According to most economists, China is the world’s second-largest economy and an essential business partner to many countries. This makes China a clear choice in which to start or expand a business overseas. However, like most countries, there are some caveats to conducting business in China. China has a few processes in place, such as establishing a Wholly Foreign-Owned Enterprise for foreigners hoping to gain access to the Chinese market, including US expats living in China.
What Is a Wholly Foreign-Owned Enterprise?
The Wholly Foreign-Owned Enterprise (commonly referred to as WFOE) was originally conceived and implemented in 1986 to drive China’s manufacturing industry and increase Chinese exports via foreign investment. Following China’s entry into the World Trade Organization in 2001, WFOEs were permitted to provide consulting and management services. At this time, most Wholly Foreign-Owned Enterprises remain rooted in manufacturing.
A Wholly Foreign-Owned Enterprise is a type of business entity in mainland China. Wholly Foreign-Owned Enterprises are business entities like a US limited liability company (LLC). The original concept behind creating WFOEs was to encourage foreign investment in China’s manufacturing industry and introduce advanced technology to Chinese industry. As the name implies, this type of entity is largely used by foreigners to conduct business in mainland China. There are three different types of Wholly Foreign-Owned Enterprises:
- Service or Consulting WFOEs
- Trading WFOEs (or Foreign-Invested Commercial Enterprise FICE)
- Manufacturing WFOEs—the most common kind
Each WFOE in China comes with a unique set of rules to structure.
Advantages of Owning a WFOE
Ownership of a Wholly Foreign-Owned Enterprise provides foreign business owners conducting business owners with a series of advantages.
- Foreigners can make business decisions without a Chinese investor or partner
- Similar to US corporations, the WFOE is a separate business entity
- The foreigner will have total control of the business within the confines of Chinese law
- The ability to invoice and receive payments in Chinese yuan
- Protections from the theft of intellectual property or trademark infringement under Chinese law
- The ability to ship goods in and out of China without a license
- Limited liability up to your original investment
- Full control of human resources
Disadvantages of Owning a WFOE
There are also several disadvantages to setting up a WFOE, such as:
- Establishment is mind-boggling and tedious, with endorsements required by multiple authorities
- Consolidation is costly: 15% of the investment is required within the first three months
- There are restrictions and prohibitions on certain industries, so foreign investors are streamlined to only the encouraged industries
- Increased liability because you are the official employer of record, so you must familiarize yourself with complex laws and regulations related to employment, contracts, payroll, and tax
There can be US tax implications for US citizens and residents who establish a WFOE, such as additional US tax filing requirements. The extra filing requirement is typically Form 5471, also called the Information Return of U.S. Persons with Respect to Certain Foreign Corporations. US citizens and US Residents who are officers, directors, or shareholders in certain foreign corporations must file Form 5471. This form is attached to a taxpayer’s federal income tax return and is used to report transactions and possibly taxable income for taxpayers. The 5471 is required if a US citizen or US resident has a particular level of control in a foreign corporation. This form is complicated and carries a $10,000 penalty if not completed or completed improperly. The IRS estimates the average completion time for the form is 55 hours. Given the additional time required to complete this form, there is often an increase in tax preparation costs.
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