We are frequently contacted by foreigners who want advice on “how to get money out of China”. Usually the questions concern the purchase of assets like real estate or stock and other securities by a Chinese entity. The standard situation is that the deal is closed, the closing date has arrived, but the Chinese side fails to perform, claiming the Chinese authorities will not allow it to remit the funds. Simply stated, the Chinese side wants to make the payment, but the government will not let them.
This problem is not limited to high value asset transactions. This common situation is, however, a result of a more general issue that arises with doing business in China. The fact is that every payment made from China must be approved. That is, it is not just large sum foreign investments that must be approved. Every remittance, no matter how small and no matter how routine, must be approved prior to remittance from China.
Approval is not automatic. Every remittance from China requires conversion from RMB to dollars or to some other foreign currency. The Chinese foreign exchange bank works with the local tax and other authorities to review every conversion and remittance.
When the Chinese government decides to limit outflows of currency, transactions that have been routinely approved in the past can suddenly become problematic. Delays occur, new taxes and fees are imposed and in some cases the payment is denied. This then means that there is real payment risk for every payment made from China. This is not limited to big investment transactions. All payments from China are reviewed by the foreign exchange bank. It is never certain what the bank will decide. For this reason, all payments from China are subject to payment risk due to government restrictions.
This issue arises in a number of business sectors:
— In the sale of high value equipment, it is common to accept payments in installments. Many problems can occur. In some cases, the Chinese buyer will make and order but then fail to pay the down payment, claiming that the Chinese authorities will not approve the payment. The Chinese side then asks for “cooperation” in providing additional documentation demanded by the foreign exchange bank or local tax office. Eventually, the Chinese side pressures the U.S. seller to start work or to ship prior to payment, blaming the delay in payment on the Chinese authorities. In a similar situation, where several installments are involved, the buyer will succeed in making the first several installments, but then will delay in making later payments, blaming the delay or failure to pay on the Chinese regulatory authorities. In these cases, the foreign seller is now trapped: the product is shipped and it is not clear whether full payment will ever be made.
— In licensing of technology or the licensing of media, there are often annual royalty payments that must be made. The Chinese side will normally negotiate a system that provides for payment of the royalty at the end of the royalty period. The payment day arrives and no payment is made because the foreign exchange bank refuses to process the payment. There are many reasons the bank may refuse to remit. One common reason is that the license has not been properly registered. Some banks will insist on a particular form of invoice. Other banks will require proof of the existence of the licensor and the validity of the license. In other cases the local tax authorities will impose withholding taxes of a type or in an amount that was not anticipated by the parties. The problem in all of these cases is that the Chinese side has obtained the benefit of the license for a full year before the issue of payment is raised. The foreign party is now assuming all of the burden for non-payment with no corresponding cost imposed on the Chinese side.
— Service contracts of all kinds are particularly risky. The reason is that a primary way Chinese entities illegally transfer funds out of China is via false service contracts. Since the risk of fraudulent transfer is quite real, Chinese banks are particularly careful in reviewing service contracts. This means legitimate service agreements are subjected to the same careful scrutiny. Since service agreement are typically quite informal and poorly drafted, the agreements often fail when examined by the banks and tax authorities. When this occurs, the Chinese entity reports that their attempted remittance has been denied or a large tax no one anticipated has been imposed. This can be a major disaster for service providers when the service has already be provided. Since the service is intangible, there is no way to repossess in the way that could be done for piece of equipment or a parcel of property.
What all this means is that every foreign business expecting payments from a Chinese entity must understand that payment risk is significant. Since the risk is real, mitigation measures are essential in order to avoid disaster. In my next post I will discuss the various ways to deal with this China payment risk issue.