I am going to be speaking at USC this weekend and in poring over old PowerPoints (to create a new PowerPoint for my talk), I came across one with a fairly extensive China law bibliography of some of our most helpful posts.  This bibliography is definitely slanted towards the legal issues that confront foreign companies doing business in China.

Here it is:

CHINA CONTRACTS

CHINA LICENSING AGREEMENTS/CHINA DISTRIBUTOR AGREEMENTS/CUSTOMS

CHINA COMPANY FORMATION/CHINA WFOE FORMATION/CHINA JOINT VENTURES

NEGOTIATING WITH CHINA

CHINA —INTELLECTUAL PROPERTY

Twice in the last couple of months while working on registering WFOEs for clients, clients have come to us and asked our thoughts about switching their WFOE formation cities.  In both cases, their basis for questioning came from having heard that some nearby city was easier for a China WFOE formation and had better labor laws.  Our response in both cases was essentially as follows:

City A (the city for which we have already undertaken company formation work) is not known for being one of the easiest places in China to register a WFOE, but it it also is not known for being one of the toughest either.  We have registered a number of WFOEs there without any major problems.  Might it take a few weeks or even a month longer to register your company in City A than in City B (the newly proposed city)?  Yes, it might.  Then again, it very well might not.
I am not aware of the labor law being any tougher in City A than in City B, though City A does have a higher minimum wage and I believe that its various employer taxes are a bit higher as well. But unless you are planning to hire a number of employees at the minimum wage (which you are not) then this probably isn’t much of a factor for you.

This person telling you that you can set the company up in City B and have operations in City A is correct, but it will not be nearly as easy as he is making it out to be in that to do this you will almost certainly need to set up a branch office in City A to do so.  Also, if your operations are in City A and your employees are in City A, you will be bound by City A’s labor laws in any event.  You will always be better off forming your China company in the city where you will be conducting your proposed operations. What is being proposed  is a type of “virtual office” arrangement, which is almost never a good idea for China. Even in the unlikely event you save some time in company formation, the problems that would follow later would far outweigh any time benefit in the formation process.

If you would like we would be happy to do a comparison between City A and City B in terms of their labor laws and their employer taxes, but those will still be only one of many factors that you should consider in terms of where to locate.  Or do you have other reasons to favor City B over City A?
As you have probably guessed by now, the point of this post is that rarely should one choose their WFOE location based on legal considerations.  There is though one glaring exception to this “rule”: trading companies, as not all cities/provinces allow those.

Around 25% of my law firm’s China legal work is done with US or European attorneys, and a good chunk of that work is helping them help their own clients form a Wholly Foreign Owned Entity (WFOE) in China. The law firms that retain us do not have their own lawyers in China but because the China work they are doing for their clients is just one part of their work for that client, quite logically, they want to coordinate that work with whichever China lawyers they retain.

We recently took on three new WFOE formation matters for US lawyers. Two of these matters are for lawyers working on behalf of their clients and one is for a lawyer who owns the (non-law related) business. All three of these lawyers told me they had spoken with company formation firms and had grown frustrated with the information they were being given.  They relayed that these firms were not giving clear answers to many of their questions, but were instead responding by saying China WFOE laws were “vague” and/or “ever changing.”

What these company formation firms are saying is just not correct.

Chinese law on WFOE formations is actually quite clear and I suspect these company formation firms were claiming otherwise only because the laws are vague to them. Near as I can tell, these company formation firms typically consist of a foreign voice or two (oftentimes in Hong Kong) who takes in the work and then farms it out to a Chinese law firm in a low cost city to do the work. The people on the phone or at the other end of the e-mail at these firms have never read China’s laws on WFOE formation and so, not unexpectedly, those laws are vague to them.

As for “ever changing,” on January 1, 2006, there was a sea change in China company formation laws for foreign companies, but they have remained static since then.

By far the biggest source of confusion/frustration for these US and European attorneys seeking information on forming a China WFOE is the minimum registered capital requirement.

The law on minimum registered capital is clear, but the amount of capital that will be required does vary, depending mostly on the nature of the business of the company to be formed and on the city in which it is going to be registered.

Every company in China must have a stated registered capital. The registered capital includes all of the components of the initial investment in the company, including its start up cash, contributed property, and transferred intellectual property.

Where the registered capital is small, the entire amount must be contributed immediately upon formation of the company. If the amount is large, it may be contributed in installments. There are a number of schedules for the percentage and timing of large amounts of registered capital.

It is a crime to state a registered capital amount and then fail to contribute. It is also a crime to withdraw registered capital after it has been contributed.

The purpose of registered capital is to provide some notice to creditors of the capital adequacy of the company. Because of this, Chinese regulators take very seriously the rules regarding registered capital.

Registered capital is an initial investment that is intended to be immediately used in the operation of the company. It is not a deposit that must just sit in a bank and never be touched. It can be used to pay salaries and rent, to purchase product, or for any other normal start up operating expense. Registered capital may include contributed real and personal property used in operating the business. Many foreign investors think registered capital is some sort of security deposit that they can never utilize. This is not true.

On the other hand, some foreign enterprises believe they can simply withdraw their registered capital to their home country after the Chinese company begins normal business operations. This also is not true. The only way to get funds from the Chinese company out of China is by repatriating profits or by liquidating the Chinese company. Both of these methods will work, but they both require paying Chinese taxes and meeting other requirements under Chinese law.

Investors should also note that the RMB is not a freely convertible currency. For companies that will earn RMB income, the issue of conversion to U.S. dollars or other foreign currency should be carefully considered.

Chinese law is quite clear regarding minimum capital requirements for a WFOE but the statute’s prescriptions on this are essentially meaningless in actual practice. Under Chinese Company Law, the minimum capital requirement is either 30,000 RMB (less than $4,000 US) or 100,000 RMB (a bit over $12,000 US) depending on whether it is a multiple or single shareholder company. However, these numbers have no real meaning for forming a WFOE in China.

The real question is what the Chinese authorities will consider as adequate capitalization for the specific project and that always depends on the type of business and its location. For example, it is very expensive to operate a business in Shanghai. On the other hand, it can be very inexpensive to operate the same business in a rural part of China. It is expensive to operate a capital intensive business like manufacturing, but relatively inexpensive to operate a knowledge based consulting business. Finally, some Chinese cities just seem to want WFOEs more than others.

The Chinese regulators usually consider all of these issues. To complicate matters, each local regulator has its own basic standards on what constitutes adequate capital for certain types of business activities. These numbers are not published, but when asked they will almost always be provided. They can only be determined through direct contact with the regulator but only after providing a clear explanation of the project.

The local regulator virtually never considers the statutory minimum in making a determination regarding adequacy of capital. Rather, the local regulator will determine what it believes is an adequate amount of capital based on all the circumstances. Once the investor has a clear idea of the outlines of a project, it is usually a good idea to engage a China attorney to contact the local regulator to see what their response will be to the proposed amount of investment. This initial screening can save a lot of time if the investor’s idea of the proper amount of capitalization is dramatically different from that of the local regulator.

My firm’s China attorneys always go to the local regulators to get this amount before we get very far along in the application process. Almost without exception, our experience has been that after we explain the nature of our client’s business to the regulator, the regulator’s decision on the minimum capital required has been a very workable one for our clients.

In determining what constitutes adequate capital, one needs to consider the peculiar situation in China that all rents are paid in advance, that payment for products for sale are usually paid in advance, and that a reasonable advance reserve for salaries is also required. Thus, the initial start up cost is going to be higher than for a comparable company in the United States, where credit and time payments are much more common. Chinese regulators will not approve a project that looks risky or under-funded.

Are we clear?

In Part IV of this series, we talked about the growth in foreign service businesses in China and their continued opportunities. In Part V, I talked about the legal framework of foreign service businesses in China. This Part VI post is on forming a Chinese entity for a foreign service business. Part VII will very briefly address other legal issues typically faced by foreign service businesses in China and Part VIII will be a case study of a foreign service business (academic editing) in Beijing.

Foreign invested service businesses are formed according to the rules for formation of all foreign businesses in China. There are no special forms of business unique to service businesses. A 100% foreign owned service business will be formed as a wholly foreign owned enterprise (WFOE). Where the foreign service business is formed together with a Chinese partner, the business will be formed as an equity joint venture (JV). Both WFOE and JV entities are formed as limited liability companies under Chinese law. Such companies are Chinese citizens, and are subject to Chinese law regulatory and tax provisions. As foreign invested enterprises doing business in China, such businesses are eligible for tax and other benefits granted to foreign invested enterprises under Chinese national and local law.

Where a domestic partner is required by the regulations, a JV is the only choice. Where not required, the foreign investor has the option to form a WFOE or a JV. Given the choice, most foreign investors in the service fields choose to operate as a WFOE and when they find it necessary to work with a Chinese partner, they do so through a contractual arrangement. Such contractual cooperation is more flexible than the equity arrangement required by a formal JV.

Though formation of service industry businesses follow the normal procedure of foreign invested companies in China, there are some issues that often arise and should be taken into account in the company formation process:

  • By their nature, service industry businesses do not usually involve a large capital investment. Chinese officials in the foreign investment area, however, are rated and promoted based on the gross dollar volume of investment they bring to their region.  Since service businesses are not capital intensive, this means that even where the regulations provide that the business is encouraged, the reality on the ground is that local officials will tend to give lower priority to such investments. This can result in delays in approval and a lack of flexibility on the part of the local official charged with approval authority.
  • As part of the approval process, the local authorities have the power to require a certain minimum investment (registered capital) for businesses they approve. In many regions, the minimum capital required for small service businesses is often higher than such businesses require to operate effectively. This artificially high minimum capital requirement can be a barrier to smaller service businesses that simply do not require a large amount of capital to start operations. This requirement for a large minimum capitalization is most likely to be encountered in the major, first tier cities. The minimum capitalization in these cities is usually well established and should be determined before deciding whether to form a service business in any particular location.
  • The opening of the service sector has been dramatic and reverses many years of prior Chinese practice. Large cities such as Shanghai, Shenzhen, and Beijing understand the change and do not pose a problem. However, in second tier and smaller cities, the local officials occasionally have not fully understood the changes in policy. In these areas, the local officials may oppose registration of a service business that is clearly acceptable under the regulations. It is usually possible to determine whether such problems will arise by consulting with the local authorities in advance.

Bottom Line: It is usually essential to communicate with the key local officials; just thrusting a completed company formation application into some clerk’s hands usually does not presage success.

By: Steve Dickinson

Yesterday, in a post called Chinese Company Formation — Forming a Wholly Foreign Owned Entity (WFOE) in China, I discussed the basic requirements for forming a wholly foreign owned entity (WFOE) in China.  One of the questions I am asked most frequently about forming a WFOE in China is how much the Chinese government requires in minimum capital.  This post follows up on yesterday’s post by addressing the minimum capital requirements issue.

Every company in China must have a stated registered capital. This amount is provided in the Articles of Association of the company and is also noted on the company register. The registered capital includes all of the components of the initial investment in the company, including its start up cash, contributed property, and transferred intellectual property. Where the registered capital is small, the entire amount must be contributed immediately upon formation of the company. A certified public accountant must be engaged to provide certification of the contribution of registered capital. If the amount is large, it may be contributed in installments. There are a number of schedules for the percentage and timing of large amounts of registered capital. It is a crime to state a registered capital amount and then fail to contribute. The purpose of registered capital is to provide some notice to creditors of the capital adequacy of the company. Because of this, Chinese regulators take very seriously the rules regarding registered capital.

Registered capital is an initial investment that is intended to be immediately used in the operation of the company. It is not a deposit that must just sit in a bank and never be touched. It can be used to pay salaries and rent, to purchase product, or for any other normal start up operating expense. Registered capital may include contributed real and personal property used in operating the business. Many foreign investors think registered capital is some sort of security deposit that they can never utilize. This is not true. On the other hand, some foreign enterprises believe they can simply withdraw their registered capital after the Chinese company begins normal business operations. This also is not true. Once the capital is contributed to the Chinese company, it can never be withdrawn. The only way to get funds from the Chinese company out of China is by repatriating profits or by liquidating the Chinese company. Both of these methods will work, but they both require paying Chinese taxes and meeting other requirements under Chinese law. Investors should also note that the RMB is not a freely convertible currency. For companies that will earn RMB income, the issue of conversion to U.S. dollars or other foreign currency should be carefully considered.

We are frequently asked about the legal minimum capital requirement for a WFOE. The answer to this question is clear as a matter of law, but this answer is essentially meaningless in actual practice. Under the new Chinese Company Law, the minimum capital requirement for multiple shareholder companies has been reduced to 30,000 RMB (less than $4,000 US). For single shareholder companies, the amount is 100,000 RMB (a bit over $12,000 US). However, these numbers have no real meaning for the formation of a WFOE in China.

The real question is what the Chinese authorities will consider as adequate capitalization for the specific project. Of course, that answer varies by type of business and location. For example, it is very expensive to operate a business in Shanghai. On the other hand, it can be very inexpensive to operate the same business in a rural area of China. It is expensive to operate a capital intensive business like manufacturing, but relatively inexpensive to operate a knowledge based consulting business.

The Chinese regulators usually consider all of these issues. To complicate matters, each local regulator has its own basic standards on what constitutes adequate capital for certain types of business activities. These numbers are not published, but when asked they will almost always be provided. They can only be determined through direct contact with the regulator and only after providing a clear explanation of the project. The local regulator virtually never considers the statutory minimum in making a determination regarding adequacy of capital. Rather, the local regulator will determine what it believes is an adequate amount of capital based on all of the circumstances. Once the investor has a clear idea of the outlines of a project, it is usually a good idea to engage an attorney to contact the local regulator to see what the regulator’s response will be to the proposed amount of investment. This initial screening can save a lot of time if the investor’s idea of the proper amount of capitalization is dramatically different from that of the local regulator.

In determining what constitutes adequate capital, one needs to consider the peculiar situation in China that rents are typically paid in advance, that payment for products for sale are typically paid in advance, and that a reasonable advance reserve for salaries is also required. Thus, the initial start up cost is much higher than in a location like the United States, where credit and time payments are more common. In addition, the foreign investor should account for the risk aversion of the Chinese regulator. The Chinese regulator will not approve a project that looks risky or under-funded. The regulator has no incentive to do this, especially for a 100% foreign owned entity.