Establishing an RO or a WFOE

To set up a representative office (RO) in China used to be a common way for foreign investors that intend to enter into China. The main reason is that an RO is easy to establish. However, China has imposed more registration restrictions and tougher tax rules on ROs since 2010. The establishment and maintenance of ROs have been restricted and discouraged. And it is becoming much more expensive from a tax point of view. On the other hand, the establishment of wholly foreign owned enterprises (WFOEs) have become much simpler and more straightforward. Foreign investors may consider setting up a service type WFOE rather than an RO now.

The main reasons are follows:

1. Scope of Business

The biggest disadvantage with ROs is that they are not allowed to engage in any profit making activities except for those activities which China has agreed on in international agreements or treaties. An RO may only act as a liaison and promotion office for its parent company. Where an RO engages in any profit-making business operation and charges in any way, the competent administration for the industry and commerce may impose penalties on the ground of operation without a license.

A WFOE can be entitled to perform many more business activities like consultancy, trading, manufacturing and etc. The business scope of a WFOE can even be expanded or changed. If a service type WFOE wishes to expand into trading or manufacturing, it can expand its business scope to include this.

2. Employment

An RO is not allowed to employ Chinese personnel directly. It shall engage a local dispatch service agency designated by the Chinese Government to employ Chinese personnel. Typically, a RO will sign a labour dispatch service contract with the agency. Under such service contract the agency agrees to provide, and the RO agrees to pay for employee hiring services. After the establishment of the employment relationship, the agency will handle on a monthly basis the employee’s mandatory contribution to the social insurance and housing fund plan. Besides, the maximum number of foreigners that can work for a RO is four.

In contrast, a WFOE can employ Chinese and foreign personnel, make salary payment and handle social insurance and housing fund contributions for the employees directly and independently. And there is no quota on the hiring of foreigners.

3. Tax Burden

Even though ROs are not permitted to earn income in China, they are nevertheless subject to taxation. Most ROs are taxed based on their expenses. The tax authority has increased the minimum deemed profit rate for an RO from 10% to 15% in 2010, which has effectively raised the tax burden for an RO. With no deductions of expenses, if deemed profit margin is 15% (which is the minimum), then average due taxes for an RO are approximately 12% of total expenses.

A WFOE is taxed differently. It pays business tax or value added tax based on its business revenue. It can deduct expenses from revenues generated from business activities and pay corporate income tax on net profit. The tax burden of a service type WFOE will be much lower than that of an RO.

4. Registered capital

The main advantages of an RO is that the investor is not required to contribute registered capital when it applies for the establishment of an RO. It can remit funds regularly based on the need to cover salaries and other expenses in China.

However, under the new Company Law of the PRC, the minimum registered capital requirement for company establishment has been abolished and the paid-up capital registration system has been replaced with a subscribed capital registration system. Now the company investor(s)/shareholder(s) may decide on the capital amount, method and deadline for capital contributions at their own discretion.

5. Conversion from RO to WFOE

A WFOE is a separate legal entity under Chinese law, whereas the RO is not. There is no direct conversion from RO to WFOE. Conversion from RO to WFOE actually involves setting up a WFOE first and then deregister the RO. Starting as an RO with plans to convert to a WFOE at some later date is usually a bad idea.

The above are important considerations that should certainly be taken into account for foreign investors wishing to enter into China and also for existing ROs.