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?