Our China lawyers have seen a spike in queries from foreign companies not getting paid by private Chinese companies without affiliates or assets abroad.
The Chinese company’s excuse for not paying is often “that the rules have recently changed so foreign payments are no longer possible.” Another one is that the Chinese company is simply not allowed to send more that $50,000 at a time or even $50,000 in total each year.
The underlying regulations have not changed and there is no limit on the amount that can be remitted abroad by a compliant Chinese company. But Chinese banks are becoming much stricter with certain remittances as the Chinese government wants to limit fraudulent capital outflows and make sure taxes are paid in China before money leaves the country.
Chinese law generally requires a Chinese company to obtain a “tax certificate” from its local tax bureau before it can convert more than $50,000 worth of RMB into a foreign currency to remit abroad. As the name might suggest, the certificate confirms the Chinese company has made all necessary tax payments or has some kind of exemption for the money. To obtain the certificate, the Chinese company must submit copies of the relevant contracts (and usually invoices as well) and provide particulars of the transaction. The tax certificate must be presented to the foreign exchange bank before payment can occur.
The regulations provide for a $50,000 exemption from approval. No proof or justification is required, up to the $50,000 limit. However, in June of last year, Chinese banks began arbitrarily denying requests for RMB conversion of amounts below the $50,000 limit.
Sometimes, problems with getting money out of China stems from the Chinese company being unable to get a tax certificate and sometimes it stems from the Chinese company not wanting to get a tax certificate because that would require it pay taxes it wasn’t planning on paying. To be fair, problems sometimes arise when the Chinese company genuinely wants to make a remittance and is prepared to pay the applicable taxes. These problems vary depending on the type of payment. They mostly affect payments for services, royalty payments and Foreign FDI or M&A payments.
Payments for purchasing of goods are usually less complicated, so long as the foreign side has its own paperwork in order as well. And often, the inability of a Chinese company to pay, stems solely from mistakes made earlier in the transaction.
1. Good Documentation and Good Tax Planning are Critical
Foreign companies that provide services to Chinese clients often neglect to consider the most important issue: how to get paid.
When operating in the U.S. and European markets, service business billing and payment are simple. There is often no contract, just an oral agreement or an exchange of emails. When payment is due, invoices are informal or not even provided. Tax issues are irrelevant, since the work is performed at the office of the service provider and taxes are paid to the local government.
This approach does not work for China.
To get paid from China, there are two critical points you must consider: documentation and tax.
2. Mandatory Documentation
A Chinese company must go to its foreign exchange bank to convert RMB to U.S. dollars or to some some other convertible currency before it can pay a foreign company for anything. This conversion is subject to strict rules issued by the State Administration of Foreign Exchange (SAFE). The foreign exchange bank acts as the agent for SAFE in enforcing the rules. These rules are used to prevent capital from illegally leaving China. Payment of falsified invoices is one of the primary ways capital illegally leaves China, so careful review of all transactions is required to prevent fraud.
To comply with these rules, your Chinese client must provide documentation proving there is a legitimate underlying transaction for which payment is being sought. Otherwise there can be no wire. The basic documentation is as follows:
1. A formal written contract, executed, dated by both parties and sealed by the Chinese party. It is best if this contract includes a Chinese translation.
2. A Formal, written invoice, signed and dated by the foreign service provider. There must be a separate, signed invoice for every required payment. It is best if this invoice includes a Chinese translation.
Depending on the specific situation, the foreign exchange bank may also impose the following additional requirements:
1. If the invoice amount is high or the bank suspects fraud, it may request proof of existence of the foreign company. For some banks, a copy of a business license is sufficient. Other banks require a formal certificate of good standing from the secretary of state or a related document.
2. If the bank determines the payment is a royalty for a technology license or similar agreement, it will require the contract be registered in accordance with Chinese law. Depending on the locality, this registration can take three days to six months or more.
China’s banks can impose other requirements, depending on their mood and their concern about the legitimacy of the transaction. The Chinese bank controls the situation and you have no real standing to discuss the matter. No payment can be made until the bank is satisfied and the bank has no incentive to approve the transaction, and delays in processing payment are common. For these reasons, our China lawyers make sure our clients have crossed every possible “t” and dotted every possible “i” before giving the go-ahead to their China clients to submit payment requests to a Chinese bank.
It comes as a shock to many foreign service providers that the amount paid to them is subject to Chinese tax, even if all service work was done outside China. The Chinese tax authorities typically deem all service work provided to Chinese clients as China sourced income and therefore subject to tax on the invoiced amount. As with the SAFE rules, the foreign exchange bank serves as an agent for the local tax office to ensure the correct amount of tax is imposed and paid. No wire transfer can be made until this happens.
We have seen tax amounts imposed from 10% all the way to 40% of the invoice amount. Even the same tax office will take an inconsistent position on the tax to impose.
Resolution of the tax issue is critical because the invoice cannot be paid until the tax amount is calculated and paid. The Chinese client acts as the agent for the foreign service provider and pays the required amount on behalf of the foreign party. Since the total amount paid by the Chinese client does not change, the Chinese client has virtually no incentive to work with the tax office to lower the tax amount. Since the foreign service provider is anxious to get paid as soon as possible, the incentive for the Chinese client is to agree with whatever the tax office decides and to make the tax payment as soon as possible without complaining about the amount imposed.
The amount of tax can be high and the time required for processing can be long. It is therefore critical that the foreign party understand the issues and enters into an agreement with the Chinese party on how to proceed. Under international commercial practice, it is common to provide in the service contract that 1) the Chinese side is liable for all taxes imposed by the Chinese government and 2) the amounts payable by the Chinese side are net of taxes. This provides certainty to the foreign party and places the burden of dealing with China’s complex, uncertain and constantly changing tax system where it belongs: on the Chinese party. Since the Chinese party is responsible for the taxes, it will have incentive to advocate for the lowest tax possible.
It is common for the Chinese party to resist this approach and to seek to place the entirety of Chinese tax system risk on the foreign party. The foreign party must consider whether to abandon the transaction or move forward without certainty on the amount of taxes it will need to pay.
In any service transaction with China, there is risk of delay and there is even a risk that payment will never be approved. It is therefore important to confirm the ability of the Chinese side to make payment. This means you should not do a substantial amount of work before you receive your first payment. In the contracts we draft, our China lawyers usually require the China party make an initial payment before our client undertakes substantial work. We do this to determine how quickly the payment will be processed and the tax that will be imposed on payment. Often, the Chinese side itself has no idea what will be the result.
Do not let your service company be another name entered onto the never paid or highly taxed casualty list.