Archives: WFOE formation

China has liberalized its minimum capital requirements for a WFOE and the amounts required have been reduced in many Chinese cities/districts. But even if the Chinese government is going to let you get away with a very small amount of registered capital, you may want to pay more.

You should think about the registered capital you should be paying by considering how much money you will need to sustain your China WFOE until it can generate enough revenues from its own cash flow in China to sustain itself. If you inject less than you need in registered capital to sustain your WFOE until it generates enough in revenues to sustain itself, your WFOE will need a cash injection from somewhere. If you transfer money to your WFOE from overseas but you do not go through the correct process of re-registering your registered capital (which typically takes at least six weeks and involves having to get a new business license issued) the funds that you (or anyone else) send to your WFOE will count as income to your WFOE and will be taxed accordingly.

We often get calls from fairly new WFOEs seeking our help in figuring out how they can problem here is that quick-buck China lawyers and China consultants are interested in securing their fees to stay in business, not in your long term well-being. Getting you a WFOE as fast and as cheaply as possible in the short term is their goal because by the time you get hit with the tax bill they have already moved on to their next victim.

A while back, we did a similar post, entitled, China Company Formation Law Is Clear — WFOEs Are Easy, in which we discussed three companies my law firm’s China lawyers were in the midst of forming and noted how China’s minimum registered capital requirement was the biggest source of confusion for all three of these companies. All three companies contacted us after having become confused about registered capital after talking with various company formation consultants. We blamed the consultants for the confusion, insisting that the law itself is clear:

The law on minimum registered capital is clear, but the amount of capital that will be required does vary, depending mostly on the nature of the business of the company to be formed and on the city in which it is going to be registered.

Every company in China must have a stated registered capital. 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.

Where the registered capital is small, the entire amount must be contributed immediately upon formation of the company. If the amount is large, it may be contributed in installments. There are a number of schedules for the percentage and timing of large amounts of registered capital.

It is a crime to state a registered capital amount and then fail to contribute. It is also a crime to withdraw registered capital after it has been contributed.

The purpose of registered capital is to provide some notice to creditors of the capital adequacy of the company. Because of this, Chinese regulators take very seriously the rules regarding registered capital.

Registered capital is an initial investment that is intended to be immediately used in the operation of the company. It is not a deposit that must 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 to their home country after the Chinese company begins normal business operations. This also is not true. 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.

Chinese law is quite clear regarding minimum capital requirements for a WFOE but the statute’s prescriptions on this are essentially meaningless in actual practice. Under Chinese Company Law, the minimum capital requirement is either 30,000 RMB (less than $4,000 US) or 100,000 RMB (a bit over $12,000 US) depending on whether it is a multiple or single shareholder company. However, these numbers have no real meaning for forming a WFOE in China.

The real question is what the Chinese authorities will consider as adequate capitalization for the specific project and that always depends on the type of business and its 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 part of China. It is expensive to operate a capital intensive business like manufacturing, but relatively inexpensive to operate a knowledge based consulting business. Finally, some Chinese cities just seem to want WFOEs more than others.

The Chinese regulators usually consider all of these issues. To complicate matters, each local regulator has 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 but only after providing a clear explanation of the project.

The local regulator virtually never considers the statutory minimum in making a determination regarding adequacy of capital. Rather, the local regulator will determine what it believes is an adequate amount of capital based on all the circumstances. Once the investor has a clear idea of the outlines of a project, it is usually a good idea to engage a China attorney to contact the local regulator to see what their response will be to the proposed amount of investment. This initial screening can save a lot of time if the investor’s idea of the proper amount of capitalization is dramatically different from that of the local regulator.

My firm’s China attorneys always go to the local regulators to get this amount before we get very far along in the application process. Almost without exception, our experience has been that after we explain the nature of our client’s business to the regulator, the regulator’s decision on the minimum capital required has been a very workable one for our clients.

In determining what constitutes adequate capital, one needs to consider the peculiar situation in China that all rents are paid in advance, that payment for products for sale are usually paid in advance, and that a reasonable advance reserve for salaries is also required. Thus, the initial start up cost is going to be higher than for a comparable company in the United States, where credit and time payments are much more common. Chinese regulators will not approve a project that looks risky or under-funded.

For more on forming WFOEs in China and the minimum capital required to do so, check out Chinese Company Formation, Part II — WFOE Minimum Capital Requirements and Chinese Company Formation — Forming a Wholly Foreign Owned Entity (WFOE) in China.

China (nationally) recently changed its minimum capital requirements to zero. Many commentators have written on this change but none as far as I can tell have written on what it really means in concrete terms for foreign companies seeking to form a WFOE in China.

We have received a number of reader emails asking us about the significance of the change, including the following one yesterday:

I am hearing a lot recently about China’s new company laws released at the end of last year and implemented this year in March. As I am hearing, the most significant change is the elimination of registered capital requirements. What is not clear, it seams, is how the new law affects the establishment of WOFE’s. I searched your blog wondering if you had weighed in on the matter yet, and I couldn’t find anything. Perhaps you are waiting for the dust to settle, but I think this topic would make a great blog post.

Thanks!

I responded to that email as follows:

It’s important. Maybe. But we are staying silent until we know what impact, if any, this is going to have. The law until a few months ago was that the registered capital for WFOEs had to be a minimum of 100,000 RMB. But so what? Most cities set it much higher. So now that the law says there is no minimum, will cities go to zero? I doubt it. We are in the process of forming a number of China WFOEs and so we should know soon.

But also, even if it does go to zero, zero will not make sense for many (really most) companies as the last thing you want to do when you are forming your China WFOE is not have enough registered capital because then if you need more money you have to bring it in from the parent company and then China will tax you on that as income. So even if cities do cease to require any registered capital, we do not expect our clients to put in zero. So in the grand scheme of things, this all might be meaningless. Maybe this is will be our post.

This reader then responded with the following:

I think the other issue to consider for companies is that the registered capital amount provides a sense of trust in that company. Some companies will not work with suppliers with a registered capital amount below a certain level. Will other companies trust a WOFE with zero registered capital? Maybe looking at the registered capital amount is an old way of thinking but sometime habits are hard to break.

Also, I think a lot of SMEs still think the minimum is RMB1mm so they look at that as a big barrier to entry. Once the word gets out the minimum is gone we may see a big rush of activity.

I think you’ve got a good start to the post. I look forward to the official one.

This is “the official one.”

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

As China’s economy continues to contract, our China lawyers are getting an increasing number of inquiries from companies seeking to sell their China WFOEs. In fact, we are aware of the following currently on the market:

  • A Shanghai consulting WFOE
  • A Beijing consulting WFOE
  • A Dalian manufacturing WFOE

Back in May, in Buying And Selling China WFOE Shell Companies. Not In My Lifetime? we wrote about the difficulties inherent in selling/buying a China WFOE:

The thing about off the shelf WFOEs is exactly that: they are off the shelf and not customized. And that is where all of the problems arise. Let’s take as an example a WFOE that someone tried to interest me in many months ago. That company was in the IT outsourcing business in a second tier city. So right there, its only real potential buyer is someone who is interested in doing IT outsourcing in that second tier city. Because if the buyer of that WFOE is interested in doing anything other than IT outsourcing, it will need to petition the government to expand or change its business scope. Similarly, if the buyer is interested in doing IT outsourcing in some other city, it will need to petition the government to move its WFOE or it will need to set up a branch in that other city, and thereby have to maintain two offices. When you throw in the fact that anyone buying a WFOE will need to conduct due diligence on it to make sure that it truly does have no liabilities of any kind (including, tax, employee, environmental, tort, etc.) and you can quickly see why forming a WFOE is going to be safer and probably equally as fast and cheap. The biggest benefit in buying a shell WFOE would be speed, but it is going to be the rare instance where saving a few months will warrant the extra risk.

In WFOE Shell Company? You’re Kidding! The China Business Hand Blog nicely sets out how difficult it can be to sell a China WFOE, and this from someone who actually did it!

The China Business Hand blogger, Steve Barru, formed a WFOE in China in 1993 but when he took a job in 2005 he sought to get out from under that WFOE. As he puts it, he “could close the business and walk away or try to sell it, [but] …. it turned out that neither option was simple or straightforward.”

At first Barru thought that closing it down would be easy, but it being China, he was wrong about that:

Closing down the business and moving on seemed the easiest way out. Until I discovered that terminating a WFOE license involved getting approval to do so from the long list of government agencies that had approved the license in the first place. To make matters worse, shuttering the business would cost me around $2,000 in fees of one kind or another.

If I had been leaving China altogether in 2005, I would have settled up with my two employees, gone to Hong Kong to convert the company’s remaining Chinese funds to US dollars, and gotten on a plane home, letting Chinese government officials sort out what to do with an abandoned WFOE. Alas, my new job was in Beijing, so this was not an option.

I went to the primary licensing authority, the Bureau of Industry and Commerce, to ask if there was a formal procedure of some kind to make the company inactive (aka: a shell company). Nope. As long as the company existed, I would have to file monthly tax reports, complete the statutory annual audit and license renewal procedures, and meet all of the many reporting requirements of other agencies. The fact that the company would not be engaged in any business activity made no difference whatsoever.

It being so difficult and expensive to shut down his WFOE, Barru then sought to sell it, which too proved difficult:

Selling the company, even for next to nothing, quickly moved to the head of the line. But transferring the business license and my legal person status to the wannabe new owner involved far more than filling out a couple of forms.

It was the buyer who had to jump through the bureaucratic hoops. For all intents and purposes he went through the same process one goes through to establish a WFOE. With one key difference – he did not have to invest new capital in the company. The original US $70,000 in registered capital (that I had put in and had later managed, for the most part, to take out) was all that was required. Since registered capital for a WFOE had increased to US $200k by 2005, there were demands for additional investment, but rather convoluted negotiations eventually got around this obstacle. Fortunately, the buyer was located in Nanjing. The need to move the WFOE to a new locale would have been a deal breaker.

Eventually, after several months of discussions and chopping forms, all the questions about registered capital, business scope of the company, the good character of the new owner, and the license transfer had been answered and the sale was complete. The price probably covered my express mailing costs and bought me a couple of dinners. But I was out from under what had become an enormous, very time consuming headache.

As Barru so accurately observes, forming and running and even closing a business in China is going to require you to get up close and personal with your local bureaucrats:

The fact is, when you are doing business in China, the local government where you operate is your de facto partner. Chinese bureaucrats were involved in every aspect of my business over the years, sometimes in reasonable ways but on occasion as meddlesome pests sticking their noses into strictly business decisions. Even the end of my days as a WFOE owner involved getting government officials to, in effect, give me permission to let my business go.

The same holds true today, though just recently there have been some efforts in China to make WFOE formation easier, but so far we have yet to see it.

We spoke with a software company the other day that has nearly fifteen “independent contractors” in China, who it views as “part of the corporate family.”  This company was contacting us to see about forming a WFOE in China.  They told me that they were not in any rush.

The first thing I did was to ask whether they knew that what they were doing in China is completely illegal. They did not.  I explained to them how there is almost no such thing in China as an independent contractor and that they essentially had nearly fifteen employees and because there was no company actually employing those fifteen people, what they are doing is illegal. I then told them of how China in the last year has stepped up even more its efforts to rid the country of foreigners there illegally and companies there illegally.  I also told them of how their existing structure puts all of their China assets at huge risk. Their China IP assets are at risk for the simple reason that they do not really own them.  A company operating illegally in China is just not positioned to be able to assert IP rights against anyone in China.  Their other China assets are at risk because the Chinese government will likely seize them if and when it cracks down on what they are doing.

They seemed very interested in going legal until I started laying out how doing so would greatly increase their China operating costs.  I told them how their forming a WFOE would necessitate their incurring the following additional costs/expenses:

  • WFOE formation fees and costs.  They expected this.
  • They would need to lease office space from an approved landlord.  This is a requirement for WFOE approval.  This would likely increase their office rent.
  • For every $1,000 in employee salaries, they would probably need to pay about $400 (40%) in employer taxes and benefits.  They were not expecting this at all.
  • In addition to the employer taxes, their employees will need to start paying income taxes. They seemed to think that their “independent contractors” are already paying all required taxes. I told them that I am virtually certain that they are not, and that their going legal will almost certainly lead to their “independent contractors” demanding higher salaries to make up for their take home pay being reduced by having to go onto the tax rolls.

I then talked of the advantages of having a WFOE, including the following:

  • You are operating legally.  Your risk of the government shutting you down tomorrow has essentially disappeared.
  • You are much better positioned to do real business in China, because you are legal.
  • You are much better positioned to protect your IP in China, because you are legal.
  • You are much better positioned to terminate employees because you do not need to keep them on forever for fear of their reporting you to the authorities.

After this phone call, I spoke with China-based co-blogger, Steve Dickinson, for the latest on how China’s government is treating foreign operations with multiple people working for them in China. Steve pointed out how the Chinese government is aggressively pursuing tax evasion claims against both the “independent contractors” and those connected to the illegal business. The government pursues the “independent contractors” for failing to pay their own taxes and it pursues the foreign business for Chinese income tax and related national and local business fees and taxes. Most importantly, the government also seeks to take action for back taxes against any representative (i.e., individuals) of the foreign company who happen to come to China. When the number of illegal employees is large, the claim for back taxes can be quite large. Often, the tax authorities time their raid on the illegal business to ensure that a representative of the foreign company is on site and, in many cities, they will not let the foreign representative leave China until after resolution/payment is achieved.

In other words, doing the “independent contractor thing” without having a registered business in China is asking for trouble.  Big trouble.

What are you seeing out there?

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 WFOE 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:

More from the Doing Business in China Seminar I co-moderated last week.

My law firm does a considerable business in forming China WFOEs.  Unlike forming a company in the United States, which costs very little in out of pocket costs (always less than USD$1000) and takes almost no time at all (a few days at most), forming a company in China can be a long and expensive process. We typically start the procedure by sending out an email with the following LONG list of questions and document requests

  • Legal Name and Structure. Full legal name, legal structure (corporation, LLC, partnership), state of formation, and registered legal address of the shareholder of the WFOE. I assume that your U.S. entity will be the shareholder. If this is not correct, please explain.
  • Company Registration Document. Most recent registration document (usually called an annual report) from the state of formation showing the name, address and officers and directors of the shareholder. Our office can obtain this document after we receive your response to item 1 above.
  • Proof of Shareholder Existence. For this we will need certified copies of a) a certificate of good standing and b) the most recent annual report for the shareholder. These documents must be authenticated by the secretary of state of the state of formation and also must be authenticated by the applicable Chinese consulate or embassy. This is a complex process. Our office will handle obtaining these documents and processing with the relevant Chinese consulate/embassy.
  • Name of WFOE in Chinese and English. We can assist in selecting the name if you wish. Chinese company names are complex. For now, what we need is the basic name that you want. We will then work with the local authorities to determine what should be the full legal name. Note that China is really only concerned with the Chinese version of the name. There is no real control on the English name that you use.
  • Lease of Space for the WFOE. The lease must be valid for at least one year beyond the eventual approval date for the WFOE. Since approval may take some time, it is best to have the initial term of the lease be at least one-and-a-half to two years. The lease must be in proper format and must be registered with the local real estate authority. We will also need proof that the landlord owns the property in question and has the authority to enter into the lease. This is usually proved by provision of a land rights certificate and proof of existence of the landlord (National ID for an individual, business license for a company). We will work with you during the leasing phase to ensure the lease is properly executed and that the landlord has proper authority. Prior to your entering into the lease, we will determine whether the proposed use is permitted for the premises and whether the proposed address is acceptable for a WFOE. Leases are often the biggest obstacle for WFOEs, so this is a matter to address right away. Note also that the specific details of the documentation requirements for a WFOE depend on the district where the WFOE will be formed. We therefore need to know the proposed address for the WFOE or at least the proposed district before we can make a final determination of the exact procedures that will be required for WFOE formation. Note also that we cannot even begin the registration process in China until we know the address of the proposed registered office for the WFOE, as well as the proposed use. This highlights the importance of the lease in the registration process.
  • Scope of Business.We must specify the scope of business of the WFOE. Please provide a statement of what services the WFOE will perform on a daily basis. We need reasonable detail for this, but no more than one page. The scope of business should address the following questions, among others.
    • How many employees will be working there? Are they full-time or part-time? Will they be working in the leased space or off-site.
    • Will the number of employees vary over time?
    • What is the nationality of these employees?
    • What will each of these employees be doing in this rented space – will they be programming? consulting? buying? selling? manufacturing? providing customer support? managing other employees? something else?
    • Who are the customers of the business? That is, who will be paying for the goods or services provided by the WFOE?
    • What is the projected cash flow of the business? Where will income go (i.e., to the WFOE, to the parent, to an affiliated entity)? How will expenses be paid (i.e., directly by the WFOE, by the parent, by an affiliated entity, etc.)? Where will the WFOE get its money to operate?

The scope of business will also be used in the company name as noted in Question 4. above.

  • Feasability Study.  We must provide a feasibility study that states the basic business plan of the WFOE. Our staff will draft that document. In order to do this, in addition to the information requested in Question 6 above, we need the following information:
    • Statement of start up expenses in reasonable detail.
    • One year and five year proforma income statement and balance sheet.
    • Statement of what services/product the WFOE will provide (to the extent not addressed in Question 6).
    • Statement of the expected cash flow of the WFOE: what entities will pay and what will they pay for (to the extent not addressed in Question 6)
    • Initial staffing plan for the WFOE with a three year and five year projection. Of particular importance is the nationality of the staff (to the extent not addressed in Question 6).
    • Statement of the business opportunity this WFOE will exploit, the expected market for the service, how you propose to meet the needs of that market and the benefit to China from the project.
  • Registered Capital.  We must state the amount of the registered capital for the WFOE. This amount is the actual amount of capital that will be paid in by the shareholder as start-up capital for the WFOE. Registered capital is not a deposit: it is the actual operating capital used by the WFOE for payment of start up expenses such as rent, remodeling, equipment and salaries. There is no set number, since the amount required for each WFOE is different. As a rule of thumb, most Chinese regulatory authorities expect that registered capital will be equal to at least the first years expenses. Some districts have a minimum amount for registered capital. For example, districts in Shanghai generally require at least US $150,000 in registered capital. Note also that certain businesses will be required to have higher registered capital minimums. The rule is that all registered capital must be paid within two years after approval of formation of the WFOE. Fifteen percent of this amount, or the required minimum, whichever is greater, must be paid within 90 days after formation of the WFOE. The amount of registered capital must be considered carefully. Any amounts paid into the WFOE by the shareholder in excess of registered capital will be treated as income to the WFOE, and taxed as such. Accordingly, it is important not to set the registered capital number so low that you would encounter this problem. We will discuss this in more detail with you as we progress.
  • Management. WFOE can be managed through a) a board of directors or b) through a single managing director. For a board of directors, the number of directors is typically three. One director is selected as the representative director who has the right to enter into agreements on behalf of the WFOE. For the managing director, a single person is appointed as the managing director. This person is also the representative director. You will need to determine which management method you will use. For single shareholder WFOEs, the managing director approach is common. You will need to designate the following:
    • Directors.
    • If you will use a board, state how many directors. Provide the full name and address of each director.
    • If you will use a managing director, provide the full name and address of each director.
    • General manager.
    • The daily business of the WFOE will be managed by a general manager. This person can be a member of the board or an independent individual. The person can be a Chinese national or a foreign national. The person can be a resident of China or a non-resident. Typically, for a WFOE the general manager is a Chinese national who does not serve on the board and who is resident in China. However, there is no fixed pattern.
    • Supervisor.
    • The supervisor is responsible for supervising the conduct of the board in order to protect the rights of shareholders. In a one shareholder WFOE, the supervisor position is not necessary. However, Chinese law requires an appointment to this position. The person must be independent and cannot be a director or the general manager.
  • Documentation for each person.For each person above, provide the following:
    • Name and address.
    • ID: For non-Chinese citizens, we will need four color copies of their passport. For Chinese citizens, we will need four color copies of their national ID card.
    • Resume: one or two page, including birth information and address, signed, four originals.
    • Photos: four 2″ visa size photos.
  • Proof of financial status. Normally, this can be done through a letter from your bank stating the basics of your deposit relation with the bank. We will provide you with an approved form for this letter. In some cases, the Chinese authorities will require an audit of the investor company. We will determine as soon as possible whether such an audit will be required.

And the above is just for a typical WFOE.  There are going to be all sorts of variations, depending on the type of WFOE being formed and even on the city or district in which it is being formed.

Everyone always wants to know how long forming a China WFOE will take and we always tell our WFOE formation clients (before they retain us) that it typically takes from 3-6 months and that our primary goal is always to work as quickly as we can, but that whenever we are faced with a situation where we have to choose between doing something 100% right and doing it fast, we always choose accuracy and precision over speed. If your WFOE is rejected once, the odds of it ever being accepted go way down.

Sometimes potential (and even existing) WFOE formation clients tell us of “someone” out there claiming to be able to form a WFOE in “just a couple of months.”  To that, I always respond that every single reputable law firm (both Chinese and American and European) with whom I have spoken has told me that three months is their bottom line estimate for the time it takes to form a WFOE.  I am bringing all of this up now because at the Doing Business in China seminar, two lawyers from two different highly reputable law firms put on their PowerPoints how long it takes to form a China WFOE.  One put six months and the other put 4-6 months.  These are the figures from start to finish and include the 30-90 days it can take once all documentation has been submitted to the appropriate authorities.

If anyone is assuring you that they can do a WFOE formation in “record time,” run, don’t walk away.  Forming a WFOE in China takes time.  Months of it.

Believe it.

For more on forming a WFOE in China, check out the following:

What are you seeing out there on WFOE formations?

One of the things we are always writing about and always trying to get a handle on is what the attitude is in China towards foreign investment.  That attitude is never static for long, always shifting with the economy and sometimes shifting due to other factors such as politics.

We are in the midst of forming a WFOE right now for a couple of companies in somewhat difficult businesses.  Our advice was that they first form a Hong Kong entity as that likely would make WFOE formation go more smoothly. We told these clients that we have in the last six months or so been seeing Chinese governmental authorities increasingly throw minor roadblocks in the way of American and European companies seeking to form a WFOE in China.  One of these clients said that they had talked with someone who claimed not to have noticed any such tightening by China’s governmental authorities. All I could say was that we are seeing otherwise. I also talked of how China is even making getting visas tougher.

I thought about this today after reading a Variety Magazine article, “China: Market loosens quotas, but still cautious.” The article quotes Mathew Alderson(our lead China entertainment lawyer) on how China’s State Administration of Radio, Film and Television (SARFT) has stepped up its reviews of Sino-foriegn co-productions in an effort to make sure there is adequate China content to constitute a co-production.

A purely foreign film entitled to share in box office revenue must be imported into China as part of China’s annual quota. An official Sino-foreign co-production will be regarded as a domestic Chinese film, to which the quota does not apply. The distinction between foreign imports and Sino-foreign co-productions is also significant because they yield different box office shares. When films are imported on a revenue-share basis, the foreign distributor now gets 25% of box office takings under the new deal announced earlier this year. In a Sino-foreign co-production, around 38% of box office is available to the producers. The share available in a co-production is the same as it is for a purely domestic production.

The Variety article highlights the Chinese government’s increased vigilence:

The country’s State Administration of Radio, Film, and Television recently highlighted that its rules for co-prods require at least one third of production funding coming from China, along with one third of the main cast, while scenes must also be shot in China.

Co-prods help boost China’s image overseas while benefitting from learning expertise.

“Co-productions were definitely not intended as de facto quota busters, which is how they are often regarded in Hollywood,” says Alderson. “The authorities are now more vigilant about what they call ‘stick-on’ productions in which the Chinese elements are contrived and insubstantial.”

The Chinese are sensitive to the idea that Hollywood might be cynically taking advantage of its booming film market. Zhang Peiming, deputy head of SARFT, accused “Looper” and “Cloud Atlas,” accusing them of making superficial attempts at co-prod status.

“These co-productions get around the quota system and take domestic investment away and threaten Chinese movies,” Zhang said at the time.

For more on China co-productions and the China movie business, check out the following:

For more on the pros and cons of using a Hong Kong entity to form your China WFOE, check out How To Form A China Company (WFOE or JV). Hong Kong Entities. They’re Baaaaack.
Are you seeing what we are seeing in terms of China getting tougher on foreign business?

 

Many a time a company has come to us wanting a Wholly Foreign Owned Entity (WFOE) formed “right away” so that they can “immediately” bring on a China-based employee or employees.

It’s not that easy.  Not at all.

First off, no matter what anyone may tell you, it is the very rare WFOE that can be formed in less than three months, and three months is possible only if everything goes according to plan.

So what’s a company to do in the meantime? Is there a any way to hire a China Employee before your WFOE is registered?

There is an established legal way to do accomplish the hiring of China employees, pre-WFOE.  The legal way to do it this is to have the person hired by FESCO or some other Chinese company created for hiring Chinese individuals on behalf of foreign entities. The Chinese individual is hired by FESCO and then is dispatched to work for the foreign entity. Under rules that apply to FESCO and others, the minimum term of the contract is two years. Usually there is an agreement between FESCO, the foreign company and the employee that at the time the WFOE is formed, the employee will voluntarily resign from the FESCO position. However, the risk of this is taken by the foreign entity, not by FESCO. This kind of arrangement is further complicated by the fact that in addition to the FESCO contract, the foreign entity will also require a series of contracts with the employee to deal with the transition to the WFOE, intellectual property/trade secrets and the like. FESCO charges a lot for the service, but it is the only way to do it while complying with Chinese law requirements.

There is also an illegal way to do it: The U.S. entity hires the Chinese individual as a consultant. The U.S. entity pays the consultant to assist with forming the WFOE. After the WFOE is formed, the WFOE hires the Chinese consultant as an employee. The Chinese consultant is paid on an independent contractor basis. That is, the Chinese individual is paid a gross amount and it is the responsibility of the Chinese individual to pay his or her taxes in China. This entire arrangement is illegal under Chinese law because China does not permit Chinese individuals to enter into consulting contracts with foreign entities. All businesses done in China by foreign entities must be done with a registered China business entity. We are aware of many companies having “hired” Chinese employees using this illegal method and years ago the odds of being caught and punished seemed pretty low.  But with the economic downturn, we are hearing more and more of foreign companies being blocked from forming their WFOEs for having engaged in this practice and we are even aware of one WFOE that was shut down after formation for having done this.

We are of the strong view that companies who want to be in China long term should either wait until their company is formed to start hiring or go through FESCO or a FESCO type company for any pre-WFOE hiring.

What do you think?

Forming a company in China. It makes my blood boil because, quite frankly, there are a number of consultants out there who are essentially lying to their clients about what it takes to form a company in China. They make it sound easy and cheap and so when one of my law firm’s China lawyers tell them it is difficult and expensive, they often think that we trying to put one over on them.

Part of the problem is that in many countries it is easy and cheap to form a company. But in China it is not easy and if it is cheap, something is wrong and something will go wrong.

One large part of the problem is minimum registered capital. Chinese law says it must be at least 100,000 RMB, which equals roughly $13,000. So fly by night company formation consultants use this to make it seem that the minimum capital requirement is always $13,000 and so when we tell prospective clients we expect their minimum capital requirement to be around $240,000, some of them are thinking we just must not be very connected.

Here’s the real deal with registered capital. That $13,000 figure is a guideline. It was originally in place to ensure that new WFOEs had enough capital to sustain their business.

More importantly even if the Chinese government lets you get away with the absolute minimum in registered capital you very well might want to pay more.

You should think about the registered capital you should be paying by considering how much money you will need to sustain your China WFOE until it can generate enough revenues from its own cash flow in China.

If you inject less than you need in registered capital to sustain your WFOE until it can generate sufficient revenues to sustain itself, your WFOE will need a cash injection from somewhere. If you transfer money to your WFOE from overseas but do not go through the correct process of re-registering your registered capital (which typically takes at least six weeks and involves your having to get a new business license issued) any funds that you (or anyone else) injects into your WFOE will count as income to your WFOE and be taxed accordingly.

The problem here is that quick-buck China lawyers and China consultants are interested in securing their fees to stay in business, not in your long term well-being. Getting you a WFOE as fast and as cheaply as possible in the short term is their goal because by the time you get hit with the tax bill they have already moved on to their next victim.

Earlier this year, we did a similar post, entitled, China Company Formation Law Is Clear — WFOEs Are Easy, in which we discussed three companies my law firm’s China lawyers were in the midst of forming. We noted that China’s minimum registered capital requirement was the biggest source of confusion for these companies after they had talked with various company formation consultants. We blamed the consultants for the confusion, insisting that the law itself is clear:

The law on minimum registered capital is clear, but the amount of capital that will be required does vary, depending mostly on the nature of the business of the company to be formed and on the city in which it is going to be registered.

Every company in China must have a stated registered capital. 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.

Where the registered capital is small, the entire amount must be contributed immediately upon formation of the company. If the amount is large, it may be contributed in installments. There are a number of schedules for the percentage and timing of large amounts of registered capital.

It is a crime to state a registered capital amount and then fail to contribute. It is also a crime to withdraw registered capital after it has been contributed.

The purpose of registered capital is to provide some notice to creditors of the capital adequacy of the company. Because of this, Chinese regulators take very seriously the rules regarding registered capital.

Registered capital is an initial investment that is intended to be immediately used in the operation of the company. It is not a deposit that must 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 to their home country after the Chinese company begins normal business operations. This also is not true. 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.

Chinese law is quite clear regarding minimum capital requirements for a WFOE but the statute’s prescriptions on this are essentially meaningless in actual practice. Under Chinese Company Law, the minimum capital requirement is either 30,000 RMB (less than $4,000 US) or 100,000 RMB (a bit over $12,000 US) depending on whether it is a multiple or single shareholder company. However, these numbers have no real meaning for forming a WFOE in China.

The real question is what the Chinese authorities will consider as adequate capitalization for the specific project and that always depends on the type of business and its 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 part of China. It is expensive to operate a capital intensive business like manufacturing, but relatively inexpensive to operate a knowledge based consulting business. Finally, some Chinese cities just seem to want WFOEs more than others.

The Chinese regulators usually consider all of these issues. To complicate matters, each local regulator has 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 but only after providing a clear explanation of the project.

The local regulator virtually never considers the statutory minimum in making a determination regarding adequacy of capital. Rather, the local regulator will determine what it believes is an adequate amount of capital based on all the circumstances. Once the investor has a clear idea of the outlines of a project, it is usually a good idea to engage a China attorney to contact the local regulator to see what their response will be to the proposed amount of investment. This initial screening can save a lot of time if the investor’s idea of the proper amount of capitalization is dramatically different from that of the local regulator.

My firm’s China attorneys always go to the local regulators to get this amount before we get very far along in the application process. Almost without exception, our experience has been that after we explain the nature of our client’s business to the regulator, the regulator’s decision on the minimum capital required has been a very workable one for our clients.

In determining what constitutes adequate capital, one needs to consider the peculiar situation in China that all rents are paid in advance, that payment for products for sale are usually paid in advance, and that a reasonable advance reserve for salaries is also required. Thus, the initial start up cost is going to be higher than for a comparable company in the United States, where credit and time payments are much more common. Chinese regulators will not approve a project that looks risky or under-funded.

Are we clear?

For more on forming WFOEs in China and the minimum capital required to do so, check out Chinese Company Formation, Part II — WFOE Minimum Capital Requirements and Chinese Company Formation — Forming a Wholly Foreign Owned Entity (WFOE) in China.

Oh, and remember what your mamma told you: you get what you pay for.

When setting up a business in China, speed kills.

Things take longer to accomplish in China than in the West, particularly during the start up phase. U.S. companies are notoriously impatient and will often attempt to speed up the process, which generally leads to disaster. To succeed in China, you need to expect everything will take longer than expected. If meetings in the U.S. or Europe require three days, plan on three weeks of meetings in China. Though Western companies with substantial China experience by now have come to understand the need for patience (if they had not, they probably would not still be here), newcomers often do not.

We spend a lot of time helping foreign companies establish Wholly Foreign Owned Enterprises (WFOE) and Joint Venture (JV) companies in China. Formation of such entities takes much longer in China than in Europe or the U.S. This process takes even longer for newcomers to China who are unwilling to provide all of the detailed documentation required by the Chinese authorities for company approval. As the company approval process drags on for many months, the foreign investor grows increasingly impatient as it watches business opportunities pass by while waiting for government approvals. This frustration is compounded by the desire of the Chinese JV partners, employees and suppliers to begin earning income as soon as possible.

In response to this frustration, there is a strong temptation to transmit funds early and to start business before the WFOE or JV company has been formally approved. This is a disastrous decision and should be avoided at all costs. I have seen companies jump the financing gun countless times, but two scenarios are by far the most common.

The first common scenario involves forming a WFOE by a foreign investor. The approval process is extending far longer than expected. The investor is approached by a potential customer for work that must be done immediately. Unable to resist the temptation, even though approval to do business has not been obtained, the investor leases space, hires contract employees and begins work in China, never mentioning any of this to its lawyer who is diligently working on forming the WFOE. When Chinese government approval for the WFOE finally comes, the investor is required to contribute its capital contribution in cash to the bank account of the WFOE. At this time, the investor will say: “We do not have enough cash to make the full capital contribution because we have already spent a substantial portion of our proposed initial capital operating (illegally) in China while waiting for government approval of our WFOE.”

The investor then wants to claim all of the pre-incorporation expenses as a credit against the required amount of its capital contribution. This simply will not work. The Chinese authorities will ignore all of the money spent operating (illegally) before approval of the company. This leaves the foreign investor in the difficult position of having to obtain additional funds to enable it to make its full capital contribution and obtaining no credit whatsoever for the pre-incorporation expenses in terms of capitalization or cost deductions for the new company.

The second common scenario involves a foreign company entering into a JV company project with a Chinese company.  In many cases, the Chinese partner needs an immediate capital infusion. Indeed, this strong and immediate need for capital is often the primary reason the Chinese side is seeking to form the joint venture. As with the investor in the WFOE, the Chinese side will often grow impatient and will convince the foreign investor to transfer its capital contribution before the Chinese authorities approve the formation of the joint venture company. This is a mistake.  Capital contributions to a joint venture company must be made directly to the bank account of the joint venture company, which account can only be opened after the joint venture company has been approved. Funds sent to China before the joint venture has been formed do not constitute a capital contribution to the joint venture. Often, if the funds are sent early, the funds must be returned to the foreign country and retransmitted after the joint venture company has been formed.

This becomes even more dangerous when the funds the Western investor transmitted are actually used by the joint venture partner for infrastructure improvements that are completed before approval of the joint venture company. Many times our China lawyers have been brought on to provide legal assistance in forming a U.S./Chinese joint venture only to learn that the U.S. side already provided funds to the Chinese partner. The Chinese partner has used the funds to build the factory that will now house the joint venture company. The U.S. side then requests that the contribution it has already given to its Chinese partner be treated as its capital contribution to the joint venture company. We then have to explain that the funds the foreign company contributed cannot be treated as a capital contribution and that the foreign investor has essentially made an undocumented and unsecured loan to the Chinese partner. The U.S. side must still contribute cash to the joint venture in the amount of its proposed capital contribution, with no credit for the funds already contributed.

In both the WFOE and the JV scenarios, foreign investors usually react with shock and disbelief to the news they have to a large extent thrown their money away.

Speed kills.

Just say no.