How to Form a WFOE in China, Part 7: We Told You It’s the Scope Stupid

This post is the second in a row to focus on the need to get the business scope right when applying to form a China WFOE. This is the seventh post in our series on what it takes to form a WFOE in China. Part 1 set out the questions our China lawyers typically ask our clients for whom we are forming a China WFOE. Part 2 was on the issues our China lawyers confront in determining whether a China WFOE makes sense for our clients at all. Part 3 was on whether it makes sense to have a Hong Kong entity own your China WFOE (or China Joint Venture). Part 4 was on the steps required to form a China WFOE. Part 5 was on China’s new minimum capital requirements. Part 6 was on why it is so critical that you list your scope correctly in your WFOE application.

Why are we doubling down on the need to get your WFOE scope done correctly? Because I received so many emails in response to yesterday’s post. Most of the emails were from people trying to get a better handle on the “scope issue” but a couple of emails were from people talking about how their having gotten their scope wrong eventually led to the closing down of their business. One of these emails concluded with the following:

I don’t think people understand how important it is to get your scope listed correctly. In fact, I think most people are like me believing that so long as they are approved for their WFOE everything will be okay. I know now from my own experience that that is just not true but I do not think you emphasized that enough in your article today.

Point taken. Hence this “re-do.”

This writer is correct. WFOEs that get approved can and do get shut down all the time when subsequently audited a year or two later. These audits are common because the Chinese government makes a lot of money from them. Here is the typical scenario. US or European company uses a third rate entity formation company for its China WFOE formation because third rate company has the lowest prices by far. Third rate entity formation company then quickly forms a China WFOE for the American or European company. Five times out of ten this WFOE will be a consulting WFOE (because those are the quickest and easiest). Nine times out of ten (yes I am guessing here) the third rate entity formation company will assure the American or European company that “this is China and this is how we do things here, so do not worry about your company not really being a consulting company.” One time out of ten, the third rate entity formation company which just lie, claiming that it formed a such and such WFOE to match the American or European company’s actual business, when it really went off and formed a Consulting WFOE. About 70 percent of the time, the third rate entity formation company will rely on the American or European company being unable to read Chinese and about 30 percent of the time it will create fake documents showing the formation of some other type of WFOE.

Zoning problems have also led to the death of many a WFOE, again, usually after one to two years in existence.

The following is a composite of some of the emails our China lawyers 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?

When I get these, I typically very nicely write back suggesting that the emailer retain local Chinese counsel because it will not make sense for them as a small company to pay us a lot 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 third rate 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. Your only real choice now is to shut down what you already have in such a way as to give yourself a chance to start all over again with a new WFOE, correctly formed.

Just to be clear, your business is illegal for the following reasons — and this is just what I am able to glean in three minutes 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. Sorry. Good luck.

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 they want to start manufacturing or 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.

In Leasing Requirements For A China WFOE, we wrote about the importance of having a valid lease for your WFOE and we 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 an “out of scope” WFOE or your WFOE is 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 from the Chinese 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. We have said it countless times before in all sorts of arenas, but I will say it again. If you go to the Chinese government with a problem and a solution, your odds of being allowed to go forward with the solution are good. But if the Chinese government discovers your problem on its own, and then you propose a solution, your odds of being able to move forward with the solution will be much lower.

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 should go to the State Administration of Industry and Commerce where your WFOE was originally registered and provide that office 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 can be relatively complicated, but doing these things will always beat having a government official tell you under threat to do these things or shutting down your business.

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. Have you checked your China WFOE lately?

The post How to Form a WFOE in China, Part 7: We Told You It’s the Scope Stupid appeared first on China Law Blog.

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.