China WFOEs: Don’t Let This Happen To You

Every so often, someone with a WFOE about to be shut down by the Chinese government (broadly defined) contacts us. These contacts seem to accelerate during economic slowdowns and that has been the case of late. The following is a totally scripted composite of some of the emails we have received relating to a WFOE shut down:

We set up a WFOE and started a small widget manufacturing business inside a residential compound in Nanjing. The local authorities came by the other day to tell us that because it would be impossible to license our venue for any sort of business (our company legal address is necessarily elsewhere) they would be shutting us down. Apparently there is only a title deed for the entire complex, which was built around 4 years ago. The property management company is completely on our side, but they seem unable to do anything or don’t know what to do. We registered as a consulting company, not an XYZ business.

We would really like to have this resolved asap, as we will otherwise need to lay off our staff. Is there anything you can do?

We usually very nicely write back suggesting that they retain local Chinese counsel because it just does not make sense for a small company to pay a large amount of money on what will almost certainly be a losing cause. But the following is what I really want to say:

You have a big, probably insurmountable problem, entirely of your own making. You no doubt used a cheap formation agent to form your WFOE and, unfortunately, you went along with what you either knew or should have known to be illegal. Your business is illegal and there is no way we can solve that.

Just to be clear, your business is illegal for the following reasons — and this is just what I am able to glean from your five sentence email:

• You registered your business as a consulting company but you are operating as a widget manufacturing business. I’m guessing you did this because your entity formation company told you that doing so would be faster, easier and cheaper and would keep your required minimum registered capital low. But you knew all along that you were not a consulting company.

• Your registered address is “necessarily elsewhere” because to get your WFOE you needed a separate and legitimate address that allows for manufacturing. Your widget business is in an apartment complex, which obviously does not allow manufacturing. You knew you provided the authorities with the wrong address and you knew exactly why you did so.

• Your existing address can never qualify for a legitimate WFOE because you need your own separate space/address for a WFOE and where it is located (as you point out by saying there is only one title for the entire complex) constitutes just one business location. You knew this and this is why you did not list this address as the address when you registered.

• Your lease is illegal and that is why your landlord cannot help you. It sounds like your landlord is not authorized to lease out a part of the property for a business. The area in which the building is located is almost certainly not zoned for business. It’s an apartment, isn’t it?

I really don’t know what else to tell you other than that you had better get a good local Chinese attorney and fast. Or maybe, better yet, you should just walk away.

In How To Form a China WFOE. Scope Really Really Matters, we talked of how the scope described in an initial WFOE application matters even after the WFOE is approved:

BUT — and this is why I am writing this post now — if you under or overreach on the description of your business scope, you might find yourselves in big trouble. My firm’s China lawyers are getting an increasing number of calls from American companies in trouble with the Chinese government for doing things in their business that were not mentioned in the business scope section of their initial WFOE.

In some cases, the companies have admitted to us that they were never “really comfortable” with the business scope mentioned in their applications, but that the company they had used to form their WFOE had “pushed” them into it as it would “make things much easier.” In some cases, the scope of the business changed after the application was submitted and the company had failed to secure approval in advance for the change. And in some cases, the company probably would never have been approved at all had it been upfront and honest in its application. In nearly all instances, the companies had managed to secure local approval but were now in trouble with Beijing, which constantly is auditing these applications. In one instance, the local government went back and changed its mind, probably after conducting an audit of its own.

I cannot go into any more detail on these matters, but I can give this advice: applying for a WFOE in China involves a heck of a lot more than just filling out a form and getting approval. It does matter for what you get approved and you (or whomever you are using for your WFOE application) need to know China’s foreign investment catalog inside and out before applying. You then must tailor your application to meet both the requirements of the foreign investment catalog AND the reality of what you will be doing in China. A failure to comply on both fronts will lead to, at best, a rejection of your application and, at worst, being shut down months or years later.

If you take away nothing from this post, please at least understand that your getting local government approval for your WFOE does not mean you are out of the woods. There is little to no benefit in getting approval for a non-conforming WFOE.

We typically see the following two fairly different WFOE scope problems:

1. The current scope of business applies to the basic type of business the WFOE is conducting, but the scope is too narrow. An example of this would be where the scope is for a service business, but now the company wants to do a service business that is not strictly within its original scope. In this case, making the scope broader can be done, but doing so is time consuming and complex.

2. The WFOE wants to go into an entirely different type of business. Take for example: service businesses, manufacturing businesses, trading companies,  and retail businesses. These are all entirely different forms of business in China. In this sort of case, the WFOE cannot simply change its scope of business; an entirely new WFOE must be formed that is then qualified to do the other type of business at a new location. Thus, shifting from service to manufacturing is not a simple matter of changing scope. It means starting over from the ground up with an entirely new business entity.

In other words, scope of business has two different functions in China. It is used to set out the basic business type and it is also used to set out what a WFOE is authorized to do within that business type.

Our China attorneys rarely confront a situation where the scope of the business is too narrow. What we mostly see is the situation where someone wants to do a business of a different type than that for which they were authorized. For example, it is common for manufacturers to want to operate as a general trading company or do basic retail. We also frequently have service companies that decide that they want to start manufacturing engaging in general trading or in retail. The issue in these cases is not that their scope of business is too narrow; it is that they want to go into an entirely different type of business for which they are not approved.

We see this a lot in software as well. The company starts its China WFOE planning to sell its software into China as a download from its U.S. server. No problem. Then after they have formed their WFOE, they decide that they want to sell their software as a service (SaaS) via the cloud or set up a retail operation in China. They think this is natural, but they are not authorized to do either and they cannot change their scope of business. They have to start over and determine how to do what they now want to do. Sometimes, what they want to do cannot be done by any WFOE in China. In other cases, the PRC staffing and registered capital requirements are so onerous that they either cannot comply or compliance is too expensive. In either case, the situation cannot be repaired by a change in business scope. They have to go back to the beginning.

Thus, even though formation agents often convince American companies to form an improper WFOE by saying that “this scope will make things easier,” what the formation agent really means is that “what you want to do is illegal or impossible so form your WFOE this way, operate illegally and hope for the best.” The point is that in these situations the matter cannot be “fixed” by manipulating the scope of business. Before forming a China WFOE, the foreign investor needs to determine how it will be doing business in China legally.

In Leasing Requirements For A China WFOE To Be, Part II, we talked about the importance of having a valid lease for your WFOE and made clear that without such a lease, you should not bother having a WFOE at all:

If you are not going to get the right space for a WFOE, you are probably better off not getting a WFOE at all. Registering a WFOE and then not complying with ALL of the requirements for having a legally operating WFOE is a classic example of trying to operate quasi-legally in China. For why this is a bad idea, check out “Quasi-Legal In China. Not The Place You Want To Be” and “Forming A Company in China. Do It Right Or Do It ALL Wrong, But Don’t Do A Rep Office.“

But what if you right now have a WFOE that is “out of scope” or located in an improper location? What should you do beyond just sticking your head in the sand and hoping that the next knock on your door is not the government?

If your location is improper, hunt down a proper one and then seek permission from the appropriate authorities to have your address changed. This usually is not so difficult and it usually works.

The same general advice applies to broadening the scope of your WFOE’s business so long as your type of business does not change. The first thing you should do is secure shareholder approval to broaden the WFOE’s scope. Once you have that approval, you should revise the WFOE’s Articles of Association to reflect the new broadened scope. You then go to the State Administration of Industry and Commerce where your WFOE was originally registered with the applicable change in scope application form. This application requires the original and a copy of the WFOE’s business license, its company seal and legal representative seal, written proof of the shareholder decision to broaden the scope of the WFOE, and the WFOE’s newly revised Articles of Association. Once you have secured the scope change from SAIC, you should then update the WFOE’s tax registration to reflect that change. This too can be relatively complicated. Nonetheless, doing these things will always beat having a government official tell you under threat to do these things or having your business shut down because you failed to do so.

The Bottom Line: Form your WFOE correctly or don’t bother forming one at all. China’s economy is on the decline and it views foreign companies operating illegally as easy pickings. If your WFOE is not living up to its registration requirements/promises, you are at risk and you should act now to clean up. If you can.

We will be discussing the practical aspects of Chinese law and how it impacts business there. We will be telling you what works and what does not and what you as a businessperson can do to use the law to your advantage. Our aim is to assist businesses already in China or planning to go into China, not to break new ground in legal theory or policy.