China WFOE formation and business scopeWhen it comes to company formations, China is from Mars and the Western world is from Venus. For most things related to doing business in China, I often stress the similarities. But when it comes to forming a China Wholly Foreign Owned Enterprises (WFOE) I make it a point to stress the differences. I do this early by stressing how when all is said and done, forming a WFOE in China typically costs more than ten times what it costs to form an LLC or a corporation in the United States or in Europe and usually takes at least ten times longer as well.

I then joke how our domestic business lawyers in Spain and in the United States barely care what they charge for forming companies in those two countries because their overriding goal is to bring in a client for life and then help the client with everything that comes after — on things like contract law work, intellectual property law work, tax law work, real estate law work, employment law work, immigration law work, and more so lately, even international trade law work. Forming corporations and LLCs is essentially a loss leader, made up for later with an onslaught of work typically needed once the company is up and running. Then I half-joke about how forming a WFOE in China is so miserable that by the time our lawyers finish that task “you will be so sick of us, you will never want to use our China lawyers ever again.” I then mention that you very well may not even need to do so.

Why so different? Very briefly, in the United States and to a certain extent in Spain as well, registering and establishing the corporate entity is relatively fast and easy; most of what is difficult comes later. In China though, registering and establishing an entity like a WFOE for the most part cannot be accomplished without doing the hard slog work first.

I will over the next few weeks write more about what must be done to form a China WFOE and why doing so is so difficult and time consuming and different from forming a company in the West. Today though, I will focus on the business scope of the WFOE you will be forming.

What exactly is business scope? Think of it as what your company will be legally allowed to do. When it comes to forming a company in Spain or in the United States, scope is more of an afterthought than anything else. Guess what. This is absolutely not true of China. In the United States, if you want to form a company that will sell men’s clothing at the front of the store and have a cafe at the back, you might list your scope in one of the following two ways:

  • Sell clothing and operate a cafe and engage in any other lawfully permitted business activities.
  • Engage in lawfully permitted business activities.

The shorter and broader type statement (the second one) would be more commonly used.

But like I said, in China how you would list your business scope is very different. Let’s take the clothing store with a cafe in the back. You might list the scope for that as follows:

  • Operate a retail business.
  • Operate a retail clothing business with a cafe.

But get this. Depending on the Chinese city (or even the district within that city) in which you are seeking to form your clothing-cafe WFOE, there is a very good chance your WFOE application will be denied for being too broad. When listing business scope for a China WFOE registration, you usually must describe the scope precisely and in a fair amount of detail. After you do that, Ministry of Commerce (MOFCOM) and the Administration of Industry and Commerce (AIC) will almost certainly review every word of your proposed scope to determine if what you are proposing your WFOE will do in China is even allowed to be done by a WFOE (as opposed to by a Chinese domestic company or by no private entity at all.

The Chinese Commerce authorities will also review your WFOE’s business scope to determine whether it can all be done within one WFOE or whether two or more WFOEs will be required. Take the clothing-cafe business. It’s impossible to know what every district in every city in China would do with that sort of scope, but I would say the odds are good that you will need to form two WFOEs to both sell clothes and coffee and baked goods.

It is important you get your business scope right the first time. If you get it wrong, in most places of China, this will mean you will need to negotiate a new scope with the Chinese authorities. But in some places, you are at risk of your WFOE being denied and your having to start all over on your WFOE formation. I repeat: it is important you get your business scope right the first time.

Choosing the correct scope of your China WFOE is also critical for avoiding problems months and even years after your WFOE has been formed. Although it’s not common for Chinese authorities to censure an organization for periodically stepping outside the bounds of its officially authorized business activities to engage in auxiliary activities, the ability to issue tax invoices to its partners for the specific services rendered is very important. These clients or customers will normally insist upon a specific invoice based on a certain value-added tax (VAT) rate for use as a tax offset or deduction, and it would not be unusual for them to refuse to make payment for services rendered if the appropriate invoice cannot be issued. Therefore, because a VAT invoice cannot be issued at the relevant tax rate for activities not specified in the business scope, it is critically important to negotiate approval of a sufficiently broad and relevant business scope with careful consideration from the beginning of one’s anticipated scope of business activities and client’s and customer’s required invoicing.

 

I then explain the various options foreign companies have for going into China — still essentially confined to going it alone as a Wholly Foreign Owned Entity (WFOE, a/k/a Wholly Owned Foreign Entity or Enterprise or WOFE), Representative Office (Rep Office) or partnering with a Chinese company in the form of a 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 it calls its “Catalog for the Guidance of Foreign Invested Enterprises.” This catalog 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 joint venture with a Chinese company. Industries that are not classified into any of the three categories are generally assumed to be permitted.

So every once in a while, I have to inform the American or European company that it simply cannot go into China at all or that it can only do so if and when it has found 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.

But this research is oftentimes not so simple and that is 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 the description of your business scope to obtain more favorable classification.

BUT — and this is why I am writing this post now — if you under or overreach on the description of 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.

In some cases, the companies have admitted to us that they were never “really comfortable” with the business scope mentioned 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 nearly all instances, the companies had managed to secure local approval but were now in trouble with Beijing, which constantly is auditing these applications. In one instance, the local government went back and changed its mind, probably after conducting an audit of its own.

I cannot go into any more detail on these matters, but I can give this advice: applying for a WFOE in China involves a heck of a lot more than just filling out a form and getting approval. It does matter 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.

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.
Corporate Business Scope

 

Funding and Registered Capital

Although China has moved to eliminate the requirement of a minimum capital injection (aka, “Registered Capital”) as a condition for incorporating a WFOE, the reality remains that each application for incorporation will be reviewed on a case-by-case basis and Chinese authorities at MOFCOM will typically require a minimum commitment of between RMB 200k to RMB 500k for a basic consulting WFOE (A manufacturing WFOE would normally be required to inject considerably more Registered Capital). They will review a “feasibility study report” submitted as part of the incorporation application (a projection of expected expenses and profits for the first three years of the WFOE’s life) and use it as a rough guide to set the minimum Registered Capital. Once injected, the Registered Capital monies will remain available to fund the activities of the WFOE until it achieves self-sustainability – or the Registered Capital would need to be increased.

There is no such thing in China as a shell holding company. All WFOEs are expected to achieve sustainability, and, if they do not, then they may be subject to undesirable scrutiny by Chinese tax and regulatory officials.

For these reasons, it is important to plan the funding and sustainability of the WFOE from the moment of incorporation until profitability and to set its Registered Capital accordingly. Investors need to strike a balance between infusing the WFOE with sufficient capital to fund its initial growth but not with so much that the capital sits idle and does not earn a return, trapped in the foreign currency account of the WFOE. Investors from foreign jurisdictions might speculate the funds could merely be returned to the foreign shareholders if not needed, but reversing and returning Registered Capital from China should be regarded as effectively impossible from a practical point of view. Therefore, investors should thoughtfully consider how much Registered Capital would be needed to achieve sustainability.

For those investors that do not anticipate achieving profitability and expect on-going operational costs for those investors whose WFOE unexpectedly fails to achieve its objectives, recourses may be given to alternative funding mechanisms. Of course, one option is to increase the official Registered Capital of the WFOE and inject additional capital. This is a tax-free transaction, and therefore highly efficient from a tax point of view. However, the challenge presented is that such a method would require that the business license be amended to reflect the increased Registered Capital, then the monies injected. This is a time-consuming and slow process, as it would require investors to resubmit their business plan and “feasibility study” to MOFCOM for approval. The business license itself would need to be reissued and a number of formal governmental registrations updated, and the WFOE may have consumed all remaining cash.

Related Link IconRELATED: Changing the Registered Capital of a Company in China

Consequently, another funding mechanism often resorted to is a related-party transaction between the parent shareholder and WFOE, whereby “consulting services” are provided to the parent under the terms of the consulting agreement in return for payments that fund the WFOE’s operations. Because this is a “current account” transaction, it can be completed rapidly despite China’s foreign exchange and capital account restrictions. The downside is that it is a taxable transaction subject to VAT of at least six percent – the VAT rate for “modern services” such as consulting – and will also be subject to corporation income tax. The transactional fees and VAT and corporate income tax would need to be anticipated and budgeted were a WFOE to be funded with this alternative funding mechanism. Despite the “dodgy” sounding nature of the transaction, it is a common means for WFOEs to receive funding if investors do not wish to repeatedly increase the Registered Capital. Many such WFOEs were originally intended to be cost centers that would not generate adequate revenue, if any, to be self-sustainable.

Since China effectively disallows the establishment of foreign not-for-profit organizations, many of those that choose to conduct operations in China establish themselves as WFOEs (for-profit enterprises) and often resort to such a funding mechanism to maintain sufficient cash flow for operations.

– See more at: http://www.china-briefing.com/news/2016/01/15/strategic-considerations-when-establishing-a-wfoe-in-china-part-1-business-scope-and-registered-capital.html#sthash.Y8PgnRRX.dpuf