We spoke with a software company the other day that has nearly fifteen “independent contractors” in China, who it views as “part of the corporate family.” This company was contacting us to see about forming a WFOE in China. They told me that they were not in any rush.
The first thing I did was to ask whether they knew that what they were doing in China is completely illegal. They did not. I explained to them how there is almost no such thing in China as an independent contractor and that they essentially had nearly fifteen employees and because there was no company actually employing those fifteen people, what they are doing is illegal. I then told them of how China in the last year has stepped up even more its efforts to rid the country of foreigners there illegally and companies there illegally. I also told them of how their existing structure puts all of their China assets at huge risk. Their China IP assets are at risk for the simple reason that they do not really own them. A company operating illegally in China is just not positioned to be able to assert IP rights against anyone in China. Their other China assets are at risk because the Chinese government will likely seize them if and when it cracks down on what they are doing.
They seemed very interested in going legal until I started laying out how doing so would greatly increase their China operating costs. I told them how their forming a WFOE would necessitate their incurring the following additional costs/expenses:
- WFOE formation fees and costs. They expected this.
- They would need to lease office space from an approved landlord. This is a requirement for WFOE approval. This would likely increase their office rent.
- For every $1,000 in employee salaries, they would probably need to pay about $400 (40%) in employer taxes and benefits. They were not expecting this at all.
- In addition to the employer taxes, their employees will need to start paying income taxes. They seemed to think that their “independent contractors” are already paying all required taxes. I told them that I am virtually certain that they are not, and that their going legal will almost certainly lead to their “independent contractors” demanding higher salaries to make up for their take home pay being reduced by having to go onto the tax rolls.
I then talked of the advantages of having a WFOE, including the following:
- You are operating legally. Your risk of the government shutting you down tomorrow has essentially disappeared.
- You are much better positioned to do real business in China, because you are legal.
- You are much better positioned to protect your IP in China, because you are legal.
- You are much better positioned to terminate employees because you do not need to keep them on forever for fear of their reporting you to the authorities.
After this phone call, I spoke with China-based co-blogger, Steve Dickinson, for the latest on how China’s government is treating foreign operations with multiple people working for them in China. Steve pointed out how the Chinese government is aggressively pursuing tax evasion claims against both the “independent contractors” and those connected to the illegal business. The government pursues the “independent contractors” for failing to pay their own taxes and it pursues the foreign business for Chinese income tax and related national and local business fees and taxes. Most importantly, the government also seeks to take action for back taxes against any representative (i.e., individuals) of the foreign company who happen to come to China. When the number of illegal employees is large, the claim for back taxes can be quite large. Often, the tax authorities time their raid on the illegal business to ensure that a representative of the foreign company is on site and, in many cities, they will not let the foreign representative leave China until after resolution/payment is achieved.
In other words, doing the “independent contractor thing” without having a registered business in China is asking for trouble. Big trouble.
What are you seeing out there?