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By Matthew, February 5, 2010 11:24 am

In China, past lenient tax practices resulted in the development of poor tax practices. One in particular has been the practice of splitting employees salaries into two components (on-shore and off-shore) with only one being reported (the on-shore component) to the tax authorities in China. Where the employee was a foreign expatriate, depending upon the tax laws of that employee’s home country, this could result in a significantly lower overall tax burden for that employee. It was also not uncommon, and still is not uncommon, for local employees to have a portion of their salary paid off-shore, usually in a Hong Kong bank account. Using this method, employers could get away with paying an amount below what the market demanded because the employees’ after tax income would still be comparable with the after tax income they would have received had the employer paid them gross  salary commensurate with the market value and not used such an arrangement.

The problems with such a strategy

In China’s tough new tax environment such arrangements as described above carry with them significantly increased risk, for both employers and employees, than previously. Despite once being relatively pervasive, such an arrangement is not a legitimate form of tax planning – it is tax avoidance pure and simple. At the very least, all employees should be aware of this and be provided with a sufficient understanding of the risks that they bear by accepting it. As the saying goes, ignorance of the law is no excuse. This is particularly an issue if the relevant employment contract, as nearly all contracts with respect to such arrangements do, contains a clause indicating that appropriate payment of taxation liabilities is the responsibility of the employee. Such clauses will make it difficult to raise an ignorance argument by the employee if the arrangement is later subject to investigation by the authorities. From the employer’s perspective, such clauses provide absolutely no protection and are effectively pointless. Employers, as withholding agents, have an obligation to withhold and remit tax to the tax authorities in accordance with Article 5 of the Provisional Measures on Withholding Individual Income Tax. A clause in an employment contract cannot alter this legal requirement.

Solution

Smart employers should adopt a remuneration strategy that complies with current tax regulations and also maximizes the organization’s overall recruitment goals. Competitive packages can be assembled that meet the overriding objective of reducing costs and that do not rely on the crude arrangements outlined above. When formulating a remuneration strategy, particularly in respect of localized foreign expatriates, employers should look at the overall cost of employment and work with the employees strike a balance between cash and non-cash benefits. China’s individual income tax regime provides various opportunities for flexible remuneration strategies.