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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.
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.
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.
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.
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.
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.