Mistake #5- Representative Office
Opening a representative office (RO) may be the easiest way to make for making your entry into China because it allows you to ‘dip a toe into the water’ before committing yourself. However, it is not always the best way. From the corporate dynamics perspective, a RO may be far less advantageous than other available organizational structures, such as a wholly foreign owned enterprise (WFOE).
A RO may engage only in indirect business activities within China. A RO’s function is limited to serving as a business liaison for its foreign parent. It is not a legal entity recognized by Chinese law and is not competent to engage in commercial activities within China. A RO cannot do the following: (a) sign contracts with suppliers or customers in its own name; (b) apply for an import/export license; (c) qualify as a taxpaying entity; (d) open bank account; (e) employ staff directly (a RO must use the Chinese version of Manpower in hiring its staff); and (f) issue invoices.
A WFOE is not so limited to its business activities. It is a legal entity in China and is entitled to perform all commercial activities of a company in China, including signing contracts; employing staff; applying for an import and export license; issuing invoices; opening bank accounts; and engaging in financial transactions.
The difference in the taxation of these two entities in China may determine your choice of a WFOE over a RO.
A RO has to run more or less as a ‘cost center’ or sales or promotion office of the foreign parent. A RO pays taxes on all expenses, including the RO’s employees’ salaries as well as payroll and social insurance taxes. These funds must be paid from the RO company account. Then the RO, which first pays taxes on all expenses — pays taxes again on the paid funds — for they were expenses that the RO paid and passed through its business account. A RO pays taxes at the rate of approximately 10.5% on every dollar that passes through its bank account. Therefore, the more it costs to run the RO the more the RO pays in taxes (subject to the caveat ROs in different industries receive different tax breaks).
A WFOE pays taxes on profits for two years and for the next three years pays taxes only at half the then prevailing corporate tax rate. However, because of the intricacies of Chinese tax laws, there is also a way for a WFOE to remain tax free for a much longer time. The Chinese Corporation Code specifically permits a Chinese company of any kind, including a WFOE, to operate tax free during any period where it does not show a profit. Meaning, you can start a WFOE with a lower level of capital investment, and rather than post ‘profits’ on the WFOEs’ books, those funds can be used to expand the operation of the WFOE in China — which legally delays the beginning of the two year tax free period.
Notwithstanding the above operational and tax benefits, we do not recommend a WFOE over a RO under all circumstances.The following scenarios may justify establishing a RO instead of a WFOE:
- You are looking to make a direct investment in the Chinese market, but feel you need to do more market research before you decide on a long-term strategy for entry into China.
- You are looking for Chinese suppliers. By establishing a RO, you can go through an authorized human resource agency and hire local staff who would then facilitate your search. This allows you to attain your goal without actually setting up a WFOE in China and incurring start up expenses.
- You already have an existing market for your products and/or services in China, but the Chinese market is not large enough to justify the start up expenses and/or the on going capital investment necessary to establish and operate a WFOE in China.
- For some types of businesses, establishing a RO is the only way to enter the Chinese market. For example, a foreign insurance company must operate a RO in China for two years before applying to change its status to a WFOE or a joint venture (JV).
You also need to understand there are some disadvantages of establishing a WFOE. It is more costly to set up and administer than either a RO or a JV. Potentially little or no local knowledge is attached. Time frames can be extensive. WFOEs are required to invest registered capital as required by the government approved mandatory investment schedules, while there is no such requirement for the establishment of a RO. The granting of an entry permit and government supervision is generally loose on ROs and strict on WFOEs. In the case of WFOEs, the qualification and market position of their overseas parent companies is considered by the government before an entry permit is granted, whereas in the case of a RO, the requirements for an entry permit are not as strict.
Take-away lesson: there is no bright-line rule deciding which organizational structure you should take to establish your business presence in China. Various factors need to be considered before you know which structure is suitable for your business presence in China.
