How to Form a WFOE in China, Part 9: Forming a WFOE Subject to Industry Specific Regulation

One of the more common mistakes we see are wrongly formed WFOEs. We typically see these mistakes when an American or a European company calls one of our China lawyers in a panic because a Chinese government agency just told them either that it will not allow their WFOE to go through or that their WFOE cannot do the business for which the American or European company formed it in the first place.

My first response when I get these calls is to suggest that the American or European company go back to the lawyer that formed the WFOE for them and have that lawyer fix the problem on his or her own dime. Not surprisingly, virtually every single time, a lawyer had no involvement in the WFOE formation.

Not good.

What is also not good (both for the American/European company) and for my law firm is that about half the time the American/European company is so frustrated at this point that they simply abandon their China plans. Probably half the time this actually makes sense in that the American/European company either would never have pursued WFOE formation in the first place or could not have pursued WFOE formation in the first place, had they actually done it all correctly.

Yesterday we highlighted how Advertising WFOEs are different from other WFOEs. Today, I am going to discuss software as a service (SaaS) companies because it those where we get the most desperate after the fact phone calls from stymied WFOEs. The reason for this is because SaaS in China by a foreign company or a WFOE is not possible. And yet, countless American and European companies have spent months and tens of thousands of dollars forming software WFOEs in China without knowing this is the case.

China allows for the SaaS method of providing software. However, for a provider to use the Internet for this requires it must acquire a commercial ICP license. And this is where the problems start. A WFOE or other foreign owned entity cannot obtain a commercial ICP license in China. There are no exceptions to the rule. Accordingly, if a WFOE or foreign entity wants to offer its software in China though a SaaS system, it must use an indirect method such as licensing the software to a licensed Chinese entity using an “Internet portal” method.

China’s Ministry of Industry and Telecommunications (MIIT) is in charge of Internet licensing and its position on foreign software providers has only hardened in response to Snowden’s NSA revelations. In the good old days, many U.S. and European software providers argued that the commercial registration rule did not apply to their businesses because they did not conduct any e-commerce on their SaaS site. Others argued that a Ministry of Commerce exception applied to their SaaS offerings. The Beijing and Shanghai offices of the MIIT have both forcefully held that neither of these arguments work for allowing future SaaS business in China by foreign companies.

This leaves WFOEs with the following two methods for selling software in China:

Direct sales to customers. Both the software and the data are installed and stored on the client server. If the Chinese client wants to make the data available to the general public, it may do so on its own Internet site, under its own license, with the WFOE not involved. The WFOE can be engaged to manage the entire process, including creating an intranet available only within the client’s premises or an Internet site available to the general public. The licensing (commercial or non-commercial) for such a public website depends on how the service is constructed.

SasS offered through a service/license agreement with a 100% Chinese owned Internet “portal.” As noted above, provision of software through SaaS cannot be done directly by the WFOE because the provision of SaaS services in China by ANY entity requires a commercial ICP license. But if a 100% Chinese owned company wants to provide its software through SaaS, that Chinese entity may do so if it can obtain its own commercial ICP license. The Chinese owned company that owns a commercial ICP license in this sort of arrangement is referred to as an Internet portal. Under an Internet portal arrangement, the WFOE contractually engages the Chinese Internet portal company to offer the SaaS software package, using the portal’s license as the applicable commercial ICP license.

Though the portal approach is a relatively new concept, MIIT officials in both Beijing and Shanghai have on multiple occasion in the last year or so told our China attorneys the following:

SaaS CANNOT be done directly by a WFOE. There are NO exceptions.
Indirectly provisioning foreign software services through an Internet portal arrangement is acceptable because the portal entity will be entirely responsible for complying with Chinese law. All MIIT offices we have contacted have affirmatively recommended the portal approach without prompting from us.
Many of our clients are contacted by ISPs, cloud service providers and related entities in China who claim to offer just such an intermediate method. Such offers should be viewed with caution as these offers frequently come from three kinds of companies: 1) companies that do not understand the law; 2) companies whose business model is built around evading/violating the law and 3) companies that neither have a commercial ISP license nor any chance of getting one (their unstated plan is to broker a deal between the American/European company and a Chinese entity that has such a license. Given China’s current legal environment regarding foreign companies, it makes little sense to operate in a way that claims to exploit a loophole or grey area.

If you wish to read our previous eight posts in this series, just work your way backwards, daily by date.

The post How to Form a WFOE in China, Part 9: Forming a WFOE Subject to Industry Specific Regulation 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.