Wikborg Rein newsletter: The Changing Laws Governing Entities in China – A Cause to Relax, or Worry?

For years, anyone doing business in China could tell you what kinds of entities are available to foreign investors wishing to invest in China, and which entities are most often utilized in a particular industry. And if they couldn’t tell you, their lawyers in Shanghai or Beijing certainly could. The laws in China governing the establishment of business entities are changing, however, and what may have been true last year no longer applies today.

As China’s business community matures, and as revenues increase for both Chinese and foreign companies, Chinese authorities increasingly discourage foreign companies who wish to do business in China from establishing a Representative Office (“RO”). In years past, the quickest, most efficient and easiest way to establish a presence in China was the RO. The Regulations for Administration of Registration of Resident Representative Offices of Foreign Enterprises, published by the State Administration for Industry and Commerce (“SAIC”) late last year and taking effect March 2011, is the first step in changing all that.

These new regulations add a layer of complexity to the formalities required for establishment, increase costs and fines, and change many of the long-standing rules governing a RO. Now, for example, only foreign companies that have been in business for at least two years can establish a RO in China, and each year between 01 March and 30 June, a RO must now submit to the government authorities an annual report detailing its business activities, along with audited financial statements. Furthermore, a RO may now only employ a maximum of four representatives (including the chief representative). Perhaps most importantly, the activities of a RO will be subject to a heightened degree of scrutiny by the local government authorities, and a RO engaging in an operational business outside its business scope will no longer be tolerated. Going forward, foreign companies who currently have a RO in China, or who may wish to establish one, should understand how these new regulations impact their operations, and what this means for corporate governance.

In contrast to a RO, Chinese authorities increasingly encourage the establishment of Wholly Foreign Owned Entities (“WFOE”) by relaxing the requirements and regulations relating thereto, and permitting new kinds of WFOEs. Generally speaking, a WFOE comes in four flavors: (i) plain vanilla consultancy; (ii) trading; (iii) manufacturing and (iv) catering to a specific industry and requiring prior approval of the relevant governmental authority (e.g., shipping service, insurance, finance or banking industries). The difference lies in the business scope, which dictates what the WFOE can and cannot do. The kind of WFOE chosen will also determine a number of other factors, hereunder the required amount for registered capital.

Significant changes have recently occurred that affect certain kinds of WFOEs. As of January, a ship brokerage consultancyWFOE must now employ a minimum of five persons who have passed ship brokerage licensing exams in China. Moreover, beginning last year, the Hongkou District in Shanghai relaxed its regulations in hopes of promoting the shipping industry in the North Bund and now permits a ship brokerage consultancy WFOE to use the word “brokerage” in its name – previously this was not permitted and ship brokerage companies in China were routinely established as a RO. Further, a foreign company wishing to establish a shipping service WFOE in China was previously required to first maintain a resident office within China for three years before it could become registered as a shipping service WFOE. This requirement has now been lifted.

Compliance, together with good corporate governance, is now more important than ever. Today, it seems that a WFOE is easy to establish, but hard to close. A WFOE is an important source of tax revenue to the local tax authority, and any attempt to wind-up a WFOE will be examined and questioned. The company’s accounting records, in particular, will be scrutinized – these should be carefully maintained throughout the life of the WFOE. Furthermore, any foreign company operating a WFOE in China will benefit from maintaining a close, friendly relationship with the local tax authority, and should schedule regular meetings to discuss any open issues.
Operating a business in China has never been an easy task, but this has become more complicated due to recent changes in Chinese corporate law, and the rules and regulations which govern Chinese entities. On a positive note; new opportunities are arising in the form of tailor-made corporate vehicles that were previously unavailable, for instance the brokerage consultancy WFOE.

Please feel free to contact any of our lawyers in the Shanghai office if you have questions regarding these complex issues.

Please note that the Chinese Ministry of Justice does not permit foreign law firms to practice Chinese law, and nothing contained herein should be interpreted as rendering a legal opinion on Chinese law or practicing Chinese law in any way.

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