Establishment of a Wholly Foreign-owned Enterprise

Establishment of a Wholly Foreign-owned Enterprise Wholly foreign-owned enterprises (WFOEs) are entities established under the Law of the People s Republic of China on WFOEs (the WFOE Law ). By definition, WFOEs are wholly owned by foreign investors. WFOEs must necessarily be established as limited liability companies, thus separate legal persons distinct from their investors, with the liability of the investors limited to the contributions made to the Registered Capital of the WFOE. This is similar to the position of limited companies in other parts of the world and is therefore familiar to foreign investors. In China, WFOEs were originally conceived for and limited to manufacturing activities that were either export orientated or introduced advanced technology. Whilst WFOEs are still encouraged in these areas, with China's entry into the WTO these conditions have been gradually abolished, and WFOEs as a whole have gained in legal acceptance and support from the Chinese government. WFOEs have become more popular with foreign investors, in part due to the increasing range of business activities in which WFOEs are allowed to participate, but also due to the full level of control that foreign investors have over WFOEs and the widely experienced problems that foreign investors have had with JVs. Specific Characteristics Wholly Foreign Owned Enterprise (WFOE) Legal Form Independent legal person with limited liability. Foreign Partner s Equity 100% Contracts None. Articles of Association Yes. Specific Investment For encouraged projects (VAT+ customs duty exemption on imported Benefits capital equipment) and export oriented or high tech status projects (income tax reduction). MOFCOM Approval Yes. Project Proposal No (unless restricted project). Feasibility Study Yes. SAIC Registration/ Yes. Environmental and fire protection procedures may be necessary. Others Capital Contribution Cash, capital goods, industrial property rights, know-how, land use rights. Highest Governing Body Board of Directors (both shareholders and professional management, appointed in accordance with Articles of Association). Export Requirement No minimum export required. Accounting Accounting as separate entity required. Accounting books must be kept in China. Double accounting for reporting to HQ customary. Profit/Loss Distribution After deduction of necessary fees and tax, profit can be repatriated overseas. Tax Corporate Income Tax Investment Term 10 to 50 years. Early Termination Liquidation permitted. Must be in accordance with the Articles of Association and Chinese law. Governing Law PRC Company Law, WFOE Law. 1

However, it should be noted that there are still certain regulations that may impact on whether a foreign investor can establish a WFOE or not. The Catalogue on Guiding Foreign Investment details certain prohibited projects in which foreign investment is banned altogether, and certain restricted projects that have to be in the form of a JV rather than a WFOE. These restricted projects typically involve industries under process of liberalization. As such, the scope for WFOEs will continue to widen, eventually including all but the most politically sensitive sectors, such as the automotive sector. Figure 1 Manufacturing WFOE Mother Company Model & Goals WFOE Assembly 100% Production Re exporting / China Sales Location Mainland China Free Trade Zone Industrial Development Zone Economic Zones Western China China WFOE Production Operational issues: Centralized contracts Invoicing in RMB/USD/Euro Own Sales Logistics & Ware housing After Sales Promotion & B. Develop. All cash payments Centralized finance HR recruitment Purchasing Sales & Retail After Sales Raw Material Import Domestic Purchase Store Source: InterChina Consulting Distributors Wholesalers I. Increasing Preference for WFOEs China modified its WFOE regulations in April 2001 in order to encourage investment in China through this investment vehicle. As a result, WFOEs are no longer required to: Meet export performance requirements. The law previously required WFOEs to export a certain percentage of their products. Now, exports are encouraged through tax incentives, but are not required. Introduce advanced technology. The law previously required WFOEs to use advanced technology and equipment so that goods currently imported could be substituted with domestically produced goods. Now, the use of advance technology is encouraged through tax incentives, but is not required. Comply with restrictive foreign exchange balancing requirements. The law previously required that WFOEs balance their foreign exchange receipts and expenditures. This is no longer required. Request preliminary approval prior to conducting direct domestic sales. Now, WFOEs can sell directly to any third party or company. Source all raw materials and fuel within China, unless unavailable domestically. Now, WFOEs can 2

source raw materials and fuel from anywhere. These modifications made WFOEs much more attractive to foreign investors, and there has been a marked increase in the selection of WFOE as the preferred investment vehicle. In 1997, for the first time, WFOEs out-numbered Joint Ventures in new project approvals, accounting for 45% of new projects compared to 42% for Equity Joint Ventures. InterChina conducted a survey of clients and other foreign investors that had selected a WFOE as their preferred investment vehicle in China. The main reasons given were as follows: Total independence and freedom in implementing the global strategies of their parent companies, in contrast to having to consult and compromise with Chinese joint venture partners. Ability to legally conduct business in China, including the issue of invoices and receipt of payments in RMB and the conversion of RMB into forex for remittance to parent companies outside China, in contrast to the limitations imposed on Representative Offices. Increased protection of intellectual property rights (IPR) and know-how, in contrast to joint ventures where there was a risk of losing their IPR and know-how via their joint venture partners. Perceived greater efficiency in operations, management and future development Advantages W FOE over JV Simpler establishment procedure than for a JV. In contrast to JVs, WFOEs allow complete control over the major decisions, operations and corporate culture. Thus, strategic alignment with parent and sister companies, and no risk exposure to partner disputes. Disadvantages WFOE over JV More restrictions on project approval than for a JV, thus some restricted industries where WFOEs not allowed and JVs are. Upfront investment required likely to be higher for a WFOE as not shared with a Chinese partner. Stronger position with customers who value a purely foreign supplier compared to having a JV with a Chinese partner. Lower risk exposure to IPR infringement than JVs, as there is no Chinese partner which may set up in competition in the future or transfer know how, trade secrets etc to third parties. Easier to terminate than an EJV. Absence of assistance from partner in such areas as obtaining government approvals, labour recruitment, sourcing raw materials, acquiring land & production facilities, obtaining access to marketing & distribution channels etc. Thus exposure to upfront investment risks if insufficient investment preparation or no transferable customers or sales contracts. In addition, may be a significant time lag and taxation on existing resources before initiation of operations. 3

II. Approval & Registration for Incorporation of a WFOE Separate Process: Trademark Registration Reservation of Company Name with SAIC WFOE 抯 in Restricted Industries Preparation of Project Proposal Decision on Project Proposal from MOFCOM Possible consultation with MOFCOM on Investment Application Conduct of Feasibility Study Submission of Project Proposal to MOFCOM Approval & Registration of Lease Contracts on Factory/Building/Land Conduct & approval of Environmental Impact Assessment Formal Investment Application of JV Contract, Feasibility Study, Articles of Association and relevant documents to MOFCOM Decision on Investment Application from MOFCOM Issue of Approval Certificate by MOFCOM Application to SAIC for Business License EJV has Legal Person Status in China Issue of Business License by SAIC Registration with relevant government bodies (SAFE, Customs Office, Tax Bureau, etc.) Possible application fro Advanced Technology Status etc Capital Contribution 4

The process should commence with the reservation of the company name with the State Administration for Industry and Commerce (SAIC). Trademark registration is an independent process, undertaken over 6 to 12 month period (at least), and thus should actually be initiated as soon as a foreign investor has business interests in China. For WFOEs in restricted industries, it is first necessary to prepare a project proposal and have that approved by MOFCOM or the relevant approval authority. Prior to making the investment application, foreign investors need to first search and locate suitable land and buildings for the WFOE. The foreign investor can sign the purchase or rental contract. At this point, the foreign investor can make the investment application to MOFCOM or the relevant approval authority. This includes submitting the Articles of Association, Feasibility Study and other documents. The Environmental Impact Assessment should be submitted to the Environmental Protection Bureau. Once MOFCOM or the relevant approval authority has made their decision and issued an approval certificate, foreign investors should apply for the business license from the SAIC. Upon receipt of the business license, the WFOE becomes a legal person in China. At this point, the foreign investor can then make the company seals for the WFOE (allowing the WFOE to sign contracts), apply for an organization code certificate, open bank accounts (in USD and RMB), and register with the relevant authorities (State Administration for Foreign Exchange, State Administration for Taxation, Customs Office, Statistics Bureau etc). The total application and registration process will take one to three months once the relevant documents/information have been prepared. Normally, the bigger the city, the longer the application process. 5

III. Documentation Required for Incorporation of a WFOE Document Business license Credit certificate Appointment letter Mandate letter Machinery/ equipment list Production technology Labor protection methods Cleaning and disinfection methods Environmental protection Organization chart Raw materials Utility consumption Production output Table 1 Documents to be Provided by Investor. Comments (To be provided in original language with an English translation, or directly in English) Copy of the investor s business license in their country of origin. Original of the investor s credit certificate issued by the relevant bank in their country of origin. Original appointment letters, issued by the investor in their country of origin and signed by the investor s legal representative, for the legal representative, members of the board, General Manager and Vice General Manager (if any) of the. In addition, copies of their passports, brief CVs and 3 passport photos each. Original mandate letter, issued by the investor in their country of origin and signed by the investor s legal representative, for the legal representative of the (the legal representative of a WFOE is normally the Chairman of the Board). If there are to be additional people with authority to sign on behalf of the WFOE, then additional mandate letters are required. A list of the machinery and equipment to be deployed by the WFOE. The list should include names, models, specifications, production origins, manufacturers, dates of production, prices, quantities etc. There should be two lists, one for imported equipment and one for domestically purchased equipment. A description of the production technology to be deployed in the WFOE. This description should include know-how, production process and production flow chart, quality standards etc. A description of the pollution (waste gases, wastewater, solid waste) that will arise as a result of the production conducted by the WFOE. This should include the composition and treatment of the pollution. Type, quantity, source (imported or locally purchased) and price of raw materials required for the production conducted by the WFOE. Quantity of water, electricity, gas or other energy sources required for the production conducted by the WFOE. Estimated production output of the WFOE for the first 3 year period. Apart from the above, the relevant authorities may require some new information/documents wherever they think necessary. 6

Document Project proposal Land purchase contract or rental contract Articles of Association (AofA) Feasibility study Environmental Impact Assessment Table 2 Documents to be Prepared in China. Comments None (unless restricted project). For the WFOE. For the WFOE. For the WFOE. Based on the materials / information prepared by the investor. For the WFOE. Based on the materials / information prepared by the investor. Should be conducted by a qualified environmental evaluation company. 7