A relaxation of longstanding restrictions on hiring residents of Hong Kong, Taiwan and Macau (“HTM”) was among a list of official changes approved by China’s State Council on August 3, greatly expanding their employment opportunities in China.

Under the pre-existing system, mainland employers had to obtain approval from three separate government agencies before they could hire staff from any of these regions, a process that normally took more than a month to complete.

The restrictions continued after employment commenced, since the work permits were valid for only two years and were non-transferable. Employees wanting to change jobs would need to find employers willing to go through the approval process. As a result, many HTM residents worked illegally in China which meant that they were not eligible for social insurance benefits such as state-subsidised medical insurance.

The State Council decision means that such employees will now be entitled to the same employment freedoms as local residents and are more fully able to obtain social insurance coverage. Under the new arrangements being implemented in cities across China, employees simply apply for jobs in China and if hired, their new employer handles all of the filings needed to register for social security and other benefits. No vetting is required.

These changes only apply to Chinese nationals and will not impact expatriate HMT residents.

So far, most commentary about these new arrangements has been focused on their supposed economic benefits, pointing to, for example, opening up China’s vast employment market access to fresh talent, particularly in knowledge-based industries. However, for HMT residents, the benefits are more personal and potentially life-changing.

First, working in the mainland, in an industry of their choice, is now finally viable since employers there will be less likely to reject these candidates on the basis of overly complicated administrative procedures. Second, these changes level the playing field for HMT residents since they are now free to seek employment elsewhere and any time without having to wait for a new employer to obtain approval.

By Dan Harris

We lawyers are known as deal-killers. Most lawyers get offended by that moniker and vehemently deny it. Me, I am more than willing to own up to it. Clients go to lawyers all excited about a deal and it is the lawyer’s job to point out the risks and to explain which of those risks can be mitigated and which cannot. I am proud of the deals I killed because my killing the deal meant I was doing right by my client. In other words, I was just doing my job.

I have put the kibosh on many a China acquisition and that is what this post is about. The following is actually an amalgamation of many such potential acquisitions, but for ease of explanation and to camouflage the identities of those involved, I have amalgamated a bunch of them into one. Trust me when I say that the following is incredibly typical, including the retirement of the owner precipitating the need for the deal.

The potential deal was for a US manufacturer that had been receiving its product from the same China manufacturer for about fifteen years. The Chinese manufacturer had been providing about 90 percent of its product output to this one US manufacturer and the two companies had a “fantastic” relationship. The owner of the Chinese manufacturer had done very well over the years and he now wanted to retire and sell his China manufacturing business to the US manufacturer.

In theory, this made complete sense.

The US manufacturer told me of its plans to buy and we briefly discussed some terms and “the numbers.” They said that the Chinese company was clearing about “a million a year” but that was not why they were buying it. They were buying it because they wanted to be sure they would be able to keep getting the product.

I then told laid out the likely reality of what was to come. I told them that if they bought the Chinese manufacturing company their profits (if any) would likely be considerably lower. I proceeded to explain why this would probably be the case.

I said that there is a good chance the Chinese manufacturer is paying half of its employees completely under the table and reporting to the government only half of what it was paying the other half. I then talked of how there is also a good chance the Chinese manufacturer is underpaying its taxes and of how its rent also may be paid under the table. I then said that this sort of thing may be all well and good for Chinese companies, but that if the US manufacturer were to buy this Chinese manufacturer, it would need to do so as a WFOE and it would then immediately be on a “whole ‘nother level” with respect to China’s various tax authorities.

I then told the US manufacturer that if it were to buy the Chinese manufacturing business, it would need to bring every single employee onto the payroll and that would likely mean the payroll expenses would be close to doubled. I then gave my estimated numbers. All of the wages now being paid under the table would need to be paid above the table and that would mean that the US manufacturer would, in turn, need to pay all sorts of employer taxes, pensions, and insurance. I told the US manufacturer to figure that these items would be about 40% of all wages. So if you have an employee who is now getting $1000 a month under the table and you then report to the government that you are paying that employee $1000, you should figure on needing to pay about $400 on that to the government.

But it gets worse. Much worse.

You see, that employee who is receiving $1000 under the table is usually quite happy to be getting paid under the table. So when you tell that employee that you are now going to be reporting his or her wages/income to the government, that employee is going to demand a raise. You see, that employee has been able to avoid having to make his or her various employee contributions and to pay his or her income taxes and your now reporting his or her income will end all of that.

You should expect needing to raise employee salaries by maybe 40 percent. So now the employee who was getting $1000 is getting $1400 and you as the employer are going to need to pay an additional 40 percent on that, which equals around $560. So all of a sudden the employee that cost the Chinese manufacturer $1000 a month is going to cost you pretty close to $2000. In other words, double.

And let’s take rent. The Chinese manufacturer is probably paying the landlord under the table and the landlord is not reporting it. Heck, there is a very good chance the landlord is not even legally able to lease out the property, but for the sake of the numbers, let’s assume that the landlord is actually authorized to lease it. If you are going to buy the Chinese manufacturer’s company you are going to have to do so as a WFOE and to get a WFOE approved at all, you are going to need to have a legitimate lease. That means that before you buy this Chinese manufacturer, you are going to need to go to the landlord and tell it that you need to get your landlord-tenant relationship “on the grid” and that the landlord is going to need to register the lease with the appropriate authorities.

The landlord will likely call you an idiot (trust me on this) and initially balk. You will then need to explain that you absolutely must get on the grid and that you are prepared to cover the landlord’s increased costs to do so. Figure on this raising your rent by around 25%. Again though, this assumes that your being able to stay at this facility is even possible.

Okay, so now that I have explained how the above will eat into your numbers, let’s talk about income taxes. You are going to have to pay income taxes on the money you make, even though the Chinese manufacturer maybe never did. Figure 25% of your profits will go to income taxes. And if you are now thinking that you are not going to have any profits, let me tell you that is likely going to matter less than you think for Chinese income tax purposes. You see, if you have no profits, the Chinese tax authorities will figure that is because your Chinese WFOE is intentionally under-pricing the product it is selling to your United States operations and it will then impute a profit to your Chinese WFOE. It’s a transfer pricing thing.

You need an accountant who understands China to look over the Chinese manufacturer’s books and to run the numbers to see if this deal is going to make sense.

A few months later, I received the following (doctored) email from our US manufacturer client:

Here is where we stand:

Our accountant is in the process of re-modeling the business from a top-down perspective, in an effort to clarify what the numbers would be for our China WFOE, while complying with the rules. We have good history on the revenue and most of the operating costs.

As you guessed, we will need to apply roughly a 2x factor to the labor costs that the Chinese manufacturer is showing, so as to properly book all of the official upcharges.

Also, as you suggested might be the case, the landlord of the factory space is not properly registered, so we will be increasing the booked rental costs as well.

The reality is that we probably will not be purchasing the Chinese manufacturing company did not sit well with its owner. He was offended when I reiterated my stance that I wouldn’t operate the business in the same manner as he has. He lost face.

A few weeks after that, I received the following email from the client (again doctored):

it is now clear that we shouldn’t consider buying [the Chinese manufacturer]. He [the owner of the Chinese manufacturer] had previously indicated that there were “a couple” more issues related to the accounting procedures. I pressed him to explain if there were any others. Of course, you know the answer to that.

In summary, it is becoming clear that we cannot be profitable in China if we follow all the rules. It is not completely clear this is really the case, since we can’t tell if [the owner of the Chinese manufacturing company] really understands the rules. What is certain is that the numbers on which we had been basing our valuations are simply not valid. The “profits” that the Chinese manufacturer was claiming to have achieved are not valid under our business model.

Amazingly enough, the US manufacturer and the Chinese manufacturer came up with a great solution which ended up working like a charm. The manager of the Chinese manufacturer bought the Chinese business and continued running it just as before and the US manufacturer and the Chinese manufacturer have maintained their “fantastic” relationship. All is well, except my law firm made a lot less money than if  the deal had gone through.

Source: “Buying A Chinese Company? Why China Deals DON’T Get Done.” from China Law Blog: https://www.chinalawblog.com/2012/01/buying_a_chinese_company_the_numbers_are_different.html 

Over the past several years, there has been a significant rise in the number of foreign-invested businesses that have been downsized or have left China altogether and this seems to be a trend that will continue as competition and the cost of doing business here increases. This article is intended as a practical overview of how to handle the closure of a WFOE.

When an investor decides that its China subsidiary is no longer sustainable, a decision has to be made whether or not to close the business or sell it. Normally, a trade sale will only be feasible if the business is profitable or a strategic investor can be found. If a buyer cannot be found, the business will need to be closed.

The preferred method for closing a WFOE (known as voluntary or solvent liquidation) involves three stages: liquidation, tax clearance, and deregistration, which altogether will require a minimum of 10-14 months to complete regardless of the industry or location of the business. The process, described below, is complicated and will require assistance from experienced lawyers and accountants.

Liquidation

This is done by paying all existing debts, including all debts to employees and to the PRC government, in accordance with a precise timetable. The process starts with the WFOE’s board of directors and, more often than not, the board of the investing entity, drafting a resolution to terminate operations and appoint a liquidation committee. This is followed by notifications to local authorities and creditors, which in turn is followed by a long, drawn-out government audit carried out by a local accounting firm. A so-called liquidation plan is generated and if, at any stage, it is determined that the WFOE is insolvent, and the investor refuses to inject additional cash, the liquidation will continue as a bankruptcy, controlled by a local court. If the WFOE is solvent, all of its assets are sold and the proceeds are used to settle all outstanding liabilities. A second audit is then carried out and a final liquidation report will be submitted to authorities for approval before tax clearance can begin.

Tax clearance

During tax clearance, the liquidation committee will be required to submit various tax returns and statutory audit reports. Depending on the nature of the business and number of years it has been operating, local tax officials may scrutinize 6-10 years of tax filings and supporting documents and will focus on any related party transactions and transfer pricing practices. Tax clearance normally takes at least 6-8 months to complete.

Deregistration

Once the WFOE has obtained tax clearance, it will cancel registrations with all of the government agencies that it registered with while being incorporated. As part of this process, the original registration certificates must be returned and a failure to find or submit any of these documents will invariably delay the process. Only after this process is completed, can any remaining funds be remitted back to the investors with the final step being cancellation of the business license.

Given that China’s liquidation process is so time-consuming and expensive, we are often asked whether it is worthwhile and whether there are any alternatives. The main advantage of closing a WFOE this way is that it avoids unpleasant outcomes such as detention of expatriate personnel and revocation of their passports. It also leaves open the possibility of both the investor and any foreign personnel being able to return to China in future. Abandoning a WFOE without liquidating it properly will invariably result in the investor being blacklisted and unable to re-establish in China and if the legal representative or other senior executives are expatriates, there is a risk that they will be detained if they return to China.

As it turns out, in most instances, there is a relatively safe, informal alternative to the above process (besides bankruptcy) but it is not sanctioned by the PRC government.

Informal Dormancy

China’s corporate laws do not officially permit the existence of dormant companies but it is possible to discharge most of a WFOE’s liabilities, effectively mothballing it until the business can be restarted or officially closed.

Investors wanting to avoid the formal liquidation process will need to first ensure that all expatriate personnel leave the country and then lay off all of the WFOE’s Chinese employees, paying them agreed severance packages and obtaining signed releases from all of them against any and all claims they might have against the business. All trade debts will need to be settled and again, releases obtained to minimize the risk of creditors later suing. Inventory and excess equipment will need to be sold and any leases that the WFOE has will need to either be terminated or let expire, whichever is more cost-effective. The WFOE will need to be relocated to a low-cost ‘address of convenience’ within the same district to cut expenses. This will be easier for non-manufacturing businesses.

The WFOE will then need to choreograph payment of all government taxes while remaining current with them. If the business was engaging in related party transactions and/or transfer pricing practices, it will be useful to engage a CPA firm to assess the amount of underpaid taxes prior to self-disclosure so the investor will be ready to challenge the official tax bill when it is issued.

Once all of the above steps have been carried out, the WFOE will still exist, but will essentially be dormant. It will be necessary to continue making NIL tax filings and pay whatever minimal ongoing taxes are levied. It will also still need to comply with all other government reporting requirements but if all of this is done properly, the cost of compliance, like the cost of the new registered office, will be minimal.

It is important to note that an informal dormancy is at best a temporary solution. Eventually, within 12-20 months – depending on the location – the local government will either start to levy higher taxes or threaten to revoke the business license. However, for many businesses, this approach defers the expense and inconvenience of liquidating the business and a decision about whether or not to remain in China. In the meantime, all major debts will already have been cleared off the WFOE’s books so that any subsequent official liquidation will be quicker and easier. The main advantage of handling the closure this way, apart from keeping the investor’s options open, is that it avoids blacklisting and still affords the investor significant control over the process.

Conclusion

Voluntary liquidations are complicated and time-consuming but avoid the unpleasantness of bankruptcy and simply abandoning the business. Informal dormancies, once rare, have become fairly common and are increasingly regarded as a ‘halfway-house’ alternative between voluntary liquation and abandonment.

None of these arrangements are for the faint of heart and are best decided on after having taken professional advice and after all other alternatives, such as a trade sale, have been considered. As with everything else related to China, careful planning is vital to the success of a business closure.