Deciding your China Structure

There are several ways to structure your investment in China. While the different options might seem straightforward at first glance, setting up a China presence is not a step that should be taken lightly. 

Apart from the fact that procedures to set up a company are more complicated and take generally more time than in the Europe, a lot of factors need to be considered in order to structure your investment in the best way possible. Several issues from both business, legal, financial and tax perspectives need to be addressed. And, if the wrong decisions are made in the beginning it might be difficult or costly to correct them afterwards. Changes in business scope or structure will often be subject to lengthy approval procedures once the company is set up.
In this article we would like to briefly introduce the possible entities that can be set up by foreign companies in China, as well as explain the most common mistakes made by foreign companies in the process of investing in China.

1. Legal Entities in China.
There are several legal entities in China which can be used by foreign companies in China, each with their pros and cons.  We list these legal entities to give you a general introduction about the possibilities when setting up a business

Representative Office (RO)
Representative Offices can be established by foreign companies for engaging in business liaison activities, quality control, promotion, market research, technology exchange and some other permitted activities in China. RO’s are considered the easiest and cheapest solution to get a presence in China, taking approximately 20 days to register from the date of application. There are no minimum capital contribution requirements for the establishment of the RO. However permitted activities are limited. RO’s are prohibited from direct revenue earning business activities, such as signing sales contracts, receiving payments or issuing invoices. The RO is not allowed to hire personnel directly but must do so through a third party HR service provider. Since January 2010, legislative changes affecting ROs have caused an increase in applicable taxes and introduced annual reporting duties. There are now stringent penalties imposed on RO’s whose activities are deemed to fall out of the allowed scope. While the fundamental characteristics of ROs remain unchanged, they may no longer be the ideal option for many companies.

Wholly Foreign Owned Enterprise (WFOE)
A wholly foreign owned enterprise (WFOE) is a limited liability company.  All the directors of the WFOE can have foreign nationality, and reside outside China. It normally takes 90 days for the relevant authorities to approve the establishment of a WFOE. The minimum registered capital requirement is at least RMB 30,000 but in reality this amount dependens on local policies and scope and industry and can be considerably higher. A WFOE can directly trade, manufacture, distribute or deliver goods and services in China. There are different kind of WFOE’s such as Manufacturing and Consulting WFOE. Another special kind of WFOE is de Foreign Invested Commercial Enterprise,a specialized structure for trading, distribution and retail.

Joint Venture (JV)
A Joint Venture is a business arrangement between two or more companies, by which the participants create a new business entity or an official contractual relationship, sharing investment and operation expenses, management responsibilities, and profits and losses. Foreign investment companies could establish a Joint Venture with a Chinese partner, under two different Joint Venture structures:  A Joint Venture could be either an Equity Joint Venture (EJV) or a Cooperative/Contractual Joint Venture (CJV).

In an Equity Joint Venture (EJV), profits and losses are shared in proportion to the partners’ equity contribution. Normally it takes Chinese authorities 90 days to approve the establishment of an EJV. The equity contributed by the partner(s) is allowed to be in a form of cash, buildings, equipment, materials, intellectual property rights, and land-use rights. Equity in the form of labour is not allowed. A minimum of 25% capital contribution of the foreign partner(s) is required while there is no minimum capital contribution requirement for the Chinese partner(s). During the life of the joint venture contract, partner(s) are restricted from withdrawing registered capital. They must first receive the approval of relevant Chinese authorities before they can transfer any share holdings.

There’s no minimum foreign contribution requirement in a Cooperative Joint Venture/Contractual Joint Venture (CJV).  Profits and losses in a CJV are shared according to the negotiated terms of the contract, which allows a more flexible schedule for investment return in cases where one investor provides cash while the other party’s investment is primarily in kind. Normally it takes the relevant Chinese authorities 45 days to approve a CJV. The duration of a CJV is subject to the contractual agreement covering the venture, and entered into by both partners.

Foreign-invested Partnerships (FIP)
Companies and individuals are now permitted, either amongst themselves or in partnership with domestic individuals or entities, to directly establish foreign invested partnerships (FIP) in China.  A FIP is not an independent legal entity. It normally takes 20 days for a FIP to finish registration. The contribution into a FIP is flexible, and can be in the form of cash and in-kind contributions (even labour services). The legal vehicle of a FIP is new to foreign investors and the relevant regulations are not yet completely worked out. However, the FIP does have its own advantages and a flexibility which could be another good option for some foreign businessmen  to start business in China.

2. Investing in China through Hong Kong
Sometimes it might be wise to structure your China investments through a Hong Kong company. There are several reasons why this might be beneficial:

  • Agreements etc. will be governed by Hong Kong law, which might be preferable over Chinese law and provide additional protection for the foreign investor.
  • It might ease the process of setting up the company as local officials in China will usually be accustomed to Hong Kong documents, while not necessarily (especially in more rural areas) with documents from other countries.
  • A Hong Kong structure might provide tax benefits due to lower taxes and favorable tax-treaties between China and Hong Kong.
  • Corporate restructuring in Hong Kong is a much easier process then in China where complicated and time-consuming procedures are necessary to do for example share transfers or otherwise change the scope or structure of an investment. In case of a Joint Venture, it might be best to set up a Joint Venture with a Chinese company in Hong Kong as this will make any changes to the JV easier.

On the other side, setting up and maintaining a Hong Kong Ltd costs money, and for the tax benefits it is usually necessary to have actual substance and activities in Hong Kong to utilize them. Therefore pros and cons of such a set-up should be considered in every individual case.

3. Common mistakes and pittfalls
Many factors have to be taken in to consideration when investing in China, and often mistakes made in the beginning when setting up your China structure might be difficult or costly to correct later.  Many companies make the mistake of jumping in too fast.  Long term planning has to be taken into account when setting up your structure. For example, depending on what you would like to do with your profits, -re-invest in China or repatriate profits to the head office-  a different kind of structure might be chosen.

An often made mistake is starting the company with a registered capital that is too low to cover operating expenses. When additional capital is needed from the mother company, this will be deemed as income and will be taxed accordingly, making this a potentially costly mistake. Also, there is more to doing business in China than just setting up a legal entity. Before starting in China make sure your planned business activities are not prohibited or restricted, and make sure that there are no restrictions on certain materials you would need for your production in China. Depending on your business there might be a variety of required permits, some which might take a long time to get.
While Joint Ventures might be a very good way to enter the Chinese market, here especially caution is necessary. Not all Joint Ventures last forever, and while they might start with the best of intentions, they might end in dispute.  An exit strategy is therefore of the utmost importance. Make sure you know everything about your partner by doing a proper due diligence research. Make sure that the land and equipment that is brought in the Joint Venture by the Chinese partner is actually owned by them, and ensuring your investment and intellectual property in properly protected in the agreements.

4. The Key to Success
In short, a proper preparation is the key to success.  There are many consultants and law firms both in China and in Europe who could help you set up a company in China, but you will risk ending up not with the solutions that you really need.
At Kneppelhout & Korthals we have years of experience helping Dutch companies and individuals doing business and investing in China. We will not only help you set up a China presence, but by asking the right questions we will work together with you too come to the best strategy as well as structure. We will help you to protect your interests and ensure you enter the Chinese market minimizing both risks and costs.

For more information, do not hesitate to contac Erik van der Molen , Joost Vrancken Peeters or Lin Li at Kneppelhout & Korthals China Practice