Why Audit is Important When Closing a China Business

October 4, 2011 Posted by China Briefing Reading Time: 6 minutes

Keeping a business dormant in China is not a viable option

Op-ed Commentary: Chris Devonshire-Ellis

Oct. 4 – With a difficult and uncertain immediate outlook to the global economy, and China still yet to deliver on its latent promise of a buoyant domestic market, some businesses hoping to ride a mini China boom are finding it difficult to make inroads to profitability at this time. The difficulty here is the choice of riding out the downturn, potentially incurring losses for a while longer, or closing up until the markets look positive again.

It is of course a financial, not legal decision to take, and the circumstances and attitude towards this will differ from investor to investor. As a China investor myself – I founded Dezan Shira & Associates in 1992 – I have considerable experience in the China market overall. That it is not always easy is an understatement, that period to date has included the Global Financial Crisis, the Asian Financial Crisis, birdflu, SARS, and many other difficulties caused by operating in an emerging, and often strangely regulated China. My personal view is to stick it out when things get tough. As an example, when the firm opened its Dalian office several years ago, we did so for the first time with an external investor. An American, he then proceeded to take all our sourced enquiries for the region and put them through his own consulting firm. It took three months to spot it (during which time my attitude towards this man turned from benevolent, to incredulous, and then to anger) and we lost a lot of money and time as a result of his deception. But rather than close that office (I’ve never closed an office in China, and we now have 12), I severed the relationship with the partner, swallowed the losses, and persevered. It took another three years to get it right, but now that office is profitable and a major asset. But it did take some sticking to guns and absorbing some losses to get there. I view current global difficulties and uncertainties in the same way – if you can, stick it out.

However, when faced with the choice of sticking with it while incurring losses, and closing a position in China, these two scenarios are really the only workable options. I’ve noticed blog commentary elsewhere that suggests running down an operation, laying off staff, and just keeping it ticking over. This may look nice on a free view blog, but it doesn’t work in reality. The reasons for this unworkability are quite simple, and are especially true of WFOEs and other light manufacturing entities. This is why it (as has been suggested elsewhere) is a very bad idea to run down an existing, loss-making business as opposed to putting it out of its, and your shareholders, misery. I identify the salient points as follows:

1) WFOEs (and most foreign-invested China investments with the exception of RO and some partnerships) are limited liability companies. This means that if they have become insolvent, there are well-defined legal and audit procedures in place that permit the use of limited liability status to limit total losses to the amount of the injected registered capital. The importance of registered capital is that it also represents limited liability status. It takes an audit to prove this, but that is why limited liability status exists. China has, and abides by, limited liability status laws that in effect protect the insolvent from further damage – as long as any debts have not been illegally obtained, in which case criminal or civil charges may follow. But assuming it is a genuine case of simply going broke – and many businesses in China do each year – it is a case proving debt versus assets and following China’s insolvency laws. An audit is a pre-requisite as it is proof that any debt was legally obtained. Under the correct procedures, investors may liquidate to the extent of limited liability and no more. If creditors have not had the good sense to examine your limited liability status – then that is their look out, not yours. Following audit and liquidation processes are a passport out of insolvency and debt with the minimum amount of fuss and with China’s own regulations on your side. That’s not to say it isn’t painful, because emotionally and financially it is – after all, money has been lost, and not just by you. The best thing however is to bite the bullet and live to fight another day. Becoming insolvent is not the end of the world. Surviving to fight again is what matters.

2) Keeping an insolvent business operational just adds to ongoing losses. To maintain a business license requires a registered office (or factory) and this involves continuing to pay rent – a major expense. Why continue this? You are under no legal obligation to your landlord other than, if necessary, to make him a creditor.

3) Keeping a business operational still means it incurs tax liabilities. These include business (turnover) tax, and other obligations. These may be minimized by running the business activity down, but are also likely to be subjected to questioning by the local authorities – and specifically the tax bureau. In many instances where this has been tried, the tax bureau often challenge the audit and if profit levels are considered too low in comparison with previous years, may either request a liquidation to settle affairs, or impose a taxable amount due, thus negating any attempt to run the operations down while still maintaining the license. China is generally not in favor of supporting “dormant” companies and will usually insist they die, close their tax and financial accounts, or survive and continue to pay tax. There is very little maneuvering for a third option.

4) Running a company down means laying off staff. This means severance pay, which can be a huge amount. It is far better to offset this against the limited liability status than to bear the full costs of redundancy, especially if the company is insolvent anyway. This may need to be negotiated, and an injection (if truly insolvent) may need to be made to pay salaries. Most honorable investors would not have let things get to this stage in any event, but if you’ve truly been caught out, this is a (tough) negotiable issue, and one best handled by hiring an insolvency expert to argue on your behalf. It’s not necessary for the foreign investor to be physically present, and if negotiations are going to be awkward, probably a good idea if they are not. However, if it really gets down to it, the local government will usually step in on the workers behalf to top up their losses. This happened a lot in Guangdong Province for example when many Hong Kong and Taiwanese invested garment manufacturers went broke. Unable to pay redundancy, the local government stepped in and paid up workers funds instead.

5) Investors like to have clean investment stories and clean money. Exiting China is a bureaucratic nuisance, but the protocols and procedures are well established, and they allow foreign investors to exit with a clean sheet. However, to do this, an audit must be gone through in order to demonstrate the inability of the business to carry on at that particular stage. Quite simply, although it costs money to go through an audit, keeping the business alive means having to go through an annual audit each year in any event. It doesn’t make any sense when with one closure audit the whole thing can be put to bed.

6) It is the audit that is key to solving serious financial problems in China. Assuming the tax bureau accepts the audit filings and the correct insolvency procedures are gone through, there are no further operational expenses that continue to add to an existing loss. With an audited set of accounts and an officially recognized liquidation, foreign investors are free to leave, no strings attached, and are also welcome to return to China at a later stage. Suggestions that this procedure need not be gone through make no financial sense, are unworkable, and at worst, illegal. The Chinese government has already stated that it intends to seek prosecution for foreign executives and legally responsible persons for not properly meeting statutory obligations when closing a business in China. It is not a good idea to try and circumnavigate around China’s rules in this regard. As always in China, it remains preferable not to attempt ill-advised short-cuts advertised on blogs, and especially when dealing with China legal and financial matters. Procedures exist to limit liabilities in China, and the law and regulatory administration exist to uphold them.

Chris Devonshire-Ellis is the principal of Dezan Shira & Associates. He established the practice in 1992. The firm advises foreign investors on their presence in China, including establishment, compliance and tax advice. The firm also provides advice concerning dealing with insolvency and passing through the liquidation process. Dezan Shira & Associates are also able to review existing company statements and give advice over continuation as a going concern and remedial measures needed to get a foreign invested business through a rough patch, or whether liquidation or downsizing is the best option. Please contact the practice, in full confidence, at info@dezshira.com.