Forming a China WFOE and Then Operating Illegally

China lawyers
Halfway for a China WFOE is not good enough. Photo by Jacqui Sadler

Earlier this week, I wrote about how China’s economic slowdown should impact how you do business in China and even with China. Today I focus on why this slowdown (and if you are an American company, the US-China trade war which is precipitating that slowdown) are why now is not the time for you to be operating quasi-legally in China.

And yet, there seem to be as many companies operating this way in China right now. For nearly a decade now, we have been stressing the need to have a WFOE if you are going to be doing business in China. Along these lines we have stressed again and again how independent contractors are almost never legal in China and how if you have “employees” in China you need a WFOE. For more on this and for how our tone on this has become increasingly strident as the Chinese government has consistently and unrelentingly stepped up both its enforcement of this requirement and the penalties for failing to comply. For more on this, check out the following posts from the following years:

  1. Doing Business in China Without a WFOE: Will the Defendant Please Rise. In this post from August, 2018, we wrote about how our China lawyers are increasingly hearing of foreigners getting arrested and imprisoned for operating in China without a WFOE.
  2. Doing Business in China with Deportation or Worse Hanging Over Your Head. In this post from March, 2017, we wrote about how our China lawyers were increasingly hearing of foreigners (especially Americans) getting deported from China and being cut off from doing business in China for having operated in China without a WFOE.
  3. China’s Tax Authorities Want You. In this Forbes article from May, 2015, I wrote about how our China lawyers were increasingly hearing of foreigners getting hit for massive taxes for having operated in China without a WFOE.

With all the pressure to have a WFOE in China, our China attorneys are now increasingly hearing of foreign companies forming a China WFOE but then continuing to operate illegally in China. This is more common than you would probably think and it also seems more common than ever.

Let me explain.

Forming a WFOE is not the same thing as operating legally in China. In fact, it is so different that around a decade ago my law firm made the decision not to simply form WFOEs for clients and then walk away. At that time we ceased doing what we called pure WFOE formations. Instead, if anyone wanted us to form a WFOE for them, we would do so only if they retained our law firm for what we called a WFOE formation package. Our explanation for this was that operating legally in China with a WFOE requires a lot more than just a WFOE and we did not want to charge clients to form a WFOE only to have them get in trouble with China’s authorities for operating illegally. One of the things we always (as in 100% of the time) require as part of our WFOE formation work is what we call our China employment package, which consists — of among other things — our drafting dual language China-specific employment contracts for all WFOE employees and Employer Rules and Regulations to go with those. See China Employer Rules and Regulations: A Must Have No Matter Your Size.

Unfortunately, many law firms and companies that do WFOE formations are not concerned with launching China WFOEs that operate illegally from day one. I say this because in the last year or so our China lawyers are hearing more and more from foreign companies with WFOEs in China that are operating illegally in China. I find this very distressing because it strikes me as so illogical. Why spend the substantial time and money to form a WFOE if doing so is not going to make you legal in China? Why form a WFOE telling the Chinese government that you are there only to make it so much easier to be discovered for operating illegally.

What are these WFOEs doing illegally? Two main things, both centered around trying to reduce costs by avoiding taxes. One is setting up a WFOE and doing various things to illegally reduce the WFOE’s income taxes. We get maybe one call every six months from someone caught for this and we tell them that the only solution is to try to negotiate down the total figure for back taxes, interest and penalties, and to do that from outside China. The other thing is China WFOEs that hire China “employees” through their foreign company and not through their WFOE. They do this to avoid having to pay the approximately 40% on salaries China employers are to pay in employer taxes and benefits and to avoid having to withhold the approximately 20% they are to withhold on behalf of their employees for their employees’ individual income taxes.

Way back in 2010, we did a post, Operating Illegally In China. Half-Assing It Does Not Help. In that post we explained how operating quasi-legally so greatly increases your risk of getting caught that you would actually be better off operating fully illegally. Back then, the issue was forming a company with a Chinese citizen (which though less common today than back then, is still an issue). Here was our position on that back then (and now too):

Legally, you pretty much cannot go into business with Chinese citizens without a joint venture. China recently started allowing partnerships, but the impact of that is still not clear.

You pretty much have two options:

1. You form a WFOE and you own it. Forming a company in Hong Kong is no different for China purposes than forming one in the United States, so forget about Hong Kong for a moment. [For an update on why having a Hong Kong company does not cut it, check out American Companies in China without a WFOE and the Impact of Donald Trump and US Tariffs and Why Hong Kong is not the Answer.] Forming a WFOE can be very expensive, in large part depending on the Chinese city in which you will be forming it.

2. You let your fiancé, her mother and cousin own the entire business. You do this and you are exposing yourself to losing whatever you put into the business. Twice, I have had men break down and cry right in front of me because they went into business with their fiancée and her family and they put 3-8 years of their lives into the business, only to be completely and unceremoniously booted out once it really started to make the big money. These are just the ones who cried. I can tell you about the guy who invested millions in condos with his fiancée and her mother, only to leave China for a few weeks and return with all of the condos sold and his fiancée and mother in law gone. Vanished.

My emails often lead to pushback, with the person complaining of how China makes things so difficult for the “little guy” and then their explaining how they know of how these things usually turn out for the foreigner, but in their case it will be different because:

a. Their girlfriend/fiancé/wife’s family would never be anything but above board.

b. Their girlfriend/fiancé/wife’s family is so “connected,” it makes sense for them to go into business with them.

They then usually ask us to write up a contract that protects them “as best as possible.” We tell them that we will not do that because those contracts are usually not enforceable in China and we are not in the business of writing contracts we know will not work.

In that same post I wrote about an email to me from my co-blogger, Steve Dickinson, to me, which went as follows:

If these people are going to go illegal in China, they should go 100% illegal. That is, enforcement either through really strong family connections (your father knows her father) or enforcement through gangsters and the like. I know people who have succeeded this way but I don’t know anyone who has succeeded with an illegal contract. This is not because contracts don’t work in China, because you and I have won enough China contract cases to know that they do.

It is because the Chinese judges are totally on to these sorts of arrangements and they know they violate or seek to evade Chinese law. They therefore have and will continue to deem such contracts void. Why do people live in this fantasy world thinking that somehow they are so different or that they have discovered the solution? Why do they think a Chinese court would enforce a contract designed to evade the law?

Take an alternative example. Remember John Smith’s [yes, it is an alias] company we formed in Beijing a few years ago? Not sure if you remember this, but that investment was with his Chinese wife. However, we did that as a very formally organized WFOE and left the wife and her family with the irregular side of the deal. His US company is the only shareholder and he runs the board. His company has had no trouble and he has had no trouble because he is legal and secure. His US LLC [and with it, the China WFOE] were just purchased by _______ [a pretty big name U.S. company]. The reason the purchase was successful is that the whole company was “clean” and therefore it could be purchased by a foreign public company.

I then went on to say that “as lawyers we are never going to tell our client to go full illegal, but in my role as a blogger, I have to think going full illegal would probably make better sense than paying a lawyer to draft a void contract. I think people know this, but their rightful discomfort at operating illegally makes them want to clutch on to something that will allow them to justify (however falsely) their actions.”

We also used to frequently see the same sort of thing by companies seeking to justify operating illegally in China with a Representative Office instead of a far more expensive WFOE. We has this to say about this situation way back in 2010:

Every couple of weeks my firm gets an email or a phone call from a small business that is seeking to justify forming a Rep Office in China instead of a Wholly Foreign Owned Enterprise (WFOE). These small businesses typically go into advocacy mode explaining why their business can and should be a Rep Office in China. They then go on to explain that they simply cannot afford to form a WFOE in China due to the minimum capital requirements, the legal fees, and the taxes.

They then want me to condone their Rep Office plans but I never do.

In fact, the increasing number of these requests has caused me to get even blunter than usual, and my most recent response exemplifies this:

What you are describing doing as part of a Rep Office is definitely not proper for an RO. Not even close.

In terms of minimum capital required, because it is Dongguan, it is likely to be pretty high. Sorry.

You pretty much have two choices. You can operate completely off the grid and risk getting shut down, or you form a WFOE. Probably the worst thing you could do would be to form an RO that operates illegally because that will just draw attention to how you are operating illegally.

I get the sense that the people contacting us on these things are hoping that they somehow have found THE loophole that nobody else has found and that if only they can get the blessings of an attorney for what they are doing, that their operating illegally will somehow not be illegal. I wish I had some magic oil I could sell (for a helluva lot of money) that I could sprinkle on illegal China businesses to make them legal, but I have no such thing.

Those who think they are going “sorta” legal by forming what is clearly an illegal Rep Office in China are very similar to those who think they are “sorta” protecting themselves legally by doing a “sorta” joint venture with their girlfriend. I wrote about those people in a post, entitled, “Operating Illegally In China. Half-Assing It Does Not Help.

I went on to explain how forming a Rep Office that then operates as though it were a WFOE “will just serve to let the Chinese government know where you are and what you are doing and will make it easy for them to realize that what you are doing requires a WFOE.” I then made clear my frustration with these sort of quasi-legal schemes:

What really drives me crazy about all this though is that on at least three occasions, companies for whom we have refused to form Rep Offices have written to tell me that “so and so” entity formation company is willing to form the Rep Office for them, as though this mere fact means my firm was wrong in declining to take money to do something we know will eventually not work.

And though I take no happiness from this, I will note that one of the three companies that went ahead and formed a Rep Office against our advice did contact us about a year later to tell us that the Chinese government was now making them form a WFOE.

It is frustrating to hear about the latest round of foreigners believing that going half-way with their China WFOE is enough, especially as most of these people we are hearing from do not even know they are operating illegally because they were told otherwise by the “experts” they hired. These companies that are hiring and paying their China employees outside their WFOEs seem to believe the following make what they are doing legal, but they don’t:

  1. Setting up a Hong Kong business and paying the employees from that. Wrong. This is no different than paying your China employees from the United States. If you are going to have employees in China you need to pay them through a legal China entity, not from overseas. See Having A Hong Kong Business Does NOT Make You Legal in Mainland China. See also, China Expat Pay: Splitting with Hong Kong is 100% Illegal and 200% Dangerous.
  2. Hiring only expat employees in China. Wrong. Expats working in China need to work for a legal China entity just like everyone else.
  3. Hiring only Hong Kong or Taiwan (or Singapore?) citizens. We have heard this one many times over the years, in large part because citizens from these places often claim to their employers that they can and should be treated differently because they are from these places. Wrong. A China-based employee is a China-based employee and a China-based employee needs to work for a legal Chinese company, be that a WFOE, a Joint Venture or a Chinese domestic company. Yesterday, in China Employment Law Update: China Work Permits no Longer Needed for Taiwan, Hong Kong and Macau Residents, our lead China employment lawyer, Grace Yang, wrote about how citizens of these places no longer need work permits to work legally in China. Just since then our China lawyers have received a couple emails from people who seem to believe this work permit change means people from these regions can legally work in China without being directly employed by a legal China entity. Wrong. This work permit change has no impact on this.

Doing business in China with employees in China? Don’t do it half right because you are only increasing your risk.

 

This article was written by Dan Harris and published on China Law Blog. Original Post: https://www.chinalawblog.com/2018/09/forming-a-china-wfoe-and-then-operating-illegally.html      

View the original article here.

Dan Harris

Dan Harris is internationally regarded as a leading authority on legal matters related to doing business in China and in other emerging economies in Asia. Forbes Magazine, Business Week, Fortune Magazine, BBC News, The Wall Street Journal, The Washington Post, The Economist, CNBC, The New York Times, and many other major media players, have looked to him for his perspective on international law issues.