Not surpisingly, our China lawyers have been getting a ton of questions on how to close a China WFOE.
It is difficult and time-consuming to form a WFOE in China. As you might expect, the procedure for shutting down a WFOE is also subject to formal procedures and regulations. You cannot simply abandon your company; PRC law requires a formal de-registration procedure be followed for the shutting down of all companies. The most important part of this de-registration process is a formal liquidation of the company, similar to a Chapter 7 bankruptcy proceeding under U.S. law. Many foreign investors figure they have already suffered enough from Chinese bureaucracy, so they avoid this formal process and simply abandon their WFOE. In taking this course of inaction, they assume there will be an administrative dissolution and that will be the end of the matter.
They are wrong.
Simply abandoning a WFOE is a major mistake that will have long-term and personal repercussions, and subject the management and shareholders of the WFOE to severe sanctions within China. When a WFOE is “abandoned,” the annual registration procedures and tax filings will not be conducted. As a result, the business license of the WFOE will be revoked (吊销) . This revocation will be publicly announced on the company information website maintained by the SAIC of virtually every district in China. For WFOEs that have simply been abandoned, there are two possible reasons for license revocation. One is failure to complete annual registration requirements such as the annual audit and payment of fees. The second is failure to file an annual tax return and to pay taxes due. In most cases, the revocation is based on both.
When a license is revoked, the following is required:
1. The company must immediately cease doing business. This means, for example, that all websites and other public announcements where the company offers to do business must be taken down.
2. The 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. Use of the company assets for any other purpose is a crime.
Though liquidation can be used to equitably extinguish the debts of normal creditors, in our experience it is impossible to formally liquidate a company if taxes and fees are owed 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. For this reason, any company considering liquidation should first ensure that taxes, government fees and employee salaries are paid in priority to other obligations of the company.
Failing to properly liquidate a WFOE results in a number of penalties that can be imposed on the management and the shareholder(s) of the company. As a basic rule, the legal representative and the other directors (but not the general manager) are personally liable for any damages caused to creditors by the WFOE’s failure to strictly comply with China’s WFOE liquidation requirements. This means abandoning a WFOE is a big mistake if the WFOE is in debt to anyone. 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.
When proper liquidation is not completed, the first step by the Chinese government is to put all the potentially liable parties on a “black list.” This includes the legal representative, the directors and the shareholders. Though the general manager is technically not liable, the name of the general manager often goes on the blacklist as well. The WFOE’s failure to pay its taxes, failure to pay its employees and failure to pay a major creditor are also normally noted on the blacklist. The blacklist is issued to all SAIC (State Administration for Industry and Commerce) offices in China and it also typically goes to the PRC border control authority as well.
The effect of being placed on this blacklist is usually the following:
1. The legal representative will not be permitted to act as a director, manager or supervisor of a Chinese company for a period of 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 a period of three years from the date of the WFOE’s revocation.
3. The name of the WFOE cannot be used for a period of three years from the date of revocation.
The above is the result 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, the PRC authorities have the right to criminally prosecute the legal representative and the directors of the company for having failed to make the required payments. Failing to pay taxes and fees is a crime in China and failing to properly liquidate is also a crime when the result of that failure means creditors were not properly paid as provided by 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.
As you can see, even when no crime has been committed, it is difficult or impossible for a person or entity named on the blacklist to engage in any future 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. If a crime has been committed, the result is more serious. China sometimes will allow this person to enter China and then immediately arrest him or her for remand to the local authorities for prosecution. We also have heard of many instances in which key WFOE personnel were held essentially under house arrest in China until their debts were fully paid. See Held Hostage in China: How to Make Like Carlos Ghosn and Escape.
Fortunately, the Chinese authorities have learned their cumbersome and expensive de-registration procedure was only encouraging Chinese and foreign company owners to abandon their company registrations and they have recently streamlined and systematized the de-registration process. For Chinese companies (including WFOEs) that have paid their fees, do not owe taxes and have paid their employees, de-registration and liquidation is now a relatively straightforward process that does not need to be approached with fear.
Bottom Line: You can run but you cannot hide. If you need to shut down your China WFOE, follow the rules. There is no alternative.