Forming a China WFOE and Then Operating Illegally

China lawyers

Earlier this week, I wrote about how China’s economic slowdown should impact how you do business in China and even with China. Today I focus on why this slowdown (and if you are an American company, the US-China trade war which is precipitating that slowdown) are why now is not the time for you to be operating quasi-legally in China.

For more than a decade, we have been stressing the need to have a WFOE if you are going to be doing business in China. Along these lines we have stressed again and again how independent contractors are almost never legal in China and how if you have “employees” in China you need a WFOE. For more on this and for how our tone on this has become increasingly strident as the Chinese government has consistently and unrelentingly stepped up both its enforcement of this requirement and the penalties for failing to comply, check out the following:

1. Doing Business in China Without a WFOE: Will the Defendant Please Rise. In this post from August, 2018, we wrote how foreigners are getting arrested and imprisoned for operating in China without a WFOE.

2. Doing Business in China with Deportation or Worse Hanging Over Your Head. In this post from March, 2017, we wrote how foreigners (especially Americans) were getting deported from China and being cut off from doing business in China for having operated in China without a WFOE.

3. China’s Tax Authorities Want You. In this Forbes article from May, 2015, I wrote about foreigners getting hit for massive taxes for having operated in China without a WFOE.

With all the pressure to have a WFOE in China, our China company formation attorneys are now increasingly hearing of foreign companies forming a China WFOE but then continuing to operate illegally in China. This is never a good idea.

Forming a WFOE is not the same thing as operating legally in China. In fact, it is so different that around a decade ago my law firm made the decision not to simply form WFOEs for clients and then walk away. At that time we ceased doing what we called “pure WFOE formations.” Instead, if anyone wanted us to form a WFOE for them, we would do so only if they retained our law firm for what we called a WFOE formation package. Our explanation for this was that operating legally in China with a WFOE requires a lot more than just a WFOE and we did not want to charge clients to form a WFOE only to have them get in trouble with China’s authorities for operating illegally. One of the things we always (as in 100% of the time) require as part of our WFOE formation work is what we call our China employment package, which consists — of among other things — our drafting dual language China-specific employment contracts for all WFOE employees and Employer Rules and Regulations to go with those. See China Employer Rules and Regulations: A Must Have No Matter Your Size.

Unfortunately, many law firms and companies that do WFOE formations are not concerned with launching China WFOEs that are illegal from day one. I say this because in the last year we are hearing far too often from foreign companies with WFOEs in China that are operating illegally in China. I find this distressing because it is so illogical. Why spend the substantial time and money to form a WFOE if doing so is not going to make you legal in China? Why form a WFOE telling the Chinese government you exist only to make it so much easier to be discovered for operating illegally.

What are these WFOEs doing illegally? Two main things, both centered around trying to reduce costs by avoiding taxes. One is setting up a WFOE and doing various things to illegally reduce the WFOE’s income taxes. We get maybe one call every six months from someone caught for this and we tell them their only solution is to try to negotiate down the total figure for back taxes, interest and penalties, and to do that from outside China. The other thing is China WFOEs that hire China “employees” through their foreign company and not through their WFOE. They do this to avoid having to pay the approximately 40% on salaries China employers are to pay in employer taxes and benefits and to avoid having to withhold the approximately 20% they are to withhold on behalf of their employees for their employees’ individual income taxes.

Way back in 2010, I wrote an article, entitled Operating Illegally In China: Half-Assing It Does Not Help [link no longer exists], explaining how operating quasi-legally so increases the risk of getting caught that companies would actually be better off operating fully illegally. Back then, the big issue was forming a company with a Chinese citizen. Here was our position on that back then and now too:

Legally, you pretty much cannot go into business with Chinese citizens without a joint venture.

You pretty much have two options:

1. You form a WFOE and you own it. Forming a company in Hong Kong is no different for China purposes than forming a company in the United States, so forget about Hong Kong for a moment. [For an update on why having a Hong Kong company does not cut it, check out American Companies in China without a WFOE and the Impact of Donald Trump and US Tariffs and Why Hong Kong is not the Answer.]

2. You let your fiancée, her mother and cousin own the entire business. You do this and you are exposing yourself to losing whatever you put into the business.

Twice, I have had people break down and cry in front of me because they went into business with their fiancée and her family and they put 3-8 years of their lives into the business, only to be completely and unceremoniously booted out once it really started to make big money. These are just the ones who cried. I can tell you about the guy who invested millions in condos with his fiancée and her mother, only to leave China for a few weeks and return with all of the condos sold and his fiancée and mother in law having completed vanished.

My emails often lead to pushback, with the person complaining of how China makes things so difficult for the “little guy” and then their explaining how they know how these things usually turn out for foreigners, but in their case it will be different because:

a. Their girlfriend/fiancé/wife’s family would never be anything but above board.

b. Their girlfriend/fiancé/wife’s family is so “connected,” it makes sense for them to go into business with them.

They then usually ask us to write up a contract that protects them “as best as possible.” We tell them that we will not do that because those contracts are usually not enforceable in China and we are not in the business of writing contracts we know will not work.

In that same article I talked about how if these people are going to go illegal in China, they should go 100% illegal. That is, enforcement either through really strong family connections (your father knows her father) or enforcement through gangsters and the like. I know people who have succeeded this way but I don’t know anyone who has succeeded with an illegal contract.

These sort of half-legal arrangements do not work because Chinese judges are totally on to them and they know they violate or seek to evade Chinese law. They therefore have and will continue to deem such contracts void. Why do people live in this fantasy world thinking that somehow they are so different or that they have discovered the solution? Why do they think a Chinese court would enforce a contract designed to evade the law?

As lawyers, we are never going to tell our client to go full illegal, but in my role as a blogger, I can tell you that going full illegal is usually better than paying a lawyer to draft a void contract. I think people know this, but their rightful discomfort at operating illegally makes them want to clutch on to something that will allow them to justify (however falsely) their actions.

I get the sense that those who contact us on these things are hoping they somehow have found THE loophole nobody else has found and if only they can get the blessings of an attorney for what they are doing, their operating illegally will somehow not be illegal.

It is frustrating to hear about the latest round of foreigners believing that going half-way with their China WFOE is enough, especially as most of these people we are hearing from do not even know they are operating illegally because they were told otherwise by the “experts” they hired. These companies that are hiring and paying their China employees outside their WFOEs wrongly believe the following make what they are doing legal:

1. Setting up a Hong Kong business and paying the employees from that. This is no different from paying your China employees from the United States. If you are going to have employees in China you need to pay them through a legal Mainland China entity, not from overseas. See Having A Hong Kong Business Does NOT Make You Legal in Mainland China.

2. Hiring only expat employees in China. Expats working in China need to work for a legal China entity just like everyone else.

3. Hiring only Hong Kong or Taiwan (or Singapore?) citizens. We have heard this one many times over the years, in large part because citizens from these places often claim they can and should be treated differently because they are from these places. A China-based employee is a China-based employee and a China-based employee needs to work for a legal Chinese company, be that a WFOE, a Joint Venture or a Chinese domestic company. Yesterday, in China Work Permits no Longer Needed for Taiwan, Hong Kong and Macau Residents, we wrote how citizens of these places no longer need work permits to work legally in China and we have already received multiple emails from people who think this work permit change means people from these regions can legally work in China without being directly employed by a legal China entity. Wrong. This work permit change has no impact on this.

Doing business in China with employees in China? Don’t do it half-right because that only increases your risk.

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