Just got back from speaking at a truly excellent doing business in China seminar at the University of Toronto. I was on a panel where the question was asked whether the rising tensions (real or perceived) between foreign companies and China were due in large part to the changing nature of their relationship with China. The question posited that in the “old days” the typical relationship was that of an American company sending money to China to buy a product, but today, the typical relationship is far more complicated and these increased complications are increasing “tensions.”

My answer was that I had never thought about it in that light, but that it was probably true. I then went on to talk about how the nature of my law firm’s China business has so drastically changed over the years. Whereas five years ago, probably 75% of our business was for companies looking to manufacture products in China, with 25% focusing on businesses that wanted to sell products or services to China, that ratio has pretty much exactly flipped.

When I got back to my computer, I had an email from a retailer asking whether it was really true that it would need to open up a branch office in every city in which it wanted to locate a store.  Our short answer was generally yes.

The big issue today is not so much how to make product in China, but how to sell product and services to China, be that within China or from outside China. Needless to say, the “within China” part is where the complicated legal regulations and hence the tensions can arise.

Twice in the week before I left for Toronto I was interviewed about this “sea change.” Once by a friend writing a book and the other by a reporter. Both of them wanted examples of American companies profiting or seeking to profit from selling their goods or services to China, and I talked a bit about the following, in an effort to show the incredible diversity of ways American companies are “going to China” these days:

  • US company that provides high end remote medical testing. It sells its testing system to hospitals and then does the diagnostics from the United States. It is not forming a company in China; it does this from the United States.
  • US company that provides movie services to China’s leading movie companies. It is not forming a company in China; it does this from the United States.
  • US and Canadian and European companies  that provide online learning to Chinese companies. These companies, pretty much by necessity, are having to work with Chinese domestic companies that possess an ICP license or have the ability to get one. Some of these companies are not forming companies in China, but selling from the United States or Canada or Europe.  Some of these companies are forming companies in China to assist in the selling or to provide support services there.
  • US and Canadian and European companies that sell enterprise level software to Chinese companies.  Some of these companies are forming companies in China and some are not.

I could go on and on with examples of how foreign companies are seeking to profit from China’s rising wealth. The point though is that the legal and business issues foreign companies face in trying to profit from China are usually very different and oftentimes more complicated than those faced by foreign companies that have their products made in China.

If you are sitting in the United States and just buying product from China, your legal issues are going to be both very different and less complicated than someone selling enterprise software to China’s hospitals. The company buying product needs to have a good contract that makes sure its IP is protected and that its widgets are of good quality and arrive on time, but the software company is going to need to deal with pretty much the full panoply of China’s laws. The software company will almost certainly need to form its own Chinese entity (almost certainly a WFOE) for China and then it will need to make sure that it complies with China’s employment laws, antitrust laws, and anti-corruption laws, just to name a few.

Inquiries to my law firm regarding how to deal with both American and Chinese anti-corruption laws have probably quintupled in the last five years and they have probably tripled in just the last eight months — thanks mostly to the Chinese government’s treatment of GSK executives. For more on how foreign companies are needing to step up their FCPA and other anti-corruption compliance programs check out China Bribery. A Few Facts And A Few Tips.  and Rule One For Doing Business In China. No Bribery. Rule Two, Make Sure Of It. and China and the Foreign Corrupt Practices Act.

The legal work that we do to decrease the chances of our clients going to jail in either China or the United States is more important and more pressing and more complicated and drawn out than the work we do to make sure a $300,000 shipment gets to Peoria on time. I say this not to in any way denigrate manufacturers, but to highlight how different (and yes more tense) it is for those on the ground in China as opposed to those able to sit at home and watch the Seahawks crush the Broncos in the Super Bowl. Needless to say the odds of going to a Chinese jail while ordering product from the United States are considerably lower than if you live in China. The same holds true on getting your business shut down by the Chinese Government.

I just read a Forbes article written by Michael Zakkour (or at least by the time I started writing this post).  The article is entitled, The China Luxury Downturn Is Real – Global Luxury Brands Must Adjust and it focuses on what foreign luxury brands are facing in China these days, and what they should/can do about it. Zakkour’s article nicely highlights from a business perspective the huge difference in issues faced by sellers to China as opposed to buyer’s from China. There too the complications and risks are generally with the sellers.

The article talks of how the “premium luxury market slowed” in China in 2013 and of how that trend will likely continue in 2014, especially for those companies that “depend on gifting.” But even that market, according to Zakkour is “still pointing up.”

Zakkour starts out listing a number of factors that have driven growth in the premium luxury segment down to about 2% and he leads it off (rightly I think) by citing to President Xi Jingping’s intent to make “a huge dent in the endemic corruption in Chinese politics and business.”

The article then lists the following reasons why luxury brands should “continue investing in China as a long-term growth market”:

  • After 30 years of exponential  economic growth and development, China’s economy is slowing, but this is relative, from 10% to 6%-7%, which is still robust — luxury purchases will continue to grow with the economy in general.
  • Urbanization and an ever enlarging middle and upper class are fueling further growth for the best things in life – While 1st Tier cities and regions have been saturated, the new growth will come from Tier 2, 3, 4 and 5 cities, representing another potential 300 million new luxury buyers.
  • Current events and government policy are always fluid in China.  When the differences between legitimate and illegitimate purchases are sorted out “this too shall pass.”
  • The accessible luxury market will continue to grow and prosper.

I agree.  The opportunities for making money in China are considerably greater today than they were five years ago and will almost certainly be considerably greater in five years time than now. But selling into China — especially selling from within China — is not the same thing as sending out a purchase order.

Chinese and American businesses are working together (or not) in a different way than they did even five years ago. Their business relationships are getting more complicated and the competition between them is increasing.

A couple days ago, we ran a guest post on Expat Stress in China and we received an unusually large number of fairly strident comments and emails from that post, most of which highlight increased tensions.

Is the business relationship between China and America fraying? And, if so, why? Is the switch from foreign companies manufacturing to selling products and services into China driving this?  Or was the relationship never really all that good in the first place?

What do you think?

A couple of years ago, we did a post on the difficulties in using “independent contractors” in China, entitled, Hiring A Chinese Employee Without A Chinese Entity. Good Luck With That. We wrote that post (and this post too) because forming a WFOE in China can be so difficult, expensive, and time-consuming, and because so many companies are looking for some way of hiring a Chinese employee without a China company.

This is our even grimmer follow-up.

In our first post, we listed out the following ways to “employ” someone in China without forming an entity there:

1.   A foreign company could have its proposed employee hired by a Chinese company and then pay the Chinese company the equivalent of the Chinese employee’s wages and taxes, plus an administrative fee. The problem with this is that if the “employee” is not going to be doing at least some work for its Chinese employer, it probably is not legal and if the foreign company gets caught, it may never be allowed to conduct real business in China again. If the “employee” does not actually do work for the Chinese company, it is nothing more than an attempt to get around the laws that require foreign companies with an employee in China to be a legitimate Chinese entity (be it a WFOE/WOFE, a Joint Venture/JV, or a Representative Office).

And if the foreign company’s goal is to have its “own person” on the ground in China, how much of “its own person” is someone employed by and paid by another? And how this foreign company protect its trade secrets from the Chinese company? There are definitely situations where this can work, but not every situation will.

Then there are all the issues for the Chinese company, which is likely going to have to lie to the Chinese government as to why it is receiving monthly foreign currency payments.

UPDATE ON THIS OPTION:  Since writing the post, we have received calls from a foreign company that was caught doing this and then effectively kicked out of China and from a couple other foreign companies that were doing this whose Chinese company stopped going along with this program out of fear of getting caught.  This has led us to conclude that this is, at best, a very temporary remedy, if even that.

2. A foreign company can hire the Chinese “employee” directly and just wire that “employee” his or her paycheck every month. Years ago, this sort of arrangement was pretty common, but it is becoming far less so as word is spreading that the Chinese government and tax authorities are very much on to this scheme and are quashing it. The problem with this set-up is that the foreign “employee” is at some point going to have to explain to the Chinese government why it is that he or she is monthly depositing foreign currency into his or her bank account and why no taxes are being paid on it.

In our last post, we noted the following big flaw with this sort of arrangement:  “We have received a number of calls in the last year from companies seeking our help in keeping their Chinese ’employee’ after they were told by their ’employee’ that the existing relationship must be discontinued. We told them that their best solution would be to form a China WFOE, but that we were very concerned about their WFOE application being rejected because of what they had already done.”

UPDATE ON THIS OPTION. Since we did our last post, we have heard from many more foreign companies that have gotten into trouble with the Chinese authorities for having employed this option.  Perhaps more importantly, we are finding that the trend is for Chinese prospective employees (particularly those with a high level of experience or skill-set) to flat out refuse this sort of arrangement.

3. The third and maybe best option (at least from a legal standpoint) is for the foreign company to have its Chinese “employee” form his or her own domestic Chinese company and then simply contract with that Chinese company for the services it is seeking from this Chinese person. This is going to require a fair amount of initiative by the Chinese employee and the downside of this is that when all is said and done, your client has an independent Chinese company out there with which it is conducting business, and not an employee.

UPDATE ON THIS OPTION.  We are unaware of anyone ever having tried this option as every foreign company has either deemed it too risky from the perspective of protecting its intellectual property or the prospective employee has simply been been unwilling to go through this convoluted process for the “job.”

4. Have your potential employee hired by a China-based staffing agency.  Under Chinese law, Representative Offices are not allowed to directly employ anyone; they must do so via a third party staffing agency.  Because of this, there are plenty of such staffing agencies in China and up to a few years ago, many of them were (for a somewhat reasonable fee) willing to hire someone for a company based overseas. Today, we know of only one such agency that will do that for  foreign companies without their own entity in China (be it a WFOE or a Rep Office) and that agency charges a 15% monthly commission on the salary to do so.  On top of that, come July 1, 2013, all of this will almost certainly be impossible as on that date, China’s labor law will be revised to make third party hiring for anything but “temporary, supplementary and backup jobs” illegal. For more on this, check out this article, entitled, “Newly amended PRC Labor Contract Law imposing stricter control over the use of seconded employees.”

At this point, I am not sure that the one remaining agency that will employ someone for a foreign company without an entity in China will remain willing to do so, but I doubt it.

For years, China has sought to force foreign companies seeking to hire in China to form a company in China. It appears that come July 1, it will have achieved this goal, which really is part of two much larger goals of increasing its tax revenues, particularly from foreign companies, and improving the lives of its working citizens. There is not going to be any going back on any of this. If you want someone working for you in China, you are going to need to form an entity — almost certainly a WFOE — to accomplish this.

What do you think?

A few months ago, the general counsel of a company for whom we had done some China work asked me to spend a few minutes alerting her to the “typical” legal issues American companies face when they do business with China. She wanted a legal checklist to give to the executives at her company so that they would know when they need to contact her so she can contact us.

I gave her the following:

Nearly every company that does business with China needs to face and resolve the following four issues: 

1. Is my company operating in China legally? Is my company able to operate as a foreign company or must it form a Chinese entity to comply with Chinese law?

2. Is my company’s intellectual property in China going to be protected? Should I register my company’s intellectual property in China so as to give it protection in China? Should I require the Chinese companies with whom my company does business sign contracts mandating they protect my company’s trade secrets/confidential information? 

3. Does my company need to hire employees in China and, if so, what sorts of agreements does it need with them?

4. What should I put in my company’s China contracts? In what language should they be? In particular, how should my company’s contracts with Chinese companies provide for resolution of any future disputes so as to provide it with the most protection?

What do you think?

 

Because Chinese manufactured goods are so cheap, a huge number of foreign businesses have set up procurement centers in China to oversee their China purchasing. For many years, these China procurement centers were formed as Representative Offices because Chinese law did not allow such businesses to be Wholly Foreign Owned Entities (WFOE).

That law recently changed and my firm has been inundated with converting these representative offices into WFOEs. These procurement centers are taking advantage of Chinese law now allowing trading companies to form as WFOEs. The typical procedure is to form a new China WFOE trading company and then “sell” the assets of the representative office to the new WFOE. The new WFOE is a Chinese entity and is subject to taxation in the same manner as are all foreign owned companies (WFOEs) in China.

Since Representative Offices in China are not permitted to conduct business in China, they are not subject to China’s business income tax. They are, however, subject to a 10% tax on their gross expenses. This tax is not considered to be an income tax because under Chinese law, Representative Offices cannot earn income. Procurement Center Representative Offices in China are converting to WFOE trading companies to take advantage of the following:

  • Employment in China:  A Representative Office is not permitted to hire Chinese employees directly. A WFOE can hire Chinese employees directly.
  • Location of Operations in China: A Representative Office is permitted to operate only in the city in which it is formed. Any office in a different city requires forming a completely separate representative office. Now that procurement centers are permitted to form as WFOEs, the Chinese authorities are beginning to crack down on those companies operating unregistered satellite offices. One government official told us “they” were no longer willing to look the other way on these violations. The typical penalty so far has been to close down the offending office or offices and impose any previously unpaid taxes. We are not aware of other civil or criminal penalties being imposed (even though available), but we expect to see those imposed on those companies that lag behind in getting legal. Things are much more flexible for a WFOE. The WFOE is formed in one city, but then, by using a simple notice procedure, can open up branch offices in other cities throughout China.
  • Taxation: A WFOE trading company operating as a procurement center normally pays less in taxes than the equivalent Representative Office. This is because a Representative Office pays taxes on its gross expenses, not on its income. If properly structured, a WFOE procurement center will earn little to no income in China because its revenues will be balanced out by its expenses. Since there is little to no income, there is little to no tax. Because these WFOE procurement centers will normally pay little to no taxes on income, they typically need not worry about locating in a tax free zone and can focus on operational factors in choosing their China location. This lack of income also means that even if China raises its tax rate on foreign companies to bring it into line with its tax rate on domestic companies, procurement center WFOEs will feel little to no impact.

Though converting from a Representative Office to a WFOE is initially fairly complicated, its long run costs savings makes it worth it for most foreign procurement centers in China currently operating as a Representative Office. Our China lawyers have already handled a number of China procurement centers going WFOE and they have, without exception, gone off smoothly, which is not something that can always be said for this sort of thing in China.