At the end of each calendar year, many nonprofit organizations, including nonprofits in China, start to appear more frequently on everyone’s radar. Recently I counseled a nonprofit organization that wanted to set up China operations in some way. Technically they are a U.S. not-for-profit (501(c)(6)) organization, rather than a 501(c)(3) charitable nonprofit, but I use the term “nonprofit” below.
This is an excerpt from a memo I wrote for the board of directors who wanted to minimize the nonprofit’s China risks. For this nonprofit’s risk profile, we suggested that they license their intellectual property to multiple third-party in-country operators that would pay royalties and be solely responsible for all China business operations and risk.
1. Essential Background on Recent Enforcement Priority Changes in China
As you are most likely aware, doing business in and with China carries significant business risks, largely because of the Chinese Communist Party’s (“CCP”) iron grip on all facets of society, including business matters. Recently the CCP has focused government enforcement on both finance and education. See “China Says Crackdown on Business to go on for Years”, “China Looks to Rein in Lending to Cool Property Boom”, and “China Steps Up Crackdown on $1 Trillion Bank Wealth Products.”
2. Government Treatment of Nonprofits in China
The CCP is already belligerent when it comes to any kind of foreign influence within China, and that is especially true where nonprofits are concerned. Nonprofits in China that fall into any potentially problematic category, including education (see here and here), finance, and healthcare, could easily be singled out by the CCP as problematic and get shut down quickly (the American Chamber of Commerce in Chengdu received only 72 hours’ notice.)
The CCP is extremely bullish on promoting “Chinese credentials” for every type of licensing, so even if you are in a less problematic industry, you may run into significant obstacles. And China’s nonprofit law includes its ubiquitous provision prohibiting any foreign entity or person from endangering state security or damaging the national or public interest. All of those criteria are intentionally broad and vague and used to target undesirable companies and individuals.
If you were to seek to enter the China market with a business entity, your business model would fit the Social Association 社会团体 (“SA”) model, which is the equivalent of a nonprofit membership association. However, because SAs are subject to significant regulatory approval and oversight by both the national Ministry of Civil Affairs and a government ministry or other state agency within your line of work, you would most likely find the prospect of entering the China market prohibitively expensive and cumbersome.
Further, you would most likely be stonewalled based on the CCP’s recent shift in enforcement priorities and the fact that China’s foreign nonprofit law does not include a provision permitting a foreign nonprofit to establish a Chinese subsidiary, instead requiring you to set up a representative office or register to carry out temporary activities (requiring annual approval). Establishing a representative office as a nonprofit requires partnership with a Chinese nonprofit with a similar mission, which will be responsible for oversight of the activities in China. But establishing a representative office would open you to full financial liability for all China activities.
It is also very likely that your revenue model could be classified as a for-profit activity that is not permitted by nonprofits in China, especially because you will be remitting profits back to the U.S. and not just engaging in an “altruistic” mission in China. You could take the tack that other nonprofits have taken with China and either set up a representative office (discussed above) or form a new for-profit entity, either a WFOE or a JV. These are the only reasonable avenues remaining for doing business in China (as opposed to doing business with China, which is how we describe your current business model). WFOEs and JVs are both expensive and carry their own sets of significant requirements and risks, all of which you are wise to avoid, as we have discussed previously.
3. Moving Forward with Multiple Licensing Relationships
We agree that a licensing relationship with a license or royalty fee is the best way for you to engage in business with China to derive revenue while mitigating your China nonprofit risks. The only remaining question is how to best structure your business relationships. Your revenue will be derived from your licensees that are sourced by your agent. Your licensees will pay a per-use fee, which requires more oversight from you but is also potentially more lucrative.
We recommend using parallel two-party contracts between you and each licensee that are tailored for enforcement in each licensee’s home jurisdiction. Although using per-person or per-use fees will make your contract damages harder to prove in court than if you utilized a monthly flat fee, with audit oversight you will be able to get some idea of any underpaid fees.
Your contract with your agent should be a standalone agreement that obligates you to remit the agent’s fees preferably after you start to receive license fees. Your agent may not agree to that arrangement and may require an upfront success fee, but we recommend pegging at least some of its compensation to license fees actually received by you rather than allowing your agent to be inserted into the license fee chain of custody.
Your contracts should ideally be established where the funds originate and be in both English and Chinese. Your licensing agreements should be governed by Chinese law, with the authoritative version in Chinese and enforcement in China. Your consulting agreement with your agent should be governed by U.S. law, with the authoritative version in English and enforcement in the U.S.
Only your licensing agreements will need to be registered by each licensee. The agreements will not be accessible to the general public, but they will be given to the appropriate government tax bureau so they can ensure taxes get paid by the licensee. The agreements will also be given to the licensee’s bank so it can authorize each remittance of the license fees.
As mentioned above, we will ensure that the licensee is solely responsible to fulfill these requirements. We often recommend an initial flat license fee payment so that each licensee can demonstrate to you that it has already undergone the initial registration process that will allow it to remit license fees on an ongoing basis.
4. Concluding Thoughts
Because you are not currently a nonprofit in China – but rather a nonprofit doing business with China – your business activities do not require you to register in China. You are wise to engage in doing business with China this way. If you had asked us to help you determine the best course of action for deriving revenue from China while minimizing your in-country risk, we would suggest your current business model. Any activities beyond merely entering into contracts and monitoring compliance with Chinese parties would likely mean you were doing business in China, which would require registration of some kind.
In our Chinese licensing agreements, we always put the onus on the licensee to pay the license fee net of any applicable in-country taxes and fees based on the license structure. You will want to discuss this plan with your tax adviser to ensure you fully understand the ramifications of receiving licensing or royalty fees from China.
5. General Advice for Nonprofits in China
This excerpt above will not apply to every nonprofit looking to do business in China. Each nonprofit will have a different mission, business model, and risk tolerance, as well as different business partners and opportunities. But all nonprofits need to know that they are in the government’s crosshairs from day 1. That will not change.