One of the things we are always preaching on this blog is the need to first ask whether what you are proposing to do in China is legal or not. I am always telling of how a company once contacted us, bragging about the huge amount it had spent on market research and proudly proclaiming it to have revealed a “huge need” for a Western company in a particular industry.  My knee-jerk response to which was that I did not even realize that foreign companies were now allowed in that industry.   Ten minutes of research soon revealed that they were not and this company ended up never going into China, wasting the money it had spent to prove it would have done well there.

We were recently contacted by a very much on the ball investement research company regarding the legality of setting up shop in China as a Wholly Foreign Owned Entity (WFOE). We did some quick research (so quick, in fact, that we did not even charge for it) and our initial response was as follows:

 The most recent version of China’s Catalogue of Foreign Investment provides the following:

Restricted Industry:

Article 9.3: Market Research (restricted to joint ventures)

Prohibited Industry:

Article 6: Social Survey

We view this as meaning that foreign companies cannot engage in company research as a WFOE. However, many companies do it by creating a service WFOE stating that it will assist foreign investors in investing in China. Then what they really do is market research. As long as you do get caught, it does not matter. If you do get caught, the risk of any real problem is pretty low. Unless that is that you say something in your research that offends the wrong person.

We actually have represented a number of market research firms operating in China as WFOEs.  Heck, we have represented some of them on contracts with large Chinese SOEs and with large multinationals.  But these companies mostly interview 3,000 people about their thinking on handbags; they are not doing in-depth research on Chinese publicly traded companies, which spin-off massive amounts of money to important people.

So here are some of your options:

1.   Do a “consulting” or a service WFOE and run the risk.

2.   Do it as a Joint Venture.  Find someone in China to do this with and set it up so that you effectively control it.

3.  Operate from Hong Kong and fly people in.

The company chose to wait.

Every few months we get a call from someone wanting to shut down their China WOFE (Wholly Owned Foreign Entity a/k/a WFOE or Wholly Foreign Owned Enterprise). Interestingly, these calls usually come from companies who have been in China for a long time (average time, maybe ten years). Their reasons for seeking to leave China are all over the map but usually involve a decision relating to their China operations lack of profitability or lack of cost-effectiveness. Surprisingly often, they say that they might return to China in three to five years. And that is the problem.

If both you (and I will define that later in this post) and your company will never ever again be returning to China AND if both you and every other foreigner in your company will never again be returning to China, closing down is easy. Essentially, just close down.

A friend of mine who does business in China found himself not being allowed to go out of the country because of a lawsuit filed against him by a Chinese company. They are saying that he owes them money while all the while they have been cheating him (cutting corners on products, using low quality materials instead of the good quality materials agreed upon, late shipments which causes cancellation of orders). He was not notified beforehand of this lawsuit against him before he came and only found out about it when he
was about to return home and was stopped at the border crossing. Is there a way he can be allowed to leave China while the case is pending?

We have written about this same thing numerous other times:

If you have any foreigners in China and you want to shut down your business, either get all of those foreigners out and have them never again return, or shut down your business correctly.

How then does one shut down a Chinese business correctly?

There are essentially three ways.

1.  Formally dissolving the company.  This is done by paying all existing debts, including especially all debts to employees and to the government. Doing this correctly (and complying with China’s myriad labor laws) involves going through a long drawn out government audit and typically takes at least a year and is far more complicated and time consuming than you would think. The advantage to shutting down this way, however, is that in the end you satisfy the government and both your company and its employees could return to China the next day (or whenever) and legally open a new business. Without a formal dissolution, there is a good chance that neither your company, nor any of its employees of whom the Chinese government is aware, will be able to return to China problem-free.

2.  Filing for bankruptcy liquidation. if your company does not have the funds/assets to pay its debts, it may liquidate under China’s bankruptcy laws. We have many times looked at this option for our clients and many times we have been of the view that this option would have been a legally viable one. However, none of our clients have yet to pursue this option because in every instance it was determined that it would be cheaper and easier to go through a formal dissolution per the above. I am not even aware of a foreign owned Chinese company that has pursued bankruptcy in China. Are you?  

3.  An informal petering out.  Due to the time and costs involved in the two scenarios mapped out above, we have “created” a third option for our clients. This option makes the most sense for those companies that really do think they will be back in China within the next few years. This option involves the compamy doing the following, at minimum:

  1. Terminating all Chinese employees with an agreed upon severance package and a signed release of any and all claims they might have against the company. It is critical that this be done pursuant to China’s labor laws.
  2. Either buying out any lease(s) or letting any existing lease(s) expire. We have generally found that Chinese landlords are not terribly willing to give decent discounts for one time lease termination payments. 
  3. Paying all government taxes, pensions, etc. and remaining current on the same.

After completing the above, the WOFE still exists, but is essentially dormant. At this point, it must still pay its taxes (which should be minimal) and still comply with any and all government reporting requirements.This is at best a temporary solution because doing this does not stop the cost meter from running entirely and there will almost certainly come a point where the government will either start imputing higher taxes or demand a formal shutdown. The biggest benefit of this method is that it is fairly cheap and if you really are uncertain as to whether to stay or go, it will buy you time while at the same time, clearing off your books so that any subsequent formal shutdown ought to go just a bit quicker and easier. The beauty of this option is that if you do eventually decide to revive your China operations, there is already an existing company in place by which to do so.

What do you think?

I have always had trouble getting my head around the fact that to secure approval of a Wholly Foreign Owned Enterprise (WFOE or WOFE) in China, the WFOE must first lease appropriate space. But how can a yet to exist entity do anything, much less lease space?

In my email box this morning was an e-mail from co-blogger Steve Dickinson to a client in the process of forming a China WFOE that explains how. To set the scene a bit more, Steve was responding to a client who had just sent Steve a copy of its proposed lease:

This is a set of standard lease documents for leasing to a Chinese entity or to an already existing WFOE. The lease document makes no provision for dealing with the situation of leasing to an entity in preparation for formation of a WFOE. In fact, the lease document requires you to provide a business license before you execute the lease. Obviously, you cannot do that since your WFOE does not yet even exist.

You should contact the landlord and ensure that the landlord understands your exact situation. If the landlord understands and agrees that it understands and will cooperate, then we can add the language necessary for the lease to be acceptable for WFOE formation purposes. The landlord should be aware that the lease will initially be in the name of the WFOE shareholder and then will be transferred to the WFOE upon successful formation of the WFOE. The landlord must agree to that transfer in advance and must agree to cooperate fully in the WFOE formation process. In addition, the landlord must warrant that the premises can be approved for the use to which you intend to make of the premises and that the lease will be registered with the applicable government real estate administration in _______. Of course, this means that the landlord will need to make all tax payments and provide tax receipts to you as the tenant. Note that the lease cannot be entered into until you know the identity of the shareholder of the WFOE.

Please discuss this with the landlord and then advise on how you wish to proceed.

I like this explanation.

The following is an amalgamation of a number (maybe 5 or 6) of conversations I have had over the years with people wanting to register a WFOE (Wholly Foreign Owned Entity) in China fast:

Potential Client: Can you help me register a WFOE in China.

Me: Yes. Not a problem. Do you have a lease yet? Do you know that a legitimate lease is required for the approval of a WFOE?

Potential Client: I know that but we are in a real hurry here.

Me:  Okay. But do you have a lease.

Potential Client: We have a lease but I don’t think it technically will qualify.

Me: What do you mean?

Potential Client: The land is zoned agricultural but my Chinese partner has secured all the okays to allow us to use it for our factory.

Me: Not a good idea. Trust me on that.

Potential Client: The factory has been there for two years without a problem and my Chinese partner assures me that the local government is fine with it.

Me: Don’t do it. Right now, the local government is okay with it. But what if the current mayor is pushed out next week on corruption grounds. Do you really want to be in a situation where you have spent a large amount of money on a space that gets shut down?

Potential Client: I am in a hurry and this is the only space that works.

Me: Are you sure? You are in a hurry, but is it really going to be worth the few months if you get shut down?

Potential Client: I am not going to get shut down. My Chinese partner is incredibly connected.

Me: Incredibly connected to the current local administration, MAYBE, but as I said, that administration could be out the door next week. Beijing checks on these things too and if they see that your facility is illegal, Beijing could see to its shut-down. I just don’t think it a good idea to go into a WFOE illegally and my firm cannot be a part of that.

Potential Client: That’s ridiculous. This is how business is done in China. Are you really saying you won’t take us.

Me: Yes. We won’t take you because we do not want our reputation damaged when you get shut down and we won’t take you because we do not want to be blamed when you get shut down.

Potential Client: Well I am sure I will have no trouble finding someone to help me on this. Good-by.

I know that at least one of these companies did end up getting shut down (within about a year) because someone at the company who had sided with me on the company not going forward emailed me to tell me of this.

I thought of the above today after reading “Cracking Down On Illegal Land Use: The BYD Case” over at the consistently excellent China Bystander blog. The post is on BYD, “the fast-growing compact automaker in which American investor Warren Buffett has a 10% stake.” Seems BYD has seven factories on land zoned for agriculture and China’s Ministry of Land and Resources is going to be ruling by September 30 on what to do about that:

China Bystander nails it in describing these situations:

It is not unknown for local officials to turn a blind eye to such zoning violations in the drive for economic growth. Companies want to bring new production capacity on stream without waiting for all the red tape to be dealt with, while officials themselves are judged on their promotion of local economic growth and local governments have become hooked on land sales for their revenue.

The ministry has said that 7,800 hectares of land had been used illegally in the first half of this year, a 14% increase over the same period last year. That reversed the trend of the figures of the past three years. They had shown the issue was shrinking, but that may just have reflected lax enforcement and reporting. The country’s farmland has continued to be eaten up by industrialization and urbanization. It has shrunk by 6% over the past decade to 122 million hectares, barely above the minimum arable land the ministry reckons China needs to be self-sufficient in food. The summer’s floods and the drought earlier in the year in some parts of the country have reduced that margin further.

China has been cracking down hard on facilities operating outside China’s zoning laws:

The ministry has hit five companies so far this year for illegal land use, following a tougher inspection regime launched in February that found examples of illegal land use in more than half the 13 cities examined in an initial spot check and officials cooking the books in four. In those cases buildings were ordered to be demolished, land taken back, executives imprisoned and official reprimanded.

China Bystander ends its post by noting that none of the companies previously sanctioned were as high profile as BYD and then wonders” how tough the ministry will be this time” and what sort of signal will it want its ruling to send?

Bottom Line:  If China is going after Chinese companies for putting manufacturing facilities on agricultural land, what in the world makes you as a foreign company think you will be able to get away with doing the same thing? And it is not just agricultural land. I am aware of a big China city office building that was shut down because it was zoned for a hospital.

What are you seeing out there?

Great post over at DiligenceChina, entitled, “China Business Entry: Business Registration is a Group Project,” [link no longer exists]on how to get your business into China. I love the post because it is written from the perspective of a highly educated and knowledgeable businessperson (NYU MBA with substantial China business experience), rather than by a China lawyer.

I apologize for citing so directly from the post, but I fear that if I do not, I will imbue it with the legalese it so blissfully lacks. So here goes, with my own (sparing) comments, within brackets:

I managed to wrangle a lawyer and a real estate consultant into a single room for a meeting yesterday. The lawyer is China attorney Steve Dickinson, of Harris Bricken, an international law firm based in Seattle with a number of lawyers in China and the real estate expert is Dan Turgel of WAT Property & Investment and I asked them to explain the company set-up process in China. Both are experts at Chinese business, fluent in Mandarin and have plenty of successful deals under their belts, so it was a very valuable session.

The results were complex and will be unique for each situation, but here are the important points:

  • WOFE (or WFOE) is rapidly becoming your only real option. That’s Wholly Owned Foreign Enterprise [or Wholly Foreign Owned Enterprise/Entity]. Representative offices are cheap and easy to set up, but you are not allowed to handle money or sign contracts. Seriously. A real drawback, and they are starting to enforce the rule. Joint Ventures with unfamiliar local partners should not even be a serious consideration until you know the terrain and the players well.
  • Get your lease taken care of early. You can’t wait until the business is already formed to start worrying about real estate issues. A 1-year lease is part of the application process. That’s one year from the date of the APPROVAL, which can take 4 months or so from the start of the application. The lease has to be certified, verified and authenticated. Chinese bureaucrats LIVE for this kind of detail, and you aren’t moving forward without one.
  • Your China accountant, China law firm and China real estate people need to be involved in the process from the very beginning, hopefully in the same room at the same time. You want your China business formation to be a single, unified process ‘ not a series of fits and starts. When you find out you are missing a signature, chop, or form – you cannot tell the Chinese authorities the dog ate your homework.
  •  It’s not quick, cheap or painless, but it is possible and manageable. Every situation is unique and every location has its own variation of The Rules, so there are no hard and fast rules. But the business formation should run you in the neighborhood of US $10,000 to $15,000 and take between 6 months and 1 year (from the start of the process, not the application!).
  • You will need to show a business plan, a manpower projection, pro-forma financials for the China project, and all sorts of verification about the existence of the US company. This will include an authentication by both the Secretary of State’s office (state level) and the Chinese Consulate in your jurisdiction back home. Start planning early.
  • You also have to deal with minimum required capital rules, which vary for every business situation. Plan on something in the neighborhood of US$140,000 – $240,000, but every situation will be unique.
  • Is there any way to cut corners and save money? Sure thing. Some methods make sense, like setting up in new industrial zones that are eager for overseas investment or lesser-known cities that encourage specific types of business development. Other methods are simply bad ideas, like using local consultants with special connections that involve forged documents, back-door approvals and other illegal methods. Steve warns investors that you’ll find that these informal methods may be effective for getting your investment funds INTO China, but will make it virtually impossible to get your money OUT when the time comes to exit.
  • The rules are a bit complex and seem daunting at first, but Steve and Dan had no trouble laying the process out quite clearly, even to a simple MBA like myself. Within 45 minutes, I had a much clearer sense of what was involved in forming a new company in China. Understanding the specific rules is a lot less important than finding international consultants who are knowledgeable and reliable.

My only addition would be to note that minimum capital requirements in many second tier cities are often more like $15,000 and that even the higher numbers set forth above should not be daunting because minimum capital sent into China is available for funding business operations pretty much from day one.