Around 25% of my law firm’s China legal work is done with US or European attorneys, and a good chunk of that work is helping them help their own clients form a Wholly Foreign Owned Entity (WFOE) in China. The law firms that retain us do not have their own lawyers in China but because the China work they are doing for their clients is just one part of their work for that client, quite logically, they want to coordinate that work with whichever China lawyers they retain.

We recently took on three new WFOE formation matters for US lawyers. Two of these matters are for lawyers working on behalf of their clients and one is for a lawyer who owns the (non-law related) business. All three of these lawyers told me they had spoken with company formation firms and had grown frustrated with the information they were being given.  They relayed that these firms were not giving clear answers to many of their questions, but were instead responding by saying China WFOE laws were “vague” and/or “ever changing.”

What these company formation firms are saying is just not correct.

Chinese law on WFOE formations is actually quite clear and I suspect these company formation firms were claiming otherwise only because the laws are vague to them. Near as I can tell, these company formation firms typically consist of a foreign voice or two (oftentimes in Hong Kong) who takes in the work and then farms it out to a Chinese law firm in a low cost city to do the work. The people on the phone or at the other end of the e-mail at these firms have never read China’s laws on WFOE formation and so, not unexpectedly, those laws are vague to them.

As for “ever changing,” on January 1, 2006, there was a sea change in China company formation laws for foreign companies, but they have remained static since then.

By far the biggest source of confusion/frustration for these US and European attorneys seeking information on forming a China WFOE is the minimum registered capital requirement.

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?