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China WFOE Formation. The Minimum Capital Requirements.

Posted in Legal News

A quasi-fascinating email just crossed my desk regarding the minimum capital requirements required for WFOE formation in China.  I was cc’ed on this email from one of my firm’s lawyers to another, musing about the minimum capital required for a company that would be profitable from day one, based on payments from its parent company:

Way back in 2005 and 2006, we worked on several consulting WFOES and I interpreted the rules just as you have.  Since payments to the WFOE were going to be guaranteed by the parent company [the company that would own the WFOE] for work done by the WFOE for the parent company, we took the position that the WFOE’s registered capital should be limited to its hard start up costs: rent, equipment, utility prepayments, etc.  For many of the service companies, this would mean a very low initial capital need of say $40,000 or so. Our idea was to capitalize the WFOE with $40,000 and then start billing the parent immediately. In those days, there was no real tax issue, so the billing was planned for the actual cost of the service. The fact that this did not accord at all with the requirement that the WFOE earn back its initial capital within 3–5 years was something we just ignored.

We took this idea to the Shanghai government and to a few other cities as well, and said, “Okay, our registered capital required is $40,000. This is substantially more than the statutory minimum of RMB 100,000 (around 12,000 back then), so let’s get going.”

The response was, “No. We require a minimum registered capital for all WFOEs in the amount of $US150,000.” We replied, “But, we don’t need this capital. We have no use for it. It is a waste. The response was, just use the capital for your operating costs until you run out. You can then start billing your parent company for the service income after the capital has been used up.”

This was all done before China adopted its new income tax law and started imposing transfer pricing rules and related. So after these things came to pass, we went back to the government in Shanghai and said,”if we follow what you have demanded in the past, this will actually reduce the amount of taxes you collect.” The officials said, “We do not care. Just do it the way we have always required because we want to determine in advance that the parent company has the financial wherewithal to fund the operations of the WFOE. Taxation is not our concern.” So in this environment, the tax advisors said, “Well, under this approach, it is best to make your registered capital as high as possible so that you can avoid taking taxable payments from the corporate parent as long as possible.” So this is what we did.

As you have identified, this approach is not consistent with Chinese tax law. On the other hand, this approach is quite consistent with the real goal of the Chinese regulators. They are very concerned that a WFOEs that is 100% dependent on payments from its parent company will in fact never get funded. They therefore want to see as much initial capital as possible up front as a pre-payment of expenses. The small amount of tax foregone is not really the issue on which they are focusing . All of this is explicitly commercially unreasonable. Please tell me something new about China.

Having said the above, things have changed a lot in China over the past three years on the tax front, so it is time we look again into this issue.

For more on WFOE formation and minimum capital requirements, check out the following:

  • Mark

    This shouldn’t be so surprising. It’s been that way for years here in China. Logic has nothing to do with the decisions of the government. Even though there may be Central Government regulations, the municipalities and provinces do what fits them best whether it is WFOE’s, driver’s licenses, residence permits, etc. As an example, last year, on the behalf of two clients in similar industries, we arranged for the establishment of WOFE’s in Beijing and Chengdu. Irrespective to the law, the requirement were totally different. The capitalization requirements were different, the filing paperwork was different, the process was different. Everything was different. For the 13 years I’ve been here, it has always been that way. It will probably remain that way. Once you’ve been here for a while, you get used to the frustration learn how to navigate all of this.

  • Tim

    A few other issues regarding the regsitered capital that are often ignored: If you intend to establish an entity using a captive business model, as is being discussed here, maximizing your registered capital can be an effective way to minimize your tax exposure for the first one or two years of operations. It might also be possible to carry forward this loss to offset income tax in subsquent years.

    Furthermore, when you begin to dip below US$150k this might impact your entity’s ability to apply for Visa’s for your expat employees; obtain General VAT taxpayer status; opening up a branch office; and, for your local employees this one is important: apply for temporary residence for talent that do not hold a hukou for the city where your office is located.

    Registered capital impacts the long-term relationship you have with the local authorities not just the setup process.

  • Kenneth Gaw

    Local Governments also have FDI targets to meet you didn’t factor that in.

  • Harland

    That is in Shanghai…totally different from many other localities. They have enough foreign investment and don’t want more. If there’s one thing that government hates, it’s small and medium sized foreign businesses. They only want multinationals to open huge factories.

  • Perry Hutter

    We have been thinking about setting up a WFOE for a while but haven’t really done our homework or footwork yet. A friend of mine said that taxation in China is risky business in that you first cough up the 25 percent company tax on net income. The remaining profit goes into the company’s capital, then if you want to pay dividend or otherwise take money ‘home’ or just out if you’re full or co-owner, then you’re getting slammed with full income tax on it, which means you’re worryingly likely to end up paying as much as 65-70 percent in taxes on your company’s profits. I assume that’s not correct though since it sounds pretty much insane,,, anyone?