China, Tax Law

China's Slowing Economy Means Its Tax Authorities Are Coming After You

The key to foreign companies weathering China's economic slowdown will be to focus on scrupulous regulatory compliance and not assume that a slowdown won't affect its business.

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The Chinese government is stepping up its tax collection efforts in response to the country’s slowing economy. This has led the government to go after American companies with off-the-grid “employees” in China.

Chinese law allows only Chinese entities to have employees based in China. This means that if you are an American company selling widgets, you cannot hire someone in China as your employee to sell widgets for you. This means if you are an American software company, you cannot hire someone in China to do your coding or to provide your support services. But what many American companies fail to understand is that a person (as opposed to a legitimate registered business entity) who performs employment-like services for you in China is your employee because China essentially does not recognize independent contractors.   

Here’s how the taxation situation typically shakes out for American companies with Chinese “employees.”

An American company retains someone in China to sell its products or services in China. The American company pays this person in China every month. Eventually, the American company hires a few more people in other Chinese cities to sell its products or services in those others cities.

The above scenario creates three big China tax problems for the American company. First, employers of China-based employees are supposed to pay employer taxes and benefits, and the American company is not doing so. These taxes and benefits vary from city to city but they usually total around 40 percent of the employee’s salary. Second, the American company should be withholding a certain percentage (around 15 percent) of its China-based employees’ wages, but is is not doing that either. Third, the American company is doing business in China (it has employees in China and it is making sales there), and so it should be paying income tax on its profits (figure around 25 percent).

The Chinese tax authorities almost inevitably discover that the American company is not paying the above taxes, usually stemming from one of the following:

  • The tax authorities discover that one of the American company’s employees did not pay his or her income taxes, and they trace that back to the American company.

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  • The tax authorities learn about the American company’s China presence from deductions taken by one of the American company’s China customers.
  • The tax authorities learn about the American company’s China presence when one of its customers requests to be able to wire funds to the American company.
  • The American company terminates one of its employees or has a tiff with one of its customers, and that employee or customer reports the American company to the China tax authorities.

The Chinese tax authorities then demand that the American company pay all back taxes, plus interest, plus a steep penalty.

The American company at this point must usually pay the back taxes or leave China entirely, never to return.

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Our advice to companies that come to us after having been caught by the tax authorities is to try to negotiate a lower tax bill and pay it. Companies that cannot or will not pay all that they owe in back taxes, interest, and penalties should get all of their people out of China (and never return) so that the government cannot hold any of them until the company’s tax debt is fully paid.

The best advice is, of course, never to allow yourself to get into such a risky situation in the first place. If you are right now paying your China workforce off the grid, your best tactic is usually to self-report to the authorities because they typically will be more lenient on interest and penalties than if they catch you. Beware though that your China workforce will likely tell you not to do this because they will be concerned about their own outstanding liabilities.

Also, as we discussed in Buying a Chinese Company? Why China Deals Don’t Get Done, putting your China employees onto the China tax grid typically means doubling your payroll:

That employee receiving $1000 under the table is quite happy getting paid under the table. So when you tell that employee you are now going to report his or her wages to the government, that employee will demand a raise. The employee has not been making employee contributions, and if my client reports him or her to the Chinese government as a wage-receiving employee, that employee’s tax-free ride is going to end. I told my client to expect to need 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 to the government, or 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.

The key to foreign companies weathering China’s economic slowdown will be to focus on scrupulous regulatory compliance and not assume that a slowdown won’t affect its business.

Dan Harris is a founding member of Harris Moure, an international law firm with lawyers in Seattle, Chicago, Beijing, and Qingdao. He is also a co-editor of the China Law Blog. You can reach him by email at firm@harrismoure.com.

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