Choosing the Right Business Structure

Setting up shop in China unfortunately isn’t as easy as incorporating a company and opening your doors. You have two overall choices:

✓	Representative office
✓	Foreign-invested enterprise (FIE), operated as either A joint venture (JV) A wholly foreign-owned enterprise (WFOE)

Whether you should set up a rep office or an FIE partially depends on whether your company will be collecting money in China. Sending money offshore can be challenging. When you receive money from customers inside of China, getting it out is harder than what you’re probably used to. Your customers may have a hard time sending money to your foreign bank account, too! (To understand these issues better, read this chapter closely with Chapter 10.)

If you need to collect money from businesses or others inside of China, select one of the FIE options. If not, opt for the representative office, which is an easier entity to establish.

Representative offices

A representative office (rep office) is technically not a company in China; it’s considered an extension of your offshore company. The representative office isn’t directly doing business in China — rather, it’s doing indirect business such as consulting, sourcing, support, and liaison activities. To set up a rep office, you need to already have a company set up in another country (offshore).

The main advantage of a representative office is that it’s usually easier to set up than an actual company. Rep offices don’t require registered capital (see the next section on foreign-invested enterprises).

China hasn’t made clear what a “direct” business activity is, but the government generally considers producing and selling to be direct. Therefore, a rep office wouldn’t work for a manufacturing operation. On the other hand, in some highly regulated industries (such as legal services), foreign investors are allowed only to use rep offices.

The most important feature is that rep offices can receive payment only to accounts outside of China for their activities within China. Therefore, your customers must pay you in your foreign currency and send the payment to your offshore account. (To understand more about paying money offshore, see Chapter 10.) You therefore have to send revenue back into your China accounts if you want to use such accounts to pay bills in China.

Setting up a rep office

The requirements to set up a rep office vary depending on location, but the procedure tends to be straightforward and transparent. To make things easy, hire a Chinese company that specializes in business services such as setting up rep offices. Try searching online to find sponsor service companies, contacting a local foreign chamber of commerce for referrals, or even asking the local Ministry of Commerce/Commission of Foreign Trade and Economic Cooperation (MOFCOM/COFTEC) branch for names (see “China, may I? Getting business approvals,” later in this chapter). One relatively large sponsor service company in Shanghai is Shanghai Corporate Consulting Co. (www.haizhixin.com).

In Shanghai and many cities in China, you can also hire the Foreign Enterprise Service Company (FESCO — discussed shortly) to set up your rep office. If you hire a service firm, the all-in cost is usually in the ballpark of $1,000 to $4,000. You need about two to three months to set up.

Many local approval authorities require that a company have at least some operating history before it can set up a rep office. If you set up a company overseas and then immediately try to set up your rep office in China, you may be rejected. Also, rep offices don’t have limited liability — the company establishing the office is liable for its debts and liabilities. Finally, a rep office’s business should stay within the parent company’s scope of business in its home-country incorporation documents.

Hiring through employment service companies

Because rep offices can’t directly do business in China, they can’t directly hire Chinese employees. Instead, rep offices need to use government appointed employment service companies, such as the Foreign Enterprise Service Company (FESCO) or the China International Intellectech Corporation (CIIC). Each company has its own standard form of labor supply contract, which is negotiable to some extent. Even when you directly recruit your Chinese employees (including those who have permanent foreign residence), they technically need to work for this type of company. You still determine the terms of employment, though.

You can hire foreign employees without going through an employment service company. They can usually sign employment contracts with either your foreign parent or local rep office.

Looking at rep office taxes

The weirdest aspect of the indirect business feature of rep offices is taxation. Because rep offices technically aren’t doing business in China, they shouldn’t have profits or taxable income, right? Nope — the Chinese know that a foreign investor must have a rep office for a reason.

In most cases, the government taxes rep offices on “deemed profits.” In most locations, that means that a rep office pays taxes of about 10 percent of its business expenses. If the rep office keeps accurate records of income and expenses, it may be able to qualify for taxes based on actual profits. In isolated cases, rep office taxes may be lower in some special economic zones (SEZs). You should hire a local accounting firm to assist your rep office with accounting and tax matters. For more on taxes, see Chapter 10.

Foreign-invested enterprises

Any company that’s at least 25 percent owned by foreign investors is considered a foreign-invested enterprise (FIE). The FIE distinction is important because the government tries to guide where and how FIEs invest, meaning that FIEs may receive additional incentives in some industries; they may be prohibited from investing in others.

With FIEs, you have a few decisions to make:

✓	What kind of FIE is better for your business: wholly foreign-owned enterprise (WFOE) or joint venture (JV)?
✓	If you choose joint venture, what kind of joint venture is better in your circumstances: equity JV (EJV) or cooperative JV (CJV)?
✓	What type of incorporation do you want: limited liability company (LLC) or joint stock company?

If you’re feeling a little confused right now, don’t worry. We step you through your FIE options in this section.

Choosing a wholly foreign-owned enterprise

An FIE that’s owned only by one or more foreign investors is called a wholly foreign-owned enterprise (WFOE, although you sometimes see it as WOFE). WFOE is usually pronounced woofie. Having a WFOE ensures that you maintain control of management and can more closely guard intellectual property.

When China first opened up to foreign investment in the 1980s, WFOEs weren’t permitted. WFOEs were created in the 1990s, and then they could operate only in a few industries. The government has since opened up many more industries to WFOE investors. Many investors aren’t willing to accept the trade-offs of JVs — particularly regarding control and cultural issues. As a result, many foreign investors are looking to buy out their JV partners and convert to WFOEs, especially when they’ve operated in China long enough to feel comfortable about proceeding without their partners’ relationships and knowledge.

Choosing a joint venture

A joint venture (JV) is a company that your company (or you) co-owns with another company (or person). In this book, when we discuss JVs, we’re referring to Sino-foreign JVs, in which at least one Chinese party owns registered capital.

Having a JV with a Chinese party presents a number of pros and cons. On the positive side, a JV can give you established sales channels, a trained workforce, and facilities (such as a factory or land). Your JV partner may also be able to walk you through the approvals, making it faster to get the operation off the ground than it would be with a WFOE. On the other hand, a JV means that you won’t necessarily have management control of the business. Having a JV may also increase the risk that you’ll lose control of intellectual property (IP). In the end, though, you may have no choice but to form a JV. Some industries require foreign investors to form JVs with Chinese companies in order to do business (see the upcoming section titled “Checking out the catalog”).

You see two types of JV in China:

✓

Equity JV (EJV): EJVs are fairly straightforward. Each party receives a share of the profits and risks in proportion to the amount of registered capital it owns. Board representation doesn’t have to be proportional to capital, but by law the minority shareholder is usually entitled to at least one seat.

✓

Cooperative JV (CJV): The CJV allows the parties to set the benefits in a way that’s not proportional to their ownership of registered capital. People generally use CJVs in businesses in which one party receives most or all the profits from the business’s operations for a certain period; at the end of the term, the other party receives most or all the assets. This type of arrangement has been most popular in infrastructure and real estate projects.

Forming a JV: Contracts and Chinese law

To form a JV, you and your partner(s) need to sign a JV contract. A well-written JV contract has no substitute, though the contract still follows a relatively standard “approvable” JV contract template that many Western lawyers may consider sparse.

Make sure the Articles of Association (AOA) are written in a way that reflects your understanding of the agreement and does not contradict the JV contract; if the two conflict, the JV contract is binding. The AOA is the foundational document of all Chinese corporations (see the upcoming “Incorporating your FIE: Limited liability companies” section). In other countries, it’s commonly called the charter or the constitution. You almost certainly want a lawyer to help you with the contract and the AOA. See Chapter 4 for more on selecting attorneys and other service providers.

If you set up a CJV, your CJV contract needs to discuss who owns what assets at expiration of the JV — again, that’s because a CJV’s benefits and risks may differ from the parties’ shares of the registered capital.

Include an arbitration clause in the JV contract. Having a properly written arbitration clause means that any dispute will be settled by an arbitration panel instead of by Chinese court. Depending on the arbitration body selected, this move should decrease the chances of favoritism and hopefully guarantee that a capable body will hear the dispute. For more on arbitration clauses and arbitration bodies, see Chapters 17 and 18.

Chinese law is very protective of minority shareholders, so don’t waste time and energy arguing over whether your company will have a majority versus supermajority of board seats. Most critical decisions require unanimity, so a supermajority often doesn’t mean anything. In fact, you may want to pause before getting into a heated discussion about having a majority versus minority of control. As a minority shareholder, you can veto a lot.

Three barriers to Chinese-foreign cooperation Rick Wang is the CEO of RetailCo, Inc. (www.retailcoinc.com), a company that specializes in apparel and food and beverage retailing. Through his work in franchising, he’s identified what he calls the three barriers that affect Western and Chinese cooperation in business. They apply to JVs, franchising, and many other forms of long-term arrangements. If both sides don’t fully get past those barriers, then your relationship will likely sour eventually. In a JV, bad partner relations cost money. Carefully consider whether you and the Chinese side can surmount the barriers: ✓ Mind: The barrier of the mind is a question of commitment to the relationship. You have to be willing to transfer money, valuable know-how, and skills. The Chinese side also needs to understand that the assets and workers it pledges to the JV will belong to the JV. The Chinese side has to commit to putting as much effort into the JV as it puts into its wholly-owned businesses. ✓ Trust: To be successful, both sides must truly trust one another. On the Western side, you hear stories about unscrupulous JV partners all the time, which can make Chinese partners seem guilty until proven innocent. Of course, good partners rarely make news. Chinese investors need to trust that you won’t push them aside as soon as the business is off the ground and you’re comfortable in China. Take your time to decide whether to JV and who your partner will be; then place a lot of trust in them. If you don’t, your lack of trust will show; and, if you can’t, don’t JV. ✓ Discipline: The barrier of discipline is more of an issue on the Chinese side. It refers to the Chinese propensity to search for ways to do things more quickly, cheaply, easily, and so on. In many respects, China doesn’t place the emphasis on quality that Western countries do, so there’s a real tendency to “cha bu duo” things, a term that literally means more or less. This tendency is a problem when you’re contributing technical and management know-how to the venture. You may discover the Chinese side has broken from your system. When you point out the changes, don’t be surprised if they tell you their way is cha bu duo what you taught them. You need to help them get past this barrier by insisting at the beginning that if you’re contributing technical expertise and management know-how, they stick to it. And if you see the Chinese side cha bu duoing things, tell them they need to fix the problem. Of course, you should be open to suggestions for improvement.

In almost all cases, the law requires that your local partner have at least one seat on the board, regardless of how small its share is. Therefore, your partner will have the legal right to veto certain major decisions. These rights include amending the AOA, terminating the JV, increasing or reducing the JV’s registered capital, and merging or selling the JV.

As a result, JVs sometimes go into deadlock, which may prevent them from continuing to operate. If that happens, you may have to go to court in order to wind up the business. You can address some of these issues in the AOA and JV contract. Also, JV partners may delay your sale of all or part of your interest onshore because Chinese law gives the partner a right of first refusal — a provision that gives your partner the potential to abuse this right.

Expiration and termination of JV contracts

When the JV contract is about to expire (or does expire), you and your partner(s) can choose to either extend the JV or wind it up. Either decision needs approval from the original approval authority (that is, the original MOFCOM/COFTEC).

After the owners receive approval to liquidate the JV, the JV has to follow China’s liquidation procedures. These procedures are essentially similar to those in many other countries. The company has to give notice and time for creditors to come forward. After satisfying its debts, it may divide the proceeds and assets among the shareholders. From the time a JV (or other LLC) receives approval to liquidate, liquidation usually takes several months to fulfill.

If you and your partner(s) decide to terminate the JV early, the winding up process is the same: Seek approval and then follow the liquidation procedures. Depending on where the JV is located, this approval may be difficult to obtain. The termination can be a bit of a political issue in that the local government is losing foreign investment and jobs. If one partner wants to liquidate but the others don’t, then the partner who wants to liquidate has to petition the court to order the dissolution and liquidation. Petitioning is not a fun process, and succeeding may be difficult.

Incorporating your FIE: Limited liability companies

Regardless of whether you choose a joint venture or wholly foreign-owned enterprise, you can incorporate in China in one of two ways:

✓	An LLC: Most FIEs in China are set up as limited liability companies (LLCs). The LLC is similar to the standard form of corporation found in many countries: Your personal liability is limited to the amount of money you invest. (Don’t confuse the Chinese LLC with the U.S. LLC, which is a hybrid of a partnership and a corporation.) The following sections discuss the characteristics of LLCs.
✓	A joint stock company: The joint stock company isn’t common for FIEs and is fairly technical, so we don’t cover it here. But we do want you to at least be aware of the option. If you really want to know more, have your lawyers look at Chinese law texts.

Ownership and registered capital

An LLC doesn’t issue shares — instead, investors own percentages of the LLC’s registered capital. (Note: “Registered capital owners” is kind of a mouthful, so we call the investors shareholders, anyway.) Whenever you set up an LLC, you’re required to contribute some money or assets as registered capital. Different industries and local governments may require varying amounts of registered capital. In some cases, the required amount isn’t that high, say $10,000. In other cases, the required amount may be over $100,000. You can contribute assets, such as machinery or technology, instead of cash for part of the contribution.

Planning ahead with offshore holding companies If you think you may sell your company (or go public outside of China), you may want to set up an offshore company to hold your interest in the FIE. That way, when somebody wants to buy all or part of your ownership, the buyer can just buy equity in the holding company. Assuming that you set up your holding company in one of the usual places (such as Hong Kong, the Cayman Islands, or the U.S.), you don’t need to go through an approval process to sell the holding company. Otherwise, if you want to sell your interest in the FIE directly, you have to go through a somewhat lengthy application and approval process with the Chinese authorities. If you consider setting up an offshore holding company, consult a tax expert who can help you choose a suitable country — China has tax treaties with many countries that may affect your decision. Note: If you’re going to set up an offshore holding company and will have a JV, your Chinese partner may want to own its share at the offshore level, too, either directly or through offshore companies it controls. The Chinese government usually doesn’t like this type of arrangement. Make sure you consult a lawyer who can determine whether your Chinese partner has received the necessary approvals to join you offshore. The Chinese government may revoke the FIE’s foreign exchange license if your partner doesn’t have the proper approvals.

The Chinese authorities have to verify the value of assets you contribute. Fortunately, you don’t have to contribute all your registered capital upfront. By law, you need to contribute only 20 percent of your capital within 60 days of receiving your business license (see “China, may I? Getting business approvals,” later in this chapter, for more on the business license), and then contribute the remaining 80 percent within two months of receiving the license. Some localities allow you even more time to make the contributions.

After you make your contributions (in cash or assets), you need to have an authorized Chinese accounting firm verify to the government that you’ve made them. The other good news is that as soon as you have your contribution verified, you’re free to use the contribution however you want — China has no requirement that you maintain or replenish cash contributed as registered capital.

If you don’t make and verify your registered capital contributions, the government may eventually force your company to liquidate.

Limited life and government approval

An LLC must have a specified life, such as 30 years. You’re usually not allowed to set up a company with an indefinite term. An LLC may apply to extend its term, though. Such applications are usually approved.

Most other major company matters — including establishing, selling or transferring ownership (even if partial), and winding up — likewise need approval from the government. Also, because of the approval processes for onshore transfers, many foreign investors set up foreign holding companies to own their onshore interests — see the sidebar titled “Planning ahead with offshore holding companies” for details.

Decision-making

Board members — not the shareholders — make all the LLC’s decisions. The company’s charter, called the Articles of Association (AOA), can specify the board approval requirements for certain decisions (for example, unanimous approval). Keep in mind that Chinese law requires unanimous approval for certain major decisions. The law will always trump the AOA! Voting rights and requirements are a crucial factor in deciding whether to JV.

Getting money out

An LLC can pay dividends to shareholders; however, China does have restrictions in place. For one, an LLC can usually pay dividends only if it’s been profitable for that year.

You can also get your money out of an LLC by using licensing/consulting/loan agreements with offshore companies that you own (see Chapter 10). Another option is getting money back when you wind up the company.

Expansion

When you register an LLC in China, you have to provide your company’s legal address. Your company can’t then automatically open up a factory or office outside the immediate area of your legal address. Your company has to go through the application procedures to open branches anywhere else you want to have a presence. This process usually isn’t too complicated, but the branches can’t have scopes of business that are different from the LLC’s.

If you want to do something outside of the scope of business, you have to set up a new company (or rep office). When you have multiple companies in China, they usually each need their own administration. In other words, you see a good deal of duplication because each company has many of the same internal functions — human resources, selling, and so on. In certain circumstances, you can set up onshore special holding companies that handle these administrative duties for your various companies, but the legal requirements make this choice hard for all but very large businesses.