Offshoring IT operations in the PRC

A number of options exist in this rapidly growing area says Nancy Leigh of law firm Baker & McKenzie.

Introduction

With large numbers of well-qualified potential employees, low labour costs and rapidly developing infrastructure, the People's Republic of China ("PRC") is becoming an increasingly competitive location for offshoring operations. This article looks at the offshoring in China of IT enabled services such as call centres and business process services, and general IT services including application development, support and maintenance services.

As discussed below, there are a number of possible structures under which the offshoring of such services can be carried out in the PRC. These include outsourcing to a third party service provider; establishment of a captive operation; or a joint venture with a Chinese party.

Choice of offshoring structure

Choice of offshoring structure will be governed by the individual requirements of each company or group proposing to offshore in the PRC (offshoring company). For example, where application development is the object of the offshoring, protection of intellectual property is likely to be of high importance; for general IT enabled services, control and protection of data may be crucial. Choice of structure must reflect these requirements and also take into account any industry restrictions imposed by PRC legislation and regulations. As the main reason for offshoring is usually to save costs, financial commitment in terms of set up, operation and exit from an offshoring operation will also need to be considered. Taxation - an important and sometimes overlooked aspect of operating costs - is discussed briefly below in the context of offshoring.

Outsourcing to third party provider

Offshoring of services may be achieved by direct or indirect outsourcing to a third party service provider in the PRC. In direct offshoring, the offshoring company directly contracts with a service provider in China; in indirect offshoring, the offshoring company contracts with a service provider outside the PRC, and this service provider subcontracts all or part of the services to a service provider inside the PRC. Advantages of outsourcing to a third party provider may include lower investment costs and quicker set-up time.

Business scope must be adequate

Although outsourcing to a third party is probably the simplest form of offshoring arrangement, careful due diligence is still required. The third party service provider must have a business scope sufficient to cover the offshoring activities, and any necessary (valid) licences. Call centre service providers, for example, are required to hold value-added telecommunications services operating permits.

Adequate contractual protection

Offshoring companies will require adequate contractual protection during the course of the third party service provider contract. The PRC Contract Law allows freedom of contract and many aspects of the agreement will be commercial decisions to be agreed between the parties. Examples of aspects that may need to be covered by contractual provisions include:

- protection of data; where IT enabled services are being provided, non-disclosure agreements in relation to data may be required;

- intellectual property protection; this is likely to be a particular issue in application development where new technology is being researched and developed;

- exit from the agreement; various factors may need to be covered with regard to exit; for example, it may be necessary to include whether, or to what extent, the service provider will provide termination assistance services to ease the transfer of services back to the offshoring company's country of origin;

- non-competition; an example of where a non-compete agreement might be required is where an offshoring company wishes to purchase specialist services from a service provider in the PRC, and wishes to enforce contractual restrictions preventing the service provider from providing similar specialist services to other users. The non-compete obligation must not violate fairness and good faith principles, or existing PRC legislation. Broad non-compete clauses may be found to violate such principles, so the non-compete clause should be drafted carefully to address only the actual needs of the offshoring company.

Captive operation

In some jurisdictions, the establishment of a wholly-owned subsidiary or "captive" operation may be a preferred option for foreign offshoring companies. The main advantages of a captive operation are a high level of control for the offshoring company and flexibility in terms of management.

In China, due to foreign ownership restrictions in the telecommunications sector, captive operations are not common in relation to IT enabled services. Call centre services and online data processing and transaction processing services, for example, are classified as value-added telecommunications services (VATS) under China's Classification of Telecommunications Services. As such, a foreign investor is only permitted to hold 50 percent of a foreign-invested enterprise (FIE) that provides such services. While the relevant rules appear to be aimed at the provision of such services to parties inside China, it seems likely that they will also apply to the provision of services to parties outside China. At present there is no indication that the 50 percent cap on foreign ownership of FIEs that provide VATS will be relaxed.

Despite these restrictions, some multinational companies have obtained special approvals to set up captive operations serving needs of group companies, including call centres and data processing centres providing supporting servicing to affiliated companies.

Holding companies

China also permits foreign investors to establish holding companies, which can provide services outsourcing in some circumstances. A holding company is a special-purpose limited liability company that allows larger companies with multiple investments in the PRC to better coordinate the operations of their different investments. Holding companies are typically established as wholly foreign-owned enterprises, although they can also be established as joint ventures.

Holding companies can conduct research and development and can perform certain services for their subsidiaries, but generally cannot engage in direct business activities by themselves. Among other things, a holding company can engage in services outsourcing for its parent and affiliates. If a holding company meets special requirements and qualifies as the regional headquarters of a multinational, it may engage in services outsourcing for affiliated enterprises inside or outside China.

Joint venture

As noted, an FIE that provides certain VATS including call centre services and online data processing and transaction processing services may only be 50 percent foreign-owned, i.e. it must be a joint venture.

PRC regulations impose restrictions concerning registered capital of such joint ventures. FIEs that provide VATS within one province, autonomous region or municipality directly under the central government must have a registered capital of RMB one million. If the services are provided nationwide or beyond a single province, autonomous region or municipality directly under the central government, the FIE must have a registered capital of RMB 10 million.

As noted, an FIE that provides VATS will have to obtain a Telecommunications Service Operating permit from the PRC telecommunications authorities.

Taxation issues

As mentioned, the main reason for offshoring is usually cost savings. Rates of taxation of offshoring structures are an important consideration in assessing potential operating costs of such operations. While specific tax issues should be considered on a case-by-case basis, the following are some general considerations.

Tax incentives

Although certain tax incentives are available for some industries in the PRC, no specific tax incentives are available for foreign-invested services enterprises unless they are located in the Special Economic Zones of Guangdong, Fujian and Hainan Province. It should also be noted that the PRC tax authorites are considering a tax reform in which the existing tax benefits available to foreign enterprises and FIEs established in the PRC might be removed or altered.

Business tax and value added tax

Income generated from the provision of IT enabled services in the PRC is subject to business tax (BT). According to the BT regulations, enterprises and individuals that provide labor services must generally pay BT at a rate of 3 or 5 percent of the gross service fee, depending on the nature of the taxable services. BT and value added tax (VAT) (levied at 17 percent) are mutually exclusive, so VAT would not apply to the IT enabled services. VAT might, however, be payable on the provision of other types of service, such as repair and maintenance.

Enterprise income tax

An FIE such as a joint venture call centre, for example, would be subject to Enterprise Income Tax (EIT) on its net profit. National tax is imposed at the rate of 30 percent on worldwide net profit, andan additional local income tax of 3 percent of taxable income will be levied by the relevant local government, resulting in an effective tax rate of 33 percent. The national tax rate is reduced to 15 percent for FIEs established in the Special Economic Zones referred to above.

Permanent establishment

A foreign company deemed to have permanent establishment (PE) in the PRC will be subject to EIT with respect to its income attributable to the activities / services performed in the PRC. To determine whether a foreign company will be considered to have a PRC PE, it is necessary to consider the PE provision of any double tax treaty entered into between the foreign country and China. Generally, where a foreign company has a fixed place of business in the PRC or services are furnished by a foreign company in the PRC, there is a likelihood that the foreign company concerned may be deemed to have a PRC PE.

Transfer pricing

It is likely that transactions between an offshore parent company and a domestic subsidiary will be subject to transfer pricing rules. Generally, PRC tax authorities require FIEs and foreign enterprises within the PRC, and their affiliates, to conduct transactions on an arm's length basis, i.e. to conduct business transactions in the same manner as transactions between non-affiliated enterprises. PRC transfer pricing rules generally stipulate that transactions with affiliated enterprises include sale and purchase transactions, provision of financing, provision of labor services, asset transfer and provision of asset use rights. Additionally, the current PRC transfer rules provide for definition of "affiliated parties" and pricing methods to determine the arm's length prices of transactions between affiliated parties.

Data protection and information security

In addition to structuring issues, other key concerns include data protection; control and monitoring of offshoring operations; and certain employee issues, all aspects that, among others, should be considered in a proposed offshoring of IT enabled services and general IT services.

Data and the processing of such data is likely to be of central importance in many operations involving IT enabled services. Offshoring companies that employ offshore employees or use third party suppliers to process personal data in the PRC (which may include, for example, medical records, credit information or tax returns, etc.) must consider whether such data is adequately protected. Failure to do so could lead to prosecution in some cases, litigation and bad publicity - there have been a number of cases reported in the press regarding misuse of data by offshore employees in other offshoring locations.

PRC data protection laws

In the PRC there are no general data protection laws or privacy laws similar to those of the European Union or US. Significantly, the European Commission has not determined (on the basis of Article 25(6) of Directive 95/46/EC) that the PRC has an adequate level of protection by reason of its domestic law or of the international commitments it has entered into. Subject to certain exceptions, EU legislation prohibits the transfer of personal data out of the European Economic Area to a third country which does not ensure an adequate level of protection, a factor of particular significance for EU companies considering offshoring operations in the PRC involving such data.

In addition to ensuring compliance with any data protection and privacy laws of their own jurisdiction, offshoring companies must also comply with certain PRC laws and regulations concerning data protection and computer security. Chinese regulations do not clearly stipulate the types of data that fall under data protection or security measures. The clearest indication has been in the financial services sector. In this sector, there are provisions governing data protection in the primary banking legislation. In particular, the Provisional Regulations for Protection of the Security of Computer Information Systems of Financial Institutions requires financial institutions to observe basic measures in security protection for the computer information networks of financial institutions. These include preventing illegal or criminal activities that use or are directed at the computer information systems of such institutions; preventing and dealing with all types of security-related incidents; enhancing the overall security level of the computer information systems of financial institutions; and safeguarding state, collective and personal property. The Regulations also require the appointment of specialists to handle security matters and sets out recommendations for financial security systems.

Although the Ministry of Information Industry has issued a set of Enterprise Information Technology Standards, effective from October 1, 2003, implementation of these standards is not mandatory.

Security of data on networks

A number of PRC regulations governing computer networks, telecommunications and specific industries require service providers to ensure that the data stored on their networks is secure. The requirements are set out in legislation such as the PRC Regulations for Protection of the Safety of Computer Information Systems, the Measures for the Administration of Protection of the Security of International Networking of Computer Information Networks, and in circulars issued by different government ministries and IT agencies. Various IT agencies have also issued technical standards, and generally, certification focuses on the compliance of the software or products used (e.g. routers, firewall, servers, etc.), rather than on the general compliance of the service provider itself.

Control, monitoring and employee issues

Issues of control are likely to be of particular concern in third party supplier offshoring activities. Depending on the nature of the business activities, areas to be addressed in contractual provisions are likely to focus on data privacy and protection; intellectual property protection; non-disclosure agreements; and permitted levels of monitoring of the employees of the third party supplier. It will be necessary to ensure adequate control and protection from the point of view of the offshoring company on the one hand, and avoid excessive (and possibly unlawful) interference on the local party on the other. Physical controls may also be put in place to increase levels of security. In software development, for example, the service provider may be required to take measures such as ensuring that facilities are restricted to authorized personnel only, that development is restricted to specific locations, or that workstations are isolated, etc.

Non-compete issues

Pursuant to the 1997 Several Opinions on Strengthening Administration of Technical Secrets in the Context of the Mobility of Scientific and Technical Staff, employers may include non-compete clauses in employment contracts, IPR ownership agreements or technical secret agreements. Such clauses can be used for administrative and management personnel, science and technology personnel and other relevant personnel that have a significant influence on the employer's technical and economic rights and interests. The clauses may provide that such employees may not work for other employers that have a competitive relationship or other interested relationship with the original employer and that produce the same type of products or carry on the same type of business for a certain period of time after leaving the original employer. The clauses may also restrict employees themselves from competing with the original employer. The period of restriction may not exceed three years.

Monitoring of employees

Another concern in certain offshoring operations will be the extent to which employees can be monitored, whether for security, quality control or training purposes. Striking a balance between the company's need to monitor operations and the rights of the individual to privacy is important but can be difficult in the PRC as in other jurisdictions.

There are currently no laws in China giving employees the full set of privacy rights. Employers should be aware of a recent decision clarifying the PRC Criminal Law issued by the Standing Committee of the National People's Congress. This provides that "invasion of citizens' freedom to communicate and right to secret communication by illegally intercepting, amending or deletion of others' e-mails or other data" can be criminal. In particular, Article 66 of the PRC Telecommunications Regulations clearly states that: "No organization or individual may, for any reason whatsoever, inspect the content of telecommunications, except that public security authorities, the state security authority and the People's Procuratorate may do so in accordance with the procedures stipulated by law in response to the requirements of state security or the investigation of criminal offences." No exemption is granted to enable private employers to inspect employee or third party communications.

Working hours

Offshoring companies with specific employee requirements should assess local employment and labor legislation as part of their initial due diligence. For some types of offshoring operation, for example, an important consideration may be the ability to provide round-the-clock services. Flexibility in working hours may be of particular relevance where there are significant time differences. 24x7 services should be achievable under China's labor laws, but employers must hire enough staff to comply with China's working hours restrictions.

The general rule is that employers cannot make employees work more than 8-hour days and 40-hour weeks. If, because of special business requirements, the employer needs to extend the working hours, it may extend them by up to one hour a day after consultations with the labor union and the employees. If there are special circumstances, working hours may be extended by up to three hours a day, but such paid overtime must not exceed 36 hours in a month.

If it is not possible to implement the 8-hour day, 40-hour week system because of the nature of the work, the employer may apply for permission to the local labour authorities to implement a variable or flexible working hour system. Notably, approval is not automatic and employers should be mindful of such over-time restrictions.

Redeployment of foreign employees to the PRC

Issues in relation to foreign staff will also need to be considered, such as ease of re-deployment of such staff to the PRC. This will usually be a consideration when setting up an offshoring arrangement, but may also be required for monitoring or training purposes during the course of operations. Foreign workers require work permits/visas to work in China and in order to comply with China's immigration, labor and tax rules, careful attention should be paid to structure such employment relationships.