Foreign investment in China started with a trickle in the early 1980s and has increased to the extent that China is now siphoning off a significant percentage of the world's available foreign investment funding. With China's accession to the WTO and the continuing vitality of its economy, this trend seems likely to continue for the foreseeable future. Nevertheless, China remains an unfamiliar and challenging place to do business for many small and medium sized enterprises (SMEs). A popular way for an SME to get its feet wet in the China market without risking a lot of capital is through the establishment of a Representative Office (RO). The author touched on this topic briefly in the article 'Investing in China: Establishing a Business Presence'. This article aims to delve into this topic in more detail.

Before going into the 'how' of establishing an RO in China, perhaps it would be best to ask 'why'?. Most companies that establish ROs in China do so because they are much easier to establish than direct investment vehicles such as joint ventures and wholly foreign owned enterprises, and generally require only about a tenth of the capital outlay. ROs are also permitted to operate in the shrinking list of industry sectors that are forbidden to direct investment vehicles.

The downside is that there are some very limiting restrictions on the type of activities that an RO may engage in. For example, an RO may not:

1. Conduct direct business activities: An RO's activities must be confined to product promotion, market research, liaison, and the like, and it may neither charge fees for its services nor engage in profitable activities such as direct sales or manufacturing (although they are subject to taxation under certain circumstances).

2. Directly invoice clients or sign contracts: These activities must be handled by the parent company.

3. Directly hire employees: It must utilize an authorized human resources agency that will refer suitable candidates to the RO in exchange for a certain percentage of employee salaries. Some ROs make an end run around this system by directly recruiting and negotiating with employment candidates and sending their names to the authorized human resources agency so that it can then 'refer' these candidates back to the RO. While this practice doesn't seem to have caused many problems with the Chinese authorities so far, the formalities of referral and salary deduction must be complied with.

In light of these restrictions, why bother establishing an RO at all?

1. A company might want to conduct market research in order to decide whether or not to make a future investment in China.

2. A company might wish to establish an RO in a business sector in which foreign investment is currently forbidden in anticipation of future liberalization of Chinese foreign investment law in line with its WTO commitments. In the meantime it can establish a presence, make local connections, and learn about the market.

3. A company might already be doing a modest amount of business with China from its home country but lack the market penetration or resources to justify a direct investment. Once the company attains greater market share it can always upgrade to a joint venture or wholly foreign owned enterprise.

4. Sectors of certain industries such as insurance and finance require foreign investors to operate an RO for at least two years before making a direct investment.

5. A company might want to use an RO to hire local employees to help them find Chinese suppliers.

6. A company might establish an RO with the aim of exceeding its legal restrictions, and thereby establish the functional equivalent of a joint venture or wholly foreign owned enterprise while avoiding much of the expense and inconvenience. This approach is not recommended, since it is likely to lead to trouble with the authorities.