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 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 deductable. Rep offices typically face effective rates of about 12% on their expenses—with little recourse for this problem. The most obvious alternative is the enter 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 is allowed to 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.
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 2015. Forming a Hong Kong company is typically for tax reasons.
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.
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:
- Description of the business conducted
- How the services and/or products 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
- 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
- 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
- A description of the customer base
- Source of Income and 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 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 cost of operations dependent on the type of business and location; Beijing is expensive, Langzhou is cheap. 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 allows 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 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.