The typical scenario is one where the Chinese company pays a modest amount upfront (maybe 25%), another portion (maybe another 25%) after our client meets some vaguely defined milestone, and then the remaining 50% after the services project is “completed.” These delayed payment structures saddle service providers with a lot of risk that they will perform their services and then never get paid. The vagueness of the various milestones (including what constitutes “completed”) only increases the risk. It is also common for the Chinese company to make so many changes to the deliverables and/or to the schedule that the foreign services company loses money on the project even though it eventually gets paid in full.
When operating in the U.S. and European markets, service business billing and payment is often quite simple and oftentimes there is just an oral agreement and maybe an exchange of emails. When payment is due, invoices are informal or not even provided. Tax issues are mostly irrelevant, since the work is performed at the office of the service provider and all tax is paid to the local government. This approach does not work for China.
If you are a service company doing business with Chinese companies, you should consider the following:
1. Demand a large upfront payment and make clear in your contract that you will not start work until you receive it. Having a large upfront payment both to proves the good faith of your Chinese counter-party and that it is actually authorized to make large payments outside China. China’s currency, the renminbi (RMB), is a nonconvertible currency and any time a Chinese entity wants to send more than USD$50,000 a year in convertible currency (mostly Dollars or Euros) it needs approval from the transmitting Chinese bank.
2. Provide the required documentation. To get bank approval to pay you in a convertible currency, your Chinese counter-party must go to its foreign exchange bank to have RMB converted to a convertible currency. This conversion is subject to strict State Administration of Foreign Exchange (SAFE) rules which are designed to prevent capital from illegally leaving China. Payment of falsified service invoices is one of the primary ways to illegally get capital out of China and so your service contract and invoices will be carefully reviewed to prevent fraud.
Your Chinese counter-party must provide the following documentation to prove that its requested payment is for a legitimate underlying transaction:
- A formal written contract, properly executed and dated by both parties and sealed by the Chinese party. Though not officially required, it is always best for this contract to include a Chinese translation.
- A Formal, written invoice, signed and dated by the foreign service provider. There must be a separate, signed invoice for every required payment. It is best if this invoice includes a Chinese translation.
Depending on the specific situation, the foreign exchange bank may also impose the following additional requirements:
- If the invoice amount is high or if the bank otherwise suspects fraud it may request proof of existence of the foreign company. Sometimes a copy of a business license is sufficient. Other times a formal certificate of good standing from the Secretary of State will be required. Because these sometimes need to be translated into Chinese, we usually do this as a matter of course to avoid additional payment delays.
- If the bank determines that the payment is a royalty for a technology or IP license, it will require the contract be registered in accordance with Chinese law. Depending on the locality, this registration can take from three days to six months (or more). This is one of the reasons why our China IP lawyers usually suggest immediately registering technology and IP licensing agreements
Chinese banks can and do impose other requirements, depending on their mood and their concerns about the legitimacy of the transaction. Two to three times a month, an American or European company will contact one of our China lawyers for help in “getting a payment out of China.” Our help often involves starting all over by drafting a compliant Chinese language contract and invoice.
3. Account for China Taxes. Foreign service companies are often shocked to receive far less for their service work than they were expecting, due to a chunk of “their” payment being withheld to pay Chinese taxes. Even if all the service work you performed was done outside China, the Chinese tax authorities will deem it to be Chinese source income and therefore taxable. The China foreign exchange bank that will be paying you serves as a tax collection agent for the local tax office and no wire transfer can be made until your China taxes are paid. We have seen tax amounts imposed ranging from 10% all the way up to 40% of the invoice amount. We have also seen foreign companies unnecessarily pay millions of dollars more in Chinese taxes simply by not properly structuring their transaction.
Our China contract lawyers usually draft service contracts that provide for the Chinese side to be liable for all taxes imposed by the Chinese government and for the amounts payable by the Chinese side to be net of taxes. These terms provide you with certainty and put the burden of dealing with China’s complex and constantly changing tax system on the Chinese party. Chinese companies will often resist this approach and seek to place all of the risk of the Chinese tax system on you. If this happens, you should consider the tax payment amount at stake and decide whether to increase your pricing or abandon the transaction or try to mitigate your tax payment risks by renegotiating/restructuring your deal.
Bottom Line. The payment risks inherent in service transactions with Chinese companies make it important that you early on confirm the ability of your Chinese counter-party to pay you and for that you not to do a substantial amount of work before you get that confirmation. Your contract should require your Chinese counter-party make an initial payment before any substantial work on your part is required. This will help you determine how quickly your payments will be processed and how much in taxes will be imposed on those payments. Failing to do these things can and does lead to foreign companies putting in months of work and never getting paid or getting paid a lot later and a lot less than expected. Do not let this happen to you.