Just sent an email to an American company setting out the basics of what it should be looking for in the initial stages of determining whether it wants to invest in another American company that has a WFOE in China. The list included that the American company make sure that the China WFOE is properly registered and structured. But in that same paragraph, I added the following, which I probably would not have done even six months ago:

You should determine whether its [the WFOE’s] employees are all signed to proper contracts and whether the WFOE has paid ALL employer/employee taxes to the government and that it is not at risk for a large number of employee lawsuits. We have in the last few months been contacted by a slew of foreign companies that are trying to decide whether to stay in China after having learned that they owe large amounts in employer taxes or large amounts to their employees that they “didn’t realize” they had failed to pay.

In one instance, the American company said that its WFOE manager never told the home office that the WFOE had not been paying employer taxes for the last few years and now the Chinese tax authorities were demanding that [very large] payment. In another instance, the American company doing business in China via its wholly owned WFOE had just learned that one of its employees had been badly injured and had sued the WFOE and won and now the WFOE owed this employee a lot of money and it did not help that it did not have written contracts with any of its employees and now it was having to deal with that as well. Both of these were in the last week!

One of our China lawyers also got an email from another American company who was being “confronted” by its lead employee because it was doing business in China with “employees” but without ever having registered an entity that would allow it to do so legally. My response to that company was as follows:

You may be in the worst situation possible. You are operating completely illegally in China at a time when the Chinese government has stepped up its searching for companies just like yours and shutting them down and issuing massive fines and worse. So on the one hand, you have absolutely no choice but to get legal fast or you might find your entire China program shut down and nobody from the US able to go there again.

But on the other hand, you have a Chinese “employee” who on one level “completely owns” you because if you do something that he doesn’t like he and all of your other “employees” can sue you for back wages/back taxes because you had no written contract and because you failed to pay their benefits and because your relationship with them was/is illegal. And if you do all of a sudden choose to go legal, your overall employee costs will increase by about 60%. Right now, you are, let’s say, paying an employee $1000. If you go legal, you will need to pay around 40% in employer taxes, which will get you to $1400. But even that won’t work. Because if you go legal, your employees are going to have to start paying their own income taxes of about 25% and that will mean that they will almost certainly demand a raise to cover that. So you give them a raise to $1300 and then your 40% will be on that amount, which will then raise the monthly salary+benefits to around $1820 a month. And this completely ignores the corporate taxes and other fees and costs that your China entity will need to pay.

So essentially you either pay a lot of money to get legal or you should just start acting as though your China operations are almost certainly going to get shut down within the next 1-12 months. One thing you do not want to do in this situation is to go to China or to send anyone from your company to China to “try to work things out.” For why this is the case, check out The Single Best Way To Avoid Being Taken Hostage In China.

Your best course of action might just be to start all over in Vietnam.

Bottom Line:  There has never been a better time than now to make sure that you know what is going on with your China WFOE and that your China operations are fully legal.

 

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?