When setting up an entity in China, there are a whole range of crucial decisions that need to be made by the shareholder, that will affect the company’s operations in the country. In this article we discuss why it is important to properly structure your entity for future operations and discuss several items that must be structured properly to set up your company for success.
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Importance of Properly Structuring Your Chinese Entity
The way that a Chinese entity is structured during incorporation will affect both the incorporation process, as well as future operations. Certain structural decisions will require companies to perform additional incorporation steps or apply for additional licenses. Furthermore, not structuring the entity in an optimal way might result in limitations and cause additional administrative procedures to correct issues, leading to unnecessary costs and delays.
As such, it is essential for companies to be well informed during the decisions process. It is highly recommended to engage a service provider who is well equipped to advise in all aspect of the incorporation process and how decisions impact future operations.
Choosing the Right Investment Vehicle (or Company Type)
Understanding how to access the opportunities that exist in China can be confusing for most and deciding on the right market entry vehicle is one of the most important decisions to make for foreign businesses exploring entry into China. The appropriate mode of entry depends on multiple parameters, with the intended activities and industry being the most important considerations. Under the new Foreign Investment Law three primary investment vehicles can be established by legal persons or non-legal persons, namely a Wholly Foreign-Owned Entity (WFOE), a Joint Venture (JV) or Representative Office (RO).
China Representative Office
As an RO is an extension of the headquarters and not a separate legal entity, it is easier to set up, but restricted in its activities. It is not restricted to marketing and liaison activities for the headquarters and cannot engage in commercial activities, independently import/export or independently hire Chinese staff. As such, it is only used by companies that are looking to conduct limited activities with limited staff, this could be for example on-site support for existing customers, market and field research or marketing activities.
WFOEs and JVs
The two other options, WFOEs and Joint Ventures are both separate legal entities and have similar characteristics, with the notable difference that the Joint Venture includes more than one shareholder.
Whereas it is possible that a Joint Venture is set up between two foreign entities, the most common setup is a Sino-Foreign Joint Venture, a limited liability company through a partnership between a foreign investor and a Chinese company or individual. The two main reasons for the establishment of a Joint Venture are accessing restricted industries in which foreign investment is only permitted through a joint venture, or for utilizing the existing network of a Chinese partner with local market knowledge and well-established contacts. When these two reasons are not relevant for a company, generally a WFOE is the preferred investment method for foreign companies, ensuring that the company retains all control over the Chinese entity.
What is the Best Structure for Your Chinese Entity?
After selecting the right investment vehicle, the next key structuring item to decide on is the operating model. For a WFOE in China, there are three operation models:
- Consulting
- Trading
- Manufacturing
The choice between a Consulting WFOE, Trading WFOE and Manufacturing WFOE depends on the activities the company plans to do in the near future, but also on future plans.
China applies strict regulations to activities that companies can perform through the business scope. This means that a consulting company that only has consulting related terms in its business scope, is not allowed to do trading activities. Therefore, it is essential to make a well-thought-out decision on which model is selected, as it will affect the company’s future operations.
When it comes to the establishment procedures, it is relevant whether a company will be a manufacturing WFOE or not, particularly related to the address. Whereas there are generally no additional requirements for Consulting and Trading WFOEs for the address, a Manufacturing WFOE is required to conduct an Environmental Impact Assessment (EPA).
If a company engages in the manufacturing processes, including full manufacturing or assembly of final products, it will be required to perform an EPA. The purpose of the EPA is to assess the estimated impact which the operations of the intended manufacturing facility will have on the environment. The EPA must be conducted by a licensed Chinese third-party. The complexity and time required for the assessment depends on the planned business activities but can take up to 4 months to complete. Therefore, it is essential to carefully select the address and to consider whether a manufacturing entity is required and suitable for the company.
When it comes to the company’s future operations, it is also advised to carefully consider the operating model. For example, if a company will initially only hire local employees to support with quality control of the products and leave the import/export procedures to a third-party, but it would want to start trading through its own entity in a few years, it may still be best to already establish a Trading WFOE from the start. As changing the operating model and business scope can be time consuming and costly, it is best to consider the company’s concrete plans for the future before making a decision, as the decision could affect the company’s operations in the future and potentially cause delays and extra costs when a change is required.
Key Structural Details
In order to proceed with the applications with the Chinese authorities to establish an entity, several structural details must be decided upon which has an impact on the company’s future operations. Here are some of the key items:
Registered Capital and Total Investment
In order to register an investment a shareholder wants to make in a Chinese entity, the company will need to select the amounts for registered capital and total investment. The registered capital refers to the total amount of equity or capital contributions to be paid by the shareholder(s).
The registered capital is a tax-free contribution which can be paid as either cash (foreign currency or overseas RMB) or contributed in technology, machinery, and/or other assets – generally it is advised that the registered capital is paid in foreign currency.
The total investment refers to the amount of funds which a foreign-invested enterprise needs to realize the company’s production or operations as set out in their Articles of Association (AoA). A WFOE company also needs to specify in the AoA what the total investment contributed to the company would be. To learn more about registered capital and total investment, you can read our article here.
It is essential for companies to select a reasonable and appropriate amount for both registered capital and total investment, as it affects the company’s financing. To learn more about financing an entity in China, read our full article.
The difference between the registered capital and total investment is that registered capital can be brought into China as a loan issued by the parent company, where the overseas parent company becomes the creditor of this loan. As such, this difference between is also known as the financing gap.
Additionally, as the registered capital is a tax-free contribution, it is generally the easiest and most cost-effective method of bringing funds into the Chinese company. Other options to finance a company are generally more complex or incur taxes. Generally, it is advised to ensure that the registered capital can finance operations for 6 to 12 months, or until the entity can start financing itself.
If the amount is set too low, the company might end up with financing issues and be required to increase the registered capital later on. If the amount is set too high, the company might not be able to contribute the funds within 30 years and the amount will affect profit repatriation in the future, in particular dividends.
Changing the registered capital after incorporation will require an update of the company business license and Articles of Association, which in turn means that all authorities will need to be updated of the change, including the bank, tax bureau, customs authority and others if applicable. Therefore, changing the registered capital in the future can be time-consuming and expensive, and setting the right amount during the setup process is key.
Business Scope
The business scope is an official description of the activities a company plans to engage upon in China. This business scope is mentioned on the business license of a company and is publicly accessible by any individual via the company registry on the website of the AMR.
It is important to note that a company is only allowed to conduct operations which are specified in its business scope. If a company performs activities outside of its business scope, it can be subject to fines, and in some instances, the company’s business license can be revoked.
Therefore, investors should carefully consider the business activities the company wants to engage upon in China when establishing the legal entity, but also consider any activities the company plans to engage in in the future, as the process of changing the business scope can be complex and time-consuming.
Address
All companies are required to have a registered address, of which proof must be provided during registration. Since it is a requirement during the company name registration procedure, you should have a lease agreement before submitting the documents for (pre-)application with the AMR.
In order for a registered address to be suitable it must satisfy the following two requirements:
- The address can be used for commercial purposes.
- No other company is registered at the intended address.
Some companies have used virtual addresses for their company registration and executed actual work from a different location. However, this does create a level of compliance risks for a company.
Many local governments and industrial parks/areas offer tax incentives, benefits and subsidies to companies to operate in their area. Depending on the industry and activities to be performed, this can be a great opportunity for starting companies. As such, it is advised to conduct a location search before deciding on an address, as there may be benefits available.
Registered Personnel
Any foreign owned limited liability company in Mainland China must appoint a Legal Representative, an Executive Director or Board of Directors, a Supervisor, and optionally a General Manager separate from the Legal Representative. It is required to determine those positions during the company establishment phase. To learn more on these positions, refer to our article.
These registered persons can be of any nationality and do not have to reside in China. From a practical standpoint it is advised to ensure that the registered personnel will have continuity with the company. With complex procedures in place to change a registered person, particularly in the case of a legal representative, it is best practice to appoint individuals that are expected to remain with the company for a long period of time, to avoid unnecessary administrative procedures in the future.
Company Name
In China, the official legal company name is the Chinese name and will be registered with all major Chinese governmental authorities. The Chinese legal name has to follow the following legal format:
- Company’s chosen name;
- Major business activity the company will perform (i.e., Consulting, Trading, Technology etc.);
- Region or place of incorporation (i.e., Shanghai);
- Legal structure of the company (i.e., Company Limited or LLC).
In addition to the Chinese name, companies can also choose an unofficial English name. The English name will be registered with the Ministry of Finance and Commerce (MOFCOM), may be represented on the company chop and can be used when registering with the bank. However, the English name does not hold the same legal power at the Chinese name, which is the only official company name.
When choosing the company name, the following items are important to consider:
- Use of certain special names in the Chinese name, such as those including ‘China’, ‘State’ or ‘International’, is only permitted if the company meets specific minimum registered capital requirements. When it comes to the English name, the rules are less strict.
- In cities, district and industries where many companies have already been registered, it can be difficult to obtain approval from the government on the desired name. The government will compare the proposed company name with other companies in the same region and industry. If the name is deemed too similar, the name will be rejected. Therefore, we advise clients to prepare a range of possible company names (at least 5) for the application. However, in certain cities and industries it is becoming increasingly difficult to find a suitable name, due to the vast number of already existing companies causing higher chances of the proposed name being too similar.
- Changing the Chinese company name in the future is particularly risky. As the Chinese company name changes, the company chop will also be changed. This will open the company up to the risk that clients, suppliers or other business partners will not recognize the updated company information and no longer honor existing contract obligations or use the situation to renegotiate terms.
- In line with the other structural details discussed above, the updating of the address is also complex and time-consuming, so choosing the right name is essential.
In the past, companies would first set up a holding company in Hong Kong, that would subsequently invest in the Chinese subsidiary. Nowadays most companies will invest directly into the Chinese entity from the headquarters.
For larger companies with several different companies within the organization, it is an important consideration which group entity will be the direct shareholder of the Chinese entity. The direct shareholder will be the entity that must make the registered capital contributions and the entity that will receive dividends.
As China has varying arrangement with different countries through the specific Double Tax Agreements, the applied taxes for dividends, royalties and other payments may vary based on the home country of the direct shareholder. However, it is notable that for dividend distributions the Tax Bureau will generally request ultimate beneficiary owner (UBO) information. Which means that if the direct shareholder of the Chinese entity is located in a country that has agreed a 5% dividend rate with China, but the UBO is located in a country that does not have preferential rate agreement with China, the preferential rate will not apply.
Lastly, it is important for companies to choose the right shareholder upon incorporation, as a future share transfer of the Chinese entity within the group, may cause tax impact in either China and/or the home country.
Closing Thoughts
In the article we have shown how important the structural details are in the incorporation process and how the decision made may impact the company’s establishment procedures and future operations. As such, it is important essential for companies to be well informed before and during the setup process.
At MSA, we support our clients with all steps along the way in entering the Chinese market, from market entry advisory, to advisory on structural details and support with legal incorporation and operationalization of the entity.
