Employment Issues and Individual Income Tax in China

October 2008

For international investors looking to enter or being already established on the Chinese market an understanding of the common employment and tax practice is significant. The new Labor Contract Law (LCL) came into effect on 1st of January this year and has been designed to provide a more "employee-friendly" environment. It is important for all companies to understand their rights in terms of contractual agreements, hiring, terminating as well as other employment issues, such as personal income tax and the dangers to the individual and company should tax evasion occur.

Impact of the New Labor Law

Many foreign investors have thought that the new LCL was created to curb the expansion of western companies in China, but in reality it was set up in order to protect Chinese staff working in local companies. As an example, prior to this year a large number of Chinese employees in the private-sector did not have work contracts. Another important issue for the government is the annual public protest started by millions of migrant workers whose employers refuse to pay their salaries.

After the announcement of the new LCL, many companies tried to get rid of underperforming staff or employees considered too expensive in 2007 anticipating that this would not be as easy once the new law was implemented. Companies are affected by the new law in three major ways:

Termination of Employees
The law makes it more difficult to fire employees even though they are under-performing or being dishonest. It also makes it difficult to fire staff when the indications for misconduct are obvious but the company lacks actual proof. Under the new law, the probation period for managers and professionals is even more important. For three-year contracts there should be a maximum of three months probation period and for open-ended contracts a maximum of six months period. This time should be used by the company to give the new staff clear criteria for the performance and attitude towards work. This should then be reviewed frequently with the new employee. Attention should be paid to the end of the probation period because in case the probation period exceeds the time limit, the company will be required to pay compensation to the employee.
Employment of Temporary Workers
The new LCL makes hiring temporary workers more expensive. Temporary workers are important for all industries that have to meet seasonal demand and they typically work in production or assembly operations. Under the new law, companies are forced to hire temporary workers under the same conditions as regular workers which means they have to receive the same pay and benefits. This increases the employer's costs dramatically compared to the past. The workers are entitled to join the company's union or the union of the agency that employed them. Additionally, in case the temporary worker ends his contract before the end of the minimum contract the agency has with the worker, the agency will seek compensation from the company.
Trade Representations / Unions
Companies with over 25-30 employees are permitted to establish worker representations or unions. Larger companies will have to pay more attention to the worker's interests. Many believe that this will lead to an increase in wages and make the lay-off of underperforming staff even more difficult. However, unions are not seen as negative by all foreign investors as the unions also take care of internal disputes between individuals which frees up the management's time and resources.

General Rules for the Employment of Foreign Staff

When deciding to employ foreigners in China particular care should be given towards the application and licensing process. This is to ensure that neither the company nor the individual overlooks or neglects to comply with any regulation that may subject them to fines, revocation of working status or in serious cases, expulsion from the country.

Application of Work Permits and Residence Visas
Once arriving in China, the foreign expatriate must receive a Health Check performed by a specific government hospital before receiving the work permit and residence permit. It is important to note that employment permits and residence permits are subject to annual inspections and renewals by the local labor authorities. It is the employer's responsibility to present these documents to the issuing certificate office. Failure to observe and follow the regulations in general can lead to fines, deportation or in severe cases, criminal prosecution.

Individual Income Tax Liabilities for Expatriate Staff
Tax liabilities of foreigners generally depend on the period of time an individual spends in China and the source of income. Individuals who spend less than 90 days in one calendar year in China are exempt from Individual Income Tax if the employment income is paid by an overseas entity. Residents of countries that have signed a double taxation treaty with China may stay in China for up to 183 days (instead of 90 days) without facing any tax obligations in this case. If an individual is paid by a China entity, any income derived from working in China will be taxable.

Individuals who stay in China for more than 90 (183) days but less than a year are subject to personal income tax on their employment income derived from work performed in China - regardless of which entity is paying. A foreign individual who holds the position of Legal or Chief Representative of a China-based entity is automatically liable for paying income tax also on employment income derived from work performed outside China and paid by the China-based entity.

Individuals who reside in China for more than one year, but less than five years, are subject to Personal Income Tax on both China-sourced and foreign-sourced income borne by a China-based entity. Finally, foreign individuals who reside in China for more than five years are taxed on their worldwide income.

Expatriates who are employed by a foreign enterprise in China are liable for Personal Income Tax from the first day they arrive in China. They must file a monthly tax return as well as an additional annual return. Penalties for late filing can be up to five times the amount that was due. Foreigners are provided with a lump-sum deduction of RMB 4,800 from their monthly salary.

Remuneration Packages
When discussing a remuneration package for foreign employees attention should be paid to the fact that they will have to pay Individual Income Tax in China, because if the employee undervalues or does not pay the correct amount, it may lead to consequences for the company as well. Foreigners may receive various non-taxable allowances for housing, relocation, children's education, business travel and home leave. As a rule of thumb, these additional benefits may amount to as much as 30% of the total employment package.

General Rules for the Employment of Chinese Staff

Employees of Wholly Foreign Owned Enterprises and Joint Ventures may be employed directly by the foreign entity. However, a Representative Office is not permitted to hire their mainland Chinese staff directly, but is permitted to employ foreign personnel directly. Chinese employees of Foreign Representative Offices must be employed through an employment agency. According to Chinese officials, as Representative Offices are not legal entities, the foreign labor service market needs to be regulated and standardized in order to guarantee that welfare and social benefits are provided to the employees by the Representative Offices.

Due to the more employee-friendly labor law regulations, many of the labor service agencies are becoming stricter in their written contracts as they will have an increase in liability and risk and this means no contracts can be signed until the entity has its Registration Certificate.

The procedure for Representative Offices is that a standard contract is signed between the agency and the Rep Office. The agency will then sign employment contracts with each staff member. Labor contracts between employees and labor service companies hiring on behalf of the employer must have a minimum length of 2 years. The social insurance and personal income tax will be handled by the agency and the employee will receive their net salary every month. The Representative Office has to pay a service fee to the agency per employee per month.

Individual Income Tax Liabilities for Chinese Staff
Local employees receive a minimum lump-sum deduction of RMB 2,000 from their total salary.

Mandatory Social Insurance for Mainland Chinese Employees

The social security system is administered by the labor and social security departments. By law, all enterprises have to contribute to the system and must register with the local social insurance institution, participate in social insurance schemes and pay social insurance premiums on a monthly basis. The part that has to be contributed by the employee will be withheld and deducted from the employee's salary and be paid to the relevant authorities by the employer. It is important to note that when negotiating with the employees in regards to their salary, whether their asking gross salary includes the social insurance deduction or not.

The following types of social insurance are mandatory:

Retirement Pension Insurance
This basic old-age insurance is jointly contributed by the enterprise and the individual and will be paid out once the employee retires. In average, the contribution of the enterprise does not exceed 20% (including the portion entered under the individual's account) of its total payroll. The actual percentages are determined by the provincial governments and may vary from region to region.

Housing Fund
Contributions to the housing fund are made by the employer and the employee and the amount depends on the region. This fund is designed to assist employees with purchasing houses.

Medical Insurance
The medical insurance is also paid jointly by the employee and the enterprise. In general, the premium paid by the company is approximately 6% of its total payroll and the premium paid by the employee equals 2% of his salary. Employees receive a medical card which they can use to pay for doctor's expenses up to a certain amount.

Unemployment Insurance
In case of unemployment, individuals are entitled to this unemployment compensation. Both, the employee and the enterprise contribute to this fund, whereas the percentage varies from place to place

Workplace Insurance
The premium for the work-related insurance is only paid by the enterprise and the rates are set by the labor departments. They depend on the type of risk, the type of injury and frequency of occurrence of the occupational disease concerned.

Maternity Insurance
The child-bearing insurance benefits female workers who will receive a maternity allowance. The contribution is based on the company's total payroll and is only made by the employer.

Risks of Hidden Employees, Under-Declaring Salaries and Expenses

Many companies setup local personal accounts in China under the name of the Chief or Legal Representative or local Chinese staff to fund the WFOE or the Rep Office and pay related expenses which are not officially booked in the WFOE or Rep Office accounts in order to reduce tax liabilities. Other common practices include the General Manager or Chief Representative withdrawing money through the local ATMs from foreign accounts to fund Rep Office related expenses, under-declaring salaries, not registering foreign or local staff in order to reduce the entity's tax liabilities.

Foreign companies should understand the common practices and put monitoring systems in place in order to avoid these occurrences from happening without the company's knowledge. If the company does not officially declare all expenses through the WFOE / Rep Office account or have separate funds to finance the local activities, then firstly, it is not in compliance, and secondly there is the risk of staff turning this against the company when they are dismissed or leave the company (blackmailing and threats to disclose malpractices to local authorities are common in order to seek own financial gains). Local staff may even manipulate the company records to ensure it is not in compliance - in order to hold leverage against the company in the event of any disciplinary action being taken against them at a later stage.

Conclusion

It is important for FIEs to take these matters of employment of staff and tax declarations seriously. There are major differences between western and Chinese business practices, which make it more effective to provide employees handbooks in conjunction with employment contracts in order to convey company policy and expectations.

Additionally China is no exception to the rule that it does not like tax evasion. The penalties for late payments, non-payment and other transgressions (naivety is no excuse) can be severe - often five times the amount due, plus the original liability. In cases of blatant evasion, businesses can have their licenses withdrawn and assets seized.

If you require assistance with the above subject, please contact us at This e-mail address is being protected from spambots. You need JavaScript enabled to view it with your detailed questions.

All information in this report is verified to the best of our ability and is assumed to be correct at time of release; however, Klako Group does not accept responsibility for any losses arising from reliance on the information provided within.