China WFOE formation

I do mean to sound alarmist here.

Almost since this blog’s inception, we have written about how if you are doing business in China you need a Chinese legal entity, be it a Wholly Foreign Owned Entity (WFOE), a Joint Venture (JV) or a Representative Office (RO). And pretty much each time, our writings on this get more emphatic and more strident. Today they reach a whole new level. Today we warn you about jail time because that is what we are hearing is happening in China right now.

In the last two years our stridency on this issue has gone into hyperdrive. Today I want to SCREAM that if you are doing business in China without a Chinese legal entity you should probably leave China immediately and consider what to do in China from the safety of your own country.  I will explain why I am saying this shortly.

In March of 2017, in Doing Business in China with Deportation or Worse Hanging Over Your Head, I had the following to say:

We have frequently been writing of late on how China has like never before been tracking down foreign companies (especially U.S. companies) that are operating in China without having a business entity (a WFOE or a Joint Venture) that allows them to legally do so. See Donald Trump and Your China Business: Double Down, Ditch It or Die and Donald Trump and Your China Business: Double Down, Ditch It or Die, Part 2. In China’s defense (not that its decision to rigorously enforce its own laws needs any defense), the new WFOE formation rules enacted last year do actually make it somewhat faster, cheaper and easier to form a WFOE.

Anyway, since we started hitting this issue hard here on the blog, we have gotten an even greater stream of emails from people who have been “caught” by the Chinese government and from people who want to know what exactly they need to do to get legal. But the most interesting emails come from those who either fully or partially refuse to believe what has been happening in China and how at risk they are. About half of the emails sent to our China lawyers evidence at least some aspect of this and about half of those mention forming a company in Hong Kong as an option for solving all problems.

So let me say right here and right now that forming a company in Hong Kong will not do a thing to make you legal in Mainland China. Nor will forming a company in Macau or Taiwan or Singapore. If you are doing business in the PRC/Mainland China, you need a PRC legal entity, such as a WFOE or a Joint Venture. See Having A Hong Kong Business Does NOT Make You Legal in Mainland China. See also A Hong Kong Company Is NOT a Mainland China Company and a Hong Kong Trademark is NOT a Mainland China Trademark. If it were otherwise, virtually nobody would go through the agony and the costs of forming a WFOE; they would instead pay some accountant in Hong Kong about USD$1,000 and have an HK company in less than a week. Please, please, please do not fool yourself into believing otherwise!

The below email is an amalgamation of two emails I received just this morning, both involving people with United States and Taiwan passports.

I came across your law blog and would like to ask a question. I’m in a slightly strange situation, professionally and nationality wise, and I I wonder if you might be able to offer me guidance.

I am a US/Taiwan dual national living and working as a freelancer in Shanghai, which is my base. I work in the _________ business on a contract-to-contract basis. Though my Taiwanese friends are always telling me not to worry about things like taxes, the more established and successful I become, the more I think I should be figuring out how to get legal in China and make myself legitimate, business-wise.

I am a ________________ and I do other related things. For example, I’ve just been asked to __________ on a relatively large project. Sometimes I am paid in RMB and other times I am wired foreign currency to accounts I hold overseas. Sometimes because I am not a legal business the companies I work for negotiate discount rates from me because my not having a China company precludes them from getting a tax deduction for their payments to me.

As I progress professionally, the amounts I charge and get paid keep increasing and I worry about what all of this means for the long term.

A friend has suggested I go to Hong Kong to set up a WFOE. However, I know some of the rules are different for Taiwanese nationals who wish to set up businesses in China.

It is not my ambition to have a big company or service but I also know that this gray area situation may not be sustainable forever. I also want to know if any of this might affect me as a U.S. citizen. At the moment, I just file federal taxes online.

Please let me know if you have encountered cases such as my own, and if you might be able to point me to resources that would enable me to best formalize my situation.

Many thanks.

Our response is always something like the following:

Setting up a company in Hong Kong will not help you one bit in terms of getting legal in China. You need to re-think what you are doing because as you get bigger you become a bigger target. I do not know how China treats Taiwan citizens, but if you are an ethnic Chinese there on a US passport, you are probably at the top of the list. My advice is that you start doing something and fast. You should consider either leaving China or setting up a WFOE in China that employs you. If you leave China you can do some business in China without triggering the need to have a WFOE in China, but because you provide services there, you will still be required to pay income tax there. So long as you are paying your United States taxes, the U.S. very likely does not care what you are doing or where you are doing it; your big concern should be the PRC, especially since you live there. The bigger you get, the more likely it is that someone will rat you out or that you will be noticed by the Chinese government. Productive legitimate businesses do not operate with this sort of hammer poised to hit them on the head. What you should do is weigh the various costs and benefits of your various alternatives and decide on one.

Then just last month, in American Companies in China without a WFOE and the Impact of Donald Trump and US Tariffs and Why Hong Kong is not the Answer I wrote again how American companies are at increased risk of serious trouble for operating in China without a WFOE:

If you are an American company doing business in China, you don’t need me to tell you how so many things have changed for you over the last year or so, and so I won’t.

But I do need to tell you — somewhat urgently — that if you are operating in China without a legal Chinese entity, you need to stop. Like right now.

Back in March, we did a post, Doing Business in China with Deportation or Worse Hanging Over Your Head in which we discussed how “China has like never before been tracking down foreign companies (especially U.S. companies) that are operating in China without having a business entity (a WFOE or a Joint Venture) that allows them to legally do so. See also Donald Trump and Your China Business: Double Down, Ditch It or Die and Donald Trump and Your China Business: Double Down, Ditch It or Die, Part 2. Our thesis — based on what we were seeing on the WFOE front and on other crackdowns involving even things like bar fightsvisasexpat taxescannabis, and employment law — was that China was toughening up enforcement against foreigners and foreign companies in China on all fronts, but especially against Americans and American companies as a sort of a slow and not terribly public retaliation against President Trump.

With all the talk now about US tariffs against China, legal enforcement in China against American companies operating in China without a WFOE has gone into hyperdrive. One of our readers, herself a China lawyer, recently wrote me to let me know how ridiculous she thought I was for believing Beijing would “quietly” go after American companies. My response to her was that we had no idea whether China’s stepped up legal enforcement is being directed from Beijing or is more in the nature of a slow and quiet and yet widespread uprising against the United States being mounted by government officials throughout China.

We can debate who is leading this enforcement charge and even the reasons for it, but to me the most important thing is that if you are an American company and you are not in full compliance with Chinese law you are at greater risk now than you have ever been. If you are doing business in China, especially if you are doing business there “through” a Chinese citizen you are paying, you need to think long and hard about your China company formation options.

Whenever we write about how China is getting tougher with such and such a law, we invariably get emails and/or comments saying how idiotic and/or unfair we are for criticizing China for enforcing its laws. Just so the record is clear, we have not said that and we are not saying that; we are as neutrally as possible merely writing on what we are seeing and we would be more than happy to leave it to the legal philosophers to put these sort of real-life China business and legal issues into some larger context.

In addition to the stepped up enforcement of China’s WFOE requirements, we are also seeing a massive uptick in American companies forming Hong Kong Companies or consulting WFOEs in ill-advised efforts to get legal. So let me use this blog post to once again make clear, forming a company in Hong Kong does not do a thing to make your business operations legal in Mainland China:

Nor will forming a company in Macau or Taiwan or Singapore. If you are doing business in the PRC/Mainland China, you need a PRC legal entity, such as a WFOE or a Joint Venture. See Having A Hong Kong Business Does NOT Make You Legal in Mainland China. See also A Hong Kong Company Is NOT a Mainland China Company and a Hong Kong Trademark is NOT a Mainland China Trademark. If it were otherwise, virtually nobody would go through the agony and the costs of forming a WFOE; they would instead pay some accountant in Hong Kong about USD$1,000 and have an HK company in less than a week. Please, please, please do not fool yourself into believing otherwise!

In fact, the more you get on the grid in China without actually doing everything the right way in China, the more you make your illegality more obvious and easier to spot. See Quasi-Legal In China. Not the Place You Want to Be andQuasi-Legal in China. Not the Place You Want to Be, Part II.

We are also hearing from many American (and some European companies as well, but we’ll save that for a subsequent post) companies that formed their WFOE in China the “fast and easy way.” Some less than reputable WFOE formation companies will tout how they can form China WFOEs quickly and cheaply and for only around USD $15,000 in minimum capital. What these WFOE formation companies typically then do is form your company as a consulting WFOE in an “easy” China city. Please don’t fall for this. If your WFOE is not going to be in the consulting business, it cannot legally operate as a WFOE in China and it will get shut down. See How To Form a China WFOE. Scope Really Really Matters, Part II. And if your WFOE is going to be operating in Xi’an you do not want it to be formed in Shenzhen, for just a whole host of reasons.

If you are not complying with Chinese laws it is important you move quickly to get into compliance. But it is also important that in moving quickly you not expose yourself to even more and potentially greater problems. To borrow from a famous legal quote, you should move to get legal in China with all deliberate speed.

China company formation done wrong is not going to be your answer.

Today I write to say that things have reached another level for people of all nationalities doing business in China without a legal entity. Today I write to say that doing this — whatever your nationality, puts you at extreme risk of being arrested and put in jail. I cannot go into much detail but I can tell you that over just the last three days I have heard of three instances (in three different Chinese cities) where foreigners (from three different countries) were put in jail for operating in China without a business license and failing to pay taxes on their China income. Jail. Prison. The clink. The slammer. The real thing people. The real thing. One of these cases also involves vague allegations of custom violations, claims for which the Chinese government has never been shy about imprisoning foreigners. See China Customs Violations and How to Avoid Jail Time.

Why are these arrests happening now? I posit the following two explanations:

  1. The arrests are happening because China is concerned about its economy and/or its general situation in light of US trade tariffs.
  2. The arrests are happening as just another “stepping up” of China tax collection efforts.

Again though, these arrests are not just of Americans. It is so early in the criminal law process that it is not clear to me how serious these charges are against those arrested. Will they merely be deported? Have they been arrested with the goal of getting evidence against others? What is it going to take for these people to be freed? Will paying off their taxes with interest and penalties be enough to get them released? See China’s Tax Authorities Want You. Will paying some part of the taxes be enough to get them released? What taxes are being pursued? Income taxes? Employer taxes? Both? Most importantly, is China serious about putting these people in jail for an extended period and if so, for how long.

No matter what the reasons for this most recent and most alarming crackdown, if you are in China right now and if you believe you or your company might be operating in China without a Chinese company when you should have a Chinese company, if I were you I would leave China quickly. I just would. And if you do get detained on your way out, you should as quickly as you possibly can retain a top-tier Chinese criminal lawyer in the city in which you arrested.

That is all. Sorry.

 

UPDATE: A loyal reader emailed me to note how this is the second day in a row that we have warned people not to do something at risk of going to jail. Yesterday, in China Tariffs and What to do Now, Part 1, I passed on advice from my law firm’s international trade lawyers regarding the criminal risks relating to changing the country of origin via transshipping to avoid the tariffs the US is imposing on products from China. This reader pointed out how the devolution of free trade is increasing the risks for companies that operate internationally. I agree with that assessment, but note that it is particularly true for those who are not careful and who are willing to operate close to the line between legal and illegal. Your thoughts?

ADDITIONAL UPDATE:  A Chinese lawyer friend of mine sent me an email stating that “the point here is that operating in China without a WFOE is illegal. This also applies to Internet/SaaS operations operating in China illegally, and you and I both know plenty of those. So long as the operators of these illegal Internet/SaaS operations stay out of China, they will avoid jail. But what about their partners who are operating in China? And what about when they take a two week business trip to China to check up on the situation there? Do you think companies really understand the fire they are playing with here?”