Proper book-tax management in China can help avoid unnecessary tax losses and penalties

Foreign companies operating in China often rush to get their finances ready for tax season, making sometimes costly mistakes. Every year, before May 31, financial managers and auditors need to properly deal with book-tax differences to avoid unnecessary tax losses and penalties.

The annual corporate income tax (CIT) reconciliation season, also called annual CIT filing, must be done yearly before the end of May. International businesses not familiar with book-tax differences in China should consider professional assistance.

Book-tax difference means that for the same transaction, the tax treatment and timing of recognition as stipulated by the tax laws are different from the accounting treatment as specified by China’s accounting standards (CAS).

The two regulatory systems have separate purposes: the accounting reflects the financial situation of a company, while the tax laws ensure that taxes are paid. Both systems differ in accounting elements and measurement principles.

The main reason for book-tax management is to maintain good tax compliance.

According to China’s basic principle of taxation, a company shall be taxed on its “income before tax”, which means a net amount of “taxable income” arrived by subtracting allowable expenses and costs from the total revenue. However, the amount of income before tax is not simply equal to the amount of CAS-compliant net profits on the accounting books.

The two ways of assessing income differ in many points. When companies do not identify these differences, the result could mean underpayment of taxes and a series of consequences, including fines, late fees, unfavourable tax records, or even criminal charges.

International businesses in China can find themselves in a much better position by learning and understanding the book-tax differences.

The most common book-tax differences are classified into two types: Temporary differences and permanent differences.

Temporary differences arise when a transaction is accounted for in the same amount under CAS and the tax laws but in different periods. Temporary differences will generate additional taxable income adjustments in the CIT return, and recognition of Deferred Tax Assets (DTA) or Deferred Tax Liability (DTL) shall be reflected in the financial statement.

Permanent differences arise when a transaction is accounted for in a different manner or is a different amount under CAS and tax laws. Permanent differences will affect the amount of the CIT payable, but not give rise to DTAs and DTLs.

For fixed assets, the book basis and tax basis for the acquisition of a capitalised fixed asset for both financial reporting and tax purposes are similar. However, the tax law generally recognises the tax basis of assets more strictly than the accounting cost to protect taxes. In some cases, the initial tax basis of the asset could be less than the initial accounting cost, because tax recognition means that subsequent costs are eligible for a pre-tax deduction.

Mergers or corporate restructurings could also cause a temporary difference. Under the tax laws, a special tax deferral treatment applies to group restructurings if certain conditions are met. When this special tax treatment is allowed for mergers, the merged enterprise will determine the tax basis of its assets and liabilities based on the original tax basis of the enterprises being merged.

The merged enterprise is not obliged to recognise any gain or loss when merging the assets and liabilities. However, the book basis of assets and liabilities shall be determined either at cost or at fair market value under the accounting standards on business combinations.

Tax laws and accounting standards have different definitions of income.

The scope of income under tax laws is much larger than that in accounting standards. On the other hand, there are also revenues recognised as income in accounting, but not by tax laws, such as interest income from treasury bonds and income from qualified investments in Chinese companies.

CAS and tax laws have differences in the timing of revenue recognition. Where an enterprise receives payment for goods in advance and issues an invoice, tax laws require that the income should be confirmed when issuing invoices (under the value-added tax (VAT) regulations) or on the due dates as agreed in written agreements (under the CIT law), while accounting standards require the revenue to be recognised when the control of goods is transferred to the customer.

Under CAS, expenses can be recognised when the outflow of economic benefits in ordinary activities is likely to result in a decrease in enterprise assets or an increase in liabilities, and the outflow of economic benefits can be measured reliably.

According to the tax laws, such as the CIT Law and the CIT Implementation Regulation, there are several requirements for expenses to be pre-tax deductible, such as employee welfare expenses.

There are some tax incentives that allow enterprises to get a super deduction on their expenses incurred for certain activities. Manufacturing enterprises (except tobacco) can deduct an additional 100 percent of R&D expenses from the taxable income thus the tax basis can be 200 percent of the actual costs for CIT purposes.

To properly prepare for tax season, foreign companies should evaluate and recognise temporary differences and permanent differences and accurately adjust the “accounting profits” in the financial statements to the “taxable income” in the tax return.

The best way to identify book-tax differences is to compare the difference between the book basis and tax basis of an item.

Enterprises can prepare CAS-compliant balance sheets and compare them with tax basis worksheets. They can also review the profit and loss items one by one to evaluate whether a difference in timing of recognition, deduction limit, tax exemption, and super deduction exists.

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