In an increasingly competitive market for skilled labor, foreign-invested companies are restructuring their salary packages as a means of hiring and retaining quality staff. We outline the fundamental components of salary in China and introduce some of the structures being used by companies to increase retention and motivation levels in their staff. We also introduce the relatively new concept of outsourcing of payroll management services in China-a business that is becoming more popular as the operations of foreign-invested enterprises in China become more diversified and complex.

Compensating your employees

Presumably because of its simplicity, a large number of employers still compensate their staff using the most straightforward salary package available to full-time workers in China-a fixed monthly salary with no extra incentives or tax-optimization strategy. Each month, mandatory social security contributions are deducted from each Chinese employee's gross salary and individual income tax (IIT) levied on the balance. These contributions do not apply to foreigners. The employer is then required to make social security contributions on behalf of employees as well. Usually mandatory employer contributions total about 40-50 percent of an employee's base salary. There are a lot of factors contributing to the exact proportion; these are examined in the accompanying article Social Security in China.

Annual bonuses

Many foreign-invested companies in China pay annual bonuses to staff. Sometimes these will be a pre-determined, fixed amount known as the 13th or 14th month salary. Other times they will take the form of individual or corporate performance bonuses. These kinds of bonus perform two main roles:

1. They provide staff with extra income. Bonuses are often paid before the Chinese Spring Festival, when local staff will traditionally spend more money than in an average month.

2. The Chinese tax system offers a special treatment for payment of annual bonuses. Once a year, a lump-sum payment to staff can be divided by 12 to derive the taxable percentage for payment of IIT. For employees, this can work out to be more tax-efficient than receiving a flat salary throughout the year. Here is an example:

An employee based in Dalian receives a monthly salary of 10,000 yuan, giving them an annual salary of 120,000 yuan. After deduction of mandatory social security, assuming it is an amount of 1,687 yuan, their monthly income is 8,313 yuan. A further deduction of 2,000 yuan gives a total on which to base their taxable income each month. According to IIT calculation rules, their monthly tax burden will be 888 yuan. Therefore, in the absence of any kind of bonus, their annual tax burden will be 10,656 yuan.

But if that employee receives a flat monthly salary of 9,000 yuan with an annual bonus of 12,000 yuan while still totaling an annual salary of 120,000 yuan, every month their taxable income will be calculated by subtracting the social security contribution of 1,687 yuan and the deduction of 2,000 yuan. Therefore their monthly tax burden will only be 688 yuan. This annualizes to 8,256 yuan. They will also have another IIT payment to make on their annual bonus. This will be calculated by dividing 12,000 yuan by 12, which equals 1,000 yuan. The percentage of tax payable on this annual bonus is set by referring to the monthly taxable bracket for employees earning 1,000 yuan, or 10 percent. After taking deductions into account, their tax burden is 1,175 yuan, and the total IIT contribution for the year will therefore be 9,431 yuan.

As you can see, by paying an annual bonus on top of a lower flat monthly salary the tax burden for the employee is reduced. In the example above, the amount of the reduction is 1,225 yuan, or 11.5 percent of the original tax burden. The company should balance this tax advantage with the downside-employees may leave the company immediately after receiving a large bonus. It is no coincidence that March is the peak time for job-hopping in China, and a large exodus around this time can cause operational problems in the following months.

Employers should note that this one-time annual bonus could be made up of several components: fixed bonus, individual bonus and corporate performance bonus. The critical factor is that the amount is reported to the tax bureau in one lump sum, and therefore it should be paid in the same month to receive this special treatment. Some companies combine a modest fixed bonus with an additional performance bonus. The individual bonus can be set high for employees that the company would like to retain and make lower for poor performers.

It is important to bear in mind that details of bonuses paid to employees should be kept confidential. This is one key reason why outsourcing of payroll is becoming increasingly popular. Using this method, it is possible to restrict details relating to salaries and bonuses for senior employees to only the human resources (HR) manager. Some organizations even prefer to base their HR manager abroad, liaising with a professional third party provider to ensure maximum control and confidentiality over the process.

(This article will be continued in Issue No. 1, 2009.)