China

Why 'Sort Of Legal' Is Not Where You Want To Be In China

Going "half-legal" in China is not only riskier than operating legally, but also riskier than operating completely illegally. Here's why.

By  
on

It is neither easy nor cheap for a foreign-owned business to operate legally in China. The following is the most basic list of what you need to do:

  1. Determine whether your business model is legal for a foreign business in China.
  2. Form and register your legal entity in China. This will typically be a WFOE, a Representative Office, or a Joint Venture.
  3. Lease property (technically, a prerequisite for the registration process above).
  4. Draft an employee manual and execute written employment agreements with all of your employees.
  5. Open a bank account with a Chinese bank.
  6. Figure out and pay all of your taxes, including company taxes, employee taxes, and social insurance payments for your employees.

Doing the above will not be cheap or easy. But it is necessary.

As China is becoming wealthier (a continuing trend despite its recent slowdown), its need for service businesses is multiplying rapidly. Chinese companies are wooing Western companies with a promise of a quick and cheap (if not free) start in China, with eventual riches to be made from China’s still-thriving consumer market. The Chinese company convinces the American company that there is demand in China for the American company’s service or product and the two companies should work together to market the service or product in China.

A typical scenario plays out as follows: The Chinese company convinces the American company to let it handle everything. The American company then leases space from the Chinese company, and the Chinese company hires a couple Chinese employees on behalf of what it calls a joint venture and puts the American company’s name and logo on an office door. Voila, the American company now has a business in China.

Except it doesn’t.

In “Forming A Chinese Company. Do It Right Or Do It ALL Wrong, But Don’t Do A Rep Office,” I wrote about Americans who form illegal Representative Offices because forming a China WFOE is too time consuming and expensive:

Sponsored

I get the sense that those contacting our China lawyers on forming a Rep Office (when only a WFOE would be legal) are hoping they have found THE loophole nobody else has found and if they can get the blessing of an attorney for what they are doing, their operating illegally in China will somehow not be “so” illegal. I wish I had some magic oil I could sell to sprinkle on these sort of illegal China businesses to make them legal, but I have no such thing.

I went on to write of how going “half-legal” is not only riskier than operating legally, but also riskier than operating completely illegally:

As lawyers we are never going to tell our client to go full illegal, but in my role as a blogger, I can state that going full illegal in China usually makes better sense than paying a lawyer and then operating half-on and half-off the grid. I think people know this, but their rightful discomfort at operating illegally makes them want to clutch on to something that can justify (however falsely) their actions.

The same holds true with forming a Representative Office when a WFOE is required. Forming a Representative Office in this situation just lets the Chinese government know where you are and what you are doing and thereby makes it easy for them to realize that what you are doing requires a WFOE and your doing it as a Representative Office is illegal.

But what really drives me crazy about all this is that on many occasions, companies for whom we have refused to form Representative Offices smugly tell us that some other company is willing to form the Representative Office for them, as though this somehow means we were wrong in declining to take money to do something we know will eventually fail.

The quasi-partnerships with Chinese companies I described above are just as illegal, and having a relationship with a Chinese entity is almost certainly not going to help you when the Chinese government finds out. It is also not going to help you when one of your employees sues you and is able to point out that you do not really exist in China.

Sponsored

Whenever I learn of one of these “fake” joint ventures, I suggest the Western company immediately register its trademarks in China because that trademark is being used in China already, but without any protection. More than once, the American company has responded by assuring me that everything was fine because their Chinese “partner” had helped with trademark registration and more than once we quickly determine that the registrations had been done in the Chinese company’s name, not that of our new client.

The biggest risk with these quasi-partnerships is that when they become profitable, the Chinese company (either directly or indirectly through the government) often simply boots out its Western partner. And when that happens, the Western partner usually has no legal recourse to stop its Chinese partner from taking over the business. If the Western company sued the Chinese company in a Chinese court (pretty much the only place that might hear the case), what would it even say? “Your Honor, I know my business was here in China completely illegally, but that is because starting up a business legally here is just so difficult and expensive, but now that the business is worth millions, it just is not fair for me to get kicked out of it and for my Chinese partner to get the whole thing.”

Good luck with that.

I also must note that every single time we’ve been retained to clean up this sort of situation in China, the Chinese partner insists to our client that bringing in lawyers is a complete waste of time and money. What else would you expect them to say?

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.

Topics

, , , ,