It has been a common practice for U.S. employers to send foreign employees to work for subsidiaries in China on a secondment basis. A secondment arrangement is where the employee maintains his or her employment relationship with the U.S. employer, but provides services to the Chinese subsidiary. In many locations in China, the foreign employee is able to obtain a work permit on this basis. The main advantages of a secondment arrangement over having the subsidiary hire the foreign employee is that it avoids bringing the employment relationship under Chinese law, which is very employee friendly, and it allows the employee to continue to participate in home country benefits.
However, in recent years, the Chinese tax authorities have scrutinized secondment arrangements more closely to determine if the U.S. employer has created a permanent establishment in China. If the tax authorities determine that a permanent establishment has been created, this will have Chinese tax implications for the U.S. employer.
The State Administration of Taxation recently released Bulletin  No. 19, “Announcement on Issues Concerning Levying Corporate Income Tax on Services Provided by Non-residents through Seconding Personnel to China” (Bulletin 19) to provide guidance regarding permanent establishment issues arising from secondment arrangements. This went into effect on June 1, 2013.
If a secondee is deemed in substance to be the employee of an overseas entity instead of the Chinese entity to which he or she is seconded to during the period of secondment, the business activities are treated as a taxable establishment (what is called a permanent establishment, or PE) in China. In such case, the income generated from the permanent establishment is subject to corporate income tax in China.
Bulletin 19 sets out a primary factor and several reference factors for determining whether a PE exists. The primary factor focuses on the employment relationship. If the overseas entity bears any portion of the responsibilities and risks for the work performed by a secondee, and regularly evaluates his or her performance, the arrangement will, in principle, be considered to create a PE.
The following are the five reference factors that focus on the financial arrangement of a secondment arrangement:
- The Chinese subsidiary pays the U.S. employer management fees or makes payments in the nature of service fees
- The payments made by the Chinese subsidiary exceeds the secondees’ wages, salaries, social security contributions, and other expenses borne by the U.S. employer
- The U.S. employer does not pass on all the related payments made by the Chinese subsidiary to the secondee
- Individual income tax in China is not paid on the full amount of the secondee’s wages and salaries borne by the U.S. employer
- The U.S. employer decides the number, qualification, remuneration and working locations of secondees in China
If the primary factor and any one of the reference factors are satisfied, the secondee will likely be considered an employee of the overseas entity providing services in China. In such case, this arrangement could have corporate income tax and business tax implications for a U.S. employer.
Given the tax risks, should U.S. employers abandon secondment arrangements?
Absolutely not. There are risks associated with putting employees under a Chinese law governed employment contract as well. It is extremely difficult to terminate employees in China and in most cases, employers need to mutually agree the termination with an employee. This involves a discretionary financial payment to get the employee to agree to the termination, which is often a multiple of an employee’s monthly salary. If the employee is a senior level employee, as often is the case with secondment arrangements, a termination will be very expensive for a U.S. employer. Each individual secondment arrangement needs to be evaluated to balance the tax and employment risks.
Bulletin 19 is essentially indicating that if a seconded employee is in substance over form an employee of a Chinese subsidiary, then despite the continued employment relationship with an overseas company, this is not the type of arrangement the tax authorities are targeting. Secondment arrangements continue to be a viable option for sending U.S. employees to China subsidiaries if structured correctly.
Bulletin 19 indicates that the tax authorities will look at the following to determine if the primary factor and any reference factors have been satisfied:
- The contract or agreement between the Chinese subsidiary, the U.S. company and the secondee
- Rules for the management of the secondee, including those regarding their responsibilities, job description and performance reviews
- Payments made by the Chinese subsidiary to the U.S. employer relating to the secondment and how they were treated from an accounting perspective
- Chinese individual income tax paid by a secondee
- Hidden payments made by the Chinese subsidiary that could be related to the secondment arrangement (offsets, forgiving debt or third party transactions)
Secondment arrangements continue to be an important option for U.S. companies sending their employees to work for their Chinese subsidiaries. However, given the increased scrutiny of secondment arrangements by Chinese tax authorities, it is now more important to carefully structure these correctly than it has been in the past.