This is the third in our series on what it takes to form a WFOE in China. Part 1 was on the questions our China lawyers ask our clients for whom we are forming a China WFOE. Part 2 was on the issues our China lawyers confront in determining whether a China WFOE makes sense for our clients at all. Today’s post is on whether or not it makes sense to have a Hong Kong entity own your China WFOE (or China Joint Venture). Future posts will delve deeper into the nuts and bolts of what it takes to form a WFOE in China and why they have become of such importance as China’s economy slows.
When making a WFOE (Wholly Foreign Owned Enterprise) or JV (Joint Venture) investment in China, an investor must consider who or what will be the shareholder(s) in the PRC entity? Will the investor invest directly, or will the investor create a special purpose subsidiary company (an SPV or Special Purpose Vehicle/a/k/a SPE or Special Purpose Entity) to act as the WFOE shareholder. If the investor chooses to use an SPV where will it be formed? In the U.S.? In a generally recognized tax haven such as the British Virgin Islands or the Cayman Islands? Or in Hong Kong in accordance with the favorable PRC/Hong Kong tax treaty?
It is relatively easy to prove the existence and organizational structure of a Hong Kong company. The process is straightforward and the Chinese investment authorities understand the documents and readily accept them. This is not necessarily true for corporate documents from other countries. The Chinese authorities want documents that are similar to their own and they oftentimes have trouble understanding foreign company systems and are known to challenge perfectly standard documents from foreign jurisdictions that do not accord with the way they think the world should work. For example, the Chinese authorities will often demand notarized documents. When the notary is from a common law jurisdiction like the United States or England, they will object to the form of the notarization because it does not look like a Chinese or civil law country notarization.
From a tax standpoint, the decision is complex and requires careful analysis by the primary investor. Ignoring the tax issue, however, from the standpoint of company formation, the use of a Hong Kong entity offers the advantage that it solves some of the technical problems in forming a WFOE or JV in China.
In other cases, we have had Chinese authorities object to United States limited liability company documents because the officers’ titles do not match the equivalent terms in Chinese. For example, in most U.S. jurisdictions, a limited liability company (LLC) does not have directors and officers. Instead, the LLC is either member managed or manager managed. We have had Chinese authorities object to both forms of management because they do not understand the U.S. system. Of course, the issues can be even worse when the investor company is based in a system even more different from China, such as the Middle East, Central Europe or Africa. In these instances we have to draft (in Chinese) memoranda explaining the foreign corporate system to the Chinese authorities. We have never failed to get a WFOE approved because of something like this, but this can lead to a 2-3 week delay.
These sorts of problems are typically solved if the foreign investor sets up a Hong Kong company as the shareholder of the Chinese WFOE or Joint Venture. For this reason, many of our clients form a Hong Kong company as the first step in their China company formation process.
However, there are several important issues that must be considered before making the final decision regarding whether or not to form a Hong Kong company to own your China WFOE or China JV, including the following:
1. The use of an SPV sometimes prohibited by Chinese law. For a number of service sector investments, the investor must prove that the foreign shareholder has been in operation for a certain number of years. In other cases, the foreign investor must prove that it has had a certain business income for a specific period or that its capitalization meets a certain standard. Where this type of requirement exists, the standard is applied to the direct shareholder in the Chinese company. That is, it is not acceptable to say that the ultimate parent company meets the requirement. For this reason, many investors in China are required to make the investment directly and not through a SPV or other subsidiary.
2. Though establishing a Hong Kong company is relatively fast, cheap, and easy, creating a bank account in Hong Kong is not. To form a Chinese WFOE or Chinese JV with a Hong Kong entity as its owner, the Chinese authorities require that the Hong Kong entity have a Hong Kong bank account and they also require a letter from the Hong Kong bank stating the details of the account formation. Under Hong Kong banking and anti-money laundering rules, a bank account in Hong Kong can only be opened by a person who is personally present at the bank in Hong Kong. And not just anyone can go to Hong Kong to open this account; this person must be the person who exercises actual control over the Hong Kong company.
For many Hong Kong companies, the shareholder will set up the Hong Kong company so that the chairman of the board is a high ranking officer in the corporate parent. For company formation purposes, this is is easily done since for company formation, only the signature of that officer is required. This then backfires when it is time to open the company bank account in Hong Kong because now the chairman must be physically present in Hong Kong and able to prove his or her identity using documentation that cannot be determined precisely without consultation with the bank. It is not acceptable for the chairman to designate another person such as a lower level staff person or a lawyer to act on his or her behalf. Only the chairman or similar officer of the Hong Kong company can act.
In our experience, it is the rare chairman of the investor company with the time or the desire to travel to Hong Kong just to open a bank account. However, no one else will be permitted to open the account and without a funded Hong Kong bank account, it is not possible to form a China WFOE or JV. For this reason, if you will be using an HK company to own your China WFOE, you should consider in advance how and when you will be opening the HK company bank account.
And then there are the tax issues….