Why Going Into China Half-Way Is All The Way Risky

It is expensive and difficult for foreign-owned businesses to be formed in China. The following is the most basic list of what you need to do to form a Chinese entity:

  • Determine whether your business model is legal for a foreign business in China.
  • Form and register your legal entity in China. This will typically be a WFOE, a Representative Office, or a Joint Venture.
  • Lease property (a prerequisite for the registration process above).
  • Draft an employee manual and execute written employment agreements with all of your employees.
  • Open a bank account with a Chinese bank.
  • Figure out and pay all of your taxes, including company taxes, employee taxes, and social insurance payments for your employees.
  • Apply to register your trademarks, copyrights and patents in China.
  • Doing the above will not be cheap or easy. But it is necessary.

As China becomes wealthier (this trend is continuing despite its recent slowdown), its appetite for Western service businesses and consumer products is rapidly growing. Chinese companies are wooing American services companies with a promise of a quick and cheap (sometimes even free) start in China, with riches to be made from China’s still-thriving consumer market. The Chinese company convinces the American company of demand in China for the American company’s service or product and of how the two companies should work together to market the service or product in China.

A typical scenario plays out as follows: The Chinese company convinces the American company to let it handle everything. The American company then leases space from the Chinese company, and the Chinese company hires a couple Chinese employees on the American company’s behalf. The Chinese company oftentimes even puts the American company’s name and logo on an office door. Voila, the American company now has a “joint venture” in China.

Except it doesn’t.

In Forming A Chinese Company. Do It Right Or Do It ALL Wrong, But Don’t Do A Rep Office, I wrote about American companies that form illegal Representative Offices because forming a China WFOE (wholly foreign-owned enterprise) takes too much time and costs too much:

I get the sense that those contacting our China lawyers on forming a Rep Office (when only a WFOE would be legal) are hoping they have found THE loophole nobody else has found and that if they can get somehow get the blessing of one of our attorneys for what they are doing, their operating illegally in China will somehow not be “so” illegal. I wish I had some magic oil I could sell to sprinkle on these sort of illegal China businesses to make them legal, but I have no such thing.

I went on to write of how going “half-legal” is not only riskier than operating legally, but also riskier than operating completelyillegally:

As lawyers we are never going to tell our client to go full illegal, but as a blogger I can state that going full illegal in China usually makes better sense than paying a lawyer to set you up to operate half-on and half-off the grid. I think people know this, but their rightful discomfort at operating illegally makes them want to clutch on to something that can justify (however falsely) their actions.

The same holds true for forming a Representative Office when a WFOE is required. Forming a Representative Office in this situation just tells the Chinese government where you are and what you are doing and thereby makes it easy for them to realize that what you are doing requires a WFOE and your doing it as a Representative Office is illegal.

But what really drives me crazy about all this is that on many occasions, companies for whom we have refused to form Representative Offices smugly tell us that some other company is willing to form the Representative Office for them, as though this somehow means we were wrong in declining to take money to do something we know will eventually fail.

The fake joint ventures I described above are also illegal, and having a relationship with a Chinese entity is not going to help you when the Chinese government finds out about it. It is also not going to help you when one of your China employees sues you and is able to point out that you do not really exist in China. For why this is the case, check out China’s Tax Authorities Want You.

Whenever I learn of one of these “fake” joint ventures, I suggest the American company immediately register its trademarks in Chinabecause they are being used in China already, but without any protection. More than once, the American company has responded by assuring me that everything was fine because their Chinese “partner” had helped with trademark registration and more than once we quickly determine that the registrations had been done in the Chinese company’s name, not that of our new client.

Another big risk with these fake joint ventures is that if and when they become profitable, the Chinese company (either directly or indirectly through the government) often simply boots out its American partner. And when that happens, the American company usually has no legal recourse to stop its Chinese “partner” from taking over the business. If the American company sues the Chinese company in a Chinese court (pretty much the only venue for such a case), what would it even say? “Your Honor, I know my business was here in China completely illegally, but that is because starting up a business legally here is just so difficult and expensive, but now that the business is worth millions, it just is not fair for me to get kicked out of it and for my Chinese partner to get the whole thing.”

Good luck with that.

I also must note that every single time we’ve been retained to clean up this sort of situation in China, the Chinese partner insists to our client that bringing in lawyers is a complete waste of time and money. What else would you expect them to say?

Text: Forbes by Dan Harris 02-11-2015

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