Forming A China WFOE: Sometimes It’s Complicated

Forming a China WFOE can range from routine to complicated. As lawyers, we seldom take on the routine WFOE formation, preferring instead to refer those out to high quality entity formation companies that are able to handle those at a lower rate. We probably refer out about half of the companies that come to one of our China lawyers to form a WFOE.

But others are so complicated and involve so many new or unusual issues that we do them ourselves to better serve the client.

I thought of this today after getting cc’ed on a couple of emails involving WFOE formations we have been working on for (in both cases) European clients. The below is an amalgamation of various emails showing how difficult even one small point can be when it comes to forming a complicated WFOE. This amalgamated email reflects one of our lawyers working to secure more financial information so as to improve the likelihood of our clients’ proposed WFOE passing muster with the Chinese governmental authorities and eventually getting approved. All identifiers have been changed or deleted:

The financials included in this spreadsheet do not address the key questions that need to be answered as part of the WFOE formation process. The main problems are: (1) the spreadsheet treats Company A and the as-yet-unformed WFOE as a single entity (and does not explain how the WFOE will be funded and operated), and (2) the spreadsheet suggests that the WFOE will be largely funded WFOE via debt financing, which is not allowed.

1. What is the cash and equipment capital budget for the WFOE for the first two years? Please clearly distinguish between contributed cash, contributed equipment, shareholder loans and loans from banks/financial institutions. Please also clearly distinguish between the U.S. LLC and the WFOE.

This spreadsheet conflates Company A (the “investor”) and the WFOE. To be clear: for this stage, we are not concerned with how the investor is funded. We are only concerned with how the WFOE will be funded. This spreadsheet must be revised so that it only contains numbers relevant to the WFOE.

Two key numbers are relevant to funding the WFOE: (1) registered capital and (2) total investment. Registered capital is the most important number. The proper amount of registered capital depends on your projected financials, but also on your projected business scope and the location of your WFOE. The latter two are important because that’s what the officials in ______ will largely consider when deciding whether to approve your WFOE. Accordingly, we will need to work closely with______ to determine the proper amount of registered capital. But _____ will not be able to give you an informed answer until they understand exactly what it is your WFOE proposes to do, and until they have reviewed your financials. A general rule of thumb, however, is that your amount of registered capital must be at least the amount of expenses for the WFOE’s first year of operation. In other words, the Chinese authorities want to make sure that you are at least depositing enough money in the WFOE’s bank account to pay the bills for the first year.

This spreadsheet proposes to fund the WFOE in large part by loans. This will not be acceptable. As discussed previously, ALL of the registered capital must be contributed as either cash or contributed equipment. We will need to check with the local authorities to determine how much of the registered capital can be contributed equipment.

The total investment amount is the amount of registered capital + some amount of (optional) loans to the WFOE. Generally speaking, those loans must be from the investor and we will need to confirm with local authorities regarding the rules in ______. The maximum amount of those loans will be some proportion of the amount of registered capital. Setting a total investment amount that is higher than the amount of registered capital allows some flexibility in financing your WFOE’s operations via loans. Otherwise, every time you send money to the WFOE it will be treated as income and taxed accordingly.

In preparing this capitalization plan, please consider the following:

2. What is the source of that capital? Please consider in particular:
a. How many machines will be acquired by the WFOE and at what invoice price?
b. How will the acquisition of the machines by the WFOE be financed? There are two alternatives:
i. The shareholder LLC acquires the machines in the U.S. and then contributes the machines to the WFOE as part of its capital contribution, or
ii. The shareholder LLC contributes cash to the WFOE and the WFOE purchases the machines directly from _______.

The spreadsheet you gave us does not answer these questions. Only question 2a is addressed in part. To be clear, the issue is: what is the source of the WFOE’s registered capital?

c. What other equipment will be acquired by the WFOE? How will that acquisition be financed?
The spreadsheet does include details on equipment that will be acquired, but does not explain how the acquisition will be financed.

d. The WFOE will have substantial start up costs: build out, supplies, rent, salary. Have these costs been clearly determined? How will these costs be financed?
The spreadsheet does have details on these costs, but does not explain how they will be financed.

3. You should note that the capital budget of the WFOE must come from either a) a cash payment from the shareholder or b) contributions of new equipment from the shareholder. It is possible for a small amount of the contribution from the shareholder to be treated as a loan. There are a number of restrictions a) the loan must be documented, b) the terms must be “arms length”, c) loan treatment applies only to cash from the shareholder, not to contribution of equipment and d) the amount of loan vs. capital is severely restricted, with the ratio for a project of this size usually limited to a maximum of 15% debt.
See comments under question 1.

As you can see, the use of loans for a WFOE project is quite complex. The rules on this vary from district to district and there have been recent changes to the regulations that have been interpreted differently from district to district.

4. To be clear, you will be required to state 1) total investment and 2) registered capital. In most cases, registered capital must be at least 85% of the total investment. The remainder can be a shareholder loan, subject to the restrictions of 3. above.

5. In reviewing the financials you provided, there is reference to substantial debt payments. Please provide a clear explanation, taking into account the restrictions on use of debt noted at 3. above.

For more on what it takes to register a WFOE in China, check out Forming a China WFOE: Ten Things To Consider and Forming a China WFOE: The Method and the Madness and if you are particularly ambitious, How to Form a China WFOE in China, Part 13 (and the 12 parts that preceded it).

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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.