically plan to form a Hong Kong company as the first step in the China company formation process.

However, there are several important issues that must be considered before making the final decision regarding formation of a Hong Kong company.

1. The use of an SPV is in many cases prohibited by Chinese law. For many investments in the service sector, the investor must prove that the foreign shareholder has been in operation for a certain number of years. In other cases, the foreign investor must prove that it has had a certain business income for a specific period or that its capitalization meets a certain standard. Where this type of requirement exists, the standard is applied to the direct shareholder in the Chinese company. That is, it is not acceptable to say that the ultimate parent company meets the requirement. For this reason, many investors in China are required to make the investment directly and not through a SPV or other subsidiary.

2. Though establishing a Hong Kong company is relatively fast, cheap, and easy, creating a bank account in Hong Kong is not. For formation of a Chinese company, the Chinese authorities require that a Hong Kong bank account exist and they also require a letter from the Hong Kong bank stating the details of the account formation. Under Hong Kong banking and anti-money laundering rules, a bank account in Hong Kong can only be opened by a person who is personally present at the bank in Hong Kong. Moreover, the rules on who this person is are very strict.  This person must be the party the Hong Kong banking authorities determine is the person who exercises actual control over the Hong Kong company. Usually this will be the chairman of the board of directors of the Hong Kong company. Where there are multiple shareholders, this will also include a representative of each shareholder who holds more than 10% of the stock in the Hong Kong company.

For many Hong Kong companies, the shareholder will set up the Hong Kong company so that the chairman of the board is a high ranking officer in the corporate parent. For company formation purposes, this is is easily done since for company formation, only the signature of that officer is required. This then backfires when it is time to open the company bank account in Hong Kong. For this, the chairman must be physically present in Hong Kong. In addition, the chairman must also prove his or her identity using documentation that cannot be determined precisely without consultation with the bank. It is not acceptable for the chairman to designate another person such as a lower level staff person or a lawyer to act on his or her behalf. Only the chairman or similar officer of the Hong Kong company can act.

In our experience, it is the rare chairman of the investor company that has the interest in or the time to travel to Hong Kong simply to open a bank account. However, no one else will be permitted to open the account and without a funded Hong Kong bank account, it is not possible to form a company in China. Once this problem arises, it can be difficult and time consuming to fix. For this reason, consideration of how a company bank account will be opened in Hong Kong should be considered in advance, before forming the Hong Kong company. We have seen many unnecessary delays in forming a Chinese WFOE or JV that arise as a result of having to deal with bank account issues.

Having said all this, forming a WFOE that is owned through a Hong Kong company is — more often than not –generally easier these days than just forming a WFOE that is owned direct from a country like the United States.

What do you think?

  • G. Alan Lucas

    So it’s a problem to open a bank account in Hong Kong as a business owner with a Hong Kong company is what you’re saying and this can delay opening a WFOE in China if you are using that same HK company to own it. I guess the Chinese are making it difficult in Hong Kong now by the sounds of it. OK, what about BVI or Caymans or Delaware as alternatives if you’re saying Hong Kong is now a problem to use to set up in China? Or maybe Macao?

  • Offshore Incorporations

    A great article about the difficulties and major operational problems about using a Hong Kong company for China.

  • Mark

    I don’t know. We have set up WFOE’s in China for several U.S. technology companies without difficulty (or hassles) in the PRC.

  • Gweilo Merchant

    Yeah man Hong Kong is going down the tubes. Better transfer all those HK companies to BVI or Caymans. Good call by China Law Blog.

  • Mi Fu

    Setting up a WFOE in China is relatively straight-forward, no need to establish another company in Hongkong. Hongkong may be a paradise of free trade, but still, if you have set up an additional company you will have additional overhead to manage it.
    In addition, there are cases (e.g. product registration) where a direct subsidiary can act on behalf of its parent company. A subsidiary of a subsidiary has the status of a distributor, it is not recognized as part of the foreign manufacturer.

  • Ray Hernandez

    Your right about Hong Kong going down the toilet and the lack of Western user friendliness. It’s way not what it was.

  • John Trolloppe

    China Law Blog is right Hong Kong is losing it’s appeal more difficult now to do business full disclosure of directors shareholders more mainland China influence in laws and freedoms it’s lost it’s advantage better use BVI. Plus Hong Kong is really expensive better off bypassing it now it just adds costs to China biz.

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

    I think some of you have misunderstood this post. Our point is not that Hong Kong is difficult. Our point is that there are now new reasons for wanting to have your China WFOE owned by an HK entity. We are saying that forming a China WFOE by way of Hong Kong is usually easier than just going direct from your home country. We are pointing out the issues that can arise in HK not to show how difficult HK is, but to let people know of some HK issues of which they should be aware.

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

    What I find weird is that you accuse us of “complaining” when that is not what we are doing at all. All we are saying is that there are “several important issues that must be considered before making the final decision regarding formation of a Hong Kong company. If you think that just telling people about how things work in Hong Kong constitutes “complaining” than I would say that you are a bit paranoid.