In my first post on payments from China, I discussed the risk that payments from China will not be made due to failure to obtain approval from the transmitting bank or from the Chinese government. In this and my next post, I will discuss the general ways to mitigate those risks. In this post I will discuss the basic principles. In my follow up post, I will give specific examples keyed to the four basic types of transactions I outlined in the first post.
The basic rules for dealing with payments from Chinese entities are as follows:
Rule Number One: Always put the the burden of dealing with Chinese banks and government authorities on the Chinese side. And always put the burden of a successful resolution on the Chinese side. China is the rare country where its resident businesses will try to shift the burdens of its own governmental actions onto a foreign party. This is not acceptable. A country resident must be liable for the actions of its own government, since the country resident is the only party to the transaction with any real chance to influence the actions of its local government and banking institutions. Think about this for a minute: are you or your Chinese counter-party more likely to be able to persuade a Chinese bank and/or Chinese government official to get money out of China? If your Chinese counter-party is trying to put this burden on you, this is a red flag and a good indicator it knows it likely will never get the money out.
In the area of payments, this means two things:
First, the Chinese side must take on the burden of paying China taxes and fees. That is, all payments to you on the foreign side must be net payments, free of the imposition of taxes and fees on the Chinese side. If a tax is or fee is imposed by the Chinese bank or local tax authority, the Chinese side must pay this tax/fee, with the payment to the foreign side being unaffected. If the payment to the foreign side is $5 million, the foreign side must be paid $5 million. It makes no difference to the foreign side whether the tax/fee imposed in China is zero, 10% or 100%; the foreign side still receives its $5 million payment.
The reason for this is obvious. First, the Chinese side must be motivated to have the tax or fee reduced. If the tax or fee is simply passed on to the foreign entity, no such incentive exists. Second, there is little consistency in the taxes and fees imposed by Chinese foreign exchange banks. The same transaction my be treated differently from region to region and from bank to bank. Even within the same region and the same bank, treatment may change from transfer to transfer. This means it is difficult to predict the amount of any tax or fee that may be imposed. The Chinese side must take the risk of this uncertainty; it is unreasonable to impose the risk on the foreign party.
Second, the Chinese side must take on the risk that payment will be approved within strict timelines. These timelines should be tight. The Chinese side should not be given 30 days to pay. Ten days should be the maximum and five days is better. The reason for imposing a tight deadline for payment is that it is critical you determine as early as possible whether the Chinese side will be able to make payment. Due to the capricious nature of Chinese banks and taxing authorities (especially in the last year or so with China’s increasingly tight capital controls), approval has to be determined for every payment. You should do no work nor take on any risk until after receipt of the applicable payment from China is confirmed, and I mean really confirmed.
Your contract should provide that if payment from your Chinese counter-party is delayed for any reason — including for lack of approval by the Chinese bank or government authorities — you have the right to terminate the underlying transaction. Chinese parties will often argue that failure to pay due to bank or government lack of approval should be treated as a force majeure event that excuses the Chinese side from enforcement. That is, the Chinese side will argue that the foreign party is not permitted to terminate and even call for a force majeure provision in the contract making this explicit.
This provision might then mean you are required to perform under the contract even though no payment is made by the Chinese side. This is not, of course, what the standard doctrine of force majeure provides. However, the Chinese side will often seek to insert this absurd provision. As clever negotiators, they will insert this in an otherwise standard force majeure clause. Since this type of clause is treated as “boilerplate,” the language is often not read carefully, leading to very unpleasant results for the foreign party. For this reason, I routinely refuse to allow any form of force majeure clause to be included in any contract I draft for China. We also have more than once been contacted by foreigners whose contract says one thing for force majeure in China and something very different in English, but the Chinese controls. Do not let these sort of things happen to you!
Rule Number Two: Force early payment. It is important to test as early as possible whether the Chinese side actually has the ability to make a payment. The test is made by providing for an early payment from the Chinese side in an amount large enough to force the Chinese side to go through the full approval procedure with the Chinese bank and with government authorities. A small, token payment is not sufficient.
One purpose of the initial payment is to ensure your written documentation related to the transaction is acceptable to the foreign exchange bank. For example, for any payment that can be classified as a royalty, a number of issues can arise concerning the documents, including the following:
- The bank may require the underlying agreement be registered with the applicable government regulatory body. This is common for technology transfer and licensing agreements.
- The bank may require the transaction itself be approved by Chinese government authorities. This is standard for outbound investments. Approval is also normally required for licensing in the publishing and audio-visual fields.
- The bank may impose various requirements on the written contracts. Typically the bank will require the main agreement be written in Chinese. Many banks also will require an written, signed invoice for each separate installment payment.
- The bank may work with the local tax office to impose various taxes and charges on the payments. Both the amount of tax and the processing of tax payment can be confusing and can cause delay.
By requiring an initial payment from the Chinese side, the parties can isolate the problems and correct them before the foreign side begins work or takes risks by relying on the ability of the Chinese side to actually make payment. Our China lawyers are constantly getting called by American and European companies that have not received payment under their contracts with a Chinese entity and in many of those instances it is because their contract has not been drafted in a way that will permit payments to leave China.
Your receiving the first payment is NOT sufficient to pass the test. You as the recipient must also check that payment for the following three things:
— First, was the payment actually made by the Chinese side from China (not Hong Kong), or was it made by another entity, perhaps located outside of China?
— Second, was the payment made through a standard Chinese foreign exchange bank, or was it made through some irregular payment mechanism such as a credit card or through a U.S. financial institution or by bitcoin?
— Third, was the payment made in a single lump sum, or is the payment an aggregate of a number of separate transfers?
All of the above are common and these sorts of irregularities show the Chinese side did not obtain China-side approval for payment. This means the Chinese side failed the test. You now know you are facing significant risk for the later, more substantial payments, unless, of course, the Chinese side for whatever reason will be able to sustain its irregular payment methods beyond its first payment, which is rarely the case.
Rule Number Three: Never get behind on getting your payments. Always get paid first. Get paid before you manufacture and ship your product. Get paid before you start the service work. Get your royalty payment at the beginning of the year, not the end. For the sale of your business (or shares in your business) and the sale of real estate, use a tight closing date with a substantial pre-closing escrow deposit.
In some cases, it is not possible to get all payments in advance. In such cases, you should limit your risk should to loss of profit and avoid getting hit with the loss of your out of pocket costs. For example, in the sale of expensive and highly customized equipment, your should set your risk of non-payment by ensuring the initial installment from China will cover all of your manufacturing cost. The risk for the final payment is then limited to your potential profits, and not to your out of pocket costs in material and labor.
A similar approach should be taken in other fields. For example, license payments may be split into a beginning of year fixed payment, with a variable payment based on sales or earnings paid at the end of the year. This approach ensures you will receive at least some payment that can cover your costs and give you a basic level of profit. It is never advisable to depend substantially on a final payment from a Chinese company; it is almost always better to agree to a smaller, secure fee than to seek a higher fee that shifts the payment risk away from the Chinese side.
The critical point is to recognize there is always payment risk when dealing with payments from Chinese companies. To succeed in selling to Chinese entities, you must recognize the risks and mitigate against those risks as I describe above. In my next post, I will describe some of the strategies our Chinese lawyers recommend for specific types of transactions where payments will be received from a Chinese entity.
UPDATE: And do not for a second believe that even China’s biggest and best-known companies are immune from payment problems. Today’s papers are proof this is not so. See today’s big China story: China cracks down on Dalian Wanda’s overseas deals.