1. Foreign Companies Are Leaving China
Foreign companies are tiring of the difficulties and the risks that come from doing business in China. 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.
2. How to Close a China WFOE
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:
- 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.
- The official company seals must be collected and deposited with the licensing authority.
- All taxes and fees owed to the national and local governments must be paid.
- All salary owed to employees must be paid.
- 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:
- 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.
- 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.
- 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 often (though not always) relatively straightforward process.
3. Some Typical China WFOE Shutdown Examples
Most companies looking to shut down their China WFOEs wish to do so because it has become too difficult and expensive to operate in China. These companies plan to contract with Chinese domestic companies or WFOEs to do for them what their WFOEs previously did for them.Other companies plan to cease doing business with China entirely. Our China lawyers typically handle these situations differently because those that plan to continue doing business in China need to be especially careful not to offend Chinese government authorities.
The below are composites of various recent emails we have sent to clients regarding the closing of their WFOEs. To preserve confidentially, we have removed any identifiers and shortened and simplified them for purposes of this post.
The first email is to a client whose WFOE (we will call it Beijing XYZ WFOE) already had its license revoked.
We were asked to review your situation with respect to your Beijing XYZ WFOE in China.
Your questions concern the current status of your WFOE and the issues of formally closing it under Chinese law. You have also asked us to explain the impact of failing to close this WFOE.
As will be fully described below, the Chinese government has already revoked the business license of Beijing XYZ WFOE. As the legal representative of XYZ WFOE, you are required to carry out a proper liquidation of the company. Such liquidation requires payment of taxes, payment of salary to employees and payment of all major debts of the company. This has not been done. In this situation, you will be held personally liable for damages caused by nonpayment. This means that your entry into the PRC may be barred. More seriously, it could mean that you could be arrested after entry into the PRC. For this reason, you should not enter the PRC until after a proper liquidation of Beijing XYZ WFOE is completed. If such liquidation is not possible or if the shareholders choose not to liquidate, you should not enter into the PRC for at least the next three years, if ever.
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 in China 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 (you) and the directors of the company must immediately liquidate the company in accordance with the China 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.
You as the legal representative and the other directors are personally liable for any damages caused to creditors for failing to strictly comply with the above requirements. In this case, since the amount of tax owed is significant, the risk for failure to follow these rules is high.
When a proper liquidation is not completed, the names of the legal representative and the company directors (and sometimes others tied to the company) are placed on a black list. Failure to pay taxes, failure to pay employees and failure to pay a major creditor are normally noted on the black list. The black list is shared with the PRC border control authority and those on the list are usually denied entry into China. This is particularly common in Shenzhen for persons entering the PRC from Hong Kong. Though not common, persons named on this list are sometimes allowed to enter China and then immediately arrested. Entrance and arrest is more likely if the monetary amounts are large or if a government agency is involved (taxes and fees). For this reason, you should not to enter into the PRC until after a proper liquidation of Beijing XYZ WFOE has been completed.
The following are the major legal consequences resulting from revoking the Beijing XYZ WFOE business license:
1. As legal representative, you 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 revocation.
2. The shareholders of Beijing XYZ WFOE will not be permitted to invest in another Chinese company for at least three years from the date of revocation.
3. The name of the company cannot be used for at least three years from the date of revocation.
4. The name of the company, the representative director, the shareholder and the directors (and perhaps others tied to the company) will be placed on a national “black list” maintained by the Chinese police, border control authorities and State Administration for Industry and Commerce (SAIC). The black list period is normally for three years. However, some local authorities will maintain the black list for five years. During the black list period, it is difficult or impossible for any person or entity named on the list to engage in investment or company management in China. Though not common, such persons may also be denied entry into China. Normally, however, if proper liquidation is completed there is no risk that such persons will be arrested after entry into China. Note though that unless and until your company pays its taxes, employees and major creditors in full, the consequences for you could be much worse and the time frames much longer.
The below email relates to a company whose business license has not been revoked, but is looking to close down its China WFOE.
We reviewed the status of Shanghai ABC WFOE with the Shanghai/Jingan office of the SAIC [now known as SAMR –State Administration for Market Regulation (国家市场监督管理总局)], which has authority over the company. The SAIC informed us that there are no current legal or administrative actions being taken against Shanghai ABC WFOE. This is confirmed by the Shanghai SAIC website. This means that the Shanghai ABC WFOE business license is currently valid and that the company is fully authorized to do business.
I must caution you that failing to properly maintain the company registration status will eventually result in a revocation of the business license. [Such a revocation would have the same consequences as reported above for Beijing XYZ WFOE].
With respect to Shanghai ABC WFOE, the shareholders have the following two options:
1. Maintain the legal status of the company. This requires 1) filing all annual reports and the annual audit, 2) filing the annual tax return and paying all taxes, 3) maintaining a legal office.
2. Liquidate the company in accordance with PRC law. With respect to liquidation, the process is complex and time consuming. Though you indicate you believe no taxes are due and there are no company debts, this cannot be confirmed without a proper liquidation. The Jingan authorities are quite creative in finding taxes and fees that have not been paid and sometimes even in finding taxes and fees that probably were never previously owed but for which they are now seeking payment. It is also not uncommon for alleged debtors to come out of the woodwork when a WFOE is being liquidated.
Please note that some of what is required to close a WFOE is local — very local.
4. The Putting Your China WFOE into “Hibernation” Alternative
When it is too difficult and/or expensive to shut down your China WFOE, it will often make sense for you to put it into what our China lawyers call “hibernation.” This hibernation essentially involves reducing your WFOE to its bare minimum. This involves properly terminating all of your WFOE’s employees and winding down your WFOE’s operations to the point that it ceases to receive any revenue. The goal is to keep your WFOE officially operating by complying with all of China’s (and your locality’s) corporate requirements, but reducing your costs as much as possible.
Hibernation requires you continue filing all required tax returns and annual reports. But because your WFOE is doing almost nothing, your tax returns will become relatively simple. You will also need to maintain a company bank account and some sort of physical address. The actual physical location required varies by city and some cities are far looser than others in terms of what is required. You can move to a less expensive address, but that new address will require government approval, and thus moving seldom makes sense.
Our China lawyers have helped put a number of WFOEs into hibernation, but whenever we do so we always make clear this should not be considered a permanent situation.
We say this for the following three reasons.
1. It does not make sense to endlessly incur costs with no real benefit beyond delaying the inevitable (shutting down the WFOE). A WFOE hibernation usually only makes sense if you want/need to buy time to come up with more funds or to decide on a long-term plan.
2. Most Chinese cities will not allow a WFOE to remain in hibernation forever. Usually after a couple of years of virtually no activity, the WFOE will start getting shut-down threats from the government and at some point that will really happen.
3. The Chinese government does not like companies that do not pay what it views as its fair share of taxes and it is not uncommon for them to impute profits and assess taxes on companies with no or virtually no earnings.
But putting your WFOE into hibernation is an alternative to shutting down a WFOE and it sometimes does makes sense, especially now when (thanks to COVID) so much in China is uncertain.
What are your China plans?