Business opportunities on China's mainland abound, but be prepared for truly foreign laws. CORPORATE COUNSEL Magazine

CORPORATE COUNSEL Magazine, New York. October 2004.

Business opportunities on China's mainland abound, but be prepared for truly foreign laws.

       In the three years since China joined the World Trade Organization, much has been written about new business opportunities "on the mainland." But setting up shop in China isn't as easy as it sounds. Companies wanting to sell or manufacture products here must understand that the legal environment in China is unlike any other in the world. All investors -- whether foreign or native -- must jump through a series of statutory "flaming hoops."

        What is the best way, then, for a multinational company looking to do business in mainland China to get started? It depends on the business's goals. Despite the recent media hype, there are still really only three primary ways for foreigners to invest in mainland China: a representative office, a wholly owned foreign enterprise (WOFE), or a joint venture. Hong Kong companies cannot be used as a basis for investment on the mainland.

        (Discussing how to bring people from different countries together into a partnership is outside the scope of this short article. Suffice it to say that joint ventures in mainland China are created, approved, and managed much the same way as we would create a partnership in the United States.)

       The simplest and most cost-effective vehicle for investing in China is a representative office. These entities can be established in a few months and often are the first step in entering a Chinese market.

       A representative office is basically not much more than a glorified trade show booth. It is a legal entity that allows foreign companies to have employees in China, doing such things as handling sales presentations, opening dealerships, and supervising quality control for goods made in China. If a company's goal is to sell products into China that will require some form of central government approval, such as pharmaceuticals, a representative office can also handle those applications.

       A representative office cannot sign contracts in its own right. It merely handles the signing of contracts between Chinese customers and the foreign-owned company. A representative office also cannot earn income in China. It is, in fact, against the law for a representative office to make a profit. They are true cost centers.

        Employees from the foreign company's headquarters should definitely be among those staffing these offices. Having people on-site who understand the company's customers, corporate culture, and short- and long-term needs will be invaluable in helping to plan its future operations. Understanding the company's business is far more important than being able to speak Chinese.

       To earn (and export) profits, protect intellectual property, and generally have more flexibility in mainland China, foreign companies should establish a wholly owned foreign enterprise. A WOFE (pronounced "woofie") is basically a Chinese company, with the addition of some benefits. A WOFE enjoys duty-free import of certain supplies, substantial tax breaks, and no local interference from government officials.

       That said, foreigners must understand that opening a company in China -- whether you are a native or a foreigner -- is a complex, demanding process. The notion that a corporation can be formed "for any valid business purpose," which we take for granted in the West, simply does not exist here. Those wanting to set up a business in mainland China are required to inform the government -- in excruciating detail -- who they are, what they want to do, and how much they will invest. All of this must be approved before investors will be allowed to open their doors. Luckily, the rules are clear and manageable.

       When formalizing a WOFE here, an investment group will be required to submit the following: 1) a business proposal; 2) an investment and business plan; 3) a list of the 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. All of these must be accepted before the articles of incorporation can be approved. Before being permitted to engage in business, however, the investment group must deposit cash, from abroad, into a Chinese bank. If a corporation has $1 million as registered capital, then $1 million has to be put in the bank before the business license will be issued.

       From start to finish, a WOFE structure can be formalized within three to four months. We advise a six-month minimum from the first contact with foreign investors until the doors can be opened for business. This allows sufficient time to resolve the unforeseen complications that are likely to arise.

       The requirement to disclose trade secrets usually seems wildly counterintuitive to Western executives. Because of this, we call setting up a WOFE with a client company a "square peg/round hole" process. From the earliest stages of deciding to set up operations in China or enter the Chinese market, companies should be tailoring their goals to fit into the Chinese statutes.

       That said, there are substantial benefits for foreign companies once a WOFE has been set up. In addition to being able to export profits -- something that Chinese-owned companies cannot do -- a WOFE can also be run entirely as the foreign company sees fit, so long as the business scope approved at formation is not altered. It can also keep its books and records in U.S. dollars and hold foreign currency bank accounts in China, a benefit unique to the country.

       Virtually anything manufactured in China (and now lots of services, too) can use a WOFE structure. WOFEs have been used in heavy manufacturing for the oil and energy sectors; as the legal foundation for clubs, bars, and restaurants; in software and chip research and development; and for medical equipment manufacturing.

       Because a WOFE is designed and constrained by statute, there are a few things a company may not do with it. For example, wholly owned foreign enterprises cannot be used as export-import operations for products made by other companies.

       There are also some financial restrictions. The statutory authority that permits the formation of a WOFE requires that a certain amount of foreign currency be "exposed," or moved from abroad into a Chinese bank, within a year of the business license being issued. Each of mainland China's 54 provinces has the authority to modify the regulation so the specifics differ regionally. In Shenzhen, 1 million Chinese yuan (about $126,000) must be exposed within a year. The first installment of this, 15 percent, has to be paid within 90 days of the WOFE's approval. Up to 20 percent of this amount can be in the form of goods or equipment being imported.

       Taxes on long-term profits also vary depending on the city or special economic zone. But they are typically 15 to 30 percent. However, almost all foreign companies get tax holidays, usually from two to five years in duration. There is competition among cities for new inbound investment, and companies should expect to be courted heavily.

       As attractive as the tax breaks may be, do not give them undue weight in making decisions about where to set up a WOFE. Before retaining our services, one company spent $500,000 to establish a stand-alone entity in Shenzhen simply because of a favorable tax treatment. The top executive ignored the fact that the business would sit at the end of a road used as a livestock thruway by local farmers. The resulting bovine traffic jams and delivery bottlenecks have long since canceled out any tax benefits.

       Getting through the legal flaming hoops seems daunting at first, but it can be done. Some foreign companies that have successfully opened shop in Shenzhen include McCawley's (an Irish pub with very nice Guinness), a Subway restaurant (that delivers sandwiches), and Starbucks -- plus lots of manufacturing, high-tech, and other investments.

       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.

       Mainland China is a huge market, and it boasts an educated workforce, a growing middle class, and a stable and predictable investment environment. While China will never operate on a North American timeline or business model, those who have chosen to work with China on its own terms are doing very well. If you are on the way to China, consider it a long-term strategy. Start small and leave your assumptions at the door.