Forming a China WOFE the Right Way to Save Money Long-Term

Deleting old emails and came across this one, which I have greatly modified to render our client anonymous:

I moved to China this year and set up a trading company based in Hong Kong. I have real confidence in an idea for a ________ service similar to what www.______.com provides. I feel that a similar service based in Shenzhen could provide far greater cost savings and I am building contacts in this region, some of which have good experience in similar fields both from China and abroad. It is done a little bit from China and HK already (which I have participated in) though on a fairly small scale and not executed very well.

My question is this. With a WOFE, is it possible that after the minimum capital requirement is achieved, that the entity would only receive money to cover its costs in China? The plan is to have the main company in Hong Kong, which takes the payments from customers, though the Chinese company in Shenzhen would have to run/lease the warehouse space and employ local staff.

If this was the case (keeping profits in Hong Kong), have you found the Chinese authorities are against such a model, or are they happy enough that the Chinese company would at least be employing Chinese staff and renting property etc?

I responded as follows:

This is mostly a tax question. Generally, China wants to see its WFOEs make a reasonable profit and if they are not making a reasonable profit, they will attribute a reasonable profit to the WFOE and tax it accordingly. The fact that you have a Hong Kong entity and that you are employing a few locals is irrelevant.

It sounds like your China company is going to be engaging in transactions that involve transfer pricing.  We recommend people retain a good China-based international accounting firm to help them figure out what a reasonable profit is because that way you can get on the lower end of “reasonable” and probably keep the tax people away. But if your profits are too low (especially if you are engaging in transactions that implicate transfer pricing issues), the chances are good the Chinese tax people will not be happy and so their definition of reasonable may not be reasonable at all.

One of the keys here is how you define your WFOE. Foreign companies often come to our China lawyers because the Chinese tax authorities think their X business should have higher profit margins and these people tell us that they are not really even in X business but that the “idiot” (their word not ours) they used for their WFOE registration told them to describe themselves that way because “the Chinese registration people would like it.” Well of course the registration people liked it; they liked it because they knew the tax collections would be high. This is just one of about twenty reasons why how you define yourself from the get-go in China is so important and that will certainly be the case here.

What do you think?