State administration of foreign exchange

Many times over the years American clients of ours have asked us whether their buyers in China are telling the truth when they claim not to be able to pay the American company more than $50,000 in one year.  Our response has always been that we were dubious of such a claim because we have other clients who get paid millions of dollars each year by their China buyers, but if they want us to research this issue for them, we would be happy to do so, at our regular hourly rates.

We had never researched this issue….until now.

And even now, we did not exactly do the research ourselves and the research is confined to money from Chinese citizens, not companies.  We are involved in a case with a number of other law firms and in that case one of the Chinese parties said that they could not pay one of the law firms more than $50,000 this year.  As you might have guessed, when a law firm’s own money is at issue, the research gets done and the following is what the law firm found:

  • China controls inbound and outbound foreign exchange flows.  If a Chinese citizen needs to make an overseas payment it is required to purchase the foreign funds with RMB from a bank qualified to do foreign exchange business.  Most banks in China are qualified to do foreign exchange business.
  • When converting RMB to a foreign currency at a Forex Bank, the bank is required to review whether the outbound capital is for investment or for regular payment.  Outbound capital investment refers to overseas equity investment and is strictly restricted. Outbound regular payments are permitted, including those for overseas tours, training, relatives visitation, business negotiations, meetings, service, labor, etc.
  • Legal service fees paid to an American lawyer for the service rendered is deemed a regular payment item.  Chinese citizens can convert and remit freely up to USD $50,000 equivalent per year. Conversions exceeding the USD$50,000 quota is still possible, but the citizen cannot complete it at a bank counter freely; he or she must apply to the local State Administration of Foreign Exchange for written approval.  Chinese banks will not let the extra conversion go without seeing SAFE’s approval letter.
  • To secure approval to exceed the USD$50,000 limitation in yearly payments to an American attorney, the Chinese citizen needs to submit documents verifying the underlying transaction. The application documents mainly include: (1) an engagement letter/contract signed between the Chinese party and the American attorney; (2) notarization and legalization of the engagement letter/ contract; (3) tax return certificates of the US payee (theoretically the US attorney needs to pay Chinese withholding tax for the revenue gained from China); (4) a request for payment from the US attorney.

Well now we know.

This is the third in a series of posts on China’s film industry. The first post was “Sino-Foreign Film Co-Productions in China.” The second was “Making Films in China. You Talkin’ To Me?

Cinemas are being built in China at unprecedented rates and we are constantly hearing of explosive growth of Chinese box office takings. Needless to say, foreign producers frequently get seduced by these trends and their promise of enrichment and they have a tendency to assume that a slice of China’s box office receipts will magically flow to investors outside of China.

Unfortunately, this usually does not happen even when the film pops in China.

Why is it so hard for foreign co-producers to get paid? There are three main reasons:

1. There are no trusted intermediaries for film in China. Collection agents, escrow account holders, trustees and the like simply do not exist here in China. The foundations of international film finance are not in place. In itself, that makes you wonder how completion guarantors can underwrite Sino-foreign co-productions.

2. You need to rely on your Chinese co-producer to collect the box office and pay your share to you outside of China. Good luck with that.

3. Even if you are lucky and your Chinese co-producer has some vague intention of paying you, they cannot pay you unless they can show the Chinese tax authorities that income tax has been paid on the gross receipts and that the withholding tax on their payment to you will be deducted. Even then, they will still need SAFE (State Administration of Foreign Exchange) approval before being able to send money overseas. The vast majority of Chinese businesses will not want to do business this way.

Even in the developed world, taxation of international films is one of the most difficult areas of taxation. For China, this situation is compounded by many orders of magnitude due to a new tax code, a non-convertible currency is not convertible and SAFE involvement from the time the money enters China to when it leaves.

In previous posts (here and here) we looked at the basic framework of rules governing foreign film production in China, as applied by the China Film Co-Production Corporation (CFCC).  As it is illegal for foreigners to independently produce films in China, a Sino-foreign co-production is required and the CFCC provides a standard co-production contract.

The CFCC contract deals effectively with Chinese approval of the production process and content and censorship of the film, but it does not deal at all with the more important issues of taxation and distribution of proceeds. The regulations and the form contracts are silent on the role of distributors; they mention no role for distributors in financing. In fact, there is no explicit provision for the role of any parties other than the co-producers. There is no mention of banks, completion guarantors, distributors, sub-distributors, or collection agents. There also is no general treatment of overseas financing and rights. Participation in the project by such entities is not prohibited; it is simply ignored.

In the CFCC contract, it is assumed the foreigners have the money and that all will be paid for “up front,” with no participation by the financing players and with little or no consideration to how and when payment will be made to the foreign financiers. On the other hand, the documents and rules are extremely flexible and are not encumbered with many of the restrictive rules that apply to joint ventures and WFOEs.

The CFCC contract clearly provides that all proceeds are collected and processed by the co-production partners. There is a bank account controlled by both sides and careful accounting controls are put in place. The Chinese side is not put in complete control of things. In essence, the co-production partnership is its own collection agent manager. At least in theory, this can work because there are only two parties: the two producers.

The problem that we have seen with this arrangement is that there is no mechanism in China for the partial or primary funding of a film project by distributors. The assumption is that all of the advance funding comes from or through the foreign producer, with no direct involvement from third parties. The structure is therefore designed so that money and other benefits flow into China, but proceeds and other benefits will not escape from China. For producers not worried about Chinese box office, so long as the physical film escapes from China, the proceeds and other benefits issue is typically not of vital importance.

In our experience, foreign producers who want to get paid are usually better off allowing their Chinese co-producers to take China distribution rights in return for an up-front payment because the back-end off the receipts is usually just a mirage.