Accurately Assessing Liquidation Liabilities in China

September 23, 2010 Posted by China Briefing Reading Time: 3 minutes

By Business Advisory Services, Dezan Shira & Associates

Sept. 23 – When liquidating a company, salaries, mandatory welfare benefits and severance payable to employees are paid second only to liquidation expenses themselves. For companies with a large workforce, this can be a large cost and needs to be quantified accurately.

Only once the “workforce” has been clearly defined can the liability be assessed. Therefore the first step should be to cross-reference the full list of employees with the corresponding labor contracts and information concerning salary payments. Employees should have been paid their salaries in full up to the end of the month preceding the announcement of the liquidation. The labor contracts will also tell you how long each employee has officially worked at the company – compensation for termination of employment will be calculated based on the salary and length of employment. Finally, evidence of payment of the various mandatory welfare benefits should be checked to ensure there is no money owed.

Checking the contractual obligations should be a relatively straightforward task. The date of contract commencement and its term should be stated on the document. Most employment contracts will have a length of one year and there will be a section where the employee signs to extend the contract every year. For employees that have worked for the company less than ten years, there is effectively no severance pay because the liability for the company is limited to the period left on their employment contract.

Some employment contracts may have a clause stipulating the amount of compensation to be paid in the event of one of the parties violating the contract terms. In this situation if the amount specified for contract violation is lower than the remaining amount unpaid in salary, the company’s liability is limited to this amount. Irrespective of whether the remaining period of the contract is paid up or whether the contract violation penalty is paid, the company should have no responsibility for payment of social welfare for the employee after official termination of employment.

However employees that have worked with a specific company for more than ten years have a right to enjoy “open-ended contracts”. These employees can receive a month of pay (based on the average salary they earned during the most recent year of employment) for every year they have worked with the company. For employees that have worked their entire life at the same company and are approaching retirement this can be a considerable amount, potentially up to three years of salary. In some cases it would be cheaper to pay their salary until retirement; however there is no allowance for this under current labor laws.

Of course most foreign invested enterprises have only been operating here in China for a decade or less, so in theory the liability for employee compensation should not be huge. Unfortunately it is not uncommon to find instances where foreign investors have taken over the operations of state-owned enterprises (SOEs), and perhaps unwittingly, absorbed the liability for payment of workers’ severance pay during their period of work for the company prior to its incorporation as a foreign-invested enterprise. Although the labor law states that labor contracts should be terminated severance paid by the old employer, and new contracts signed with each worker, in practice these payments have not always been made. Certain areas in China have issued regulations requiring the new owner of the business to be responsible for all such legacy liabilities. Investors involved in projects of this nature where workers used to be affiliated to SOEs would be advised to check the exact status of the potential liabilities they have incurred or may incur.

Once the basic salary liability has been calculated, the social welfare and housing fund situation should be verified. Some companies going into liquidation face cash flow problems, and one of the first expenses to be neglected is often employees’ benefits. Checking the receipts from the social security bureau and the housing fund center will tell you when the latest payments were made for each employee. Note that the social security bureau has the right to add on a late payment penalty for outstanding contributions at a rate of 0.3 percent per day, but the housing fund center cannot do this. This can also mount up to a large sum if such payments remain outstanding for a number of months.

Dezan Shira & Associates is a foreign direct investment practice offering corporate establishment, business advisory, tax, accounting, due diligence, payroll and audit services for multinational clients in China, Hong Kong, India and Vietnam. For professional advice and assistance with tax and regulatory matters, please contact info@dezshira.com.