As the world's second-largest economy and a major manufacturing hub, China offers tremendous opportunities for foreign enterprises seeking international growth. The process of establishing a legal entity in China, however, can be complex and costly. One workaround is the use of service agreements, which enables foreign businesses to engage Chinese professional individuals for particular projects or tasks without registering an entity.
This article provides an overview of the benefits associated with service agreements, discusses their applicable use cases, and examines potential limitations.
What is a service agreement?
A service agreement is a contractual arrangement between a company and an individual, which outlines the specific tasks or services that the individual will perform. Unlike employment contracts, service agreements do not constitute an employer-employee relationship. They are commonly used for consulting, marketing, quality control, and regulatory coordination. Service agreements can be terminated without generating severance payments, making it a flexible and mutually beneficial arrangement.
Benefits of using service agreements in China
1. Faster market entry without a WFOE or JV
In general, foreign companies must establish a registered entity – such as a Wholly Foreign-Owned Enterprise (WFOE) or a Joint Venture (JV) – to hire employees or conduct business directly in China. Establishing these entities can take several months and involve a range of processes, including business registration, licensing, as well as bank account opening and tax setup.
Alternatively, companies can use service agreements by contracting with independent contractors to access talent and services without creating a formal legal presence. This model is particularly well suited to time-sensitive projects, pilot programs, seasonal campaigns and specialised consulting work.
2. Lower cost of accessing expertise in China
The process of establishing and maintaining a legal entity in China requires substantial financial investment, which includes legal fees, office and warehouse rentals, payroll, social insurance contributions, and ongoing compliance requirements. Service agreements allow companies to pay based on the specific services received, which may be structured as fixed fees, hourly rates, or project-based payments. This method can help manage capital and limit financial risk for startups or small and medium-sized enterprises entering the Chinese market.
3. Flexible engagement terms and workforce solutions
Service agreements provide flexibility regarding scope and duration. Companies may engage contractors for temporary projects, specific tasks, or occasional support rather than entering into long-term employment contracts. Should business requirements change, contracts can be adjusted or ended with limited impact.
4. Access to local expertise and market knowledge
China's unique business culture, consumer behavior, and regulations can be challenging for foreign firms. Service agreements allow companies to leverage local expertise without building a full team. Contractors offer insights into regional trends, language, and compliance, improving marketing, customer engagement, and operations.
5. Market experimentation
Service agreements enable companies to experiment with different business models, markets, and service providers before committing to a full-scale operation. For instance, a company may introduce its product in tier one cities with the assistance of local marketing consultants and later consider expanding to tier two cities based on results. This step-by-step approach supports data-driven decision-making and helps reduce potential operational risks.
Key limitations and considerations when using service agreements
1. Control and oversight
Contractors function independently, in contrast to employees. It is essential that service agreements define the scope of work, expected deliverables, and project timelines with clarity. Nevertheless, foreign companies should refrain from imposing significant control such as specifying working hours or incorporating contractors into internal teams, as such actions may be construed as establishing an employment relationship.
2. Intellectual property (IP) rights
Work created under a service agreement does not automatically become the property of the company. If the contract does not specify ownership, contractors may retain intellectual property rights, which can result in disagreements, particularly when proprietary technology or branding is involved.
3. Tax compliance
Independent contractors in China are required to handle their own tax filings. For service fees to be deductible, contractors must obtain a labour service invoice from the tax bureau as evidence of tax payment. This process involves several administrative steps, which may influence individuals’ decisions regarding contract work. Foreign companies should ensure correct deduction claims to avoid potential audits and penalties. Engaging a professional service provider like Hawksford to manage tax payments can help streamline administrative burdens.
4. Social insurance and benefits
Independent contractors, as non-employees, are not entitled to mandatory social insurance contributions (including pension, medical, unemployment, maternity, and work-related injury insurance) from the engaging company. Unlike formal employees, such benefits are not legally required to be provided by the company. However, this lack of benefits can make contract roles less appealing to top talent and may raise ethical concerns for companies committed to fair labour practices.
5. Business sustainability
Service agreements are ideal for short-term engagementsbut may present difficulties for long-term operations. Contractors may not be available for subsequent projects, and continually onboarding new individuals can reduce efficiency. Additionally, reengaging the same contractor frequently – especially with consistent work arrangements resembling employment – could lead to attention from labour authorities. They may reclassify the relationship as a “de facto employment relationship”, requiring the company to assume employer liabilities.
Applicable use cases for service agreements
- Build a local workforce: Engage and manage sales or technical professionals with expertise in the Chinese market who can provide deliverables remotely. These individuals can attend industry events and engage with potential business partners to foster business development.
- Strengthening supplier networks: Appoint a local representative to maintain positive relationships with suppliers and select appropriate vendors. For example, trading companies can utilise the existing logistics infrastructure, warehousing systems, and distribution channels of local partners to facilitate swift market entry.
- Oversee quality control and streamline logistics: Engage local inspectors and logistics coordinators to ensure product quality and optimise distribution channels for greater efficiency and reliability.
- Facilitate regulatory communication: Designate a local liaison to handle communication with authorities such as customs, banks, warehousing providers, and other regulatory bodies, to ensure smooth operations and compliance.
When to consider a legal entity
Service agreements represent an effective solution for foreign enterprises seeking to enter the Chinese market. These agreements facilitate swift implementation, cost efficiency, and access to local expertise, while helping to manage operational complexities in an unfamiliar market.
However, the absence of a Chinese entity may still face challenges in some scenarios. For instance, customs authorities may undertake more detailed reviews of transactions associated with non-local entities. It is possible that document submission procedures could become more complex, and there may be ambiguity regarding responsibility in the event of customs disputes. Certain regulations may involve on-site inspections or require engagement with local representatives, which may present further challenges for foreign companies that manage operations remotely.
As businesses expand and acquire market understanding, they are suggested to transition towards establishing a legal entity for sustained growth or consider an Employment of Record (EOR) arrangement as a viable long-term solution. In light of China's evolving investment and labour policies, it is necessary for companies to stay informed and adaptable.
How Hawksford can help
Hawksford offers comprehensive HR and payroll services designed to assist clients in drafting and managing service agreements, as well as calculating and filing individual income tax. We facilitate effective communication between companies and individual contractors regarding the provision of services. With over a decade of experience in the China market, our team delivers tailored solutions and provides up-to-date insights on regulatory developments, helping your business remain compliant with evolving requirements. Please contact our team when you are ready to commence operations in China.
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