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Establishing a Wholly Foreign Owned Enterprise in China

Wholly Foreign-Owned Entities have become very popular with foreign investors setting up businesses in China.
15th May, 2019

ILS World reviews some important considerations.

Patience is required

Compared with modern business jurisdictions which offer online registration and same-day incorporation, registering a foreign-owned company in China is a long and bureaucratic process. To summarize, there are four application stages, a minimum of four separate registrations once approval has been granted, and two stages required to finally inject foreign capital into the company. The minimum time period you can expect for all of this to be completed is over a month, but in reality, this is often significantly lengthened by the time required to arrange the correct legal documents needed for each stage of the process.

It is always worth keeping the potential for delays in mind as they can significantly alter the course of a new business in China. The sooner you can get started the better. It is also worth considering the ownership structure of the WFOE, as a simple holding company, preferably in a jurisdiction which is familiar to Chinese authorities (i.e. Hong Kong), with the minimum possible signatories, can result in substantial time and cost saving advantages.

Every district is different

It is worth dealing with a formation agent familiar with a range of different business districts, as the variety of potential advantages which are available to foreign companies depending upon where the application is made, can be decisive, given the priorities of the business being registered.

Advantages of specific districts for certain industries might include the availability of tax incentives and grants, reduced minimum authorized capital requirements and the availability of a free (or a low cost) registered office.

This last point, in particular, can be very attractive to some investors. Having a registered office address included with the registration gives a new business the ability to operate in whichever district or office setting is most attractive at a given time, allowing for future growth and a quick office relocation without needing to make costly changes at the registration level.

You need to be specific

In contrast to the global trend for increasingly flexible corporate vehicles, WFOEs require very specific business scopes and a corresponding business name, which can only be accepted in accordance with China's formulaic company naming conventions. The centralized approval authorities treat a range of business activities as being sensitive and many are entirely restricted. The capital requirements of the company will also be dependent upon the business scope.

An ILS client recently required us to register a company as an investment vehicle for a planned joint venture within China. The use of the word "investment" was considered too sensitive for the application, however, despite the fact the company was clearly not being used to sell investments (a restricted activity for foreign companies in China). In this case the business scope was written to describe the entity as a service ompany to the Hong Kong parent, effectively servicing the parent company's investment into the joint venture. Knowledge of the authorities' expectations in this regard is vital.

Generally speaking, they are most familiar with service companies, trading companies and "International Business Consultancies" and applications for such activities are most likely to be successful without suffering delays.

Capital contribution requirements have been relaxed

Since foreign entities are no longer required to "pay up" their authorized capital (and suffer the cash-flow drag this previously entailed), it is common for new businesses to register a higher level of capital at their outset. This gives rise to a couple of advantages: first, approving authorities prefer to see a high level of capital, and second, it allows the investing shareholder to inject operational funds into the business without taxation, given that the capital of the company can be freely used for operational purposes.

This being said, accepting a high level of capital obviously increases the liability of the shareholders for their investment in China and so an acceptable balance should be found, depending upon the profile of the business being started.

The board has a peculiar structure

In contrast with the balance of powers which Western standards of corporate governance seek to achieve, WFOE companies are structured with a sole individual bearing the final authority of the company and the corresponding legal responsibility. As the position of "Legal Representative" –so important to the effective management of the entity – needs to be filled by a single individual, selection of the right person is crucial. A certain amount of power balance can be achieved by appointing a board of directors, which is made up of three individuals, including the legal representative; while a "supervisor" can also be appointed to audit the board from an independent corporate governance perspective. ILS provides supervisory services to clients who want to have an impartial third party to fill this role.

Whoever holds the Chops holds the power

Working in the corporate services industry in China, you don't have to wait long to hear horror stories of rogue individuals taking the company Chops (which are the legal seal of a Chinese company taking the form of simple ink stamps) and using their inherent power to effectively seize the entity. Notwithstanding the criminality of such acts, it is possible for a determined individual to completely undermine the integrity of an operational business simply by having possession of the Chops.

As the company Chops are also regularly required for use as the signing authority of the company (the actual signatures of company officers carry no weight in China), stakeholders in the business should take comfort by ensuring these innocuous looking stamps are only handled by trusted individuals and kept under lock and key when not in use. ILS has recently had the dubious pleasure of helping one of our clients achieve the substitution of an entire corporate structure in order to circumvent the loss of their Chops to a disgruntled former employee.

VAT is a revenue tax, not a consumption tax

The VAT scheme in China effectively replaced the various business rates which were charged to foreign entities. Despite being called VAT, this ad valorum tax is in fact a revenue tax suffered directly by the entity, rather than the consumption tax which VAT describes in the West. The given rate depends upon the size and status of the company, with the lowest rate of 3 per cent applying to small scale VAT payers, while higher rates peak at 17 per cent but can be offset against output VAT. Profits are generally taxed at 25 per cent.

Withholding tax rates vary, favouring Treaty jurisdictions

Many WFOEs are structured as service companies for a foreign parent, while it is usually at the parent company level that the business structure will want to realize any profits from their China based activities. Typically, a structure might invest into a Chinese operation from Hong Kong and (applying arms-length transfer pricing standards) realize the profit of the services provided in Hong Kong, where corporate tax on overseas income is 0 per cent, with only a smaller, percentage based agency fee being realized as profit in China, taxable at 25 per cent.

A withholding tax will be applied to dividends paid up to the parent company, with a statutory rate of 20 per cent currently reduced to 10 per cent for all jurisdictions. Some countries which have the benefit of a double tax treaty with China, enjoy a further reduction in this rate, however, with jurisdictions including Hong Kong, Singapore, UK and Ireland enjoying a preferential rate of 5 per cent.

You'll need to pay for business services

Having read this far into the article, you will have already gathered that WFOEs are burdensome in their nature. Each entity is required to register for tax and submit declarations on a monthly basis. These tax declarations need to be supported by a full set of accounts and all company payments need to be booked along with official "fapiaos" (printed purchase vouchers), which must be obtained and kept in order alongside each item of expenditure. Being classified as a foreign entity, you might expect that facilities for maintaining such records and for making the declarations would be available in foreign languages, but this is unfortunately not the case.

Even if you are able to recruit the necessary staff skillsets to complete this work in-house, the final set of annual accounts will need to be audited by a third party provider, which is why it is so common for foreign businesses to simply outsource the accounting functions of the company.

You can employ staff, but be careful

Having a WFOE entity allows a business to directly employ staff in China, whether they are local Chinese workers or non-Chinese expatriates. In fact, having foreign staff is one of the most common reasons compelling a business to register a WFOE with ILS, as the costs of otherwise employing a foreign member of staff can be very high (if they are on a business visa, for example, they will need to leave the country every month). Employing staff directly requires a detailed understanding of Chinese labour rules as these differ from Western standards significantly, both in spirit and application. We encounter many businesses which prefer to outsource the HR function of the company, primarily to avoid the legal risk of being an employer. Given a solid understanding of the issues, however, it is usually preferable to remove this operating cost from a business wherever possible.

It is also important to understand that Chinese and non-Chinese staff are treated very differently in respect of the employer tax contributions paid. In Shanghai, for example, the effective employer contribution for a Chinese worker is just over 39 per cent of their salary, but effectively 0 per cent for a non-Chinese member of staff (this is because non-Chinese staff are not able to benefit from the social security programs provided by the Government).

Individual income tax for non-Chinese workers is applied on a sliding scale, with a tax free allowance of RMB 4,800 and further deductions available. The level of tax can be calculated according to the following rates and deductions:

Monthly net taxable income (RMB) Tax Rate (%) Quick calculation deduction (RMB)
≥ 1,500 3 Nil
≥ 1,501 < 4,500 10 105
≥ 4,501 < 9,000 20 555
≥ 9,001 < 35,000 25 1005
≥ 35,001 < 55,000 30 2755
≥ 55,001 < 80,000 35 5505
≥ 80,001 45 13505

Individual income tax = taxable salary, minus tax free 4,800 RMB * tax rate, minus quick deduction.

To take as an example an individual who earns RMB 25,000 per month, with an accommodation allowance of RMB 10,000 per month, the taxable salary would be 15,000. Deducting the tax free allowance gives you 10,200, which is then multiplied by the applicable rate of 25% to give 2,550 and, finally, 1,005 is subtracted to give a total monthly tax bill of RMB 1,545.

Understand the issues, move forward with confidence

The inherent complications of operating a business in a foreign country can often seem daunting and the Chinese marketplace provides a notoriously steep learning curve.

This being said, it is now easier and cheaper than ever to operate using a Wholly Foreign Owned Enterprise and as the market has matured, the standard of corporate service providers has also increased. Finding a trusted partner to help you take your first steps into China will not only provide you peace of mind but will also save you time and money as you progress.

For further information contact Cindy at cindy.cheng@ils.world