Earlier this week, in China-US Decoupling Continues and Will Continue, but Must be Done Right, we wrote about how to terminate your relationship with your China supplier so as to avoid allowing that supplier to essentially hold your business for ransom. In this post, we focus on how to shut down your China WFOE so as to avoid the Chinese government cracking down on you and your company right away and for a long long time. With so many foreign companies looking to eliminate or reduce their interactions with China, our China corporate lawyers have been seeing an increase in companies looking to shut down their China WFOEs or “put them on ice.”
As our regular readers know by now, forming a WFOE in China is itself no mean feat. See How to Form a China WFOE: A Roadmap. So as a bit of a side-note, if anyone suggests you form a China entity “to test the waters in China,” run (don’t walk) away.
As you should expect, the shutting down a China WFOE has its own long set formal and complicated procedures and regulations. You cannot simply abandon your Chinese company. PRC law requires a formal de-registration procedure be followed for closing down any foreign entity. The most important part of this de-registration process is formally liquidating the company. Many foreign investors feel they have already suffered enough from China’s bureaucracy (and no doubt they have!) and they use that as their excuse for not following this formal process and simply abandoning their WFOE. In taking this course of inaction, they assume there will be some sort of administrative dissolution and that will be the end of the matter.
This is flat out wrong. And potentially very dangerous.
Simply abandoning a WFOE is a major mistake that will have long term and personal repercussions and subject WFOE management and shareholders to severe sanctions within China. When a WFOE is “abandoned,” its annual registration procedures and tax filings will cease to be conducted and its business license will be revoked (吊销) . There are two possible reasons for revoking the license of an abandoned WFOE. One is for failing to complete the annual registration requirements, such as the annual audit and payment of fees. The second is failing to file an annual tax return and to pay taxes due. In most cases, the revocation is based on both. This revocation will be publicly announced on the State Administration for Industry and Commerce (SAIC) website and the following will be required:
1. The WFOE must immediately cease doing business. This means all websites and other public announcements where the company offers to do business must be taken down.
2. The WFOE’s official company seals must be collected and deposited with the licensing authority.
3. All taxes and fees owed to the national and local governments must be paid.
4. All salary owed to employees must be paid.
5. The legal representative and the directors of the company must immediately liquidate the company in accordance with China’s Company Law and local procedure. All company assets must be used to pay creditors in accordance with the liquidation procedure. Using the company assets for any other purpose is a crime.
Though liquidation of a WFOE ostensibly can be used to equitably extinguish the debts of normal creditors, in our experience (and that of various other China lawyers we know) it is pretty much impossible to formally liquidate a China WFOE if it owes any taxes or government fees or if employee salaries have not been paid. The government agencies normally treat taxes, fees and salaries as obligations that cannot be extinguished through liquidation and they often do the same for vendor debts as well. For this reason, any WFOE considering liquidating should first ensure that it is — at minimum — current on all of its taxes, government fees and employee salaries.
Why though is all of this so important?
Properly shutting down your China WFOE is important because failing to do so will almost certainly lead to a series of penalties being imposed on both the WFOE’s management and shareholders. Generally, the legal representative and the other directors (but not the general manager) are personally liable for damages caused to creditors by the WFOE’s failure to comply with China’s WFOE liquidation requirements. If your WFOE owes anyone (be it the Chinese government or another legal entity or a person) any money it will be a big mistake for you to just walk away from your WFOE. Abandoning a WFOE automatically pierces the WFOE’s corporate veil, leading to personal liability for the WFOE’s legal representative and its directors. In a nice twist, the shareholders are off the hook in this situation as all the blame and the penalties/fines/sanctions/criminal liability/black listing falls on the WFOE’s legal representative and directors.
When a China WFOE does not properly liquidate the Chinese government will first put all of the potentially liable parties on a “black list.” This list of potentially liable parties includes the WFOE’s legal representative, directors and shareholders. Though the general manager is technically not liable, the name of the general manager usually will go on the blacklist as well. This blacklist will usually note the WFOE’s failure to pay its taxes, its employees and its creditors. This blacklist is issued to all SAIC offices in China and it also typically goes to China’s border control authorities as well. Note that China has gotten really good at disseminating information/data like this to any and all relevant governmental entities. The old days of counting on the left hand not knowing what the right hand is doing are over!
Being placed on the improperly abandoned WFOE blacklist will usually result in the following:
1. The WFOE’s legal representative will not be permitted to act as a director, manager or supervisor of a Chinese company for at least three years from the date of the WFOE’s revocation.
2. The shareholders of the WFOE will not be permitted to invest in another Chinese company for at least three years from the date of the WFOE’s revocation.
3. The name of the WFOE cannot be used for at least three years from the date of revocation.
The above three things will occur when the WFOE does not owe any taxes, fees, salaries or debts to creditors. If the WFOE is abandoned owing any taxes, fees, salaries or debts, the situation is far more serious. In this situation, China may criminally prosecute the legal representative and the directors of the company for having failed to make the required payments. Failing to pay taxes and government fees is a crime in China and failing to properly liquidate is also a crime if the WFOE’s creditors were not properly paid pursuant to China’s WFOE liquidation rules. This is not treated as an administrative or civil violation. Failing to follow the liquidations rules by failing to make the required payments is a crime.
Even when no crime has been committed, it is difficult or impossible for a person or entity named on the blacklist to again engage in investment or company management in China. In these cases, where a name appears on the list, it is not uncommon for the border authority to refuse entry for the named person. This is particularly common in Shenzhen for persons entering the PRC from Hong Kong. Even worse though is when China allows this person to enter China and then immediately arrests him or her for remand to the local authorities for prosecution. We also are aware of many instances where key WFOE personnel were held in China until the debts of their WFOE were fully paid. See How to Avoid Being Detained in China.
Fortunately, the process for properly de-registering and liquidating a China WFOE has become somewhat more systematic and easier to handle as many local governments have streamlined and systematized their de-registration process. For China WFOEs that have paid their taxes and government fees and have paid their employees and their creditors, de-registration and liquidation is now a relatively straightforward process. This is why the first question our China lawyers always ask any foreign company with a China WFOE that is looking to leave China is whether they owe anyone anything.
Bottom Line: If you need to shut down your China WFOE you should be sure to follow China’s rules for doing so.