By: Steve Dickinson
More and more foreign service companies are providing services to Chinese clients. This is a good thing, because the Chinese companies need the help. We have noticed, however, that foreign service providers continue to neglect to seriously consider the most important issue: how to get paid.
When operating in the U.S. and European markets, service business billing and payment are quite simple. Usually there is no contract, just an oral agreement or exchange of email. 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 all tax is 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.
When the Chinese client pays your bill, it is not a simple matter. The Chinese client must go to its foreign exchange bank. At the bank, RMB must be converted to U.S. dollars or some other convertible currency. 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 were originally designed to protect China’s foreign exchange reserves but now they are used to prevent capital from illegally leaving China. Payment of falsified invoices is one of the primary ways that capital illicitly leaves China, so careful review of all transactions is therefore required to prevent fraud.
To comply with these rules, your Chinese client is not permitted to simply make a wire transfer request. The Chinese side of the transaction is required to provide documentation that proves there is a legitimate underlying transaction for which payment is being made. The basic documentation is as follows:
- A formal written contract, executed, dated by both parties and sealed by the Chinese party. Though not required, it is best if this contract includes a Chinese translation.
- A Formal, written invoice, signed and dated by the foreign service provider. There must be a separate, signed invoice for every required payment. Again, though not required, it is best if this invoice includes a Chinese translation.
These first two requirements are mandatory and will always be required. Depending on the specific situation, the foreign exchange bank may also impose the following additional requirements:
- If the invoice amount is high, or if the bank otherwise suspects fraud, the bank may request proof of existence of the foreign company. The proof required varies from bank to bank. For some banks, a copy of a business license is sufficient. Other banks will require a formal certificate of good standing from the secretary of state or a related document.
- If the bank determines that the payment is a royalty for a technology license or similar agreement, it will require that the contract be registered in accordance with the requirements of Chinese law. Depending on the locality, this registration can take from three days (Shanghai) to six months or more (Shandong Province).
Banks can impose other requirements, depending on their mood and their concern about the legitimacy of the transaction. The bank is totally in control of 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. Delay in processing payment for services is therefore the norm rather than the exception.
It comes as a shock to many foreign service providers that the amount paid to them is subject to Chinese tax, even if all the service work was done outside of China. The Chinese tax authorities deem all service work provided to Chinese clients as Chinese source income. The local tax authorities therefore will impose a tax on the invoice amount. As with the SAFE rules, the foreign exchange bank serves as an agent for the local tax office to ensure that the correct amount of tax is imposed and paid. No wire transfer can be made until this happens.
Unfortunately, there is no agreement in China on the correct amount of tax to impose. We have seen tax amounts imposed ranging from 10% all the way to 40% of the invoice amount. Even the same tax office will take an inconsistent position on the amount of tax to impose. One payment will be taxed at 10% and the next payment for exactly the same services will be taxed at a substantially higher rate.
The 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 complaint about the amount imposed.
The amount of tax can be high and the time required for processing can be very long. It is therefore important that the foreign party understands the issues and enters into an agreement with the Chinese party on how to proceed. Under international commercial practice, it is most common to simply 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. That is, the amount invoiced by the foreign party must be paid in full without regard to any taxes imposed in China. This provides certainty to the foreign party and places the burden of dealing with the complex, uncertain and constantly changing Chinese tax system where it belongs: on the Chinese party. Since the Chinese party is responsible, the Chinese party will then have the appropriate incentive to advocate for the lowest tax possible. Certainly the Chinese party is better positioned to do this than the foreign party.
It is common for the Chinese party to strongly resist this standard approach and to seek to place all of the risk of the Chinese tax system on the foreign party. The foreign party must consider whether to abandon the transaction or move forward without any certainty on the amount of payment that will be made. If the foreign party will move forward, there are various complex ways to mitigate the risk of tax payment. These measures must be negotiated carefully in advance.
As you can see, the risk for payment in service transactions in China is considerable. There is risk of substantial delay and there is even the risk that no payment will ever be approved by the Chinese bank. It is therefore very important to confirm the ability of the Chinese side to make payment very early. This means that you should not do a substantial amount of work before you receive your first payment. Usually we provide in the contracts we draft that the Chinese side will make an initial payment before any substantial work is done.
We do this in order 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. You must therefore protect yourself by getting paid at least once before you take the risk of doing a substantial amount of work for a Chinese client. I have seen service companies go out of business by failing to heed this advice.
We also often get called by service companies upon learning that their payment is going to be delayed and taxed heavily. By that point, there is little we can do.
Please do not be another name entered onto the casualty list.