what we think

How To Determine Your Optimal Investment Structure

28 November 2012

Continued uncertainty in Europe and the US is leading more international companies to expand activities in China, both in terms of sourcing, and – increasingly – by selling directly on the Chinese market.

The key question to this new boost of investment is how to optimally structure an investment into China, which we hereby divide in two main components: Choosing the optimal legal structure to invest in China, and (in the second part of this article) establishing a corporate governance system to allow the investor to control the business.

Representative Office, Consultancy WFOE or Trading WFOE?

Several structures are available to an international business that invests in China. For those businesses that want to partner with a local company, there is the Chinese-Foreign Joint Venture (JV). The JV allows an investor to share risks, and take advantage of the local partner’s local resources. It is also the only vehicle allowed in certain restricted industries such as car manufacturing and recruitment. However, the track-record of JV’s in China is mediocre at best. As a result, most companies prefer to choose a structure that allows them to fully control operations:

  • The Representative Office (RO);
  • The Wholly Foreign-Owned Enterprise in consultancy services (Consultancy WFOE);
  • The Wholly Foreign-Owned Enterprise in trading (Trading WFOE).

Representative Office (RO)

This vehicle is meant for companies that only make a limited (capital) commitment, with a need for people on the ground to conduct market research, quality control activities and liaison with (new) suppliers. The RO’s main disadvantage is that it cannot directly engage in business activities – it is not permitted to invoice (in China or abroad) goods or services. Moreover recent regulations have expanded the already complex procedures ,and made the RO much more expensive from a tax perspective. As a result, few RO’s are being established these days, and many investors with existing RO’s have turned to the Consultancy WFOE or the Trading WFOE as an alternative structure.

As opposed to the RO, the WFOE is a full-owned, independent legal entity or limited company owned entirely by its foreign investor. This structure is straightforward to establish, convenient to operate and relatively easy to control – as long as the right systems of checks and balances are in place. The key issue when establishing a WFOE is to determine what kind of business activities it will engage in. This determines what type of WFOE should be established.

Consultancy WFOE

To replace the RO function, it may be sufficient to establish a Consultancy WFOE since this company can provide the same activities as the RO, such as marketing, liaison and QC functions to headquarters or to third parties in China and abroad, with much less restrictions than the RO and subject to more flexible fiscal policies. In addition, the WFOE can retain employees directly, which has advantages in terms of lower service fees, better protection against claims and control of IP and confidential information.

Trading WFOE

To have a better grip on the market, foreign companies that source from or sell to China can consider going one step further: establishing a local trading company. A Trading WFOE can import and export, purchase and sell domestically. It allows for a more direct relationship with domestic suppliers and customers (including foreign customers), the possibility of warehousing in China, and the opportunity to buy Chinese goods and sell them directly to Chinese customers (and issue a local invoice fapiao) without exporting these goods first, thereby avoiding transportation costs and customs duties.

The Trading WFOE is more complicated to establish than the Consultancy WFOE, and generally requires a slightly larger investment. Thus investors that want to start slow to support their existing sales or sourcing activities often choose to establish a Consultancy WFOE first. Once the business is big enough and local invoicing is required, they can then expand the business scope to include trading as well.

Establishing a Corporate Governance System: The Legal Representative

To have sufficient control over the business in China, international companies must understand the Chinese system of corporate governance, appoint the right people in relevant positions, and ensure that documentation is in place to counter or respond to any abuse. One of the key figures in this system is the legal representative, and its appointment and the practical steps to restrict its authority, is an important challenge.

Every Chinese limited company - whether Chinese invested, solely invested by one or more foreign shareholders (i.e. WFOE) or jointly invested by foreign and Chinese shareholders (the Chinese-foreign joint venture), has a Board of Directors or one Executive Director, who represents the investors in the most important decisions.

However to represent the company to third parties such as government departments, business partners and employees, the investor(s) or the Board of Directors must appoint one person as the legal representative.

Chinese law sets some conditions to the appointment of the legal representative, including:

  • this person must be a natural person;
  • only one person can take this position (i.e. it cannotbe shared);
  • this person must also be either the company’s general manager, the chairman of its Board of Directors, or its Executive Director.

There are no rules on the nationality of this person, nor does the law establish whether this person is actively involved in the business, resides or visits China on a regular basis. Thus investors should avoid being led by a local manager who says that only he can be the legal representative.

Key Considerations on Appointment

Many investors grapple with the choice of appointing as legal representative the manager in charge of the Chinese business, or choosing someone from headquarters. Some investors prefer to completely empower their local (general) manager, however this results in considerable risks. When leaving the local manager with legal as well as physical control, it is extremely difficult for the shareholders to forcefully remove him from his position.

The safer approach is to appoint someone from headquarters as the legal representative, thereby separating legal and physical powers. Legal authority can be delegated (in writing) to the local manager in China through the signing of an authorization document.

Meanwhile, physical control is either fully or partially delegated to the local manager by effectively using China’s system of company stamps. In Chinese practice, the Company Stamp (which is registered with local police) is even more effective than the legal representative’s signature in representing the company, and so physical control over commercial decisions lies with the party that controls this Company Stamp.

Usually it is either controlled directly by the local manager (giving him the power to represent the company in practice), or by a Chinese proxy of the legal representative (e.g. a local law firm or accounting firm) for use at the manager’s detailed request and subject to confirmation from the shareholder or legal representative.

A similar system can be established if investors prefer a strong system of financial supervision and/or control. Usually the financial stamp and the legal representative stamp together give access to the company’s bank account - either one can be kept by a proxy to avoid abuse. Internet banking is also widely available in China, and can be controlled directly by the investor or through the proxy as well.