Offshore companies are widely used by businesses and individuals for a variety of purposes. So pervasive is their use in China that even smalltime accountants in Hong Kong offer incorporation services in jurisdictions like the British Virgin Islands (BVI). While there is nothing inherently wrong with the use of offshore entities, you should be wary of entering into contractual relationships with them when doing business in or with China, particularly in the manufacturing context.
The Importance of Direct Contractual Relationships in Manufacturing
As a general rule, when entering into a manufacturing agreement, you want to contractually bind the entity that will actually be making your goods. It could be the case than an offshore company owns a Chinese corporate entity (most like a WFOE), which in turn owns the manufacturing facility in China that will make your products. However, having a manufacturing agreement with such an offshore company will likely be of no use to you if problems arise.
The Challenges of Offshore Jurisdiction Opacity
For starters, offshore jurisdictions are notoriously opaque. Even confirming the existence of a company can require jumping through hoops. If you want to confirm whether a company called WashCo LLC is incorporated in Washington State, you can do that for free in 27 seconds (I timed it) using the Washington Secretary of State’s search system. In Hong Kong, there is also no charge for confirming that a company exists, though the search will take a bit longer, because the Companies Registry now requires you to provide identification details. However, in the BVI, you must pay a $50 fee, and then a report will be sent out “within 24 hours.” Not that much money nor time in the grander scheme of things, but still.
Offshore Companies Create Legal Risks and Structural Fluidity
In addition, if sued, an offshore company could claim that it did not do anything wrong, arguing that it was rather the China entity that messed up, and that it (the offshore company) does not control the activities of the China entity. And to be fair, there is a good chance that the offshore company’s “management” consists of someone random who serves as director for a price, who may never have even stepped foot in China, let alone had any dealings with the China factory in question.
Meanwhile, at any hint of trouble, the corporate structure could be changed so that the offshore company no longer owns the China factory. At that point, the offshore company becomes little more than a box with corporate documents – hardly an ideal defendant in a suit for damages. Or it might be dissolved entirely. In this sense, keep in mind that, despite its exotic address, the offshore company is just a tool being used by folks with whom you are dealing.
Identifying the True Manufacturers
Finally, the use of an offshore company could be a sign that the people you are dealing with are not really the manufacturers. Someone who actually runs a factory in China will have no choice but to form a China corporate entity – even if it is overlaid by a Hong Kong or offshore company. However, for someone who is simply taking orders and then farming them out to factories, it is far easier and cheaper to set up a corporate presence offshore than in China. Why would someone working from a Starbucks in Shenzhen bother dealing with China’s onerous company formation requirements, when they can just arrange to have a company set up in a tropical paradise for a few hundred dollars?
Exercise Caution with Offshore Entities
When choosing your manufacturers in China, offshore corporate entities should raise immediate red flags. Their opacity and detachment from actual production can severely complicate legal recourse.
Rather than taking assurances at face value, you should diligently vet and contractually bind the Chinese entity that will actually be manufacturing your goods. Trace the ownership path to its origin to cut through any corporate veils. For more on conducting due diligence on Chinese companies, check out Due Diligence in China Just Got a Lot Harder: Now What?
The bottom line is that you should be wary of entering into China agreements, such as manufacturing agreements and NNN agreements, with an offshore company. There is nothing in it for you and it could greatly complicate things in case of a dispute. Get the right entity on the hook.