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:
- 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.
- 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.
- 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.