This post focuses on the need to get your business scope right when applying to form a China WFOE. registered capital needed to form a China WFOE. This is the fifth post in our series on what it takes to form a WFOE in China. Part 1 set out the questions our China lawyers typically 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. Part 3 was on whether it makes sense to have a Hong Kong entity own your China WFOE (or China Joint Venture). Part 4 was on the steps required to form a China WFOE. Part 5 was on China’s new minimum capital requirements.
The China lawyers at my law firm are always getting contacted by American and European company with big plans for China. These companies have usually spent months researching China for their business and in traveling back and forth to China to scope things out. Now that they have completed their China market research and made their China contacts, they are ready to form their own China company (typically a WFOE) to conduct business in China.
Not so fast.
We then explain to them the various options foreign companies have for going into China — still essentially confined to going it alone as a Wholly Foreign Owned Entity (a/k/a Wholly Owned Foreign Enterprise or WOFE or WFOE), Representative Office (Rep Office) or partnering with a Chinese company in the form of a China Joint Venture (JV).
Then we start talking about what sort of entity makes sense for this particular company. Nine out of ten times, the company wants to go into China on its own as a WFOE and that is where the problem sometimes starts. The company has heard that China is very capitalistic and “wide open” and did not know that is not really the case, particularly as it relates to foreign companies.
China has what is called its “Catalog for the Guidance of Foreign Invested Enterprises.” This catalog, which comes out about once a year, divides foreign investment into “encouraged,” “restricted” and “prohibited” investments. Foreign companies cannot invest in prohibited industries and foreign investment in restricted industries typically requires the foreign company enter into a joint venture with a Chinese company. Industries not classified into any of the three categories are generally assumed to be permitted.
So every once in a while, we have to tell the American or European company that despite all its research it cannot go into China at all or that it can only go into China if and when it finds a Chinese company with which it can joint venture. The moral of the story is that it makes sense to find out whether your proposed company can work in China at all, and to do so before funding market and operations research or China trips. Years ago we had a company that had spent close to a million dollars on market research to determine that there was a strong need for foreign companies offering its service in China. When they told me this, my first thought was, “Yeah, of course there is this need, because foreign companies are not allowed into this industry.” Ten minutes of research confirmed this and when I told this company that what they were proposing was illegal, they went silent for what seemed like five minutes. They never went into China.
But determining what is and is not legal for foreign companies in China is often not as simple as just looking at the catalog and saying yes or no, because a lot depends on how the business is defined when the application is made. The business scope is relevant to the catalog on foreign investment because a business sometimes can fit within one or more categories of the catalog and how you describe your business scope on your WFOE application can make the difference between approval and rejection. You sometimes can massage your business description to obtain more favorable classification. On the flip side, many a company has come to my firm after having provided the wrong business description and then been rejected. If you under or overreach in describing your business scope, you might find yourselves in big trouble. We are getting an increasing number of calls from American companies in trouble with the Chinese government for doing things in their business that were not mentioned in the business scope section of their initial WFOE. Some Chinese cities are making it a point to go after WFOEs with improper scopes and forcing them to form new WFOEs (with new fees) in addition to or instead of their existing WFOEs.
In some of these cases, the foreign companies (American or European) admit to us that they were never “really comfortable” with the business scope they had listed in their applications, but that the company they had used to form their WFOE had “pushed” them into it as it would “make things much easier.” In some cases, the scope of the business changed after the application was submitted and the company had failed to secure approval in advance for the change. And in some cases, the company probably would never have been approved at all had it been upfront and honest in its application. In many instances, these companies had managed to secure local approval but were now in trouble with Beijing, which constantly is auditing these applications. In other cases, the local government had gone back and changed its mind, probably after conducting an audit of its own and often after a new government administration had been installed. Too many of these cases were egregious, like companies that were manufacturing or selling products, but were listed as consulting WFOEs.
Applying for a WFOE in China involves much more than just filling out a form to get approval. It matters for what you get approved and you (or whomever you are using for your WFOE application) need to know China’s foreign investment catalog inside and out before applying. You then must tailor your application to meet both the requirements of the foreign investment catalog AND the reality of what you will be doing in China. A failure to comply on both fronts will lead to, at best, a rejection of your application and, at worst, being shut down months or years later. Our law firm is frequently called to help salvage a WFOE application that is spiraling downward and many times in that situation our advice is to simply start over because there is no salvaging to be had. It is far far better to do things the right way from the get-go, then to have to explain to a Chinese government official why what you initially told them is no longer the case. Say what you will about Chinese bureaucrats (government bureaucrats anywhere in the world for that matter), but flexible is not a word one typically uses to describe them.
Bottom Line: If you take away nothing from this post, please at least understand that your getting local government approval for your WFOE does not mean you are out of the woods. There is little to no benefit in getting approval for a non-conforming WFOE.