As one of the world’s biggest economies, China offers significant business opportunities for foreign companies. But attached to the lucrative benefits of doing business in the country come a set of rules and regulations, which when not taken seriously may result in tax audits, penalties, and other serious consequences.
Taxes represent one of the most important sources of revenue for the Chinese government, and tax authorities have recently stepped up their efforts on enforcement and collection of corporate taxes. Even well-intentioned and honest businesses can get penalized for unqualified fapiao, missing supporting documents, and simple mistakes made by employees.
In the past few years, the Chinese government has improved the country’s business environment to allure foreign investment and offset a slower economic growth. At the same time, they have tried to increase the overall awareness of the society and to pre-empt taxpayers from engaging in any non-compliance tax practice.
The message is simple: no more business as usual. The days of hiding profits and avoiding paying taxes in China are over. So, how do you avoid a tax audit for your China business?
For foreign companies, the best way to avoid these tax risks is to maintain a complete and accurate set of books. The reality in China is that most businesses may have to deal at some point with these hidden tax risks caused by negligence or simply by poor quality accounting.
If audited, a poorly kept set of books creates additional tax liabilities for the business. Companies can also see their credit level decrease from A to B, C or D, with devastating consequences and limitations on future business operations.
The tax system in China is complicated and it can be difficult for foreign investors and individuals to understand it. Tax audits are extremely time-consuming and their impact on the business can be negative. In general, a targeted taxpayer should start by finding out what the tax authorities are after.
A corporate tax audit usually focuses on the appropriateness or validity of tax treatments on specific items that may result in a "material" tax impact. Some common examples are taxability of an income item, the reasonableness of transfer price for related party transactions, the deductibility of material expenditure and the eligibility for preferential tax treatments, among others.
It is crucial to understand the motives and agenda of the tax authorities, in order to develop an effective strategy for handling the tax audit and submit the proper information and documents to the officials.
Knowing what can trigger a tax audit allows business owners and managers to take the necessary precautions to minimize the likelihood of receiving unwanted attention from tax officials. Respecting and following all tax regulations is fundamental.
There are different circumstances that can potentially attract the tax authorities’ attention and that you should consider, to avoid a tax audit.
Certain red flags in your financial reports could represent a possible reason for an audit. If the Chinese tax authorities identify in their system a miss-match of gross salary between Individual Income Tax (IIT) declaration report and Corporate Income Tax (CIT) declaration report, this creates an alert that they will want to investigate.
Under China’s “Golden Tax III” big data, Chinese tax authorities have the capability to spot any potential fraudulent practice systematically and efficiently. Tax reports, financial reports, fapiao information, social security filing, customs clearance, business registration and many other documents are integrated into a unified system.
Most of the fraudulent activities which business in China engage in to minimize their tax liability are easily spotted through big data. Repeated irregularities in financial figures will seem suspicious to the tax experts. With every subsequent alert, your business will likely need to produce supporting documents or risk an audit.
In China, relationships are everything. They can be extremely beneficial for your business or they can be damaging. One example of this is being reported to the tax authorities with or without substantiated cause. Even when there is a lack of any substantial wrongdoing, a tip from one individual could trigger unwelcomed attention.
Unhappy business partners, disgruntled employees, minority shareholders, and even clients could be responsible for reporting your company. It is crucial that managers and business owners ensure that their business dealings with employees, clients and partners are clearly laid out in the terms of their contracts.
Termination of these contracts should be done in full compliance with the terms of the contract
and applicable laws, as well as with appropriate concessions to avoid creating potential liabilities for your business.
Changing the company’s culture by educating your staff on how to deal with unsuccessful client relationships, how to terminate contracts and implement the right policies for your human resources could help your business maintain a better working environment and avoid tax risks.
Another situation that may require a tax audit is if you apply for a tax refund for overpaid CIT or VAT. Unless the amount is very small, an audit will be necessary and a portion of the amount claimed back might be offset by any hidden tax risks exposed during the examination.
In China, applying for a tax refund is not easy. The CIT is paid quarterly based on estimated profits followed by an annual tax clearance based on the actual profits at year end. If you overpay your CIT for the financial year you might find yourself assessing whether to take the risks associated with requesting a tax refund and being audited. Tax planning and proper financial controlling are the best ways to minimize the costs related to claiming back overpaid taxes at year end.
A tax audit is also required when deregistering a company in China to prove that the business does not have any outstanding tax liabilities. This is the last chance for the tax authorities to collect tax revenue from the business, and they will do everything in their power to find any owed payment. Before closing a company, you must be sure that you will pass the corporate income tax clearance and avoid a hefty tax payment upon reregistration.
Many businesses take advantage of the lower tax rate associated with being a small-scale taxpayer by opening several legal entities. They often fail to maintain an accurate set of books. The financial reports often contain significant tax risks that result from poor quality bookkeeping. Unfortunately, in this scenario, a tax audit is unavoidable. Make sure to eliminate any tax liabilities your business might have before considering deregistering to avoid fines and penalties.
Tax audits are usually carried out by independent tax investigation teams within the tax bureau at the local level or provincial level. Selection is based on certain sampling criteria such as the taxpayer's financial and tax position, level of sales, industry specific, nationality or origin of the parent company.
Maintaining a complete and accurate set of books is the best way to minimize the negative consequences associated with being audited. Complete and accurate bookkeeping also help minimize the chances that the scope of the audit increases from the past 1 year to up to the past 5 years or more.
A number of Chinese companies use unqualified fapiao to reduce the amount they need to pay in taxes. At their most basic, a fapiao is an official receipt that allows a Chinese company to make a deduction for an expense. Fake fapiao are rampant in the country.
Foreign businesses in China need to realize that what they got away with in the past is no longer possible.
However, many companies try to not show profits in China and practice illegal accounting tactics and bribes to get around paying taxes.
Making better financial choices can help you and your company avoid the serious consequences that a tax audit can cause. The Chinese tax authorities that might in the past have been happy to look the other way in return for receipt of their own rewards have reevaluated the risks they faced and have chosen to impose more strict ways of compliance.
In case your company is subject of a tax audit, you may require the assistance of tax specialists who have extensive experience in dealing with the Chinese tax authorities to help you prepare and handle queries from officials. More significantly, the taxpayer may take a more proactive role in managing its China tax audit risk by performing a tax-risk assessment of the foreign investment enterprise or representative office. By doing so, the enterprise will be able to identify tax risk areas and correct them before a tax audit is ordered.
Woodburn Accountants & Advisors is one of China’s most trusted business setup advisory firms.
Woodburn Accountants & Advisors is specialized in inbound investment to China and Hong Kong. We focus on eliminating the complexities of corporate services and compliance administration. We help clients with services ranging from trademark registration and company incorporation to the full outsourcing solution for accounting, tax, and human resource services. Our advisory services can be tailor-made based on the companies’ objectives, goals and needs which vary depending on the stage they are at on their journey.
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