How to navigate the maze of doing internet business in China.
How to navigate the maze of doing internet business in China.

As we pointed out in China’s SaaS Market: WFOEs Need Not Apply and again in Foreign SaaS in China: Get Off of My Cloud, current regulations in the PRC do not permit foreign entities to make direct sales of SaaS products from servers located within China. For foreign software companies, this is a major issue since the trend is decidedly towards SaaS products.

What is to be done? For many years, foreign software developers simply held off on the China market, assuming that if China’s regulations did not change some clever “back door” method would be found to escape the regulatory burden.

During the past several years, foreign software developers have started to deal with the PRC regulations directly. Since China will not permit direct sales of SaaS product from servers located within China, the foreign software developer has two difficult alternatives. The first is to maintain its software on a foreign server and sell into China under the threat of being blocked at any time by the Great Firewall. The second is to license the software to a Chinese entity under threat that its software will be “appropriated” by the licensee. Both alternatives face the further difficult issue of accurately monitoring the validity of payments from the Chinese side.

Both alternatives are unattractive. However, in a world of difficult alternatives, a choice has to be made. To paraphrase the great American philosopher Tom Waits: The two roads are both dead ends, but you still have to choose. In this post I will assume that the idea of giving the entire software bundle over to a Chinese entity is too hard to handle for a start. So we will begin this series with a discussion of the first alternative where the software remains safely on a server located outside of China.

When the SaaS software is located outside of China, there are three fundamental issues. First, what should be done about the Great Firewall and the threat of being temporarily or permanently blocked? Second, how will the software be marketed? Third, how will the customer pay for the software? After many experiments the major developers have essentially settled on the following basic system for selling business software in China:

  1. If you do not want your software product to be blocked in China, you must carefully monitor the content made available in China. The simple and clear rule is that if any content that is politically unacceptable in China is housed on the foreign site and made available in China, it will be blocked. This can be a very difficult issue for software services that are primarily cloud storage systems used for file sharing of documents, photos and other media. Since the content of any such media can potentially be considered politically unacceptable, any file storage site can unintentionally fall into disfavor with the Chinese censors. For this reason, most such foreign sites find China impossible to deal with. For other software sites the message is clear: if you cannot be certain that your site will not provide politically acceptable content at all times, then do not bother with China as a market. This is especially true of content in the Chinese language.
  1. To penetrate the China market, foreign software developers have found that they need a sales team in China. However, where the software is hosted outside of China, it makes little sense to form a WFOE to set up a China sales team. Under the current system, foreign developers hire resellers in China. The resellers then make the direct contact with potential customers in China. Often the reseller is in a related business. For example, the reseller for an accounting package may be a accounting or bookkeeping firm. The reason for using a Chinese entity as your reseller relates back to the political issue. In principle, ALL foreign Internet content is not permissible to sell in China. However, bowing to reality, China allows foreign content to be sold in China provided that the political issue is not raised by the content of the software. More deeply, the Chinese government is also concerned with other issues that extend from the simple question of quality assurance to the complex issue of potential infection of Chinese networks with viruses and other tools of the hacking world. Using a Chinese reseller means that a Chinese citizen is now both responsible and potentially liable for all of these issues. Many resellers do not understand how much liability they are taking on when they agree to act as a reseller and when they do figure out their role, many have second thoughts.
  1. Resellers handle all of the payments from customers. The reseller provides a user number and a password to the customer in exchange for payment of the fee. The reseller collects the fee, deducts its service fee, and then remits on a monthly or some other periodic basis the remainder of the fee to the foreign software developer. During the remittance process, the foreign exchange bank will convert the funds from RMB to U.S. dollars and deduct applicable taxes, and then wire the remainder out of China. The tax imposed is normally a withholding tax of 10% to 15%, but the exact amount can vary from city to city. Note that the payment from the customer is taxed twice: once from the income and business taxes paid by the reseller and a second time in the withholding tax paid on remittance. Note that this system provides no way for the reseller to cheat on the amount of payment that is due. Since the user name and password are provided by the foreign software developer, the developer knows exactly how many customers have been sourced by the reseller. If no payment is made to the developer, the developer can simply cut off access. This system is therefore much easier to manage than the typical licensing system where the licensor ha not direct contact with the customer and cannot directly monitor the number of users and the appropriate fee.

This basic description of the process shows the critical role played by the reseller. The reseller performs two critical functions in this system. The reseller takes personal liability for the software product and ensures that taxes are paid on the income earned from the software sales. Attempts to work around this system virtually always fail. For example, many foreign software developers are willing to hire a Chinese sales entity, but they want payments to be made directly to them, with no involvement by the reseller. This type of arrangement is open tax evasion and will never be permitted by the Chinese authorities. The only system that will work for any major sale of business software is a system where where liability falls on a Chinese reseller and where China taxes get paid.

But for software developers who are serious about China, this model has two fatal flaws. First, as noted, access to the foreign server can be blocked by the Great Firewall at any time. This risk is well known. There is, however, a second and more important problem. Most large companies in China are owned or controlled by the Chinese government and these SOEs (State Owned Enterprises) are effectively prohibited from using SaaS software hosted outside of China. Even large (and many small) private companies have a strong preference for using only of software hosted in China, both for technical and for political reasons. Therefore, any software developer seriously intending on taking advantage of the China market needs to have its software hosted in China. Like it or not, this means using the licensing model I will look at in my next post.