One of the first tasks in forming a WFOE in China is to determine what entity will be the shareholder of the WFOE. It is possible for an individual or individuals to own a China WFOE, but for various reasons, our China WFOE formation lawyers nearly always discourage that.
The basic analysis runs as follows:
1. Direct ownership of a WFOE by the foreign operating company parent company is most common for single owner WFOEs.
2. For clients that either do not want their company to be easily identified with the WFOE or for various other reasons do not want their company to own the WFOE, forming or using a Special Purpose Vehicle (SPV) — a separate holding company not directly linked to the main company — is possible.
When considering an SPV for owning a China WFOE, the following considerations can be important:
a. Over the past decade, the Chinese government has become suspicious of SPVs. At one point, it even moved to prohibit SPVs for WFOE formations. However, with the adoption of the new WFOE formation rules in 2017, the Chinese government now permits using SPVs. So current Chinese government rules are neutral on this issue.
b. In the past, one reason investors used an SPV was to hide the true identity of the owners of the WFOE. Under China’s new WFOE formation rules, the investor must provide a complete organizational chart that details ownership of the shareholder(s) and that identifies the actual controlling person. It it therefore impossible to conceal ownership. Accordingly, SPVs are no longer useful to conceal actual ownership from the Chinese government.
c. SPVs continue to be used where there are several investors in the WFOE. Often these investors are resident in different jurisdictions. In that case, it is common to take all these investors into a single SPV. The SPV is then the single shareholder of the WFOE. Issues such as management, distribution of profits and purchase and sale of ownership interests are handled at the SPV level. In many cases, the SPV is formed in a tax haven such as Hong Kong to allow distribution of profits free of tax. These considerations do not apply in a single shareholder setting.
d. In terms of limiting upstream shareholder liability, there is little to no benefit in using an SPV. The WFOE will be a limited liability legal entity. The limitation of liability rules apply in China in somewhat the same way as in the United States, Australia, Canada and the EU (including the UK). The financial liability of the WFOE is limited to the amount of investment. Liability beyond the investment amount generally occurs only in the case of illegal acts. In China this liability would generally be as follows:
- The shareholder will be held liable if it does not contribute required capital to the China WFOE and that failure results in the WFOE not paying its taxes, employee salaries, or in a fraud against creditors.
- A WFOE’s director will be liable for instructing the WFOE to commit an illegal act. Examples of illegal acts are tax fraud or commission of a significant safety violation.
- Directors and the shareholder will be liable if the WFOE terminates business and does not liquidate pursuant to Chinese company law. An improper WFOE shutdown leads to both the investors and the directors being placed on a black list and prohibited from engaging in other investments or business in China. Individual directors should not travel to China since they may be detained. See Shutting Down a China WFOE: Don’t Go There.
The above three basis for liability are all very real, but creating an SPV does not noticeably reduce any of these risks. This is because most of the liability risk falls on the individual directors, not on the shareholder. Second, the Chinese government will use the org chart/actual controlling person information to “pierce the corporate veil” to assign liability to what the Chinese government determines in its own discretion is/are the actual party/parties in interest.
Other basis for liability arising from WFOE operations are so rare that they can in most instances be discounted. On the other hand, the three basis for liability set forth above are common and care must be taken to avoid these sorts of liability situations.
3. There are sometimes tax or other operational or accounting reasons for creating an SPV for China WFOE ownership. In considering whether to do an SPV, a cost-benefit analysis makes sense. Most of our clients find using an SPV to own their China WFOE more trouble than it is worth. However, each situation is different and there are definitely times where SPV ownership of a China WFOE makes good sense.