February 2009

The chill from the world financial crisis has begun to take its toll on China's own still robust growth, with the worst damage seen in export-oriented industries most vulnerable to decreasing demand overseas. However, one area in which China is thriving in, is the new attraction of tertiary-oriented industries, such as consulting companies and design companies, for example, that are looking to come to the tier-one cities of Beijing, Shanghai, Shenzhen and Guangzhou to establish their presence. Many companies have the strategy to come straight in, attacking the market and establishing a Limited Liability Company in the form of a Wholly Foreign Owned Enterprise.

A Wholly Foreign Owned Enterprise (WFOE) is a limited liability company wholly owned by the foreign investor(s). WFOEs allow foreign investors to deliver services in China, without joining together with a Chinese partner. Limited liability is recognized by the amount of registered capital injected into the business. Although this may in fact be a combination of two assets, cash and equipment, the total value of these also represents the extent of the WFOE's liability. For consulting companies it will generally only be in the form of cash, which will then be used to pay for any type of software or other form of equipment needed.

Requirements for a Limited Consulting Company

Investor
There is no longer a requirement that the investor (if it is a company) be established for one year; however a bank reference letter must still be issued stating the current standing with the bank. Additionally the investor's business license must be notarized by the Chinese embassy in the home country.

The investor can also be an individual. In this case a bank reference letter must also be issued but in relation to the individuals standing with the bank.

Corporate Structuring
The Investor (company or individual) is the designated shareholder. The investor shall than appoint a Board of Directors, whereby there should be a minimum of three persons and a maximum of 50 people. A supervisor must also be appointed by the Investor. The supervisor's role is to "supervise" all activities being conducted by the Board of Directors.

Generally (by default, but it is not a requirement) the Chairman of the Board will be the designated Legal Representative. The Legal Representative can also be a person not appointed as a member of the Board of Directors. This person will be responsible for the activities of the Limited Company and is considered the "legal face" allowing him to sign all related government forms and any documents that are required by the government offices. That said this person can also have automatic authorization on bank accounts and can create any type of Powers of Attorney.

It is advisable to companies to choose somebody who is familiar with the China business, will be travelling to China and knows the staff and the people that are or will be in the Limited Company. The reason for this is that when it comes down to the end-of-year audit and/or liquidation of the Limited Company (if it would ever occur), generally the tax official will ask to see whether the individual has paid all necessary personal income tax. It is a requirement that the Legal Representative be automatically liable to pay personal income taxes in China, even if they are not residing in China.

Business Scope
Setting up a Limited Company does not necessarily mean that you can engage in any sort of activities, as may be the case in the West and certainly in Hong Kong. WFOE's can only be operated within the scope of business as approved by the authorities. If, at a later date, the WFOE wishes to add other activities, these are subject to further approval by the relevant government authorities. It is therefore very important from the onset of your establishment to determine what will be the functions of the WFOE.

In terms of consulting companies, it is necessary to list the current as well as long-term services that may be offered to clients.

Registered capital requirements
These vary from type of company and from industry to industry and also on a regional basis. Wherever you site your Consulting WFOE, however, basic investment criteria remain the same, the government will look at the general viability of the project and a reasonable cash requirement for a particular type of investment. It is stipulated in China that at least RMB 100,000 is required for a consulting company.

Registered capital and total investment figures are both required during the application procedure. The total investment is what is necessary to realize the company's operations; while the registered capital is the equity pledged to the local authorities (i.e. the actual amount to be remitted into the bank account). Limited liability is recognized by the amount of registered capital injected into the WFOE.

Office Space
A Consulting Company must have an office space prior to registration purposes of the company. The address must be in a commercial building. A list of rental certificates and contracts are required and must be submitted to the government authorities for approval. In many cities, such as Shanghai, Shenzhen and Guangzhou, a real estate certificate must be provided to the government authorities as well - the landlord should handle this procedure.

Accounting and Tax Filing, Tax Exemption Applications and Annual Audit Requirements

A Limited Consulting Company is liable for filing and paying Business Tax on all service invoices which are issued to a customer in China (5%), Foreign Enterprise Income Tax - otherwise known as Profits Tax (25%), Individual Income Tax for the employees, Stamp Tax and potentially a series of other taxes. It is therefore required that the company has an approved accounting software system to conduct monthly bookkeeping, and to create all government required financial statements and tax declarations.

Annual Audits and Annual Inspections are necessary for Limited Consulting Company's and must be submitted before May each year. The annual audits must be conducted by a local Certified Public Accounting firm.

Besides an annual audit, Limited Companies also have to submit a range of other documents and licenses to the authorities for checking and renewal if necessary. The so-called annual renewal is a bureaucratic process, but also a good time to take stock and ensure all your paperwork is up to date. The Audited Financial Report, the Foreign Exchange Audit Report, and the Annual Report must be submitted to seven government departments. These documents must be submitted before June 30th each year.

Additional Requirements for Limited Consulting Company's

If there are any changes associated with the Company, such as change of office address, change of Legal Representative, change in business scope, these must be approved by the original approving authority and all certificates associated with the Company must be changed.

Employment of Mainland Chinese and Foreigners

Limited Companies are permitted to hire their mainland Chinese and foreign staff directly without using an employment organization as is the case with Representative offices. Employment organizations can still be used to hire the local employees on behalf of the foreign companies. Whether the Limited Company or employment organization employs the staff, either entity must guarantee that welfare and social benefits are provided to the employees by the Company.

Consideration for Ease of Application Procedures

Company Registration Documents
Company registration applications are all about the paperwork. Investors will often involve consultants from both China and their home country in the discussions for the formulation of the Articles of Association, Feasibility Study, Appointment Letters, etc. It is advantageous that time is spent formulating these documents however, it is important for a foreign company to additionally follow up on the registration procedure of the company so as to make sure no changes have been made and to make sure that all necessary applications with the government bureaus have been made. It is highly recommended to ask for copies of the certificates at each approval step.

Registered Capital Issues - Undercapitalization
One of the most common - and serious problems with WFOE applications, especially for small service businesses, is the issue over registered capital. This is a much misunderstood area. Confusion exists, and many ill-advised investments are made in China due to misinterpretation of the local governments term "minimum registered capital". This is meant as a guideline only as is not supposed to be a ruling on how much you need to invest. Actually, the amount of registered capital needed in the business depends on a number of different factors:

• Location: Some regions in China apply different levels of capital requirements than others to reflect their lower or higher operational costs, such as rental rates, salary levels, social insurance rates, etc.
• Cash flow: This is critical and often overlooked. Registered capital is also required to fund the business operations until it is in a position to fund itself. Generally speaking this should be catered for in the 'feasibility report' - which is a business plan type document that is submitted to the authorities as part of the application process. Often the foreign investor will naively assume he's gotten away with stating the 'minimum amounts' as all that is required. However, the business can come to a shuddering halt if the registered capital amount is insufficient to support the operations cash flow. In China it is not just a simple matter of wiring additional funds into the account to support the operations. It is vital that a company properly capitalize its business in China in accordance not just with government guidelines over 'minimum registered capital' but also pure economic and operational realities. Businesses can and do go broke in China because of this issue.

Exit Strategies
In China, should the investor decide to close down their China operation approval must be obtained by the government. In case the government decrees the business can be continued, and perhaps faces unemployment issues or loss of tax revenues if it does close, obtaining permission to exit may not be easily granted. The way to deal with this is to have the articles of association worded (this is not in standard drafts) in such a manner as to link the termination clauses to customer clauses or profitability scales. In this way, an economic trigger is identified that can be pulled should the business under-perform. This needs to be built into the articles of association prior to registration with the authorities. If approved, the licensing authority must follow its own approvals process for the behavior of the company if it decides to exit for economic reasons. It avoids any type of ambiguity.

Recommendations for Ease of Operation

"Expert" Employees
In any consulting company it is important to hire proper "experts in their field". It is of up most importance in China to check the background of each staff member as it is common for employees to embellish their resumes. Virtually everyone working in China appears to be an expert of some sort. It is important to not only check the resume and references but also to contact the previous employer (who are normally more forthcoming by phone) for more details.

Set Guidelines for Employees
Many of the problems consulting companies meet with is due to a lack of clarity in what is authorized and what procedures are to be followed. It is recommended to prepare internal operational guidelines and management directives so that all employees, whether they be administrative staff or consultants are familiar with the companies protocol. More importantly foreign managers need to make sure that the company policies are compatible with the relevant PRC laws in order for proper implementation.

Meet all the Employees
Every case of incompetence, fraud or deliberate non-compliance is known by someone within the company who is willing to tell. It is important for the investor to maintain contact with all staff, particularly if it is a small operation. Naturally the authority of the General Manager should not be undermined but it is also reasonable for the investing company / individual to be exposed to skeptical or critical voices within its subsidiaries. Naturally, not all rumors or critical statements can be accepted at face value. However, such information will provide headquarters with guidance as to which areas should be investigated in particular during the internal audits.

Ethical Situations
Many service-oriented companies feel that it is appropriate to promote business activities without having the proper licenses in place or add additional services into their repertoire without having permission to do. In most cases they themselves would never do this in their home country, but because it is China they believe they can get away with it. This is a wrong perception of China. It is important that foreign investors stay within their prescribed business scope and conduct all business according to PRC Law.

Outsourcing Company Establishment and Administration Functions
Many companies look to outsource their company establishment procedures and administrative functions, such as accounting, tax filing, payroll and other corporate governance functions to external consultants. This benefits the investor in two ways:

1. Professional advisors often provide a "new set of eyes" or they can predict what problems may arise and they offer a greater level of understanding of the corporate environment; bringing experience and best practice across all business functions - from finance, accounting, legal and IT
2. They can act as independent "Administrative Managers" making sure that the Limited Company is in compliance in all aspects of operations.

This can be an asset for investors who want to only focus on the company's day-to-day activities and alleviate any financial and business risks.

Protection of the Parent Company by having a Holding Entity
Many foreign companies feel it is a risk to establish an entity in China. The establishment may not require a high capital investment but there can be a risk factor. Due to these aspects, more and more investors are establishing offshore companies to act as a holding entity for their China investment and thereby creating a buffer layer to take over the full liability for the Chinese operation from the parent company. The establishment of many of these offshore companies is an easy process and due to an uncomplicated tax system and accounting requirements, simple to operate. Double taxation agreements have been drafted and implemented between China and many of these offshore jurisdictions, which adds an additional benefit.

Conclusion

Many problems in Foreign Invested Enterprises (FIEs) can be traced back to their initial establishment and the project's structure. The main reason for this is that many foreign companies come into this new country and this new culture with high expectations and their western style of doing business, which may not always work in China. It is very good to come into a new market with high expectations and with these great opportunities being offered, however one should be prepared for unexpected occurrences and obstacles. After experiencing China many investors will find that "everything in China does take much longer than expected and nothing ever turns out the way one imagines," however this should not be a reason for a company to "give up" on its China strategy. With patience and understanding for the market and the culture, many companies have been able to overcome these pressures and operate very successfully.

If you require assistance with the above subject, please contact us at This e-mail address is being protected from spambots. You need JavaScript enabled to view it with your detailed questions.

All information in this report is verified to the best of our ability and is assumed to be correct at time of release; however, Klako Group does not accept responsibility for any losses arising from reliance on the information provided within.