How to Avoid the China VAT Tax Trap

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Consider the following situation. Your company is a service provider. Let’s say your business assists domestic and foreign entities register drugs with the FDA. You are contacted by a Chinese entity to do a registration. Having read China Law Blog (See Getting Money out of China, Part 5), you submit a written, signed invoice to the Chinese entity and you require payment in advance. Within five days, you receive payment.

But you are surprised to see your payment amount has been reduced by 6 percent. You complain to your Chinese client, and your Chinese client explains the 6% was deducted as VAT tax on the payment, as required by the local tax authority. You explain that all of your services were performed outside China and so there is no basis for the Chinese tax authorities to impose any tax of any kind. The Chinese side says they agree, but if we had complained to the tax authorities, our payment to you would have been denied and you would not have received any payment at all.

This has become a standard scenario for foreign companies that provide all sorts of services to Chinese entities, including the following:

  • Legal services
  • IP registration services
  • Product and advertising design services
  • Software development services
  • Environmental consulting services
  • Architectural services, both structural and landscape.

In all these areas, the Chinese foreign exchange banks will refuse to make payment without documentation. Often the request for documentation is onerous and can cause considerable delay and the foreign exchange bank typically deducts and keeps a portion.

Now get this: the amount of the deduction varies from bank to bank and from region to region. We have seen deductions range from 5% to 40%. What is the reason for this wide variation? Since there is no legal basis for the deduction, its amount and its supposed basis vary. This variation means there is no way to predict in advance the amount of the deduction. Even within the same bank for the same services we have seen the amount of the deduction vary from payment to payment, depending on the attitude of the bank at the time or the bank officer or local tax office personnel involved. Of course, the status of the Chinese payer in the local economy is a factor. An SOE that is the sole employer in a small town is treated differently than a small privately owned business in Shanghai.

Our China lawyers constantly get calls seeking help from American and European service providers whose payments have been held up by China’s banks. We tell them the following: “we can help you get the money out, but it will be net of taxes and we do not know what that amount will be.” A classic good news/bad news scenario.

What though can you as the foreign service provider do to eliminate this tax deduction risk? The only solution is to put all  payment risks onto your Chinese customer by providing in your service contract that all payments must be made net of taxes and fees. If the amount of the invoice is $60,000, the service provider must receive $60,000. All taxes and fees are paid by the Chinese customer on behalf of the foreign service provider.

This approach places the risk where it belongs: on the Chinese side. The Chinese government/foreign exchange bank is imposing the fee. The Chinese payer is the only party that can object to the fee and argue it should not be imposed or should be reduced. You as a foreign entity receiving payment have no standing and no power to impact the decision of the Chinese authorities, but your Chinese customer does. Placing the risk on the Chinese payer is the only practical way to deal with this issue.

It is essential to deal with this issue in advance in the written service contract and in the written invoice for services. If the written documents are silent, the Chinese side will fall back to the basic rule putting VAT and income tax liability on the foreign party and make little to no effort to prevent or reduce it.

So this then leads to the following basic rules when performing services for Chinese entities:

1. Execute a written service agreement.

2. Provide a written, signed and chopped invoice for every payment.

3. Provide in the agreement and in the invoice that payments to you are net of taxes and fees.

4. Do not start work until you receive full payment.

Service providers outside China normally operate with a relaxed contracting and billing system. The rules for China are very different and contrary to service provider culture. Moreover, many Chinese entities will resist following the rules. My response to all this is: So what? As my first law firm boss explained to me: there is only one thing worse than working. That is working and not getting paid. If you want to get paid by a Chinese customer, you need to follow the rules.

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