Outsourcing Options for FDI into China

July 12, 2017 Posted by China Briefing Reading Time: 9 minutes

Op-Ed by Chet Scheltema

Gone are the days of China foreign direct investors simply choosing between an RO, WFOE, or JV. Now they are presented with a range of options and acronyms that even the most determined investor may become bewildered: PEO, EOR, VIE, HRO, ASO, BPO, etc., not to mention the traditional Dispatch and Secondment.

These alternatives have developed with the growth of the outsourcing industry in Western economies, yet they do not necessarily translate neatly into China, and they present risks to the unwary and ill-advised foreign investor.

Despite this, some consultants may heartily promote one or more of these options, and this may belie a true understanding of the local legal and business environment, and the risks each approach entails.

In this article, we review contemporary options available to foreign investors and highlight the advantages, disadvantages, and risks, specifically within the Chinese context. For discussion purposes, we divide the options into three: insourcing, selective outsourcing, and what we will call “hosting”.

Insourcing

Insourcing means the business performs most or all work internally. Few businesses rely exclusively on insourcing; they will from time-to-time supplement their resources with a professional accounting or law firm, temporary staffing, third-party logistics, and other services.

Insourcing offers investors the strongest level of control, and it offers the highest return on investment for high-performing management, as one needs not to pay outsourcing partners. However, organizations must invest early in developing the internal resources to grow. Situations where insourcing may be desirable are:

Where rapid, profitable growth is expected, and a robust, independent, scalable platform is needed soon
Where successful execution requires close supervision and coordination of consolidated operations
Where specialized knowledge, expertise, or resources can only be developed and managed internally
In highly competitive industries that require tight control of intellectual property (IP), trade secrets, and sensitive information

Technology firms with valuable IP or trade secrets will also prefer insourcing to avoid loss of proprietary assets. Additionally, high performing firms and publicly-traded firms will be attracted to insourcing.

There is another reason to consider insourcing. Although requiring a greater initial investment, it offers a more solid and stable foundation for growth and future profitability. It clearly communicates to employees and partners that the business is committed to China; entering China “on the cheap” often sends the wrong message, and it often ends up costing more later.

Selective outsourcing

Selective outsourcing ranges from limited use of outsourcing partners to near total reliance on outsourcing at the extreme. The business retains its own unique legal identity and brand, but its internal operations might be entirely outsourced.

Human resources outsourcing (HRO) should be considered an all-encompassing term referring to any one,or all, of a broad range of activities related to human resources (HR). Temporary staffing, recruitment, and payroll services represent commonly outsourced HR activities.

Administrative service outsourcing (ASO) includes outsourcing payroll and compensation elements, including public and private insurance. An ASO’s offering would not normally be as all-encompassing as an HRO.

The Chinese state-owned FESCO is an example of a firm offering a wide array of HRO services. Many firms take the name FESCO, but they are just local companies borrowing the name.

Some HROs in China directly hire foreign workers to obtain a Chinese work visa and permit for them. In other words, they sponsor foreign workers for purposes of obtaining a work visa and permit. They may refer to this as “HR outsourcing”, but these firms likely are not authorized to engage in this activity. FESCO-Adecco may be one of the only HROs in China fully authorized to do so.

Situations where a firm might seriously consider selective outsourcing are:

Where speed of implementation is critical
Where internal recruitment, supervision and specialized training may take too long
In industries with rapidly changing, complex regulatory frameworks (tax, payroll)
For temporary, low-skill activities easily outsourced with minimal risk

Where such outsourcing may become problematic is when the firm offering the services does not have a qualifying business license to do so or the firm receiving the “dispatched employees” exceeds the 10 percent threshold under Chinese law.

e-Commerce as outsourcing

e-Commerce has grown dramatically in China, and presents an unusual outsourcing opportunity. Many or most of the Chinese e-commerce platforms (eg. Tmall, JD, etc.) offer a global e-commerce option whereby foreign companies need not establish a legal presence in China.

Instead, foreign companies outsource their China business operations to one of the e-commerce platforms – and a number of related e-commerce consulting firms (eg. logistics providers, marketing firms, etc.). While very appealing in theory, Chinese e-commerce platforms are now very crowded and have become highly selective about who may join their global platforms.

Hosting

The final option is hosting. While not a new option, it has recently regained popularity by being dressed up in new terms such as “PEO”, “International PEO”, “HR Outsourcing”, “4PL,” or even “VIE”.

Hosting occurs when a business borrows the legal structure, and legal rights, of another company to operate a business on a temporary, or permanent, basis.

Hosting has long been a common, practical approach to investing in China. When a Chinese investor and a foreign partner wish to establish a business and avoid the complexity of establishing a Sino-foreign joint venture (JV), they instead set up a locally-invested corporation where the foreigner is an informal equity shareholder.

This structure is a natural choice in industries restricted to foreign investment because the foreign equity partner has no formal ownership. More than a few English schools, and other small and medium-sized businesses in China, take such a form.

PEO as hosting service

Professional Employer Outsourcing (PEO) is an industry that has come of age in the US. There is formal legislation in nearly 20 US States to regulate its activities. Not so in China.

No such industry exists and no such service may be lawfully offered to clients. Foreign investors encountering claims to provide POE services should approach with a critical mind.

A PEO provider works like this: it takes responsibility to hire and employ workers on behalf of the client, perhaps for the duration of their career. In other words, the PEO provider “hosts” the employees on behalf of another business. Such providers become the “employer of record” and ensure full compliance with all applicable employment laws.

Providers typically offer benefits to employees that might not otherwise be available to employees of smaller enterprises. Taking responsibility to navigate the complex regulatory environment of employment benefits, particularly in the US, can be a true “godsend” to smaller firms.

PEOs are not the same as staffing or dispatch agencies in the sense that they are not aiming to offer temporary staffing solutions. As mentioned, there is no legal basis for PEO services in China.

It is not permissible to hire workers on behalf of another business, unless a dispatch license has been secured. Yet, some consulting firms may advertise themselves as “PEO“or “International PEO” providers.

Full Outsource hosting model

Some consulting firms go further: they offer to host the entire operation of the foreign client in China for a period of years, thereby, it is claimed, dramatically reducing the start-up costs to enter the Chinese market.

They may offer their existing, experienced staff to manage the foreign investor’s operations, reducing the learning curve for new market entrants. Many call such an approach a “full outsource.”

Risks of PEO,“full outsource” models

PEO and full outsource hosting providers may place themselves and their clients at risk because:

There is no clear authorization to engage in such outsourcing within the Chinese regulatory context;
Outsourcers may be pressed to unlawfully engage in activities outside their license’s scope to satisfy many clients;
Conflicts of interest and resources arise within outsourcers that serve competing clients;
Difficulty returning legal rights back to client (IP, staff, etc.) upon separation of the outsourcer and client;
The client’s only legal claims are by contract and resorting to a lawsuit despite the outsourcer functioning as a type of JV partner;
Employees and business partners of new foreign investors will sense a lack of commitment from the investors.

Among these many concerns, tax is an often-overlooked concern. As an example, this author was approached by a successful and profitable business in Beijing, locally incorporated and utilizing a hosting arrangement. The foreign investor who had provided the initial capital to start the business (set up a locally owned company through a Chinese friend) now wanted to normalize the business and become the true shareholder of record under a foreign-invested business structure.

Unfortunately, he realized that the proposed transfer of the assets, and/or equity, to himself would result in the imposition of a burdensome tax upon the then-current shareholder of record, his local Chinese friend – and this friend’s wife. If the business had been incorporated in the beginning as a foreign-invested entity, rather than through hosting, then this tax problem would never have arisen.

Beyond this, accountants and tax lawyers will quickly point out that, while foreign investors using a hosting model do not technically have ownership of an enterprise in China (only the host does), the Chinese tax bureau may take a “substance over form” approach. They could conceivably pursue the foreign investors for back taxes, which is the permanent establishment risk.

However, hosting remains a viable option given the following conditions:

In jurisdictions where it is legally permitted or at least tolerated under local practice;
Where other options, such as selective outsourcing, are inadequate;
Where speed of implementation is critical and delay means a completely lost opportunity;
In high risk business environments where “PEO” or “full outsource” risks are justified.

Under these conditions, a foreign investor should only enter into a hosting services agreement that has been very carefully reviewed and negotiated by good business lawyers.

The VIE as hosting

Hosting has become more sophisticated over time, and the variable interest entity (VIE) is now viewed as an option. A VIE is a combination of a locally invested corporate supervised controlled by a wholly foreign owned enterprise (WFOE) through a series of legal contracts.

The locally owned corporation can obtain licenses in restricted industries; yet, the WFOE can, in theory, still control operations and receive the economic benefits of the arrangement. This is really nothing other than a sophisticated hosting.

The VIE terminology arises from US GAAP, and describes an affiliated enterprise effectively controlled by another enterprise, thereby allowing consolidation of financials. Many of the Chinese Internet-based businesses traded on US public exchanges are VIEs. However, the VIE structure has come under the scrutiny of Chinese regulatory authorities, and its future is uncertain.

Choosing the right option

The Chinese operating environment is a perilous one. Some level of dependence upon third party service providers is certainly justified. For this reason alone, one might easily argue for the benefits of outsourcing at least accounting, payroll, tax compliance, legal matters, third-party logistics, and some other functions. In such rapidly changing, tricky practice areas, outsourcing is a natural fit.

However, extending outsourcing to the extreme version of a complete hosting arrangement, where all business operations are managed by another entity under a contract outsourcing model, should be considered very critically.

One would be well advised to resist the temptation to jump into such arrangement to save money and invest in China on the cheap. Such an approach introduces a high level of risk and sets the new Chinese venture on a poor foundation for growth, profitability, and success. Costs saved now inevitably arise later when fixing the originally unstable structure.

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