How to Reduce China Payment Risks

Our China lawyers are often contacted by companies on “how to get money out of China”. Usually the questions concern purchasing assets like real estate or stock and other securities by a Chinese entity. The standard situation a Chinese side has failed to perform on its deal payment obligations and is claiming Chinese authorities will not allow it to remit the funds. Simply stated, the Chinese side wants to make the payment, but the government will not let them.

This problem is not limited to high value asset transactions. This common situation results from a more general issue that arises with doing business in China. The fact is that every payment made from China must be approved. That is, it is not just large sum foreign investments that must be approved. Every remittance, no matter how small and no matter how routine, must be approved prior to remittance from China.

Approval is not automatic. Every remittance from China requires conversion from RMB to dollars or to some other foreign currency. The Chinese foreign exchange bank works with the local tax and other authorities to review every conversion and remittance.

When the Chinese government decides to limit outflows of currency, transactions that have been routinely approved in the past can suddenly become problematic. Delays occur, new taxes and fees are imposed and in some cases the payment is denied. This then means that there is real payment risk for every payment made from China. This is not limited to big investment transactions. All payments from China are reviewed by the foreign exchange bank. It is never certain what the bank will decide. For this reason, all payments from China are subject to payment risk due to government restrictions.

This issue arises in a number of business sectors but we most often see it in the following:

1. In the sale of high value equipment, it is common to accept payments in installments. Many problems can occur. In some cases, the Chinese buyer will make and order but then fail to pay the down payment, claiming that the Chinese authorities will not approve the payment. The Chinese side then asks for “cooperation” in providing additional documentation demanded by the foreign exchange bank or local tax office. Eventually, the Chinese side pressures the U.S. seller to start work or to ship prior to payment, blaming the delay in payment on the Chinese authorities. In a similar situation, where several installments are involved, the buyer will succeed in making the first several installments, but then will delay in making later payments, blaming the delay or failure to pay on the Chinese regulatory authorities. In these cases, the foreign seller is now trapped: the product is shipped and it is not clear whether full payment will ever be made.

2. In licensing of technology or the licensing of media, there are often annual royalty payments that must be made. The Chinese side will normally negotiate a system that provides for payment of the royalty at the end of the royalty period. The payment day arrives and no payment is made because the foreign exchange bank refuses to process the payment. There are many reasons the bank may refuse to remit. One common reason is that the license has not been properly registered. Some banks will insist on a particular form of invoice. Other banks will require proof of the existence of the licensor and the validity of the license. In other cases the local tax authorities will impose withholding taxes of a type or in an amount that was not anticipated by the parties. The problem in all of these cases is that the Chinese side has obtained the benefit of the license for a full year before the issue of payment is raised. The foreign party is now assuming all of the burden for non-payment with no corresponding cost imposed on the Chinese side.

3. Service contracts of all kinds are particularly risky. The reason is that a primary way Chinese entities illegally transfer funds out of China is via false service contracts. Since the risk of fraudulent transfer is quite real, Chinese banks are particularly careful in reviewing service contracts. This means legitimate service agreements are subjected to the same careful scrutiny. Since service agreement are typically quite informal and poorly drafted, the agreements often fail when examined by the banks and tax authorities. When this occurs, the Chinese entity reports that their attempted remittance has been denied or a large tax no one anticipated has been imposed. This can be a major disaster for service providers when the service has already be provided. Since the service is intangible, there is no way to repossess in the way that could be done for piece of equipment or a parcel of property.

Every foreign business expecting payments from a Chinese entity must understand payment risk is significant and set up mitigation measures to avoid disaster. The three basic rules for dealing with payments from Chinese entities are as follows:

Rule Number One: Always put the the burden of dealing with Chinese banks and government authorities on the Chinese side. China is the rare country where its resident businesses try to shift the burdens of its own government’s actions onto a foreign party. This is not acceptable; a country resident must be liable for the actions of its own government, since the country resident is the only party to the transaction with any real chance to influence the actions of its local government and banking institutions. Think about this for a minute: are you or your Chinese counter-party more likely to be able to persuade a Chinese bank and/or Chinese government official to get money out of China? If your Chinese counter-party is trying to put this burden on you, this is a red flag and a good indicator it knows it likely will never get the money out.

In the area of payments, this means two things:

First, the Chinese side must take on the burden of paying China taxes and fees. That is, all payments to you on the foreign side must be net payments, free of taxes and fees on the Chinese side. If a tax is or fee is imposed by the Chinese bank or local tax authority, the Chinese side must pay this tax/fee, with the payment to the foreign side being unaffected. If the payment to the foreign side is $5 million, the foreign side must be paid $5 million. It makes no difference to the foreign side whether the tax/fee imposed in China is zero, 10% or 100%; the foreign side still receives its $5 million payment.

The reason for this is obvious. First, the Chinese side must be motivated to have the tax or fee reduced. If the tax or fee is simply passed on to the foreign entity, no such incentive exists. Second, there is little consistency in the taxes and fees imposed by Chinese foreign exchange banks. The same transaction may be treated differently from region to region and from bank to bank. Even within the same region and the same bank, treatment may change from transfer to transfer. The Chinese side must take the risk of this uncertainty; it is unreasonable to impose the risk on the foreign party.

Second, the Chinese side must take on the risk payment will be approved within strict timelines. Ten days should be the maximum and five days is better. The reason for imposing a tight deadline for payment is that it is critical you determine as early as possible whether the Chinese side will be able to make payment. Due to the capricious nature of Chinese banks and taxing authorities, approval must be determined for every payment. You should do no work nor take on any risk until after receipt of the applicable payment from China is confirmed, and I mean really confirmed.

Your contract should provide that if payment from your Chinese counter-party is delayed for any reason — including for lack of approval by the Chinese bank or government authorities — you have the right to terminate the underlying transaction. Chinese parties will often argue that failure to pay due to bank or government lack of approval should be treated as a force majeure event that excuses them from enforcement. That is, the Chinese side will argue that the foreign party is not permitted to terminate and even call for a force majeure provision in the contract making this explicit.

This provision might then mean you are required to perform under the contract even though no payment is made by the Chinese side. This is not, of course, what the standard doctrine of force majeure provides. However, the Chinese side will often seek to insert this absurd provision. As clever negotiators, they will insert this in an otherwise standard force majeure clause. Since this type of clause is treated as “boilerplate,” the language is often not read carefully, leading to unpleasant results for the foreign party. For this reason, our China lawyers routinely refuse to allow any form of force majeure clause to be included in the contracts we draft for China. We also have more than once been contacted by foreigners whose contract says one thing for force majeure in the Chinese portion of their contracts and something very different in English, but the Chinese controls. Do not let these sort of things happen to you!

Rule Number Two: Force early payment. It is important to test as early as possible whether the Chinese side actually has the ability to make a payment. The test is made by providing for an early payment from the Chinese side in an amount large enough to force the Chinese side to go through the full approval procedure with the Chinese bank and with government authorities. A small, token payment is not sufficient.

One purpose of the initial payment is to ensure your written documentation related to the transaction is acceptable to the foreign exchange bank. For example, for any payment that can be classified as a royalty, a number of issues can arise concerning the documents, including the following:

  • The bank may require the underlying agreement be registered with the applicable government regulatory body. This is common for technology transfer and licensing agreements.
  • The bank may require the transaction itself be approved by Chinese government authorities. This is standard for outbound investments. Approval is also normally required for licensing in the publishing and audio-visual fields.
  • The bank may impose various requirements on the written contracts. Typically the bank will require the main agreement be written in Chinese. Many banks also will require an written, signed invoice for each separate installment payment.
  • The bank may work with the local tax office to impose various taxes and charges on the payments. Both the amount of tax and the processing of tax payment can be confusing and can cause delay.

By requiring an initial payment from the Chinese side, the parties can isolate the problems and correct them before the foreign side begins work or takes risks by relying on the ability of the Chinese side to actually make payment. Our China lawyers are constantly getting called by American and European companies that have not received payment under their contracts with a Chinese entity and in many of those instances it is because their contract has not been drafted in a way that will permit payments to leave China.

Your receiving the first payment is NOT sufficient to pass the test. You as the recipient must also check that payment for the following three things:

1. Was the payment actually made by the Chinese side from China (not Hong Kong), or was it made by another entity, perhaps located outside of China?

2. Was the payment made through a standard Chinese foreign exchange bank, or was it made through some irregular payment mechanism such as a credit card or through a U.S. financial institution or by bitcoin?

3. Was the payment made in a single lump sum, or is the payment an aggregate of a number of separate transfers?

All of the above are common and these sorts of irregularities show the Chinese side did not obtain China-side approval for payment. This means the Chinese side failed the test and you now know you are facing significant risk for the later, more substantial payments.

Rule Number Three: Never get behind on getting your payments. Always get paid before you manufacture and ship your product. Get paid before you start the service work. Get your royalty payment at the beginning of the year, not the end. For the sale of your business (or shares in your business) and the sale of real estate, use a tight closing date with a substantial pre-closing escrow deposit.

In some cases, it is not possible to get all payments in advance. In such cases, you should avoid getting hit with the loss of your out of pocket costs. For example, in the sale of expensive and highly customized equipment, your should set your risk of non-payment by ensuring the initial installment from China will cover all of your manufacturing cost. The risk for final payment is then limited to your potential profits, and not to your out of pocket costs in material and labor.

A similar approach should be taken in other fields. For example, license payments may be split into a beginning of year fixed payment, with a variable payment based on sales or earnings paid at the end of the year. This approach ensures you will receive at least some payment to cover your costs and give you a basic level of profit. It is never advisable to depend substantially on a final payment from a Chinese company; it is almost always better to agree to a smaller, secure fee than to seek a higher fee that shifts payment risk away from the Chinese side.

There is always payment risk when dealing with payments from Chinese companies. To succeed in selling to Chinese entities, you must recognize the risks and mitigate against those risks as described above.