Pre-establishment Considerations for Setting Up a WFOE in China

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By Dezan Shira & Associates
Editors: Zolzaya Erdenebileg and Tongyu Zhang

Before committing to the WFOE as an investment vehicle in China, there are several pre-establishment considerations that investors should take into account. In recent years, there have been numerous changes made to the basic pre-application process of setting up WFOEs in China, particularly surrounding how they are taxed, their required registered capital, and their intellectual property. In order to expedite the process and decrease the risk of costly errors, investors should carefully analyze each of these developments to ensure that they enter the market with eyes wide open.

Registered capital

Choosing an appropriate amount to dedicate towards registered capital is an important, but difficult, consideration. If the amount is too little, then the WFOE application may be rejected by officials, and may put the company at risk of insolvency. However, if the amount is too much, then the company risks having idle funds and missing opportunities.

On paper, China’s recently implemented PRC Company Law offers more flexibility to investors:

  • As of March 2014, there is no minimum registered capital requirement, except for a few select industries;
  • Investors can choose the period of contribution of the capital, which must be laid out in a schedule of contributions specified in the Articles of Association; and
  • It is no longer required that 30 percent of registered capital consist of a cash contribution.

In practice, however, proposed registered capital contributions will be closely examined by the Ministry of Commerce (MOFCOM) to assess whether the amount is sufficient to support the WFOE’s activities for at least one year after establishment. The amount of “sufficient” capital varies depending on various factors, such as the region of incorporation and the industry. A basic consulting WFOE will typically require a minimum commitment of between RMB 200,000 to RMB 500,000. Manufacturing WFOEs, on the other hand, will require more. Investors can abide by investment to capital ratios, as shown in the table below.

CB 2017 0102 issue_infographic_page 07 copyIt is important to note that registered capital contributions, whether paid in cash, as a lump sum, or through installments, must be injected by the overseas investor from outside of China. Once paid, registered capital cannot be freely wired out of the country.

Business scope

The business scope is a one-sentence description of a company’s activities within China. While seemingly innocuous, it directly affects the legal operations of a company, and the company’s ability to issue official invoices (fapiao) to clients. Once written and approved, the business scope is printed on the company business license. The process of changing business scope is complicated, as shown in the flowchart below. Such altering process is also time-consuming, requiring several months. Therefore, business scopes should be prepared and agreed on in advance of incorporation.

The business scope is connected to the Catalogue, which lists the encouraged, permitted, and prohibited industries for foreign investment into China. Depending on this, the business scope will need to be structured to set the range of activities and operations that the company is allowed to engage in.

After submission, the scope will be examined word-for-word by authorities at MOFCOM and the Administration of Industry and Commerce (AIC). If the scope is found to be problematic – which can happen if the proposed activities are formally or informally restricted – then a negotiation will occur. A communicative and trustworthy agent will be necessary in this process.

Professional Service_CB icons_2015RELATED: Business Advisory Services from Dezan Shira & Associates

Crucially, the business scope affects the company’s ability to issue fapiao, which clients need to receive reimbursements and offset value-added tax liabilities. If unable to issue the correct fapiao, companies may find that clients are unable or unwilling to work with them.CB 2017 0102 issue_infographic_page 08

 

Intellectual property (IP) protection

China observes a ‘first-to-file’ policy, meaning that whoever is first to file for intellectual property rights (IPR) obtains those rights. This can pose a problem for foreign companies looking to expand their brand in China, as sometimes the IPR has already been filed by an opportunistic investor. Checking one’s trademark and ensuring that the necessary paperwork is correctly filed with the appropriate Chinese authorities should be one of the first steps towards entering the market.

Despite recent progress, IPR violations continue to be troublesome for investors in China. In addition to securing their IPR, companies must then be proactive and vigilant about protecting it. Many companies do regular online research, as well as attend trade shows and other functions, to check for possible violations. Additionally, companies can request that Chinese customs monitor for trademark infringement free-of-charge (at the time of writing).

Below are some general measures that companies should take to protect their IPR:

Copyrights: register works with the National Copyright Administration to ensure evidence of ownership;

Patents: follows ‘first-to-file’ system and must be filed with the State Intellectual Property Office in Beijing. Those without a commercial office in China must file patent applications through an authorized patent agent;

Trademarks: follows ‘first-to-file’ system and must be filed with the Trademark Office of the State Administration for Industry and Commerce (SAIC) in Beijing and its 13 local offices. Careful attention should be paid to the category under which the trademark is filed, as the trademark will be protected only within that category. Foreign companies must file through an authorized trademark agency.

Transfer pricing

Transfer pricing concerns the price charged for intercompany transactions of associated enterprises in different tax jurisdictions. China adheres to the ‘arm’s length principle’, meaning that related party transactions must be treated the same as transactions between unrelated parties. With a relatively low threshold for applying transfer pricing rules, WFOEs should be aware of their tax filing obligations, particularly those with overseas parent companies. Obligations mainly consist of two parts: (a) ensuring that related party transactions are appropriately disclosed in the tax return; and (b) preparing and maintaining detailed transfer pricing documentation, if required.

As an active participant in the base erosion and profit shifting (BEPS) project, China has enhanced its transfer pricing regulations. For example, in 2016, a three-tiered documentation framework was introduced by the State Administration of Taxation (SAT). WFOEs, under the scheme of tax assessment by accounts examination, need to submit the ‘Enterprises Annual Reporting Forms for Related Party Transactions of the People’s Republic of China’, in Chinese, by May 31st of the following year. As of 2016, this contains 22 separate forms. In some cases, a nationality report will be required when submitting the report on related party transactions. WFOEs should additionally prepare and maintain contemporaneous transfer pricing documentation in compliance with China’s transfer pricing regulations, which shall be kept for 10 years for future reference. Reviewing transfer pricing related requirements, as well as preparing proper internal management in the pre-establishment period, is therefore essential for WFOEs.

Tax planning

In consideration of China’s tax structure, WFOEs should pay extra attention to income tax and VAT for tax planning. During the process of setting up a WFOE in China, investors will inevitably incur costs. Determining whether these costs can be deducted from the company’s tax bill is critical, especially for large projects involving factory set-up or machinery purchases. A key point is the definition of the pre-operation period. In practice, the period starts from the establishment date on the business license, or the day that the company gets its name confirmation from the AIC. The end date is when the company issues its first invoice, or first generates revenue.

For income tax deduction, some of the costs incurred in the WFOE pre-operation period – such as wages, training fees, printing fees, transport fees, registration fees, and purchases of items not considered fixed assets – may be deducted if valid tax invoices can be provided.

Under China’s reformed VAT system, in order to obtain tax planning benefits, and gain an advantage through permission to issue special VAT invoices and obtain VAT deductions, WFOEs usually register as general taxpayers. During the pre-operation period, a WFOE may still be in the process of tax registration without having obtained general taxpayer status, even while some input tax cost was incurred. However, if the company does not derive any income from business activities and does not make simple computation of VAT, input tax may be kept as credit when general taxpayer is eventually confirmed.

Holding company issue

Foreign investors may use an intermediary holding structure, otherwise known as a holding company, to serve as the formal investor shareholder of its WFOE. There are two key advantages to using a holding company, namely tax benefits and a simpler process to follow in case of restructuring or divestiture.

Tax benefits

Investors may benefit from preferential tax treatment by locating a holding company in a region that has favorable tax treaties with China. Traditionally, Hong Kong has served as a preferred jurisdiction, but many other countries now offer similar advantages. However, qualification for such tax benefits has become stricter, as China’s authorities have started closing loopholes.

Restructuring or divestiture

In addition to possible tax benefits, a holding company also offers a simplified procedure for WFOEs looking to change their shareholders. Formally changing the shareholders of a WFOE registered in China requires tax clearance, including a potential valuation of the WFOE, followed by updating registration information with all relevant Chinese authorities. It is also possible that the Chinese authorities will object, forcing investors to spend more time, effort and money towards the change.

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Key takeaways

Pre-establishment considerations are increasingly important in the Middle Kingdom. Making correct and strategic choices from the onset can position a company for long-term success in China, while businesses that fail to do so risk incurring additional costs and wasting valuable time.

Investors have to carry out prior research to ascertain the applicable authorities and approval procedures for their business venture. From the business scope to tax planning, every step requires strong attention to detail, and familiarity with Chinese law. This is particularly important as Chinese code continues to undergo changes, as evidenced by the recent VAT reform and transfer pricing regulations.

Investors should also be aware that entering the competitive Chinese market requires time and patience. Some regulations and procedures may be vague and complicated, and are often available only in Mandarin. In these cases, procuring the services of experienced and qualified professionals can go a long way.

New Considerations when Establishing a China WFOE in 2017 cover 90x126This article is an excerpt from the February issue of China Briefing Magazine, titled “New Considerations when Establishing a China WFOE in 2017” In this edition of China Briefing, we guide readers through a range of topics, from the reasons behind foreign investors’ preference for the WFOE as an investment model, to managing China’s new regulations.

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