Late last year, China revamped its WFOE formation rules. The below email from one of my law firm’s WFOE lawyers to a client explains some of this.
As we discussed today, the first task in forming a WFOE in China is to determine what entity will be the shareholder of the WFOE. The basic analysis for this is as follows:
1) You will be creating an entity that will perform services for a fee for its shareholder parent. For this type of WFOE, the normal procedure in China is for the shareholder to be the specific entity for which the WFOE will perform services. In this case, this entity would be ABC US. The Chinese WFOE would then be another of your company’s several direct subsidiaries. Direct ownership of the WFOE by the operating company parent is most common in single owner WFOEs, such as that planned for ABC US here.
2. The alternative you are considering is whether or not the shareholder should be a separate holding company not directly linked to ABC US. This is what is referred to in China as a Special Purpose Vehicle (SPV). It would be unusual but permissible to make use of an SPV in your situation. The analysis here is as follows:
a. Over the past decade, the Chinese government has become quite suspicious of SPVs. At one point, the government even moved to prohibit SPVs for WFOE formations. However, after recently adopting the new WFOE formation rules, the Chinese government now permits the use of SPVs. So the current Chinese government rules are neutral on the issue.
b. In the past, one reason investors used an SPV was to hide the true identity of the owners of the WFOE. Under the new rules, the investor must provide a complete organizational chart detailing ownership of the shareholder and identifying the actual controlling person. It is therefore impossible to conceal ownership. Accordingly, an SPV can no longer be used to conceal actual ownership from the Chinese government.
c. SPVs continue to be used in situations where there are several investors in the WFOE. Often these investors are resident in different jurisdictions. In that case, it is common to take all these investors into a single SPV. The SPV is then the single shareholder of the WFOE. Issues such as management, distribution of profits and purchase and sale of ownership interests are handled at the SPV level. In many cases, the SPV is formed in a tax haven such as Hong Kong to allow distribution of profits free of tax. These considerations do not apply in a single shareholder setting.
d. In terms of limiting upstream liability to the shareholder, there is no benefit in making use of an SPV. The WFOE will be a limited liability legal person. The limitation of liability rules apply in China in the same way as in the United States in that the financial liability of the WFOE is limited to the amount of investment. Liability beyond the investment amount occurs only in the case of illegal acts. In general this liability would be as follows:
i. The shareholder will be held liable if the shareholder does not contribute capital and the failure to contribute capital results in non-payment of taxes, non-payment of employee salaries or fraud against creditors.
ii. Directors will be held liable for instructing the WFOE to commit an illegal act. Examples of illegal acts are tax fraud or commission of a significant safety violation.
iii. Directors and the shareholder will be held liable if the WFOE terminates business and does not liquidate in accordance with the provisions of Chinese company law. The penalty here is that both the investor and the directors are placed on a blacklist and prohibited from doing other investments in China. In addition, individual directors will not be able to travel to China since they may be detained.
All of the above liability is very real. However, creating an SPV does nothing to reduce this liability. First, most of the liability falls on the individual directors, not on the shareholder. Second, the Chinese government will use the org chart/actual controlling person information to “pierce the corporate veil” to assign liability to what the Chinese government determines in its own discretion is the actual party/parties in interest.
Note that other reasons for liability arising from WFOE operations are so rare that they can usually be discounted. On the other hand, i, ii and iii above are common and care must be taken not to incur these forms of liability.
3. There may be tax or other operational or accounting reasons to create an SPV for China. In that case, as noted above, the Chinese government is neutral about the use of such SPVs. In considering whether to make use of an SPV, you should do a cost-benefit analysis. Most of our firms’ clients have found the SPV approach to be more trouble than it is worth in the single shareholder setting. However, your situation may be different and we should explore the tax ramifications before you make this decision.