There are several structures through which foreign entities can establish a business platform in China. Common structures include the representative office (“RO”), the wholly foreign-owned enterprise (the “WFOE”) and the joint venture (“JV”). Other structures include foreign invested partnerships, holding companies, and regional headquarters. The ideal structure for investment depends on an investor’s commercial goals, as each structure presents its own advantages and challenges.
The most appropriate structure depends on an investor’s commercial goals and on environmental parameters. Any investor should step back to analyze options prior to selecting a specific structure.The primary differences between the common foreign investment structures are summarized in the table below.
Representative Office
Although not technically a structure for investment, an RO serves as the offshore parent company’s window into the Chinese market. An RO enables a parent company to introduce products or services, conduct market research, and engage in technological exchange.
Advantages Establishing an RO is fast and inexpensive relative to other investment structures. It also gives strong financing control to the parent company: it can be financed directly by its parent company on an as-needed basis, allowing its parent company to scale expenditures.
Challenges A potentially significant downside of an RO is the limitation on activities. An RO’s business scope is restricted to liaison activities, and it cannot technically engage in profit-making activities, issue invoices or enter into agreements (although there may be expectations to actually do so from time to time). An RO is similarly restricted in hiring; it cannot have more than four foreign employees nor can it directly contract with any employees.
Furthermore, an RO faces comparatively high operational costs. According to relevant laws and regulations, an RO’s registered address must be in a Grade A commercial buildings which tend to be in relatively up-market city centers. Additionally, ROs face increasingly strict supervision requirements (e.g. the need to re-register annually), which can translate into ongoing administrative burdens.
ROs are generally taxed on a deemed profit basis, though they are not permitted to directly generate profit. Thus, taxes are primarily calculated based on the expenses of the RO, which can be quite high. Additionally, the RO’s chief representative (who is appointed by the parent company to serve as the legal persona and manager) is automatically liable for individual income tax in China, even if he or she does not reside in China.
Finally, because an RO is not a limited liability entity, it places burden and risk on its parent company (and, as with any structure, even the chief representative can ultimately become de facto personally liable). The parent company bears unlimited liability for the RO until the RO is duly closed (the process of which is generally highly resource-intensive).
Wholly Foreign-Owned Enterprise
The WFOE is the most commonly used foreign investment structure in China. A WFOE is a foreign-invested legal identity that does not require the investment of a Chinese partner. While certain sectors remain restricted to WFOEs, such restrictions have eased in many cases.
Advantages
WFOE’s are comparatively easy to manage, control, and close (assuming proper accounting and management throughout the term of operation). The primary advantage of the WFOE is that it allows the foreign investor to fully own and control a company that can engage in actual revenue-generating business activities. As the parent company is generally the sole investor (although a WFOE can have multiple offshore investors), the WFOE can be highly responsive to the parent company. Moreover, a WFOE does not face the degree of restrictions that apply to an RO: it may conduct business, issue invoices, receive revenue in Renminbi, and directly hire employees.
The WFOE is a limited liability company, and thus the parent company is theoretically only liable to the extent of the WFOE’s registered capital. However, it is not unheard of for extralegal liabilities to develop for officers, directors or the legal representative of the WFOE or the parent company.
Challenges
The establishment of a WFOE is challenging compared to that of an RO. The registration process is more time and resource intensive; additionally, a WFOE has minimum capital requirements, a certain portion of which must be injected within three months of establishment.
A WFOE requires ongoing administrative attention and corporate controls to ensure that the parent company is not burdened with a renegade subsidy. Developing and maintaining a system of checks and balances to ensure corporate and accounting control requires considerable ongoing resources.
One of the primary advantages of a WFOE presents a parallel challenge. A WFOE allows a parent company to independently establish a legal identity in China, which also means that the parent company does not benefit from the expertise of a knowledgeable Chinese partner. Thus, the parent company must be fully responsible for active management. A WFOE’s operations, and ultimately its success, depend on a significant commitment of time, energy, and other resources. Despite this challenge, it is far better to commit such resources rather than embrace the common flaw of a poorly suited economic marriage.
Joint Venture
A JV is an entity created through investment by at least one Chinese investor and at least one non-Chinese investor.
JVs are typically either equity JVs or cooperative JVs. Equity JVs are limited liability companies where rewards, risks and losses are shared among investors in proportion to the ratio of respective investments. By contrast, a cooperative JV may either be a limited liability company or a commercial partnership (without the formation of a limited liability company) where the investors are subject to unlimited liability. In a cooperative JV, profits may be distributed according to investor agreement. Investors may also determine that one of the investors will recover its investment through a repayment structure while another investor gradually becomes the owner of the JV’s assets.
Advantages
There are many benefits to investing in a China-based enterprise with a Chinese partner. For one, JV investors benefit from sharing the capital investment burden and, as a result, sharing the JV’s risks. The Chinese investor may also make many important contributions beyond capital, including know-how, market knowledge, and connections.
Challenges
JVs present the key challenge of integrating the management of the various investors. According to relevant laws and regulations, unanimous board approval is required for key company decisions including registered capital, mergers and acquisitions. Such unanimous approval may be difficult when investors have varied motivations. Moreover, the foreign investor may face a power disparity if the Chinese investor is more actively involved in the JV’s management, or if the foreign investor is not sufficiently aware of China’s legal and business-cultural norms. If a dispute escalates into a decision to cancel the company, the resulting cancellation process may be extremely resource intensive.
JV investors must also consider the exposure of intellectual property to other investors. Close consideration of methods to mitigate intellectual property theft (e.g. contractual protections, intellectual property registration, operational measures) are crucial in a JV structure.
Concluding Notes
Investing in China requires significant resources, and involves a host of regulatory issues, navigation of bureaucracy, a number of bilingual documents, and an at times opaque approval process. Despite the challenges, the promise of establishing a presence in China, and the advantages associated with the selected foreign investment structure, may be well worth the effort. Foreign investors who are committed to establishing a presence in China should view the selection and establishment process as just one part of a foreign investor’s ongoing development in (and comprehension) of China.
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