Respect is the fundamental building block of business, be it custom manufacturing or any other niche. When conducting business in China, this truth stretches even further. Underpinning the business world is a concept termed “Face”. Summarized, Face is effectively a level of reputation. It can increase and decrease and is a measure of how others view you. Through actions such as a manager dressing down an employee one would lose Face. On the other hand, if a manager praises a worker’s efforts, they would then gain Face.
This concept is deeply rooted into Chinese culture. As a foreigner, you may be given a little be more leeway when it comes to following local customs. However, you will still be expected to follow them, and if you do not follow the concept of Face your business plan may be ruined. The power of face can fracture business relationships, make negotiations go sour, as well as close previously open doors.
If you want to conduct business in China, you must respect their culture, abide to the laws and stay in line with all the rules and regulations. These qualities serve as your building blocks to success. If you can’t practice them, then might as well not consider starting a business in China.
Entering China: A Brief Overview
If you’re thinking about getting into custom manufacturing and retail, you are undoubtedly thinking about sourcing from China. However, China’s emerging global economy is poorly regulated, leading to copyright problems and illegal business activities. As a result, trade with China can become complicated. Here are the basics you need to know as a newbie in the custom manufacturing and retail business world of China:
- On Dealing with China in General: Successful traders say that it’s possible to do well in China but extreme caution must be taken for scam artists.
- Chinese Products: To buy branded goods at wholesale prices, you must contact an authorized distributor of the product.
- Finding Manufacturers/Suppliers: Most traders recommend either using a buying agent who can be the go-between in finding manufacturers/suppliers.
Starting a Company in China: What You Need to Know
Foreign companies are essentially confined entering China as a Wholly Foreign Owned Entity (WFOE), Representative Office (Rep Office) or Joint Venture (JV). China has a “Catalog for the Guidance of Foreign Invested Enterprises” which divides foreign investment into “encouraged,” “restricted” and “prohibited” classes: Foreign investment in restricted industries requires a joint venture. Industries that are not classified into any of the three categories are generally assumed to be permitted.
Rep Offices versus Wholly Foreign Owned Enterprise
A Representative Office in China has numerous benefits: it’s simple, cheap and quick to do. Typically, it is the first step for ALL and not only manufacturing companies entering China, but it definitely shouldn’t be the last. The main problem is that such a legal arrangement is limited in scope. When the firm moves beyond the scope, it costs outweigh the benefits. Usually, the downside is directly related to the tax burden rep offices encounter.
In our previous post on fapiao’s in China, we discussed the benefits of issuing a fapiao; a rep office cannot enjoy these privileges. More importantly, expenses are not tax deductible. Rep offices typically face effective rates of about 12% on their expenses — with little recourse for this problem. The most obvious alternative is entering as a JV company, but this too has so many downsides. We’ll merely discount this approach all together.
Most often forgotten (largely due to the difficulty in the process) is the Wholly Foreign Owned Enterprise (WFOE): A WFOE is a separate legal entity from the company under Chinese law where as a rep office is associated with the foreign company.
Remember, the rep office cannot generate revenue, thus financing the company must come from abroad through transfers. Conversely, the WFOE can garner profit — domestically — meaning it incurs tax deductible expenses which would minimize the corporate income tax (CIT). A typical WFOE can achieve a tax rate of 10%.
Another caveat is the opportunities available for WFOEs. As a legal entity in China, it has access to nearly anything through expanding its scope of business. Also, if the WFOE’s services to overseas companies fall under the scope of “logistics auxiliary services” and “general offshore outsourcing services” the company can apply for a VAT tax exemption status.
1. Forming the WFOE Step 1: Company Structure
A typical WFOE registration will require the applicant to provide some sort of legal information:
- Each shareholder’s legal name
- Legal address
- The state and country of formation
- The state and country of the principal place of business
Once upon a time, forming a Hong Kong company made the process easier, but this is 2018. Forming a Hong Kong company is typically for tax reasons.
2. Forming the WFOE Step 2: Physical Premises
After you have the corporate structure in place, you’ll need to think about location of the WFOE. This requires you to have corporate address (document needed) with your landlord’s contact information (with I.D. Card) and proof of ownership (titled “Provision of a land rights certificate”). The lease should be for at least one year beyond the eventual approval date for your WFOE. Afterward, you’ll have to take these documents to the local real estate authority.
3. Forming the WFOE Step 3: Company Name and Description
Like everything in China, the WFOE’s English name will be unofficial and is, for the most part, up to you. That means that you must have a Chinese name with a description of the company’s activities which includes the following items:
General Business Structure
- Description of the business conducted
- How the services and/or products or business plan will change over the next 5 years
- Staff information (i.e. number of employees and how it will change over the next 5 years)
- Job descriptions and management structure
- A description of the customer base
Upper Management Roles
- Will the company have a board of directors or a single director?
- General Manager (the general manager and the managing director can be the same person and do not need to reside in China)
- Supervisor (The person in monitoring the directors)
- Legal Representative (The person who acts in the company’s name, Usually this is the chairman of the board)
- Source of Income (How it is generated)
- Use of Income (i.e. reinvest in China or transfer abroad)
- Will the WFOE’s income stay in China or be paid to an entity in another country?
- A detailed first-year manufacturing cost projection
- The major expenses and entities the WFOE will pay (along with estimates in currency of transaction)
- Purpose of Expenses
- One-year and five-year pro forma statements.
Amount of “total investment” and the amount of “registered capital”
- Registered Capital = Money given from parent company after formation
- Total investment = registered capital and debt capacity
***WFOEs with low capital amounts must have registered capital at least 70% of total investment
Getting Accepted: Capital Requirements and Total Investment
China has liberalized its minimum capital requirements for a WFOE, reducing the total amount in cities/districts. While the law on minimum registered capital is clear, but the amount of total capital varies dependent on the scope and city. Stated registered capital must include the initial investment, including start up cash, contributed property, and IP. Small registered capital requires immediate payment while larger quantities can have installments. A firm cannot withdraw registered capital after contributing it and any such action is considered a crime.
However, the above section on scope and description is important because you can use your registered capital for payments of the above items. So, if you have employees or expenses not listed, you may not be able to use the money for that reason. If you want to get funds out of China is through profit repatriation — a taxable expense. While Chinese Law states the minimum capital requirement is either 30,000 or 100,000 RMB depending on the shareholder structure, having the minimum capital requirements may not be the best strategy or one acceptable by the government.
Chinese authorities will consider if the capitalization is sufficient for the project—not the minimum capital requirement. This means they will estimate the manufacturing cost of operations dependent on the type of business and location; Beijing is expensive, Langzhou is cheap. Custom manufacturing is capital intensive, consulting is not. You should ask the local regulator for the capital requirements; they will provide it.
Of all, consider most of your costs as upfront. A good starting point would be to consider all costs for the first year and assume they must be paid in advance. Then work down from that.
Getting Accepted: Scope is Key
The key is the business scope which can typically allow the firm to fit within multiple categories of how you describe your business. Creative descriptions help but can get you into trouble. Operating beyond the scope increases your chances of legal issues as your company grows. Changing scope of business will allow you to develop as you see fit, but often manufacturing companies fail to do so. Your application must be tailored around the investment catalogue and what you are doing. Just because you get government approval now will mean you will automatically pass the audit.
Negotiations for Business in China
The act of negotiating and reaching the conclusion of a business agreement is no quick task most especially in China. Forming relationships is key to getting your foot in. The end goal is usually the main concern for Western companies, whereas in China the overall journey is more important. Guanxi is another concept similar to Face which is important.
Effectively, the term refers to personal connections and relationships. It is about who you know, not necessarily what you know. Chinese manufacturing companies prefer to deal with familiar parties. To be able to set up a meeting and negotiations to proceed, Guanxi comes into play. You may need a referral or an introduction to a client before they will consider you as a business partner. Here are a few things you need to be wary of when negotiating for a business in China.
Due diligence is important in China more than you may expect. Ensure you take the time to receive appropriate legal advice from a representative familiar with Chinese business laws. Extended this to protecting your intellectual property as well. Protect your IPR when dealing with unknown parties. IPR infringement is uncommon but does exist. Regardless take suitable precautions. Registering your IPR within China is a great start. Before entering into any business contracts seek professional legal advice.
Venturing into the unknown can be exciting and scary. Experience can make anyone feel at ease. Having a professional firm to guide you along is generally worth the price. Not only do you learn quicker, you also receive the advice of industry experts familiar with the market.
Different Risks of Doing Business with China
Risk is naturally a part of venturing into business. You simply must be courageous enough to face failure in case things don’t fall to place. Success is never a sure thing in the world of business but there are things you can do to keep failures away. Here are different types of risks you can expect when doing business in China.
1. Strategic Risk
To mitigate against strategic risk, the best method is through planning. Strategic risk occurs when a business plan is implemented unsuccessfully. In the context of China, this could mean a fragmented implementation of moving contract manufacturing into the country from abroad. Teething pains occur with smaller projects like moving contract manufacturing to a new facility. Moving the factory internationally creates a higher probability of something going wrong. Dependent on the size of the company, this risk can successfully be managed by partnering with an established firm specializing with contract manufacturing in China.
2. Operational Risk
As a broad overview, operational risk appears through inadequate processes, people or systems. Looser control exercised by outsourcing operations to China does increase the level of operational risk. Workplace safety is a fitting example. Lower health and safety standards in China may adversely affect your company’s brand. Large corporations have received frequent criticisms about their factories in China, with Apple coming under the spotlight for the environment at Foxconn.
Professional companies exist to ensure operational risk is reduced to a minimum. Perfection can never be achieved. Therefore; operational risk will always exist. Companies generally accept operational risk as a cost of business. Before moving operations to China, weigh up the perceived benefits against the increase in operational risk and in most cases, the advantages of China shine through.
3. Compliance Risk
The major concern for companies outsourcing to China should be compliance risk. Failing to meet industry regulations can result in significant financial penalties. Cheap custom manufacturing can result in corners being cut. Quality is usually the first. Chinese manufacturing companies have been known to fake trade certifications. Failure to meet set standards could result in lawsuits and reputational damage.
Compliance risk comes under corporate governance. Comprehensive risk assessments should be undertaken prior to any outsourcing. Majority of Chinese factories are reliable, reputable and compliant. However, due diligence along with good manufacturing practices must always be carried out to mitigate any risks of rogue suppliers.
Risk comes in all shapes and forms. Risk is present domestically and internationally. Occasionally, the risks outweigh the benefits of outsourcing to China. However, in the vast majority of cases, China wins. A solid business plan and due diligence are the two greatest tools to mitigate risk. Implementing a plan and continuous monitoring are also required to keep risk levels under control.
Outsourcing custom manufacturing ultimately makes managing risk much harder. However, many firms have successfully used companies based in China to their advantage. Visiting factories and performing checks is difficult if you are based thousands of miles away. Partnering with an established manufacturing specialist or an inspection company for quality assurance can enable your firm to benefit from China through mitigating risk.
Starting a business in China may have complexities but also has its own set of advantages which you can be beneficial to you later on. If you are optimistic enough to see through all the complications, having a custom manufacturing business here in China is definitely the best option you have out there.