Setting Up Your Own Factory in China: The Basics

There is an old saying about how lawyers do well when times are good and lawyers do well when times are bad. The only bad times for lawyers are when there is little or no change at all.

In spite of the trade tensions, China’s declining economy, and overall uncertainty, our China lawyers have of late been getting a stream of requests from companies (mostly European for some unknown reason) looking to set up their own factories in China. These are companies that supply parts to multinational manufacturers that make products in China and the manufacturers are pressuring their suppliers to set up factories in China, presumably out of tariff concerns.

The below email is an amalgamation of what we have been sending out in response and I post it here because it nicely explains the basics of what it takes for a foreign company to set up a factory in China, which is not much different from setting up a factory in Vietnam or Thailand or Cambodia or the Philipines or Mexico or wherever. The below email is an amalgamation of internal emails from one of our international manufacturing lawyers to one of our Spain lawyers.

We can certainly help them [the client] with this project. The first thing we typically do is work with our clients to help them determine what it is exactly what they want to do. I say this because this is often not entirely clear. After we get clear on their objectives, we then work with them to  design a plan that is both consistent with Chinese law and on the ground realities and the client’s own objectives. I note that we have several good contacts in China who are expert in ___________[parts] who could help as the situation becomes clearer.

Generally, the __________ manufacturers want their parts subcontractors to operate out of a factory located in China. For that reason, the idea of using a non-China based factory as the parts supplier will not be accepted by the _______ manufacturers located in China. It is important to note that the parent manufacturing company often has ideas that are completely rejected by its China based subsidiary.

Setting up a factory in China is not an easy process. China now imposes a large number of anti-pollution, safety, local energy supply, and local transport issue regulations that must be complied with in setting up a new factory. These rules must be complied with even when the factory will be located in a well established industrial zone.

The below are what is normally required:

1. Find the best location.

The search for a good location should be started as soon as possible. However, it is not possible to find a location until after the general plans for the factory have been completed. The local government/industrial zone operator will require a basic plan for the factory building and a basic business plan before they will consider the feasibility of factory operations in their district. I note that it would be unusual for this type of factory to be located in the _______ area.  Dongbei or Shandong are more likely locations. Most of the _________ factories are in  ______________. These districts are somewhat less concerned about the environmental and other feasibility issues.

2. Form a WFOE.

Once the location has been determined, the foreign company will be required to form a Chinese legal entity, or WFOE. WFOE stands for Wholly Foreign Owned Entity and it is just a 100% foreign owned subsidiary. The application for a WFOE formation involves the following two separate sets of procedures.

a. Formal process for company formation. This is the standard Chinese company formation process. Though this process was recently streamlined, it is still highly bureaucratic and it still focuses on obtaining a large number of documents from the home country. The process is tedious and time consuming and it should therefore be started as soon as possible. Detailed rules depend entirely on what district in what city the company will be formed. But the basic rules are clear enough and we can start work immediately if the client is serious about forming an entity in China.

b. Approval process for operating the local factory. This involves a number of steps/issues including the following

i. Will the factory building be owned or rented. Both options are possible.

ii. Feasibility study performed by a local professional.

iii. Environmental impact statement drafted by a local professional.

iv. Other environmental and safety reports as required by the project.

Normally, a and b are done at the same time so that the company formation approval and the project approval are completed at the same time. The key issue is determining the factory location. Every jurisdiction in China has a different set of rule and so there is no way to know what will be the requirements in detail until after the factory location has been determined.

Note that the PRC just adopted a new Foreign Investment Law that will go into effect in 2020. This means the old rules will be discarded in favor of an entirely new system. This change may happen in the middle of this project, which could cause delay.

The process above normally takes from 6 to  18 months. The fees from our side depend entirely on how much of the process we handle. Some of our clients have us handle just the company formation and the other legal issues that stem from that (leases, employment contracts, vendor contracts, IP registrations). Many others have us handle things like the location analysis, the feasibility/EIS drafting, etc., in which case our fees are of course more.

IF it is possible for the supplier to use a parts factory outside China, the Chinese entity would be formed as a trading company. This makes for an easier formation process because the feasibility/EIS/safety analysis can be waived. However, as I noted above, the _______ manufacturers in China usually reject this alternative. Moreover, the local governments want jobs, so they can also be difficult to work with when a trading company is proposed. That said, the new Foreign Investment Law is supposed to make this type of trading company approach easier, but who knows whether this will really be the case. If the client is serious about this alternative, we should start researching it right away. In the simplest terms, there is no reason to do a lot of research if the _________ manufacturer will reject the idea.

It is also important to note that the procedures in China always take longer than any European company believes possible. In addition, there can be two additional sources of delay: a) EU companies often resist providing the intrusive company information required by the Chinese government and b) the advent of the new Foreign Investment Law and recent unclear changes in company formation procedure mean local governments are often reluctant to proceed, which itself leads to delays. I cannot tell you how many times I have found myself explaining new laws to local Chinese government officials and having to convince them that what our client is proposing to do is perfectly legal. That said, _______ parts is a favored industry in China and we should expect the districts in the traditional production areas will welcome this project. That is, the attitude will be more positive than our more recent projects which involved troublesome chemical and other polluting/unsafe projects.

The point of my comments is to say that the planning process should begin as soon as possible. Delay is a mistake. We have done this in the past and we have successfully worked with a phased fee structure and this is a project where that type of structure is appropriate.

One of my best friends in [city in China] is an industrial engineer. For the past 15+ years, his main work has been taking over the operations of __________ parts companies that set up in China to supply parts to ___________. He has to take over these operations because the formation process was rushed and the entire project is a complete mess. It usually takes him two to three years to fix these things. It would be good for this client to avoid this result, since these messes have two bad results: a) they are costly and b) they cause the major company buyer to develop a very bad impression of their parts supplier.