1. Essential Practices when Providing Services to Chinese Companies
Securing payment should be your prime concern when providing services to Chinese clients. To mitigate potential issues, our China transactional lawyers incorporate certain clauses in their service contracts they draft for our clients, including provisions mandating the following:
1. Upfront Payment: A substantial initial payment should be received before work commences. Do not transfer your final work product to a Chinese entity until after you have received full payment.
2. Net Payments: Payments to your company should be net of Chinese taxes. The Chinese client should pay you a sum certain, irrespective of their tax obligations.
These provisions are crucial for two reasons:
- Reluctance to Pay for Intangible Services: Chinese companies often resist paying full price for intangibles like consulting or design services, leading to protracted negotiations and potential fee reductions.
- Regulatory Challenges: The Chinese government maintains stringent foreign exchange controls, making the payment process unpredictable and time-consuming.
Thus, a surefire protection against non-payment is to refuse to work until the payment is received in your bank account.
These provisions are essential for two reasons. The first is the general reluctance of Chinese companies to pay full price for services. Most Chinese companies suffer from what is sometimes referred to as “contempt for the intangible.” Though they accept that they have to pay for hard goods like minerals or machinery, they resist paying for intangibles such as consulting or design services.
This contempt for the intangible means Chinese companies will often work to reduce the amounts they have agreed to pay for services. The standard technique is to convince the service provider to start work before payment. Usually this is the result of protracted contract negotiations. The contract is finally signed several months late, and the Chinese side now expresses panic that work must start immediately.
The foreign company service provider is then convinced to begin work before payment. Then, after considerable work has been done, the Chinese side will demand a reduction in the fee. The service provider is too deep in the project to refuse and is forced to accept a substantial discount. If the service provider has already provided the work product, the common result is that no payment of any kind is made.
These days, Chinese companies are employing a second trick. They get the foreign company to agree in writing to reduce its fee and then they do not pay anything on that fee. Then the foreign company will call one of the lawyers at my law firm saying that they want to sue the Chinese company for one million dollars, but we then tell them that their new contract provides for payment of only $600,000 and it is very unlikely they will get more than that.
The only way to prevent the above from happening to your company is to insist that no work begins until your Chinese counterparty has made a substantial initial payment. This often will kill the deal and the Chinese side will walk away. This though is a good result. Trust me. As my old mentor used to say: “There is only one thing worse than working and that is working and not getting paid.”
The second reason you need tough provisions in your China services agreement is because the Chinese government is fundamentally hostile to payments made by Chinese companies to foreign service providers. It thus often happens that Chinese companies in good faith try to make the required payments but are prevented from making payment due to the actions of the Chinese authorities.
China still maintains strong controls over foreign exchange. When a Chinese company seeks to pay a foreign party, it must first convert RMB to the foreign currency. The local foreign exchange bank acts as the agent in determining whether the proposed exchange and transfer of funds meets with central government regulations and policy. The rules for service payments are unclear. As a result, the approach taken by one local bank may be completely different than the approach taken by a bank in another city.
Some of the problems that arise are as follows:
1. The bank refuses to make the exchange on the grounds that all payments for foreign services are suspicious. Though this is entirely contrary to Chinese law, this happens surprisingly often.
2. The bank rejects payment because the contracts and invoice are not sufficiently formalized or because the documents are not in Chinese and are therefore not reviewable by the bank. Many service providers are extremely casual about their contracts and invoices. Often, the fact that an invoice is not signed and sealed by the service provider will lead to the bank rejecting payment. At least once a month our China lawyers are called on to help a foreign service provider that has not gotten paid because its documentation is not in good order. Fortunately, we are able to clean up the documents after the fact so that payment can ensue.
3. The most serious issue relates to taxes. Even in cases where all the work is done outside China, Chinese banks will deem that some tax must be paid. The amount of tax is deducted from the payment made to the foreign party. There is no consistency in China on what tax applies and the amount of tax that will be imposed. Over the years, our China lawyers have seen the following:
- A 5% business tax imposed on the gross payment amount
- A 10% withholding tax imposed on the gross payment amount
- A 15% withholding tax imposed on the gross payment amount
- A 17% value added tax imposed on the gross payment amount
- A 20% income tax imposed on an imputed profit
- A 25% income tax imposed on an imputed profit
- A 30% income tax imposed on an imputed profit
It is also not uncommon for more than one of the above to be imposed on the same payment. As a result, the tax bill can be quite high.
The imposition of these taxes causes a number of problems:
- Negotiation of the final amount can be time consuming. This delays payment.
- Because the amount of tax imposed is uncertain, the parties cannot predict in advance what it will be. To relieve this uncertainty, the foreign party should require its payments be net of taxes. The Chinese side will resist this strongly but in the end it will usually relent. If the Chinese side agrees, then the Chinese side is responsible for payment of the tax. The Chinese side will then enter into even more protracted negotiations with the tax authorities, further delaying payment.
- The final result of this process is that even when a Chinese company in good faith intends to make payment, due to the actions of the foreign exchange bank and the local tax authorities, it may be impossible for payment to be made. And even if payment is made, it is never certain how much of the invoice payment amount will actually be paid to the foreign party.
There is only one surefire way foreign service providers can be assured of protection against non-payment: refuse to work until payment is received in the bank account of the foreign service provider.
2. The Rule When Providing Services to Chinese Government Entities
As the New York Times so aptly puts it, China’s Cities Are Buried in Debt, but They Keep Shoveling It On. Or put another way by the Wall Street Journal, China’s Cities Struggle Under Trillions of Dollars of Debt. Or, as CNN says, Chinese cities are struggling to pay their bills as ‘hidden debts’ soar. If you have provided services to a Chinese government entity, or you are contemplating doing so, it is important you realize that if you do not get paid upfront, there is a good chance you will never get paid at all. Like ever.
I say this because in the last year about a half dozen service companies — mostly architect firms from the United States and the EU — have reached out to our international dispute resolution lawyers for help in getting paid money they’ve been owed by Chinese municipalities (mostly) for years. These are not typical lawsuits in that suing a Chinese municipality in that municipalities local court is not likely to go well. Our strategy has been to apply subtle pressure on these municipalities to convince them to pay our clients close to what they owe our clients, so as to avoid embarrassing themselves in front of Beijing and the CCP, and equally importantly, to avoid embarassing China on the world stage. Truth is though that these are not easy cases and the odds of getting all that is owed are not high.
So, here’s my advice regarding providing services to a Chinese governmental entity:
1. Upfront Payment: Ensure you get paid enough in advance to make the project worthwhile, even if you receive no further payment. If this isn’t possible, it’s often better to walk away.
2. Seek Specialized Debt Collection Help: If owed money by a Chinese government entity, seek specialized help for your collection efforts. Do not just hire some local Chinese law firm that will take your case and your money and then a few months later tell you that your case is hopeless. Chinese government collection efforts require a grand strategy and “encouragers” who understand how these collection matters work.
3. Conclusion
Engaging in business with Chinese companies and government entities can prove fruitful if navigated correctly, but a time and money suck if not. The key is ensuring you have proper payment procedures in place, no matter the urgency of the project or the prominence or connections of the client.
