If you are a foreign business, it will not be easy or cheap for you to set up a business to operate legally in China. The following is just the most basic of lists of what you need to do to set up and operate legally in China:

  1. Register your legal entity in China. This will typically be a WFOE, a Rep Office or a Joint Venture.
  2. Lease property that will permit your company registration to go through.
  3. Enter into written employment agreements with all of your employees. You should have an employee manual as well.
  4. Figure out and pay all of your taxes, including all of the taxes and mandatory benefits on your employees.

To put it bluntly, doing/complying with the above is not going to be cheap or easy. But it is necessary. I have lately been seeing an increase in foreign companies setting up “quickly and cheaply” in China through their Chinese “partners.”

Let me explain.

As China is becoming wealthier, its need for service businesses is multiplying rapidly and it is almost exclusively in the service sector that I am seeing this troubling new trend. I usually “see” it when the Western service company calls me to “review” its contract with its Chinese partner and I immediately realize that the Western service company needs a heck of a lot more than that.

Here is what is happening. The Western service company goes over to China and gets wooed by a Chinese service company, usually in the same or an allied industry. The Chinese service company convinces the Western service company that there is a huge demand in China for the services the Western service company can provide — this is easy, because there almost certainly is. The Chinese company then convinces the Western service company that their two companies should work together to market their services in China.

The Chinese company then convinces the Western company that it will handle “everything” and get the Western company up and running in a few weeks. The Chinese company then has the Western company lease some space from the Chinese company and the Chinese company even hires a couple Chinese employees on behalf of this putative joint venture. To top it all off, the Chinese company puts the Western company’s name and logo on the door and, voila, the Western company now has a business in China.

Except it doesn’t.

In “Forming A Chinese Company. Do It Right Or Do It ALL Wrong, But Don’t Do A Rep Office,” we talk about those who choose to form illegal Rep Offices because forming a WFOE is too time consuming and expensive:

I get the sense that the people contacting us on forming a Rep Office (when only a WFOE would be legal) 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 (one of the China lawyers at my law firm) for what they are doing, their operating illegally in China will somehow not be “so” illegal. I wish I had some magic oil I could sell (for a helluva lot of money) to sprinkle on these sort of illegal China businesses to make them legal, but I have no such thing.

Those who think they are going to become “sort of” legal by forming what is clearly an illegal Rep Office in China are very similar to those who think they are “sort of” protecting themselves legally by doing a “sort of” joint venture with their girlfriend.

I went on to write of how going “half-legal” is not only riskier than operating legally, but also riskier than operating completely illegally:

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. [UPDATE — After I wrote this post, a company contacted me to let me know that their illegal Rep Office had been shut down within three months of its having been formed. All it took was one knock on their door to be discovered as having too many employees for a Rep Office!]

These quasi-partnerships with Chinese companies are the same way and having a relationship with a Chinese entity is likely not going to help you if the government discovers you are operating illegally. It is also not likely going to help you if one of your employees sues you and is able to point out that you do not really exist in China.

In fact, I have very strong suspicions that your relationship with the Chinese entity is only going to hurt you in your dealings with the Chinese government and overall.

Whenever I learn of these “fake” joint ventures, the first thing I suggest is that the Western company immediately register its trademarks in China because it is using them already, but without any protection. More than once, one of these Western companies has assured me that everything was fine because their Chinese partner had registered their trademarks, only for us to learn that the Chinese companies had registered the Western company’s trademarks in their own names and not in the names of the Western company. Fortunately, in both instances, the relationship at that point was good enough that (with a bit of cajoling) we were able to get the Chinese company to assign the trademarks to the Western company.

My biggest fear with these partnerships is that when they have become really successful, the Chinese company will either directly or indirectly through the government, simply boot out the Western partner. And when that happens, the Western partner will very likely not have any legal recourse to stop its Chinese partner from taking over the business. I mean, if the Western partner is going to sue its Chinese partner, what will it even say?  “Your honor, I know my business was here in China completely illegally, but that is because starting up a business legally here is just so difficult and expensive, but now that the business is worth millions, it just is not fair for me to get kicked out of it and for my Chinese partner to get the whole thing.”

Good luck with that.

I will note that every single time we have been retained by the Western partner to clean up this sort of situation in China, their Chinese partner insists the whole time that what we are doing is a complete waste of time and money. But what else would you expect them to say?

What are you seeing out there?