The Recorder, San Francisco, California, Scaling The Great Wall - A Look on the Other Side, 14 July 2004

While it is not possible to itemize every element of a successful foreign investment in Mainland China in a few thousand words --- based on responses from our last submission to this publication, we wanted to provide a compass rose for those considering a journey here. Any useful map will show the user North-South-East-West in the compass rose.
 
In the United States, this means the compass rose will show you North. The transliteration of the word compass in Mandarin Chinese is needle-point-south. Here, we'd like to point out a few items to help keep the map from being looked at upside down.
 
All gibberish in the media aside, there are still really only three primary foreign investment options here for 95% of inbound capital: a Representative Office, a Wholly Foreign Owned Entity ("WOFE") and a Joint Venture ("JV").
 
WTO and CEPA accession agreements do not expand this list. Only what types of business can apply for setting up shop here has changed. All the China specific flaming hoops are still there and still need to be jumped through. Statutory compliance is still statutory compliance.
 
Before spelling out some essential details of a Representative Office and a WOFE, we should also note some institutional differences between East & West. These notes apply to Chinese investment as well as foreign investment, so should not be thought of as barriers to entry of Foreign Direct Investment. Also, as Joint Ventures are extremely intricate affairs they will have to be discussed in a subsequent article.
 
One major difference to be recognized is that a corporation formed 'for any valid business purpose' does not exist here. There is no such thing. Thus, no business license can or will be issued on that basis.
 
For example, when formalizing a WOFE here, an investment group will submit and have approved, 1) a business proposal, 2) an investment and business plan, 3) an overview of products to be produced, materials used, infrastructure required and staff to be hired and trained, and 4) new technology, business methods and skills to be brought to China. Once all that is approved, then the articles of incorporation will be approved and the investment group must expose capital, from abroad, before being permitted to engage in business here.
 
With our clients, we call this a square peg-round hole process. Starting with the business development executives in the West, those ideas of what clients want to accomplish have to be tailored to mesh correctly with existing statutes. There is also a need to work with foreign CFO's to ensure there is a complete understanding of how to get funds into, and later out of, China.
 
Another major difference is that there are no 'shell' companies on the Mainland. Of course, the existing statutes in Hong Kong permitting tax-free operation, when no business is conducted inside of Hong Kong, still exist. But Hong Kong is not China, and a Hong Kong company cannot be used as a basis for investment on the Mainland. There are certain tax and other liability reasons why a Hong Kong company might be inserted between Western capital and an entity on the Mainland, but that discussion is outside the scope of this article.
That said, what is the best way to use the existing statutes to protect your investment and set clients up in Mainland China? Well, it depends on what the goals are.
 
Are you selling into China? Exporting products out? Using segregated manufacturing for existing customers abroad? Do you need duty free import of commodities as part of your manufacturing process? Will you need Chinese Government approval before you can sell your products here? Is there intellectual property that will need to be protected?
 
Generally speaking, a Representative Office is the most simple and cost effective vehicle. For example, sales presentations, market openings, after sales service, technical coordination and quality control for foreign manufacturers and the like are common tasks undertaken.
 
They never made the Christmas market that year-or the following year
 
A Representative Office does not sign contracts on its own right. It signs contracts between new Chinese customers and the foreign company. No funds are 'earned' or paid in China, and in fact it is against the law for a Representative Office to make a profit. Therefore they are true cost centers. If a client's goal is to sell products into China and those products will require some form of Central Government approval, a Representative Office can also be the promoter of those applications.
 
Foreign personnel can, and should be sent in as part of this, or any, type of entity. Those individuals already part of and comfortable with your customers, corporate culture and short and long term needs will provide essential feedback on how to modify your plan as time passes. Parenthetically, language ability is less important than a solid industry specific business understanding of customer needs. Translators can be hired. Those with the existing intellectual capital of knowing your customers overseas and what needs to be accomplished are extremely difficult to find locally.
 
As the most easily set up and most cost effective option, a Representative Office is often a first step in entering the market here. They can be established in a few months from start to finish, including all licensing, visas, banking and tax matters.
 
A higher level of flexibility, the ability to earn (and export) profits and the only solid way to protect intellectual property requires a Wholly Foreign Owned Entity/WOFE. A few points on establishment of a WOFE were outlined above. Why are the steps towards the formation of a WOFE so inclusive? Well, the answer is easy. Once established, a WOFE enjoys duty free import of certain supplies, substantial tax holidays, no local interference from Government officials as well as other benefits. A WOFE also has no Chinese partner requirement, which is part of a Joint Venture structure.
 
In addition to exporting its profits, a WOFE can also be run entirely as the foreign investors see fit, so long as the business scope approved at formation is not modified. It can also keep its books and records in US Dollars and have foreign currency bank accounts, which is a unique benefit here in China.
 
What does one do with a WOFE? In our practice, they have been used to establish specialized heavy manufacturing for the oil and energy sectors, as the legal foundation for clubs, bars and restaurants, in software and mask-works research and development, as medical equipment manufacturing and other applications. Because a WOFE is designed, and constrained by statute, there are a few things one may not do with a WOFE. For example, this special entity cannot be used as an export-import company for the products of other companies.
 
With those limitations aside, virtually anything made (and now lots of services too) can use a WOFE structure. There are some basic misunderstandings that we have to resolve with the Chinese Government at formation, especially in the technology sector. But that is more of a fledgling, but growing, understanding of intellectual property as a product and not merely an idea.
 

The statutory authority permitting the formation of a WOFE, as applied in ShenZhen, Guangdong Province, requires exposing RMB 1 Million (about USD 126,000) within one calendar year from the issuance of the business license. The first installment or 15% of the RMB 1 Million need be paid in and certified within 90 days of the WOFE's approval. Also, a total of 20% of that entire investment can be credited off the total exposed capital by approved goods and technology that may be imported duty free.
 
Long-term profits taxes, after the tax holidays expire, are between 15 & 30 percent depending on the City/Special Economic Zone Chosen for establishment of a WOFE. Often there is much competition between these cities for new inbound investment, and clients should expect to be 'courted' heavily.
 
However, in our experience, keeping in mind the short and long-term infrastructure needs of the investment should weigh more heavily than taxation issues. Spending half a million dollars to establish a stand-alone entity here should not create its own long-term difficulties and bottlenecks by taking advantage of favorable tax treatment at the end of a road used as a thru way for local livestock. (A client really did this before he met us!)Other questions to ask are: How far is your proposed land off the power grid? What are the local environmental regulations that Chinese investors may not be compelled to follow, while you will? Has your business plan incorporated dorms for your staff to live in? (This is common in a manufacturing context.)
 
How long does it take to form a WOFE? From start to finish, a WOFE structure can be formalized within three to four months, for all China specific matters. However, we advise a six-month minimum timeline from first contacts with foreign investors until a turn-key solution can be in place. This allows sufficient time to address all the square peg-round hole issues that will arise. For they certainly will. If one is looking to use the new CEPA agreements from Hong Kong, a flurry of regulations, only now being implemented for the first times must also be dealt with. Thus the exposed capital savings of liberalization come with a doubling or tripling of statutory compliance to get you going here.
 
Some local successes here that have jumped through all the necessary flaming hoops are: an Irish Pub (with very nice imported Guinness), a Subway Sandwiches (which delivers to our office), a second Starbuck's Coffee going in now…. among lots of manufacturing, high-tech and other investments. In some senses, there is a blank slate here. There is a lot than can be accomplished here, with patience, persistence and understanding. We all just have to look at the map in the right way.