Our international real estate lawyers often review leases for companies early in the process of forming a China WFOE. Our work in this area has been growing exponentially as word has gotten around regarding WFOE registrations going awry and landlord problems stemming from WFOE leases.
The pendency of a WFOE formation is a complicated time for a commercial lease because of issues surrounding who the tenant on the lease should be. Should it be the foreign company that will be owning the WFOE or should it be the not yet formed WFOE?
Most of the time when we are called in to review these leases, the line on the lease where the tenant’s name should go has been left blank. The company that retains us has no idea what company to list as the tenant and so they hire us to help. Choosing the tenant is a significant issue and — as is typical for so much else in China — different cities require different procedures.
The following two approaches are typically followed in China for the tenant of a WFOE to be:
- Specify the foreign country parent company as the tenant on the lease. If this is done, it is important the tenant be the company that will be the parent company of the WFOE (and not some other entity). The lease should also specifically provide that when the WFOE is actually formed, the landlord will allow the lease to be assigned to the WFOE at no cost. Some landlords will require a time limit, some do not care. Failing to put this into the lease upfront can lead to the landlord charging an exorbitant amount to allow the assignment, which assignment you will need to get your WFOE registered.
- Specify the WFOE as the tenant. You cannot use this method unless a name for the WFOE has already been approved. Under this approach, the landlord normally will require a time limit for the formation of the WFOE. Various remedies are proposed for dealing with the situation where the WFOE is never formed. This is an awkward method, since a non-existent entity is being specified as the tenant. However, the Shanghai and various other governments will often insist this method be used. Again, it is critical that your method complies with local requirements.
Determining how to proceed regarding the named tenant on a China commercial lease requires input from the local governmental authorities who will approve the WFOE. If your lease does not handle the lessee issue properly, the government generally will not approve your WFOE and/or you will end up having to incur all sorts of additional landlord and contracting costs.
If the foreign company is listed as the tenant on a Chinese commercial lease, the foreign company will be required to pay the rent and the security deposit and other fees. Since the foreign company is not a Chinese company, it will be required to pay these fees in dollars or Euros and that creates the following issues, among others:
- The landlord must be willing to accept payment of initial rent and deposit in dollars or euros.
- The management company must be willing to accept payment of its management fees in dollars or euros
- The utility companies must be willing to accept payment of their fees in dollars or euros.
All of this can be quite complex and in many Chinese cities, the utility companies simply will not accept dollar or euro payments. Many landlords will also refuse to accept dollar or euro payments and it seems that the number of such landlords has been increasing.
It is also important that the lease for a potential WFOE address the issues arising from WFOE formation. Our China real estate lawyers typically draft a lease addendum that addresses the following:
- The landlord acknowledges that the lease will be used as the legal address for a WFOE.
- The landlord warrants that the leased premises are legally suited for use as a WFOE address.
- The landlord agrees to cooperate with all documentation and procedures required for using the lease in the WFOE formation process.
- The landlord agrees to register the lease as required and to provide tax receipts for all rental payments. If there is a problem with the premises in terms of zoning or payment of fees, the government will virtually always refuse to register the WFOE.
- The landlord agrees to provide proof of ownership of the premises before execution of the lease.
- The landlord agrees that if the lease is rejected by the government in connection with the WFOE formation process, the lease will terminate and the landlord will refund all payments made up to the date of termination.
Many landlords — particularly smaller landlords and landlords in cities with little foreign direct investment — will refuse to execute such an addendum. When that is the case, our job as lawyers is to discuss with our client the costs and benefits of increased due diligence and the various risks involved in moving forward, or not.