Every couple of weeks my firm gets an email or a phone call from a small business that is seeking to justify forming a Rep Office in China instead of a Wholly Foreign Owned Enterprise (WFOE). These small businesses typically go into advocacy mode explaining why their business can and should be a Rep Office in China. They then go on to explain that they simply cannot afford to form a WFOE in China due to the minimum capital requirements, the legal fees, and the taxes.

They then want me to condone their Rep Office plans but I never do.

In fact, the increasing number of these requests has caused me to get even blunter than usual, and my most recent response exemplifies this:

What you are describing doing as part of an RO [Rep Office] is definitely not proper for an RO. Not even close.

In terms of minimum capital required, because it is Dongguan, it is likely to be pretty high. Sorry.

You pretty much have two choices. You can operate completely off the grid and risk getting shut down, or you form a WFOE. Probably the worst thing you could do would be to form an RO that operates illegally because that will just draw attention to how you are operating illegally.

I get the sense that the people contacting us on these things are hoping that they somehow have found THE loophole that nobody else has found and that if only they can get the blessings of an attorney for what they are doing, that their operating illegally will somehow not be illegal. I wish I had some magic oil I could sell (for a helluva lot of money) that I could sprinkle on illegal China businesses to make them legal, but I have no such thing.

Those who think they are going “sorta” legal by forming what is clearly an illegal Rep Office in China are very similar to those who think they are “sorta” protecting themselves legally by doing a “sorta” joint venture with their girlfriend. I wrote about those people in a post, entitled, “Operating Illegally In China. Half-Assing It Does Not Help.” In that post, I described the following email I had recently received from my co-blogger, Steve Dickinson:

We had one of these the other day and it precipitated an email from my co-blogger, Steve Dickinson, to me, which went as follows:

If these people are going to go illegal in China, they should go 100% illegal. That is, enforcement either through really strong family connections (your father knows her father) or enforcement through gangsters and the like. I know people who have succeeded this way but I don’t know anyone who has succeeded with an illegal contract. This is not because contracts don’t work in China, because you and I have won enough China contract cases to know that they do.

It is because the Chinese judges are totally on to these sorts of arrangements and they know they violate or seek to evade Chinese law. They therefore have and will continue to deem such contracts void. Why do people live in this fantasy world thinking that somehow they are so different or that they have discovered the solution? Why do they think a Chinese court would enforce a contract designed to evade the law?

Take an alternative example. Remember John Smith’s [yes, it is an alias] company we formed in Beijing a few years ago? Not sure if you remember this, but that investment was with his Chinese wife. However, we did that as a very formally organized WFOE and left the wife and her family with the irregular side of the deal. His US company is the only shareholder and he runs the board. His company has had no trouble and he has had no trouble because he is legal and secure. His US LLC [and with it, the China WFOE] were just purchased by _______ [a pretty big name U.S. company]. The reason the purchase was successful is that the whole company was “clean” and therefore it could be purchased by a foreign public company.

I then concluded that post with the following:

As lawyers we are never going to tell our client to go full illegal, but in my role as a blogger, I have to think going full illegal would probably make better sense than paying a lawyer to draft a void contract. I think people know this, but their rightful discomfort at operating illegally makes them want to clutch on to something that will allow them to justify (however falsely) their actions.

The same holds true with respect to forming a Rep Office when a WFOE is required. Forming the Rep Office in that situation will just serve to let the Chinese government know where you are and what you are doing and will make it easy for them to realize that what you are doing requires a WFOE. On top of that, as I am always saying, you should not form a Rep Office with plans to form a WFOE in a year or so “if everything works out.” You should not do this because you will end up paying THREE times as you will pay for forming the Rep Office, pay for shutting down the Rep Office (and this is not cheap), and then pay for forming the WFOE.

What really drives me crazy about all this though is that on at least three occasions, companies for whom we have refused to form Rep Offices have written me to tell me that “so and so” company formation company is willing to form the Rep Office for them, as though this mere fact means that my firm was wrong in declining to take money to do something we know will eventually not work.

And though I take no happiness from this, I will note that one of the three companies that went ahead and formed a Rep Office against our advice did contact us about a year later to tell us that the Chinese government was now making them form a WFOE.

For more on what is involved in forming a company in China, check out the following:

Doing business in China? Don’t do it half right because you are only increasing your risk.

What do you think?

  • Thank you for this useful article. I was turned on to your RSS feed by a friend of mine recently, and I really appreciate the pertinent legal issues you tackle with your posts. Keep up the good work, and thanks again.

  • Dan,
    Thanks for the wonderful and timely advice. I have 3 interviews with company setup firms here in Beijing. I’m looking to create some educational videos that explain exactly what you talk about in this article. I had contacted you about making these products and you are too busy. 🙂
    Thanks again for the great reminder, and I especially like the advice about either going 100% illegal instead of “Rep office then WFOE in 1 year”.
    Steve

  • Chris

    While a Rep Office has low start up costs (ie. no registered capital requirement), the tax rates are significantly higher than for a WOFE. In addition, the Tax Office and Bureaus of Industry and Commerce scrutinise Rep Offices FAR more closely than they do WOFEs. Our Rep Offices get Tax Office audits or further requests for information far more often than do our WOFEs.
    A Rep Office is useful where overseas HQ never has an intention to set up a manufacturing, sales, or income earning operation in China. 10 years ago this was a credible business model. Simple liaison between overseas HQ and domestic companies where contracts were directly between HQ and the domestic partner were far more common then.
    These days most foreign businesses will want to operate and generate income within China. Local partners will want locally enforcable Contracts and Chinese tax deductible receipts, all of which a Rep Office cannot provide. A Rep Office is completely inappropriate for this form of business relationship.
    Dan’s points are valid. Too many foreign HQs mistake capital requirements as a cost, rather than a fund the Chinese Govt wants to see in place to ensure the viability of the business. Capital funds are fully available to the business to use in operations. In the start up phase, losses on the capital can be written off against future profits. These is no issue here.
    Even where the sole client is Overseas HQ, (for example, an outsourcing operation working for HQ, software development for overseas HQ use etc) then a WOFE funded via a Services Agreement between the WOFE and HQ and governed by transfer pricing tax rules, is a much better model than a Rep Office.
    The days of the Rep Office are over…

  • You seem to get stuck with many people looking for a shortcut. I feel kind of bad for you!

  • We have a RO in Suzhou and use it as an RO and nothing else. If we decide to branch out we intend creating a WOFE. I want to highlight that our whole experience of setting up in China was one of a straight forward, clear and unambigous process. Our accountant and lawyer work closely with us and our accountant is almost daily in contact with us to help us manage the financial side of the business according to the Chinese rules. I am surprised that people looking to enter the Chinese economy still think that they can “fly under the radar”, move in illegally or “half assed” as you aptly describe it, make bucks (illegally) and ride off in the sunset. Come on people you are entering the 2nd largest economy in the world. You’re a foreigner in a foreign economy. Play by the rules, apply basic, tried and tested legal and business techniques/principles and the dragon will smile on you, you’ll make your fortune or provide the cost benefit to your home company.
    Some of the rules are a bit of a pain in the arse but if you look at the flipside of the coin, China is not only protecting their own economy from foreign investors stripping their resources and providing value BUT they are also protecting foreign investors coming to China by forcing them to provide a proper thought out business plan before entering and committing capital before they come to China. Countries looking to attract foreign investors should maybe copy China in that regard and raise the requirements before entering.

  • Joel P.

    I did the half-way thing and the government caught us, issued a steep fine, which we paid, then issued another steep fine and told us that if we didn’t pay that too, they would shut us down and export us. The whole thing ended up costing us about $100,000 in fines and legal fees, not even counting the costs of setting things right. I learned my lesson.

  • Bayonet

    Interesting article, wonder how the international law firms can justify their rep offices doing business in China? Oh, they are just suggesting the Chinese legal environment to their clients…that sorta thing is still in the grid.

  • Johann K. Jaeger

    As a lawyer consulting on China access myself, I find the discussion regarding the merits of WFOEs versus JVs to be ever evolving. I agree with the vast majority of Dan’s posts with respect to the superiority of WFOE in many cases. From time to time however, I come across a review by a more than reputable source that contributes to the nuance of the debate.
    For anyone who hasn’t seen this, McKinsey has published a new(-ish) report on the resurgence of the China JV in their quarterly:
    https://www.mckinseyquarterly.com/Corporate_Finance/M_A/Past_lessons_for_Chinas_new_joint_ventures_2717?gp=1
    Upon perusal, I don’t know if there is anything groundbreaking in light of the fairly exhaustive discussion on China Law Blog but I would be interested in hearing what others think.
    Thank you for the excellent blogging and superior insight as always.

  • Prada Man

    I agree. I’ve seen the same thing. Companies want to act like they want to do the right thing, but they really don’t. They just want to look like they are, but in these days if you are a foreigner you had better do it 100% right because if you don’t there will be someone out there who will completely fuck you for not having played by the book and you will be gone. I’ve been here long enough to know that.