Building and Operating a China Factory, But Why?

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With production costs and supply chain challenges on the rise, many businesses are considering whether building and operating a factory in China or elsewhere in Asia is viable. In my experience it is almost always viable, but it often does not make sense.

Consider this example. A client of mine emailed me a post on starting a factory in China and asked me if it was accurate.  I told him yes and, if anything, it had sugar-coated things. The post was Creating a factory in China to replace your suppliers, and it essentially warned of the “huge” risks inherent in a foreign company starting its own factory in China.

The post stemmed from the blogger, Renaud Anjoran (who knows Asian manufacturing incredibly well), being asked by one of his clients about opening a “small factory” in Guangdong Province so as to be able to “control fully the level of quality he needs to receive.” Renaud had this to say in response:

I think it would create a huge amount of work for you. And a lot of risks.
Of course it is possible, if you create the right legal structure, you rent a factory building, you hire a manager and then a whole workforce.

You can do it on your own — no need for a local partner. But there are two problems:

1. The amount to invest in a manufacturing WFOE (wholly Foreign Owned Enterprise) is in the millions of RMB. And you can’t get that money out of China easily.

2. Simply due to the fact that your small factory is a foreign-investment company, costs will be 20% higher. There are many things that local bosses can get away with, and that you can’t. (Of course, if a smart engineer sets up production lines in a very efficient manner, you might be able to get your costs in line with those of the local competition.)

I would say, by all means avoid Chinese partners. In most cases they just suck the profit out of the joint venture in a way the foreign partner cannot find.

I would have answered in much stronger terms, saying something like the following:

What? Are you serious? First off, in your first year, you are going to essentially waste around $50,000 in just forming your WFOE, securing various government approvals, paying someone to figure out your taxes, and making up for all the mistakes you will make because you will be in — what is for you — a very strange land. Then there will be the taxes, which you are going to need to pay on just about everything.  Figure 20% on profits and even if you do not make profits, figure on them being imputed to you. And figure on having to pay around 40% to various of the Chinese governments as taxes on the salaries you pay your employees.

What Is a WFOE?

Operating a business in China as a non-Chinese entity is more than hanging an open sign on the door. Not that you’d do that with a factory, but you get the point. Creating a wholly foreign-owned enterprise (WFOE) might be the best option.

The WFOE is similar in structure to an American limited liability company (LLC), a separate legal entity from its owners. The WFOE has a group of shareholders who are foreign to China. Generally speaking, it’s an organization type that allows your company full ownership of and control over your entity.

These organizations are one form of Foreign Invested Enterprises (FIEs) and must comply with all points of the recent Foreign Investment Law (FIL), which are quite complex. The objective of the FIL is to level the playing field between domestic Chinese companies and foreign-owned businesses in terms of the law.

WFOEs include two primary steps — the formal creation process and the operating approval process. As with many bureaucratic processes, the formal creation involves incredible amounts of documentation and meticulous attention to detail, making it a time-consuming task. The operation approval stage focuses on your operation’s environmental impacts and its practicality, known as the feasibility study. This step is less lengthy time-wise but intensive nonetheless.

Do I need a WFOE?

Probably, but maybe not. Every scenario is different, and the right solution depends on your objective, industry and scope of business you want to conduct. There are some situations where a WFOE is required. Familiarize yourself with those scenarios to prevent going through the rigorous process needlessly.

Benefits of a WFOE

There are several advantages to creating and having a WFOE — even if not required — if you’re establishing or buying a business in China. These benefits include the ability to:

  • Do business: As the autonomous owner of your WFOE, you maintain control over your company’s operations. That means you have the opportunity to conduct actual business, contrary to a Representative Office that limits permitted activities.
  • Protect intellectual property: The new FIL provides legal remedies for WFOEs against common expropriations and extends protections for intellectual property rights.
  • Withdraw profits from China: Although hiccups occur, a well-documented package of paperwork usually satisfies the legal requirements to bring your money back home.

The relative cost of building a factory in China

We’ve talked about how much you’ll need to invest in setting up a WFOE and why you might do so, but those factors are only one piece of the cost puzzle. How much does it cost to open a factory in China? Honestly, it depends. I know that’s vague, but the actual number will vary based on some of your choices.

Registered capital

As part of your WFOE formation, you’ll declare an amount of “registered capital” that represents the entire investment you intend to make. You have 30 years to invest the total figure, and up to 20% of that amount can comprise in-kind contributions, like equipment and intellectual property. You don’t have to set these funds aside as a reserve, but you must deposit the entire amount before the 30-year timeline expires. The government expects you to spend this registered capital, not just deposit it somewhere.

There is no set minimum requirement for many businesses, but statutes demand specific amounts in some industries. There’s also a de facto amount you should expect to deposit, even if not mandated by law. Generally speaking, you’ll want to declare at least two years’ worth of predicted operating expenses and set aside an account with 50% of that figure to meet legal requirements in their entirety.

You see where this is going in terms of cost, right?

Buy, build or rent?

After having a building plan in mind, the next step is identifying a location. Depending on the area, you’ll face vastly different rules and regulations. The government has been cracking down on pollution and promoting local efforts, making these standards more complex to navigate. Feasibility studies and environmental impact reports are also factors.

What if you want to lease an existing facility? Will that be more cost-effective? Not necessarily. The current manufacturer may be paying the landlord under the table, and the landlord may not be reporting it. Heck, there is a chance the landlord cannot legally lease out the property. For the sake of the numbers, let’s assume that the landlord is actually authorized to lease it.

If you are going to buy an existing Chinese manufacturer’s company that rents space, you are going to have to do so as a WFOE. To get a WFOE approved at all, you are going to need to have a legitimate lease. That means that before you buy this Chinese manufacturer, you are going to need to go to the landlord and tell it that you need to get your landlord-tenant relationship “on the grid” and that the landlord is going to need to register the lease with the appropriate authorities.

The landlord will likely call you an idiot (trust me on this) and initially balk. You will then need to explain that you absolutely must get on the grid and that you are prepared to cover the landlord’s increased costs to do so. Figure on this raising your rent by around 25%. Again though, this assumes that staying at this facility is even possible.

Taxes on wages, rent and profits

Then there will be the taxes, which you are going to need to pay on just about everything. Figure 20% on profits and even if you do not make profits, figure on them being imputed to you. And plan to pay around 40% to various sectors of the Chinese government as taxes on the salaries you pay your employees.

And all of this is going to mean your costs are going to be considerably higher than whatever Chinese factory you are currently using to make your product. In Buying A Chinese Company: Why China Deals DON’T Get Done, we wrote of how this domestic-foreign price differential works in the context of a client looking to buy its Chinese manufacturer:

I said that there is a good chance the Chinese manufacturer is paying half of its employees completely under the table and reporting to the government only half of what it was paying the other half. I then talked of how there is also a good chance the Chinese manufacturer is underpaying its taxes and of how its rent also may be paid under the table. I then said that this sort of thing may be all well and good for Chinese companies, but that if the US manufacturer were to buy this Chinese manufacturer, it would need to do so as a WFOE and it would then immediately be on a “whole ‘nother level” with respect to China’s various tax authorities.

I then told the US manufacturer that if it were to buy the Chinese manufacturing business, it would need to bring every single employee onto the payroll and that would likely mean the payroll expenses would be close to doubled. I then gave my estimated numbers. All of the wages now being paid under the table would need to be paid legitimately and that would mean that the US manufacturer would, in turn, need to pay all sorts of employer taxes, pensions, and insurance. I told the US manufacturer to figure that these items would be about 40% of all wages. So if you have an employee who is now getting $1000 a month under the table and you then report to the government that you are paying that employee $1000, you should figure on needing to pay about $400 on that to the government.

But it gets worse. Much worse.

You see, that employee who is receiving $1000 under the table is usually quite happy to be getting paid under the table. So when you tell that employee that you are now going to be reporting their wages/income to the government, that employee is going to demand a raise. You see, that employee has been able to avoid having to make their various employee contributions and pay their income taxes. You reporting their income will end all of that.

You should expect needing to raise employee salaries by maybe 40 percent. So now the employee who was getting $1000 is getting $1400 and you as the employer are going to need to pay an additional 40 percent on that, which equals around $560. So all of a sudden the employee that cost the Chinese manufacturer $1000 a month is going to cost you pretty close to $2000.

And let’s take rent. The Chinese manufacturer is probably paying the landlord under the table and the landlord is not reporting it. Heck, there is a very good chance the landlord is not even legally able to lease out the property, but for the sake of the numbers, let’s assume that the landlord is actually authorized to lease it. If you are going to buy the Chinese manufacturer’s company you are going to have to do so as a WFOE and to get a WFOE approved at all, you are going to need to have a legitimate lease. That means that before you buy this Chinese manufacturer, you are going to need to go to the landlord and tell it that you need to get your landlord-tenant relationship “on the grid” and that the landlord is going to need to register the lease with the appropriate authorities.

The landlord will likely call you an idiot (trust me on this) and initially balk. You will then need to explain that you absolutely must get on the grid and that you are prepared to cover the landlord’s increased costs to do so. Figure on this raising your rent by around 25%. Again though, this assumes that your being able to stay at this facility is even possible.

Okay, so now that I have explained how the above will eat into your numbers, let’s talk about income taxes. You are going to have to pay income taxes on the money you make, even though previous manufacturers may not have. Figure 25% of your profits will go to income taxes. And if you are now thinking that you are not going to have any profits, let me tell you that is likely going to matter less than you think for Chinese income tax purposes. You see, if you have no profits, the Chinese tax authorities will figure that is because your Chinese WFOE is intentionally under-pricing the product it is selling to your United States operations and it will then impute a profit to your Chinese WFOE. It’s a transfer pricing thing.

You need an accountant who understands China to look over the Chinese manufacturer’s books and to run the numbers to see if this deal is going to make sense.

A few months later, I received the following (doctored) email from our US manufacturer client:

Here is where we stand:

Our accountant is in the process of re-modeling the business from a top-down perspective, in an effort to clarify what the numbers would be for our China WFOE, while complying with the rules.  We have good history on the revenue and most of the operating costs.

As you guessed, we will need to apply roughly a 2x factor to the labor costs that the Chinese manufacturer is showing, so as to properly book all of the official up-charges.

Also, as you suggested might be the case, the landlord of the factory space is not properly registered, so we will be increasing the booked rental costs as well.

The reality is that we probably will not be purchasing the Chinese manufacturing company did not sit well with its owner. He was offended when I reiterated my stance that I wouldn’t operate the business in the same manner as he has. He lost face.

A few weeks after that, I received the following email from the client (again doctored):

It is now clear that we shouldn’t consider buying [the Chinese manufacturer]. He [the owner of the Chinese manufacturer] had previously indicated that there were “a couple” more issues related to the accounting procedures. I pressed him to explain if there were any others. Of course, you know the answer to that.

In summary, it is becoming clear that we cannot be profitable in China if we follow all the rules. It is not completely clear this is really the case, since we can’t tell if [the owner of the Chinese manufacturing company] really understands the rules. What is certain is that the numbers on which we had been basing our valuations are simply not valid. The “profits” that the Chinese manufacturer was claiming to have achieved are not valid under our business model.

I am not saying there will never be any circumstances in which it will make sense for a foreign company to start and operate its own factory in China, because in many cases doing so will make complete sense. But I am saying that if you are a small company looking to get your product manufactured in China, you should think long and hard about doing the manufacturing yourself because sticking with your Chinese factory will in most cases make better sense than seeking to manufacture on your own. But if you do decide to open your own factory in China, you probably will want to do so on your own via a WFOE and not via a Joint Venture.  For why that is the case, check out Chinese Joint Ventures — The Information The Chinese Government Does Not Want You To Know and Joint Venture Jeopardy.

What do you think?