Establishing a WFOE


Posted: 27th July 2011 11:39

The wholly foreign-owned enterprise has become the investment vehicle of choice for the international investor wanting to manufacture service or trade in China.  In addition to the WFOE’s expansive business scope, its unrivaled popularity arises from multiple other factors:

 

 

Your organization has decided to invest in China.  Deciding which entity to establish based on your short and long-term plans is the next step.

Structuring your WFOE

Business scope

You need to ensure your business scope is accurate and genuine.  The requisite administrative government offices will quickly pass your proposed business scope, but that does not mean you are finished.  Your proposal will then make its way to the state and local tax bureaus, and they will also thoroughly check your application.  Any attempts to fool the tax bureau into thinking you are producing one thing when you are actually producing another will inevitably fail.

WFOEs can only operate within the business scope approved by the authorities.  The scope of business article within your articles of association will define exactly what your company is going to do.  If you are going to be selling your product domestically, be sure to mention China’s required compliance with the WTO treaty.  This will allow easier access to the domestic marketplace.  Also, your business focus must be clearly indicated or problems with the tax bureau and customs will arise when seeking due tax refunds.  This does not mean your WFOE must be one-dimensional, but that you must be honest and prescient when planning your operation.  Beyond being a complicated approval process, it is also a lengthy one due to the requisite translations and multiple bureaucratic departments.

Registered capital requirements

Registered capital requirements are dependent on location and industry and are used as an entry barrier to ensure foreign-invested enterprises are of sufficient quality and financial strength.

Minimum capital requirement

The legal minimum capital requirement for a domestic commercial, manufacturing or service enterprise is RMB30,000 but immediately jumps to RMB100,000 for entities with only one shareholder is present.  In reality, however, the minimum capital requirements vary drastically by location and industry. For instance, a manufacturing WFOE in Beijing may face different capital requirements than a manufacturing WFOE in Tianjin, a service WFOE in Shanghai, or a FICE in Guangzhou.  Shop around and compare regional differences.  But beware; people are often duped into attractive but untenable minimum capital requirements proffered by local magistrates trying to meet their quotas. This will lead to complications with the central and local tax bureaus, both of whom will be intimately involved in your business life.  It might be helpful to note that your registered capital is also your limited liability and this is also reflected in this amount.  This could become a deal-breaker if a potential client wants to do business but cannot determine whether or not you are sufficiently capitalized.

Total investment

Registered capital and total investment figures are both required during the application procedure.  The total investment is the amount necessary to realize the company’s operations, while the registered capital is the equity pledged to the local authorities.  The difference between registered capital and total investment represents the debt of the investment and can be made up by loans from the investor or foreign banks.  Pay attention to the relationship between registered capital and total investment in case you need to obtain further debt or other financing from your holding company or other financial institution.  Keeping this window open will cost you nothing, but closing yourself off from further financing by equating registered capital and total investment may leave you handcuffed.  The payment schedule of the WFOE registered capital also needs to be specified in the articles of association. The investor may choose to pay it as a lump sum or in installments.

It is crucial for the investor to understand the importance of minimum registered capital, total investment, and working capital; but beyond that, basic investment criteria remain the same.  The government will look at the general viability of the project and a reasonable cash requirement for a particular type of investment.  Injections of cash and plant equipment take place after the WFOE license is approved, making it a no-risk investment in terms of money up front.

Working capital

The amount of working capital required until a business is self-sufficient is often underestimated.  When the time comes, do not simply put in the minimum registered capital requirement during initial capitalization as you may later find the business is under-capitalized, unable to pay its bills and out of funds.  Injecting capital is costly in terms of time and money.  Any money sent to make up an operational shortfall that does not follow the government’s business cash injection protocol can be subject to the 25 percent corporate income tax.  Err on the side of over-funding.  It is an operational cash flow issue, not a regulatory licensing matter. Bear in mind that newly established foreign businesses in China must still make a tax deposit to customs for VAT and remit duty on initial imports, usually for a period of about six months.  Many new businesses do not cater for this as initial working capital (as part of their registered capital requirements), leaving them short of cash later on.  Again-factor in your working capital requirements as your registered capital amount as opposed to any ‘minimum’ suggestions.

Set-up process

Feasibility study report

The feasibility study is one of the first steps in the application process.  Reviewed by the Ministry of Commerce or its local counterpart to assess foreign direct investment in China, this non-binding report is also used to assess exactly how much thought and planning has gone into your business.  You will need to address your operating budget and the raw material inputs, among other pertinent information.  The application follows a standard format and is provided by the authorities to you as part of your application documentation.  It needs to be translated into Chinese for application.

Environmental protection valuation report

The Environmental Protection Bureau will issue you a document that is intended to control manufacturing production processes in accord with specified environmental norms.  The bureau will require information about the raw materials used, the machinery and equipment, and consumption and safe disposal of toxic products.  Please note that all assembly and manufacturing WFOE applications must obtain approval by this bureau. In some cases, a full report on the environmental impact issued by an appointed agent shall be required (for example, the leather processing business) and this may represent a major step to go through as it would affect the time frame to get your factory up and running.

Key articles of association

The articles of association are one of the most important documents in establishing a WFOE.  These are the operating rules of the company and it is vital that they are properly structured, if they are not, you could run into problems later on.  Unfortunately, many foreign investors make the mistake of regarding them as a simple formality and do not take the time to properly formulate them.  When establishing a company with a limited life span of, say, 40 years, know what you are agreeing to. Here we highlight some of the articles, what they mean and what should be included.

Business scope article

The business scope article expresses the limits of your WFOE’s business practice.  It needs to be a clear, honest assessment of your intended business scope while leaving the possibility for expansion.

Production scale article

This can be useful for expressing an exit strategy by linking production and profitability scales to unacceptable levels of business, thus permitting liquidation under such circumstances.

Liquidation audit article

A board of director’s resolution approves liquidation and termination in conjunction with the production scale article included in your articles of association.  Liquidated assets are then paid in the following order: liquidation expenses, employees, outstanding taxes, secured debts, and other debts. Any funds remaining after business deregistration can be repatriated to the investors.

Total investment article

The relationship between your registered capital and your total investment capital can affect debt financing and the ability to obtain parent company loans. Clarity is important. 

Profits repatriation article

This gives the parent company the right to bill the WFOE for services, royalties, and R&D costs for example.  This will make it easier to overlay expenses, send money out as an invoice payment and save on your profits tax bill.

Trade union article

In China, the staff has the right to form a trade union but not to strike.  They can however, elect a representative that you will need to deal with.  It is wise to attempt to control the union’s budget and influence its expenditure.  The articles of association should be studied in great detail and redrafted to fit your business situation.  Once completed, they need to be translated into Chinese.  It is important to note that the Chinese language version of your articles of association will take legal precedence over any other version. For these reasons, this stage of the application needs to be handled with the utmost precision and care.

 

Dezan Shira & Associates is a foreign indirect investment practice offering business advisory, tax, accounting, due diligence, payroll and audit service to multinational clients in China, Hong Kong, India, and Vietnam. For professional advice on common accounting practices in China, please contact Dezan Shira & Associates at info@dezshira.com or visit www.dezshira.com

To read another article from Dezan Shira & Associates on China's green sector please click here


 


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