If I were to list the ten biggest/most common mistakes the China lawyers at my firm see committed by foreign companies doing business in China, not forming a WFOE and forming a WFOE unnecessarily would no doubt both be on that list.
Let me explain….
We have written constantly about the risks of doing business in China without a WFOE. For more on that, check out the following:
- Doing Business in China Without a WFOE: Will the Defendant Please Rise
- Doing Business in China with Deportation or Worse Hanging Over Your Head
Today’s post is going to focus on the mistake of forming a WFOE in China when no such WFOE is actually necessary or advised, an incredibly common and very expensive mistake.
It is expensive and time consuming (usually 3-5 months) for foreign-owned businesses to be formed in China. The following is the most basic list of what you need to do to form a Chinese WFOE and then operate it legally and safely in China:
- Determine whether your business model is legal for a foreign business in China.
- Form and register your WFOE in China. This will typically be a WFOE, a Representative Office, or a Joint Venture.
- Lease property (a prerequisite for the registration process above).
- Draft an employee manual and execute written employment agreements with all of your employees.
- Open a bank account with a Chinese bank.
- Figure out and pay all of your taxes, including company taxes, employee taxes, and social insurance payments for your employees.
It is complicated and expensive to form a WFOE in China and it is complicated and expensive to operate a WFOE in China. Very. To do so in most cities, you need good office space and you need employees and you need to meet with the tax authorities four times a year and you need to calculate and pay all sorts of taxes and….
To make matters even worse, shutting down a WFOE makes forming one seem like a piece of cake. See Closing Down a China WFOE: You Can Run But You Can’t Hide (Part 1) and Closing Down a China WFOE: You Can Run But You Can’t Hide (Part 2). Let’s just say that I once heard a China accountant at a seminar analogize it to a colonoscopy. Not kidding.
Because forming a China WFOE is very expensive, there are scads of companies in every tier 1 or tier 2 China city that exist solely or mostly to form China WFOEs. This means that if you go to one of these companies to form a WFOE the odds of them telling you that you do not need a WFOE are slim to none. The odds of them questioning you on why a WFOE might or might not make sense for you and then analyzing whether it does or does not are about the same.
The result of this is that countless foreign companies go through the pain and expense of forming a WFOE they don’t need, then operating a WFOE they don’t need, and then closing down a WFOE they never needed in the first place. Ugh.
Even worse are the entity formation companies that encourage foreign companies to start with a Representative Office that the foreign company does not need and then a year or two later encourage that foreign company to shut down that Rep Office because a WFOE is now allegedly needed and then charge for shutting down the Representative Office and for forming the new WFOE. This allows the entity formation company to charge for two additional processes that were never needed in the first place — forming and shutting down the Rep Office. Ugh. Note: Rep Offices cannot directly employ anyone nor can they get paid in RMB and just to give you an idea of the utility of China Rep Offices, we have not written about them since 2013!
My law firm and most law firms (both foreign and Chinese) do not play these tricks. What we do before forming any company in China (WFOE or otherwise) is to determine whether any such company makes sense at all. In Forming A China WFOE: The Agony and the Ecstasy, I wrote the following:
At least once a month, one of our China lawyers will get a call from someone asking us to form a “China company” for them before they start doing business in China “next month.” Half the time when we get this sort of call, the better solution is not to form a China entity at all.
That “half the time estimate” is still true but I should also mention that many times when our China lawyers get a call from someone having a problem with their WFOE, additional discussion reveals they should never have formed their WFOE in the first place. Ugh.
Do YOU need a China WFOE? Generally speaking there are two main situations when a China WFOE is legally necessary and a third situation where it can make good sense to have one, even though not legally required.
It is legally necessary to have a China WFOE (or some other legal Chinese entity such as a China Joint Venture) if you will have one or more employees in China. Note that you should assume that anyone you are paying in China as an “independent contractor” is in fact an employee. See Four Common and Dangerous China Employee Hiring Myths, in which Grace Yang, my firm’s lead China employment lawyer, lists “Hiring without a Chinese legal entity (WFOE or Joint Venture) is fine so long as you only bring on independent contractors.” as Myth 1.
It is also legally necessary to have a China WFOE (or some other legal Chinese entity) if you are going to get paid in RMB.
If neither of the above are or will be true for you, you probably do not legally need a WFOE.
There are though many instances where a WFOE is not legally required yet forming and having one still makes sense. If you sell products or services to universities, banks, hospitals, governmental bodies, SOEs or Chinese businesses with any sort of governmental ownership it might make sense for you to have a WFOE, even if you are not legally required to do so. These sorts of businesses are often pressured by the Chinese government to buy from Chinese entities and if you don’t have a WFOE your sales could be way less or non-existent. We also have seen instances where having a WFOE is worth the money and pain because it increases sales by convincing Chinese buyers that you are in China to stay and that there will be someone local to whom they can go if ever they have problems.
But just to complicate things even more, our China lawyers often see instances where a foreign company formed a China WFOE to hire employees in China and/or to get paid in RMB in China and yet would have been better off without having done so. These are cases where the foreign company did not realize that it had better options for accomplishing its China goals without need for a China WFOE. The following are the two most common examples we see of this:
1. Foreign company forms a WFOE in China to sell its widgets. Foreign company hires two employees in Shanghai to do this after having been convinced that it needs a WFOE because it will have employees in China and because it will be getting paid for its widgets in RMB. In Want Your Product In China? Try Using A Local Distributor, an article I wrote for Forbes Magazine, I emphasized the benefits of selling widgets to China through a distributer, rather than going it alone:
Joint ventures are notoriously risky, while a WFOE can take three to five months to form, leaving you with a company in China to operate (that includes bookkeeping, hiring employees, etc.).
But there’s actually an easier option. Companies can enter into a distributorship relationship with a Chinese company (or companies).
Use a Chinese distributor
From a business perspective, taking most products into China (be they industrial or consumer) is a massive task for any foreign company. China is a big and diverse country and it should be viewed as many markets, not just one. Using an experienced Chinese distributor is oftentimes the best way for to sell your product in China.
And from a a strictly legal perspective, distribution (and reseller) relationships between foreign and Chinese companies are fairly straightforward.
Distribution contracts with Chinese companies can have much in common with U.S. distribution agreements, but they also almost always also have stark and important differences.
Licensing your brand name and/or your technology is another excellent (and far less risky) way to profit from China without setting up and operating a WFOE there. See China Technology and Trademark Licensing Agreements: The Extreme Basics.
2. Foreign company forms a WFOE to hire one or two people to handle its China quality control. There are many very good and very inexpensive QC companies in China and oftentimes that is a better way to go. And here’s the thing. Oftentimes if you want a QC person in each of the two or three cities in which you are having your products made, you need to form a separate WFOE (or at least a branch office) to be able to legally hire employees in all of those cities and then deal with China’s highly localized employment laws.
Bottom Line: Forming and operating a WFOE in China is difficult and expensive and you likely have all sorts of other options. It would behoove you to explore those options before you form your WFOE.