Foreign companies are increasingly providing services to Chinese clients, yet they often neglect to consider the most important issue: how to get paid.
When operating in the U.S. and European markets, service business billing and payment are simple. There is often no contract, just an oral agreement or an exchange of emails. When payment is due, invoices are informal or not even provided. Tax issues are irrelevant, since the work is performed at the office of the service provider and taxes are paid to the local government.
This approach does not work for China.
To get paid from China, there are two critical points you must consider: documentation and tax.
1. Mandatory Documentation
To pay a foreign company for services, a Chinese client must go to its foreign exchange bank to convert RMB to U.S. dollars or to some some other convertible currency. This conversion is subject to strict rules issued by the State Administration of Foreign Exchange (SAFE). The foreign exchange bank acts as the agent for SAFE in enforcing the rules. These rules were originally designed to protect China’s foreign exchange reserves but they are now used to prevent capital from illegally leaving China. Payment of falsified invoices is one of the primary ways capital illicitly leaves China, so careful review of all transactions is required to prevent fraud.
To comply with these rules, your Chinese client is not permitted to simply make a wire transfer request; it must provide documentation proving there is a legitimate underlying transaction for which payment is being sought. The basic documentation is as follows:
1. A formal written contract, executed, dated by both parties and sealed by the Chinese party. Though not legally required, it is best if this contract includes a Chinese translation.
2. A Formal, written invoice, signed and dated by the foreign service provider. There must be a separate, signed invoice for every required payment. Again, though not legally required, it is best if this invoice includes a Chinese translation.
These first two requirements are mandatory and will always be required. Depending on the specific situation, the foreign exchange bank may also impose the following additional requirements:
1. If the invoice amount is high or if the bank otherwise suspects fraud, it may request proof of existence of the foreign company. For some banks, a copy of a business license is sufficient. Other banks will require a formal certificate of good standing from the secretary of state or a related document.
2. If the bank determines the payment is a royalty for a technology license or similar agreement, it will require the contract be registered in accordance with Chinese law. Depending on the locality, this registration can take from three days (Shanghai) to six months or more (Shandong Province).
Banks can impose other requirements, depending on their mood and their concern about the legitimacy of the transaction. The bank totally controls the situation and you have no real standing to discuss the matter. No payment can be made until the bank is satisfied and the bank has no incentive to approve the transaction. Delay in processing payment for services is therefore the norm rather than the exception. For these reasons, our China lawyers make sure our clients have crossed every possible “t” and dotted every possible “i” before giving the go-ahead to its China client to submit the payment request to the bank.
It comes as a shock to many foreign service providers that the amount paid to them is subject to Chinese tax, even if all service work was done outside China. The Chinese tax authorities deem all service work provided to Chinese clients as Chinese source income and subject to tax on the invoiced amount. As with the SAFE rules, the foreign exchange bank serves as an agent for the local tax office to ensure the correct amount of tax is imposed and paid. No wire transfer can be made until this happens.
Unfortunately, there is no agreement in China on the correct amount of tax to impose. We have seen tax amounts imposed ranging from 10% all the way to 40% of the invoice amount. Even the same tax office will take an inconsistent position on the amount of tax to impose. One payment will be taxed at 10% and the next payment for exactly the same service will be taxed at a substantially higher rate.
The resolution of the tax issue is critical because the invoice cannot be paid until the tax amount is calculated and paid. The Chinese client acts as the agent for the foreign service provider and pays the required amount on behalf of the foreign party. Since the total amount paid by the Chinese client does not change, the Chinese client has virtually no incentive to work with the tax office to lower the tax amount. Since the foreign service provider is anxious to get paid as soon as possible, the incentive for the Chinese client is to agree with whatever the tax office decides and to make the tax payment as soon as possible without complaint about the amount imposed.
The amount of tax can be high and the time required for processing can be long. It is therefore important the foreign party understands the issues and enters into an agreement with the Chinese party on how to proceed. Under international commercial practice, it is common to provide in the service contract that 1) the Chinese side is liable for all taxes imposed by the Chinese government and 2) the amounts payable by the Chinese side are net of taxes. This provides certainty to the foreign party and places the burden of dealing with the complex, uncertain and constantly changing Chinese tax system where it belongs: on the Chinese party. Since the Chinese party is responsible for the taxes, it will have incentive to advocate for the lowest tax possible. Certainly the Chinese party is better positioned to do this than the foreign party.
It is common for the Chinese party to resist this approach and to seek to place Chinese tax system risk on the foreign party. The foreign party must consider whether to abandon the transaction or move forward without certainty on the amount of payment it will eventually receive. If the foreign party moves forward, there are various complex ways to mitigate the risk of tax payment. These measures must be negotiated carefully in advance.
As you can see, the risk for payment in service transactions in China is considerable. There is risk of substantial delay and there is even the risk payment will never be approved. It is therefore important to confirm the ability of the Chinese side to make payment. This means you should not do a substantial amount of work before you receive your first payment. In the contracts we draft, our China lawyers usually require the China party make an initial payment before our client undertakes substantial work.
We do this to determine how quickly the payment will be processed and the tax that will be imposed on payment. Often, the Chinese side itself has no idea what will be the result. You must therefore protect yourself by getting paid at least once before you take the risk of doing a substantial amount of work for a Chinese client. We have seen service companies go out of business by failing to heed this advice.
Please do not let your service company be another name entered onto the never paid or highly taxed casualty list.