Dan Harris wrote a pretty good overview of the risks of paying an individual as a sourcing/QC employee in China.

He relates a recent change he noticed. (On our side, we also heard that controls on incoming flows of money have gotten much tighter over the past 2 months.)

China banks (owned by the Chinese government) are providing information to China’s tax authorities regarding account-holders who consistently receive money from foreign companies. China’s tax authorities are apparently going to these individuals and pressuring them into spilling the beans on why they are receiving their funds from overseas. Upon learning of a foreign (usually American) company that has “employees” or “independent contractors” in China, the Chinese government pounces.

Dan reminds us of some legal realities that most foreign buyers ignore:

Chinese law limits hiring China-based employees to only Chinese legal entities. […] This means that if you are a British company that has your products manufactured in China, you cannot hire someone in China to do your quality control for you.

Why is it a issue in China to pay an individual sourcing employee?

Any person (as opposed to a registered China business entity) performing employment-like services for you in China is your employee because China does not recognize independent contractors in anything other than extremely limited circumstances (and your circumstances do not qualify!). And Chinese law requires you pay both employer taxes and benefits on that employee. These employer taxes and benefits vary from city to city, but they usually total around 40 percent of an employee’s salary. China also mandates employers withhold around 15 percent of their China-based employees’ wages for individual income taxes. […]

So when all is said and done, the foreign company owes a heck of a lot of taxes to the Chinese government, plus steep penalties, plus interest.

And, generally, how does this blow up in the foreign company’s face? Here is one way that is, in my observations, pretty common:

The other example was a US company that used its China operations to source and to oversee the manufacturing of licensed products for a very large US entertainment company. The US company owner was denied a visa to go to China and his employees in China used that as an opportunity to take over the China operations and they did so pretty much without missing a beat. They went to the US entertainment company and offered to continue with “business as usual” but at prices 20 percent lower than they had been. The US company said yes and the US company owner wanted us to sue. But sue whom and where and for what? How can you sue someone in China when you have never had a company there and everything you have done there has been completely illegal?

And here is another way it sometimes blows up:

One, we are hearing of long loyal “contractors” going to their employers and saying that if their employer does not double or triple their pay, they will report the foreign company to the Chinese authorities because their doing so will get them a tax amnesty (and perhaps even a portion of the taxes collected?). We are also hearing of vendors with whom the foreign company has no beef making essentially similar threats. Two, and most importantly, we are hearing that the Chinese government is poring over bank records and questioning people (your “employees”) who regularly receive funds unreported funds from overseas.

Dan then explains that foreign companies have several options, including setting up a legal entity in the form of a Wholly Foreign Owned Enterprise (WFOE). That’s good advice when it makes business sense.

Yet another option is to work with a professional sourcing agency. It might cost more in direct fees, but it usually more than pays itself through the lower incidence of serious issues.