BizChina

This post is a re-hash of a post Steve did more than three years ago. We are re-running it now as part of a series of posts we will be running over the next few weeks on the Basics of China Business Law. We are even forming a new category for this series, the first since we started this blog!

This post focuses on the forming of a Wholly Foreign Owned Entity (WFOE) in China. I am starting with this type of entity because it is the one we do most often. Subsequent posts will detail the steps required to register other forms of entities in China, such as a representative office (RO) or a contractual or equity joint venture (JV). Each of these forms of foreign invested enterprise (FIE) is subject to its own specific laws and to numerous regulations that apply to all FIEs. Every FIE is formed as a Chinese limited liability company (LLC).

Where the special laws and regulations of an FIE do not apply, the provisions of the Chinese Company Law control. The Company Law was recently completely rewritten to conform more closely to international standards for company formation and management.

The steps for forming a WFOE in China typically consist of the following:

1. Determine if the proposed WFOE will conduct a business approved for foreign investment by the Chinese government. For example, until recently, China prohibited private entities from engaging in export trade. All export trade was handled through certain large, state owned trading companies.

China recently abandoned this system, and now both foreign and domestic companies can set up trading companies.  Restrictions on export oriented trading companies have essentially been eliminated, but there are still controls on import oriented trading companies that can increase expense and raise costs. Because these rules were only recently changed, the local regulators who must approve these projects do not have a great deal of experience with the attendant issues. This can lead to some delay in the approval process. It also results in an extremely cautious approach towards adequate capitalization even for export oriented trading  companies. I discuss capitalization requirements in greater detail below.

2. Determine if the foreign investor is an approved investor. Basically, any legally formed foreign business entity is authorized to invest in a WFOE in China. China especially welcomes investment that promotes the export of Chinese manufactured products. The investor must provide the documentation from its home country proving it is a duly formed and validly existing corporation, along with evidence showing the person from the investor who is authorized to execute documents on behalf of the investor. The investor also must provide documentation demonstrating its capital adequacy in its country of incorporation.

To meet these requirements, the following documents are normally needed from the investing business entity:

a. Articles of Incorporation or equivalent (copy)

b. Business license, both national and local (if any) (copies)

c. Certificate of Status (Original)(U.S. and Canada) or a notarized copy    of the Corporate Register for the investor or similar document                 (original)(Civil Law jurisdictions)

d. Bank Letter attesting to sound banking relationship and account status of the company (original).

e. Description of the investor's business activities, together with added materials such as an annual report, brochures, website, etc.

a-d are translated into Chinese. e is either translated into Chinese or summarized in Chinese.

Many investors created special purpose companies to serve as the investor in China . The Chinese regulators have become accustomed to this process. However, the Chinese regulators will still seek to trace the ownership of the foreign investor back to a viable, operating business enterprise. Investor secrecy is not an option in China. However, the corporate register for the Chinese company will merely state the name of the foreign, special entity investing company as the owner. In that sense, as far as public disclosure is concerned, the investor privacy can be maintained. The foreign investor should also understand that this tracing process will add some time and cost to the Chinese company formation process.

3. Chinese government approval for the project. In China, unlike in most countries with which Western companies tend to be familiar, approval of the project by the relevant government authority is an integral part of the incorporation process. If the project is not approved, no incorporation is permitted. The two are inextricably linked.

The following documents must be prepared for incorporation/project approval:

a. Articles of Association. This document will set out all of the details of management and capitalization of the company. Nothing can be left for future determination; all basic company and project issues must be determined in advance and incorporated in the Articles. This includes directors, local management, local address, special rules on scope of authority of local managers, company address, and registered capital.

b. Feasibility Study. The project will not be approved unless the local authorities are convinced it is feasible. This usually requires a basic first year business plan and budget. We typically use the client produced business plan and budget to draft up the feasibility study (in Chinese) that will satisfy the requirements of the Chinese approval authority.

c. Leases: An agreement for all required leases must be provided. This includes office space lease and warehouse/factory space lease.   It is customary in China to pay rent one year in advance and this must be taken into account in planning a budget because the governmental authorities will be expecting this.

d. Proposed personnel salary and benefit budget. If the specific people who will work for the company have not yet been identified, one must specify the positions and proposed salaries/benefit package. Benefits for employees in China typically range from 32% to 42% of the employee base salary, depending on the location of the business. Foreign employers are held to a strict standard in paying these benefit amounts. The required initial investment includes an amount sufficient to pay salaries for a reasonable period of time during the start up phase of the Chinese company.

e. Any other documentation required for the specific business proposed. The more complex the project, the more documentation that will be required.

All of the above documents must be prepared in Chinese.

4. It usually takes two to five months for governmental approval, depending on the location of the project and its size and scope. Large cities like Shanghai tend to be slower than smaller cities. The investor must pay various incorporation fees, which fees vary depending on the location, the amount of registered capital and any special licenses required for the specific project. Typically, these fees equal a little over 1% of the initial capital.

On large and/or complex projects, the approval process often involves extensive negotiations with various regulatory authorities whose approval is required. For example, a large factory may have serious land use or environmental issues. Thus, the time frame for approval of incorporation is never certain. It depends on the type of project and the location. Foreign investors must be prepared for this uncertainty from the outset.

Tomorrow's post will discuss a WFOE's minimum capital requirements. 

Yesterday, in a post entitled, "How to Start a Business in China -- WFOE," we discussed the basic requirements for forming a wholly foreign owned entity (WFOE or WOFE) in China. One of the questions we are most frequently asked about how to form a WFOE in China is 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. Beginning in 2006, this company register is available to the general public. 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. 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 operating the company. It need not 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 for anything other than paying company expenses.

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 and a failure to abide by Chinese law all the way along the process will likely lead to an inability to get money out of China at some point down the road.

Under the new Chinese Company Law, the minimum capital requirement for multiple shareholder companies has been reduced to 30,000 RMB (less than $5,000 USD). For single shareholder companies, the amount is 100,000 RMB (around $13,000 USD). 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 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 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.

In determining what constitutes adequate capital, one needs to consider the peculiar situation in China that building rents are virtually always paid in advance, that payment for products for sale are virtually always paid in advance, and that a reasonable advance reserve for salaries is also required. Thus, the initial start up costs are much higher than in a location like the United States, where credit and time payments are more common. In addition, the foreign investor needs to take into account 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.

The government sometimes permits the minimum capital to be paid in installments over up to two years, though the first installment must be at least 15% of the total amount required and it also must be at least the statutory minimum for total capital. The capital contribution can be made in money, equipment, intellectual property, or other transferable property, but the monetary contribution must be at least 30% of the total capital amount. The government will appraise the value of any non-monetary contribution and our experience has been that it will come in fairly low in its valuation.

We frequently see two big mistakes being made by foreign investors when it comes to their putting in the required minimum capital. Foreign investors hear that assets can be used as a contribution towards the minimum capital requirement, so they go ahead and ship certain assets over to China, with the expectation of then using those assets towards minimum capital. The problem with this approach is that unless the proper authorities have been notified and granted their approval in advance of the shipping, the assets you just shipped to China will not be applied towards minimum capital, and you will have a huge problem on your hands.

The other common mistake we see is the foreign investor putting a value on its assets (including its intellectual property) and assuming the Chinese regulators will put the same value on those assets in determining the contribution towards minimum capital. The Chinese regulators will require their own appraisal (at your expense) l of anything other than monetary contributions towards the minimum capital requirement, and those appraisals tend to come in low, particularly for IP.

Though most of my law firm's practice involves helping American and European companies go overseas, at least ten percent of our business involves helping foreign companies enter the United States. This number always fluctuates, depending on how things are going economically in the United States versus the rest of the world and on how the US dollar is doing on currency markets.

During the dot.com boom, I was getting a ton of work from Korean and Japanese and Russian and other companies seeking US venture capital funding or just seeking to make their mark on the US market. During the height of the US real estate boom, we were handling a fair number of matters for Russian and Korean and a few Chinese clients seeking to own a piece of the American real estate pie. We are starting to see a few inklings of incoming work by foreign (mostly European) investors looking at the United States companies again, now that prices have fallen so much.

And then we have always and somewhat consistently had the bizarre practice of setting up US companies for companies from mostly less developed countries (Vietnam is the prime example) who want a US company so that they can go back to their home country as a US company. This tactic is known as a "round-tripper." Let me explain.

Just by way of a hypothetical example, you have a large Vietnamese or Russian company and you are getting squeezed by the authorities for whatever and for whatever reason. Maybe the government knows you are doing well and wants a piece of your action. Or maybe you are tired of the local bureaucrats always hitting your company up for a bit o' the baksheesh and you believe that this sort of thing will be less likely to happen to a foreign company (see the Sopranos episode involving how the mob was unable to collect from a new "Starbucks-like" cafe in the neighborhood" for one explanation of why this might be the case). So you form a US company and you take that company and return (hence the name round-tripping) to your native country with it. These round-tripper companies were very common for China back in the day when China's tax structure greatly favored foreign companies as an incentive to get them to invest in China.

Or let's suppose you are a large Ukrainian construction company and you are bidding on a large airport project in Poland. Let's face it, being an American company is going to give you more credibility and trust than being a Ukrainian one. The reasons for wanting a US company are endless, especially since US tax laws are (or should I be saying were) not that oppressive as compared to many other countries.

The other day, my firm got its first China WFOE (Wholly Foreign Owned Entity) that wants to form a US company. Now when you think about that, it is not so strange and, if anything, it is maybe a bit strange that we had not gotten such a matter until now. But I do think this is really noteworthy. What we have here is a Chinese company owned by a European company in a country with very high taxes and this company now wants to go into the United States to sell the product it has been manufacturing in China and selling in Europe. And rather than come into the United States with a company owned by their European company, they want their US company to be owned by their China WFOE. We have just begun looking into the legal aspects of this deal from all perspectives.

But I thought of this new client this morning when I started reading more on how the China Joint Venture (JV) between General Motors (GM) and Shanghai Automotive Industry Corporation (SAIC) will be moving into India.

This all makes sense. Foreign companies, be they in China independently as WFOEs or be they there as part of a joint venture, are going to be looking to expand worldwide as their China operations become stable.

I think we are looking at a trend.

What do you think?

A couple weeks ago, I got what for my law firm is a fairly typical phone call. This was from someone in a second tier city who had been operating a business there for seven years, all done on a business visa without having registered the business and without having secured a long term Z (employee) visa. Seems the local authorities had sent him packing and he essentially had to turn over his fairly profitable business to his five employees. He was calling us to see if there was anything we could do. My response was something along the lines of the following:

Let me get this straight. You have been operating this business in China for seven years, yet you never registered it and you never paid any taxes on it. You built it up to five employees, none of whom are legal. Do you think one of these employees might have been the one to turn you in? In any event, what is it you think we can help you with?

He very wisely chose not to hire us. We get calls like this just about every month and I have written about many of them. This post is a little different, based on something this guy told me at the end of the call. He said something along the lines of the following, though I have to admit by that point I was thinking more about getting off to my lunch appointment so I didn't question him any further:

The local official told me that they are going after everyone who has been in China for more than five years without a Z visa (employment visas) and making sure they are here completely legally and, if they are not, they are making them leave the country immediately.

I thought absolutely nothing of this until today when I read a James Fallows post that talked of something very similar happening to veteran English teachers in China. Fallows' post contained the following quote from a "young Westerner who has taught in China but is now in Europe as a graduate student:"

I am just hearing from two of my expat friends who have been teaching in Chengdu for 3 and 4 years each, that a new visa regulation is being enforced, which will force all but a very select group of people to leave the country for at least one year after having been there for 5 years more or less continuously. Whats that all about? Great teachers who like their jobs and would be happy to stay are forced to leave the country for a year? I don't want to know how many of them will find a job some place else in that year off and never come back.

Only a few days ago, we did a post on how China's attitude towards foreign investment was becoming more rigid and less welcoming as the government becomes more convinced that China's economy will be fine. So certainly this possible new call to crackdown on China expat veterans without proper visas would fit in perfectly with that.

I know people who have been living in China for more than ten years on business or tourist visas. Are their days numbered? What are you hearing/seeing out there?