A large number of foreign companies opened representative offices and established joint ventures (JVs) during the early 1990s wave of enthusiasm for investing in China. Now that these companies have been in China for the better part of a decade, often with mediocre business results, many are looking to convert their representative offices and JVs to the more promising wholly foreign-owned enterprise (WFOE) form.

The WFOE structure has several advantages over that of the JV. The absence of a Chinese partner minimizes the need for large amounts of registered capital and allows for total foreign control over management. It also provides numerous tax and customs duty benefits to the investor, particularly if products are to be exported. In 1997, the WFOE replaced the JV as China's most popular foreign investment vehicle in terms of both value of new projects and investment. In 2000, China approved 6,481 WFOE contracts with a total of $15.9 billion in contracted capital and 5,401 JV contracts with a total of $11.7 billion in contracted capital, according to the Ministry of Foreign Trade and Economic Cooperation.

When foreign-invested companies decide to upgrade from representative offices or JVs to WFOEs, they often explore the above business issues at the expense of the human resources implications. Foreign companies can avoid the delays and unplanned costs associated with human resources problems by allocating staff to this dimension of the transition. This staff can then distinguish between issues that must be handled before the transition and those that will arise after the formal transition. They also can keep abreast of relevant regulations guiding WFOE labor issues, which are spelled out by the local labor bureaus and vary by location.

Pre-transition issues

A company faces a complicated series of steps in preparing its personnel structure and operations for the transition to a WFOE:

• Labor agency contracts
  One of the first things a company should look at when considering the conversion to a WFOE is the company's existing contract with a labor agency, such as the Foreign Enterprise Service Corp. (FESCO) or China International Intellectech Corp.. China has hundreds of labor agencies, most of which operate locally and are controlled by the government — though some have ties to private Chinese companies.
  
  Companies need to understand all contract terms prior to the transition in case costs are incurred as a result of the contract's termination. For instance, labor agencies generally require advance notice before a contract is terminated. Contracts signed before 1996 or 1997, depending on the agency, often have rigid termination clauses. The standard labor agency contract also usually requires some form of severance payment (typically one month per year of service) to both the labor agency and the employee if the contract is terminated. In certain situations, the severance or termination costs may be waived, particularly if the company opts to continue using the labor agency to administer the WFOE's benefits plans.
  
  A company that decides to continue using the labor agency needs to sign a new contract that defines the new service terms. The new contract should spell out all services — which may include personnel-file maintenance, passport and visa application procedures, social insurance administration, and supplementary insurance services, among others — in as much detail as possible. (Every legally registered Chinese citizen has a personnel file, which includes birth, school, work, criminal, and other records. Only government administrators are permitted to view the files, which they reportedly review on a regular basis and during registration or application procedures, including those for social insurance.) Many companies choose to sign short-term contracts with labor agencies to leave themselves open to better offers in the future.
  
  
• Direct employment contracts
  A WFOE has the right to bypass labor agencies entirely and hire its employees directly under a company employment contract. Most companies allow employees to remain officially employed by labor agencies if they choose not to be directly hired. In contrast, representative offices may not directly hire employees, and JVs rarely do so because the Chinese partners are usually responsible for hiring employees.
  
  If they choose the direct employment option, WFOEs must pay special attention to the drafting of new employment contracts. The local government labor bureaus have a standard contract that they urge companies to use. Fortunately, WFOEs have the option of drafting employment contracts that are more suitable to their needs than these standard contracts. Local labor lawyers agree that many of the clauses in the standard labor contracts are not actually contained in the labor law and hence may be eliminated or altered. For example, companies can dictate the number of vacation days for employees even though standard labor contracts specify the number of days. In the past, companies were reluctant to make any changes to the standard labor contracts out of fear that they would not hold up in cases of dispute. They have since found that regular consultation with labor bureau officials can help avoid this problem. They have also found it useful to register contracts with the local labor bureau as part of the pre-transition process, even though this is not required before — or even after — the transition.
  
  
• Registration with authorities
  Companies are required to register with the district labor bureau, the statistics department of the labor bureau, the social security bureau (the local outpost of the Ministry of Labor and Social Security), and the municipal housing fund. These registrations must be completed in all cities in which the company will establish a WFOE or branch.
  
  
• Explaining the direct hiring process
  Foreign representative offices or JVs often take for granted that employees want to be directly hired by the new WFOE. Unfortunately, this is not always the situation, as Cisco Systems, Inc. discovered when it established a WFOE in 1999 (see Cisco Systems China: Lessons Learned). Before moving ahead with the conversion, the company should take an informal poll of the employees who may work in the WFOE. The company should then manage separately any employees with special circumstances so as not to slow down the transition process. For instance, employees who do not sign new direct contracts can be hired as contract or temporary employees but will be unable to participate in the new WFOE's benefits and other programs.

• Mandatory benefits costs
  Representative offices and JVs that use labor agencies must pay the agency a management fee ranging from $120-$200 per employee per month. Included in the management fee is the cost of an employee's benefits plan, including both mandatory employer contributions to social insurance and supplementary benefits such as medical plans (see Table). Though the management fee appears to be quite high, it does not even cover all the costs of mandatory social insurance. These labor agencies generally contribute less than the required amount of social insurance: regulations dictate that they contribute based on 300 percent of the city average earning (CAE) of the previous year, or in some locations, the employee's average monthly salary for the previous year. Instead, most contribute based on only 100-200 percent of CAE. For example, Beijing's CAE in 2000 was ¥ 1,300 ($157). The pension contribution for an employee earning ¥ 5,000 ($604) per month is ¥ 1,300 x 300% x 19% (the percentage contribution to the pension fund), or ¥741 ($90). The labor agencies contribute based on only one to two times the CAE, or ¥247-¥494 ($30-$60).

WFOEs must pay additional fees equal to 17.5 percent of an employee's salary. These costs are broken down into an education fee, a trade union fee, and a welfare fund fee totaling 1.5 percent, 2 percent, and 14 percent, respectively, of the employee's previous year's average monthly salary. While these costs need not be registered monthly on a company's profit and loss statement as an expense, they must be included in a balance sheet account on a monthly basis and spent by the end of the year. Companies may offset existing costs, such as training expenses, health spending, and company activities, against these costs — once they have obtained approval from the tax and social insurance authorities.

• Supplementary benefits costs
  The benefits plans that labor agencies provide for representative offices and JVs are typically less generous than the benefits provided by WFOEs that manage their own plans. Labor agency plans are not tailored to a company's needs, offer less flexibility in the selection of insurance vendors, and often include sub-standard benefit levels. Therefore, a company converting into a WFOE typically designs a new benefits plan that is competitive with those of companies in its labor market segment. Such supplementary plans usually include housing, retirement, medical, life, total permanent disability, and accidental death and dismemberment insurance. The cost of this new plan should be taken into consideration when planning the transition process and selecting the appropriate insurance vendor. Any insurance contract the company signs should probably be short term, because of the expected future proliferation of insurance JVs with foreign carriers and the rapid evolution of the insurance market generally.
  
  
• Administrative costs
  Part of the management fee that a representative office pays to a labor agency covers the cost of administering the employee's mandatory and supplementary benefits, payroll, personnel-related costs, and personnel-file management. A WFOE should forecast the cost of administering such a company-sponsored benefits program should it decide to employ staff directly. The new plans can be administered in-house or can be outsourced to one of the labor agencies. In-house administration of the plan has the advantage of preserving the confidentiality of the WFOE's payroll information.
  
  If a WFOE decides to outsource, it should consider several factors when evaluating which labor agency or benefits administrator to use. The first consideration is the labor agency's ability to service the company in the cities in which it operates. A national provider makes the process and contracts easier to negotiate. The WFOE should also understand the costs and types of services it requires. Administration costs range from ¥ 50 ($6) to ¥ 400 ($48) per month per employee depending on the level of service. Lower levels of service generally involve only file management while the top levels include administration of mandatory and supplementary benefits, travel assistance, and additional third-party insurance such as life and accidental death and dismemberment. Finally, the WFOE should investigate the labor agency's reputation and service quality thoroughly.
  
  
• Compensation costs
  In general, representative offices pay higher cash salaries to employees than do WFOEs — largely because they offer fewer benefits. Companies that are converting to a WFOE thus sometimes reduce salary increases during that year in order to afford a new benefits program. This also allows existing cash compensation to adjust to WFOE levels.
  
  
• Explaining the new plans to staff
  After devoting resources and energy to setting up a new benefits program, the WFOE must be sure to communicate the plan's features to employees clearly. These sessions also serve as opportunities to answer any questions employees may have about the program and to ensure that employees fully understand and appreciate the newly implemented plans.

Post-transition issues

To facilitate a smooth transition process, foreign companies must pay attention to a number of issues in addition to those surrounding the labor contract:

• Payments to the local social security bureau and the municipal housing fund
  Hiring a labor agency to administer mandatory and supplementary benefits minimizes the number of steps the company must take to register all employees. The labor agency will assist the company with opening individual employee accounts for pension, housing, and other benefits. The labor agency will submit the changes in the employee census and calculate the amounts due to the social security bureau and municipal housing fund and the monthly withholding from an employee's salary.
  
  
• Personnel file transfer
  If a WFOE asks a labor agency to keep personnel files, the employees are usually asked to sign forms authorizing the labor agency to transfer the files. The social security bureau requires that an authorized agent hold the personnel files and that the employees have the appropriate residency (hukou) status when making the necessary payments primarily their mandatory pension contributions. If employees have problems with their files then the company must address the problems. For example, if employees do not have a hukou in the city in which they are employed, the company may want to pay their social insurance contributions in the city where the employee is registered.
  
  
• Statutory audits
  In recent years, particularly in Shanghai, the social security bureau has been conducting random audits of multinational companies, especially WFOEs, to determine if the companies have been paying the required social insurance. The fine for noncompliance is a steep 0.2 percent of the amount owed per day. Many representative offices have failed to comply with social insurance payment requirements sometimes unintentionally. Companies are not always aware that labor agencies do not include the full required government contributions in their fees, as mentioned above. In the past, companies were able to use ignorance as an excuse for noncompliance; this is no longer the case.
  
  
• Administrator and benefits provider performance
  China's labor agencies and insurance carriers today are not necessarily equipped with the technology to provide adequate customer service to multinational corporations. These providers are often slow and inefficient in filing and processing claims, non-transparent in disapproving claims, and inadequately staffed to handle customer inquiries. Companies should therefore monitor these service providers and be prepared to change providers if necessary.

A delicate balance

To be successful as a WFOE in China, a company must devote time and effort to addressing human resources issues during and after the transition process. Unfortunately, the costs associated with employee benefits will undoubtedly increase when a representative office or JV becomes a WFOE. These costs can be offset, however, by the improvements in employee satisfaction, loyalty, and economic security that result when a company assumes direct responsibility for employing its workers and controlling their benefits. In fact, these potential strategic advantages can be important factors in a company's decision about whether to establish a WFOE in China in the first place.