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Providing Service To Chinese Companies. Get Paid Upfront Or Don’t Bother.

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By: Steven M. Dickinson

U.S. consulting companies are increasingly selling their services in China.  This is part of the general trend towards sales into China that we have noted.  In confirmation of this trend, we have recently worked with several U.S. based consultants in selling their services into China. The approach taken by U.S. consultants is consistently naïve and almost guarantees problems in China.

The most important issue in selling services to Chinese clients is how to get paid. The payment issue with service providers is far more complicated than with those who sell goods. Service providers must therefore focus carefully on the payment issue.  In drafting service contracts for service providers that will be providing services to Chinese companies, we typically put in provisions that mandate the following:

1. Payment must be received by the service provider before it begins work. It is not required that 100% of the fee be received in advance, but a substantial payment must be received in the U.S. company bank account before any work starts. In addition, it is essential that final work product not be transferred to the Chinese side until after final payment is received.

2. All payments to the U.S. side are net of Chinese taxes. That is, the Chinese side must pay a sum certain to the American service provider and that amount is payable regardless of the taxes the Chinese side is required to pay before making the payment to the foreign service provider.

These provisions are essential for two reasons. The first is the general reluctance of Chinese companies to pay full price for services. Chinese companies in general suffer from what I call the “contempt for the intangible.” Though they accept that they have to pay for hard goods like minerals or machinery, they resist being required to pay for intangibles such as consulting or design services.

This contempt for the intangible means that Chinese companies will often work actively to substantially 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 (American) 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.

The only way to prevent this from happening is to insist that no work begins until a substantial initial payment has been made. This often will kill the deal and the Chinese side will walk away. This is a good result. As my old boss used to say: “There is only one thing worse than working. That is working and not getting paid.”

The second reason is that 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. How does this happen?

China still maintains strong controls over foreign exchange. When a Chinese company goes to make a payment to a foreign party it must 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 ground 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.
  3. The most serious issue relates to taxes. Even in cases where all the work is done outside of China, Chinese banks uniformly will hold 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. Recently, we 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 that its payments be net of taxes. The Chinese side will resist this strongly. 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 the payment to be made. Even if the payment is made, it is never certain how much of the invoice payment amount will actually be paid to the foreign party.

There really is only one way the foreign service provider party can be assured of protecting itself against non-payment: refuse to work until payment is received in the bank account of the foreign party.  For more on the difficulties of doing service work for Chinese companies, check out Representing Chinese Companies. I See Some Light.

  • http://www.postlinearity.com gregorylent

    why bother doing business with/in china, is my conclusion

    • hanmeng

      Apparently people still believe they can make money. Good luck to them! (Didn’t someone say that luck favors the prepared?)

    • johnscattiglio

      ditto.  when the dust settles, is it really worth all the aggravation?

    • Gilman Grundy

      I’m sure it varies from industry to industry, but in the firms I’ve worked for the flow of business was always fairly one-way. This, though, did have it’s advantages for the foreign party - the Chinese firms we worked with were much more reliant on us for new business than we were on them, and if there was a dispute (one which happens very often in patenting is disputes over who pays extension fees where a delay in filing mean they must be paid) the foreign firm would usually get its way.

  • Robert Walsh

    Agree 100% with this post.  We have a procedure and policy for writing a proposal that states very clearly what we expect to see from the Chinese (or Korean, or Malaysian, etc) side before we begin work.  Ideally, we write the thing for 175% of what we really want, and only entertain a single round of negotiations before we walk away.  We don’t allow the issue of Chinese taxes to even come into the equation.

      The only people we allow any slack are the handful of companies we’ve been working with for years; for some of them, we’ll start work based on a text message.

  • http://www.chinavortex.com pdenlinger

    This is why many consulting companies set up in HK, then demand payment through HK. The HK govt has a long history of hiring highly-paid western consultants, and the banks have a history of dealing with them. It’s very easy to set up a company in HK, then do all the billing through the HK office to the HK subsidiary of the Chinese company; the Chinese parent company and HK subsidiary can then balance their books internally at the corporate level. 

    • Erik

       This is exactly what keeps Hong Kong as a center for doing business in China. The rule of law and predictability that is still lacking in the PRC. As long as this is the case, Westerners will use Hong Kong as their entrepôt into Greater China.

  • Jon

    This is a fair enough solution for sellers who don’t understand and don’t want to understand China. What I’ve determined for myself is that because the only motivation for Chinese companies to pay is the continued relationship, someone who wants to be paid must make sure the Chinese client believes that the future benefit to be gained from the continued relationship is higher than the amount that will be lost by paying for services received.
    If I don’t have a way of doing that, I’ll take my money up front as you suggest.

    • Albert

       Excellent point. This would fall under the tired metaphor of guanxi.

  • Ed

    ‘Contempt for the intangible’ is a nice turn of phrase.

    We’ve worked on service projects with a couple of Chinese ibanks. We structure a 30%-50%-20% payment in the contract: 30% received before we start; 50% received after a deliverable review (usually at our offices); 20% after delivery and acceptance. The final 20% is doubtful, and priced into the project as such.

    A native Mld manager is needed to work the client relationship, which is time consuming and often painful. In my experience, they do pay…eventually, and occasionally in full. These issues are ironed out after a couple projects.

    Agree with China Vortex on the HK presence, but often in practice they prefer to go with providers invoicing in RMB. Unless they have an uber-unique selling point, service companies not localizing are only looking at a tougher competitive environment.

    • Hua Qiao

      The final 20% is doubtful.  Indeed.  So often, Chinese firms stay in test mode and never formally accept the project (especially software).  I know half a dozen project firms that have had this experience.  And I agree with Jon, the only way you get paid in full is if they need you for future projects. 

      We have a saying around our firm when dealing with the Chinese on contracts.  “That was then and now is now.”  A Chinese executive uttered that phrase when we pointed out that he had previously signed a contract to do what he now refused to do.

  • http://www.politicomix.net/ Roberto

    Excellent and worthwhile post for those who have not figured this out themselves at the metaphorical coal face. :-)

  • ChinaMike

    Dan, we are taking on more and more Chinese companies and bringing them to the US.  I have some experience in what works or doesn’t work with that.  But, do your general rules apply for same or is there a 2nd set of rules for coming this way?

    M

  • Gilman Grundy

    The patent firm I used to work for in Japan did this kind of thing for a lot of our clients – not only in China but in the US and elsewhere – we put them on ‘pre-paid’, which meant that essentially we wouldn’t lift a finger for them until we had the cash in our bank accounts. Given the payment records of some of them this was only the wise thing to do, but it did mean that sometimes we would have to delay doing the work until the very last minute, at which point sometimes essentially nothing could be done.

  • China not worth the risk.

    Too much downside risk involved with doing business with the Chinese. Knowing this, and knowing you are essentially not welcome there on equal terms make it a financially hostile environment. There are friendlier places to do business in the world.