Forming a China Subsidiary: Needed or Not

If I were to list the ten biggest/most common mistakes my law firm’s China lawyers see, not forming a China subsidiary when necessary and forming a China subsidiary when not unnecessary would both be on that list.

We write constantly about the risks of doing business in China without a subisidiary. See Doing Business in China Without a WFOE: Will the Defendant Please Rise and Doing Business in China with Deportation or Worse Hanging Over Your Head.

This post focuses on the mistake of forming a subsidiary in China when no such subsidiary is necessary or advised, a very common and expensive mistake.

It is expensive and time consuming (usually 3-5 months) for foreign-owned businesses to be formed in China. The following is the most basic list of what must be done to form and and then operate such a business legally and safely in China:

  • Determine whether your business model is legal for a foreign business in China.
  • Form and register your subsidiary in China.
  • 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.

It is complicated and expensive to form a subsidiary company in China and it is complicated and expensive to operate such a company in China. To do so in most cities, you need office space and employees and you need to meet with the tax authorities four times a year and you need to calculate and pay all sorts of taxes and . . . .

To make matters worse, shutting down a China subsidiary makes forming one seem like a piece of cake. Let’s just say that I once heard a China accountant at a seminar analogize it to a colonoscopy. Not kidding.

There are scads of companies in every tier 1 and tier 2 China city that see their role as getting paid to form legal entities, not helping someone figure out whether a legal entity actually makes sense for what they want to do in China. The odds of one of these company formation mills questioning you on why a subisidiary company might or might not make sense for you, and then analyzing whether it does or does not are slim to none. Consequently, countless foreign companies go through the pain and expense of forming a Chinese legal entity they don’t need, then operating that entity they don’t need, and then closing down the entity they never needed in the first place.

My law firm and most American and European law firms do not play these tricks. Before forming any company in China, we first determine whether that actually makes sense. Our China entity formation lawyers often get calls from someone asking to form a “China company” for them before they start doing business in China “next month.” Most of the time when we get this sort of call, the better solution is not to form a China entity at all.

Many times when our China lawyers get a call from someone having a problem with their Chinese legal entity, additional discussion reveals they should never have formed their China company in the first place.

Generally speaking there are two main situations when a China subsidiary is legally necessary and a third situation where it can make good sense to have one, even though not legally required.

It is legally necessary to have a China legal entity if you will have one or more employees in China — you should assume anyone you are paying in China as an “independent contractor” is in fact an employee. See Four Common and Dangerous China Employee Hiring Myths.

It is also legally necessary to have a China legal entity to get paid in RMB.

If neither of the above are or will be true for you, you probably do not legally need a Chinese company.

There are though many instances where a Chinese legal entity is not legally required but forming and having one still makes sense. If you sell products or services to Chinese universities, banks, hospitals, governmental bodies, SOEs or Chinese businesses with any sort of governmental ownership it might make sense for you to have a Chinese legal entity, even if you are not legally required to do so. These sorts of businesses are often pressured by the Chinese government to buy from Chinese entities and if you don’t have a Chinese company your sales could be way less. We also have seen instances where having a Chinese company is worth the money and pain because it increases sales by convincing Chinese buyers that you are in China to stay and that there will be someone local to whom they can go with problems.

But just to complicate things further, our China lawyers often see instances where a foreign company formed a Chinese legal entity to hire employees in China and/or to get paid in RMB in China and yet would have been better off without having done so. These are cases where the foreign company did not realize it had better/cheaper options for accomplishing its China goals without need for a China the China legal entity. The following are the two most common examples we see of this:

1. Foreign company forms a subsidiary company in China to sell its widgets. Foreign company hires two employees in Shanghai to do this after being convinced it needs a Chinese subsidiary company because it will have employees in China and because it will be getting paid for its widgets in RMB. In Want Your Product In China? Try Using A Local Distributor, I (in this Forbes Magazine article) emphasized the benefits of selling to China through a distributer, rather than going it alone via a subsidiary company:

When foreign companies want to get their products into China, they often think they only have two choices: go it alone via a China WFOE or form a joint venture with a Chinese company.

Joint ventures are notoriously risky, while a WFOE can take three to five months to form, leaving you with a company in China to operate (that includes bookkeeping, hiring employees, etc.).

But there’s actually an easier option. Companies can enter into a distributorship relationship with a Chinese company (or companies).

Use a Chinese distributor

From a business perspective, taking most products into China (be they industrial or consumer) is a massive task for any foreign company. China is a big and diverse country and it should be viewed as many markets, not just one. Using an experienced Chinese distributor is oftentimes the best way for to sell your product in China.

And from a a strictly legal perspective, distribution (and reseller) relationships between foreign and Chinese companies are fairly straightforward.

Distribution contracts with Chinese companies can have much in common with U.S. distribution agreements, but they also almost always also have stark and important differences.

Licensing your brand name or your technology is another far less risky way to profit from China without setting up and operating a subsidiary there. See China Technology and Trademark Licensing Agreements.

2. Foreign company forms a Chinese subsidiary company to hire one or two people to handle its China quality control. There are many good and inexpensive QC companies in China and they are often a better way to go. And here’s the thing. Oftentimes if you want a QC person in each of the two or three cities in which you are having your products made, you need to form a subsidiary company (or at least a branch office) each of those cities to be able to legally hire employees in those cities and then deal with China’s highly localized employment laws.

Forming and operating a company in China is difficult and expensive and you likely have other options. It would behoove you to explore those options before you form a company in China.