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China WFOE Formation. The “New” Rules on Minimum Capital.

Posted in Basics of China Business Law, Legal News

In the bad old days (last year), every company in China was required to have a stated registered capital. This amount is provided in the Articles of Association of the company and is also noted on the company register. 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. The purpose of registered capital was to provide some notice to creditors of the capital adequacy of the company. Because of this, Chinese regulators took very seriously the rules regarding registered capital.

Registered capital is an initial investment intended to be immediately used in operating the China-based WFOE. It need not 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 Once the capital is contributed to the Chinese company, it can never be withdrawn for anything other than paying company expenses.

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 and failing to abide by Chinese law all the way along the process will likely lead to an inability to get money out of China at some point down the road.

Under Chinese Company Law, the minimum capital requirement for multiple shareholder companies was around USD $5,000 and for single shareholder companies around USD $13,000. However, these numbers never really had meaning for forming a WFOE in China.

The real question was what the Chinese authorities would consider adequate capitalization for the specific project and that varied by type of business and 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 area of China. It is expensive to operate a capital intensive business like manufacturing, but relatively inexpensive to operate a knowledge based consulting business.

The Chinese regulators usually considered all of these issues. To complicate matters, each local regulator had 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 considered the statutory minimum in making a determination regarding adequacy of capital. Rather, the local regulator would determine what it believed to be an adequate amount of capital based on all the circumstances.

In determining what constituted adequate capital, one needed to consider the peculiar situation in China that building rents are virtually always paid in advance, that payment for products for sale are virtually always paid in advance, and that a reasonable advance reserve for salaries is also required. Thus, the initial start up costs are much higher than in a location like the United States, where credit and time payments are more common. In addition, the foreign investor needed to take into account the risk aversion of the Chinese regulator. The Chinese regulator will not approve a project that looks risky or under-funded. The regulator has no incentive to do this, especially for a 100% foreign owned entity.

We frequently would saw three big mistakes made by foreign investors regarding required minimum capital. Foreign investors hear that assets can be used as a contribution towards the minimum capital requirement, so they go ahead and ship certain assets over to China, expecting to use those assets towards minimum capital. The problem with this approach is that unless the proper authorities have been notified and granted their approval in advance of the shipping, the assets you just shipped to China will not be applied towards minimum capital, and you will have a huge problem on your hands.

Another common mistake is the foreign investor putting a value on its assets (including its intellectual property) and assuming the Chinese regulators will put the same value on those assets in determining the contribution towards minimum capital. The Chinese regulators will require their own appraisal (at your expense) l of anything other than monetary contributions towards the minimum capital requirement, and those appraisals tend to come in low, particularly for IP.

The third common mistake was believing that the lower registered capital the better, when in fact that is rarely the case. If your WFOE starts out with too little in registered capital and then needs more to fund salaries or to pay rent or any other expenses, it typically needs to get that money from its foreign parent company and those funds are taxed to the WFOE as income. It is possible to secure government approval to increase the registered capital, but that can be time consuming and when wages are due, there is usually little time to waste.

But earlier this year, China eliminated any minimum registered capital requirement for WFOEs and my firm’s China lawyers have received a number of emails from companies asking about the impact of that change. Our answer has mostly been that we do not expect the change to have much impact for most companies. We say that for the following three reasons:

  • We are not convinced that all localities will be doing away with minimum capital requirements.
  • The law change does not change the tax considerations discussed above.
  • This last one comes from one of our readers, who rightly states that “having a substantial registered capital amount provides a sense of trust in the company. Some companies will not work with suppliers with a registered capital amount below a certain level. Will a WFOE with zero registered capital be trusted? Looking at the registered capital amount may be an old way of thinking but sometimes habits are hard to break.

“What are you seeing out there with WFOE minimum capital requirements?

For more on China WFOE formation, please check out the following:

  • On the Corner

    China…you can check out any time you like but you can never leave….not with your money anyway…

  • http://www.student-market.com SM

    I wonder what would be the correct approach in determining the minimum reasonable capital during WFOE’s start up phase. Is it better to prepare a reasonable 1-2 year feasibility plan that would include items such as rent, salaries, taxes and other expenses and submit it to the regulators and hope that your feasibility is reasonable enough for the regulator to approve as sufficient initial capital amount or to expect that they will determine the appropriate initial capital themselves and what if they say that you are supposed to allocate 3-4x more than truly necessary. What’s the better way?