China: Best Practices to Structure Investments into China

Last Updated: 24 November 2011
Article by Maarten Roos

Part I: How to choose between a Representative Office, a Joint Venture and a Wholly-owned Subsidiaries

In 2008 when the global financial crisis struck, European companies put on hold most of their plans to develop the business in China – preservation of cash was a greater priority. The recent uncertainty in Europe and to a lesser extent in the United States, however, is having the opposite effect. Many European and American companies are starting to see China as a promising region to expand, and are therefore devoting more resources to developing their business in China.

This increased attention is leading to a lot of questions on how to optimally structure an investment in China. Structuring has two main components: ensuring that the right vehicle is used to carry out the business in China, and building corporate governance that enables the investor to control its investment. The first part of this article will focus on investment structuring, while the second part will focus on best practices in structuring the corporate governance of a foreign-invested company.

Investment Structuring – Representative Office, Joint Venture or WFOE?

China offers foreign companies several options to structure their investments. The representative office (RO) is meant for companies that make only a limited (capital) commitment, with a need for people on the ground to conduct market research, liaison with suppliers or customers. The Chinese-foreign Joint Venture (JV) is the main choice for foreign companies that want to establish an independent legal entity in China, but either want or need the participation and resources of a local partner. For everything else, there is the wholly foreign-owned enterprise (WFOE), a full-owned, independent legal entity that can be designed and controlled entirely by its foreign investor(s).

Very Few Companies Still Establish a Rep. Office

One clear trend is that the RO and the JV are losing some of their significance in the Chinese market, to the WFOE. The RO's main disadvantage has always been that as a liaison office, it cannot directly engage in business activities – it is not permitted invoice (in China or abroad) for goods and services. But more recently, the RO has been subjected to increasingly complex procedures, and it is becoming much more expensive from a tax point of view. Other drawbacks to this structure include:

  • It creates liabilities directly on the investor
  • it can only hire a limited number of expatriates;
  • it must hire Chinese employees through labor agents; and
  • its chief representative needs to report taxes in China even if he does not live in China.

As a result, the number of RO's being established has severely diminished, and many foreign companies with existing RO's have been convinced to look at alternative structures to replace the RO, such as a (wholly-owned) consultancy or a trading company, or even a manufacturing company.

Joint Venture Only If a Local Partner's Resources Are Really Necessary

The JV has seen a different kind of impact. In many industries, partnering with a local company used to be mandatory; and government contacts and other resources (e.g. land-use rights) of a Chinese partner were often deemed important to the success of such a venture. Experience has taught us, however, that a majority of JV's fail within only a few years of their establishment, for example because the interests of the partners are no longer aligned, or the partners develop different ideas on the future of their co-investment. The JV remains an important part of the landscape especially where the law mandates the use of JV's or where a local company's resources are essential to commercial success; but those investor that do not need a partner are often better off concentrating their resources on going at it alone.

That leaves the WFOE, a vehicle which 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.

Choosing the WFOE's Business Scope

To replace the RO, establishing a simple consultancy WFOE is usually sufficient. The consultancy can provide marketing, liaison and QC functions, to headquarters or to third parties in China and abroad, and it does so with much less restrictions than the RO and subject to more flexible fiscal policies. However, the sale and purchase of goods remains directly between the foreign company and the suppliers, customer or distributor in China. The consultancy merely provides added-value services to the investor, and can then invoice these to the investor or an affiliate on a cost-plus basis.

Many businesses that source from or sell to China also consider going one step further and they establish a local trading company. To sourcing companies and companies focused on the Chinese market alike, a local trading company allows 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.

The third category of WFOE is the most complicated: manufacturing. As opposed to trading, manufacturing involves adding value – from simple assembly to complicated manufacturing processes. Over the years, China has been a major destination for foreign investors to manufacture goods more cheaply than in Europe. Rising costs however have impacted this model. Some foreign investors have responded by moving inland where costs are cheaper, but this also complicates operations and control.

Producing for the Local Chinese Market

To counter rising costs, others have found a new market to produce for: instead of manufacturing exclusively for Europe and the US, many international manufacturers now invest in China to reach the local Chinese market. As China's economy continues to develop and many more Chinese enter the middle-income bracket, there is an increasing demand for all kinds of products of quality, especially where these products are sold under a reputable international brand.

Choosing the optimal investment structure – RO, JV, or a WFOE in consultancy, trading or manufacturing – is one legal component to a successful China strategy. Another is ensuring that the right persons are appointed in the right positions, i.e. building an effective system of corporate governance. This will be discussed in the second part of this article.

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Maarten Roos
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