The long-standing ‘levying upon assessment’ method for corporate income tax (CIT) was cancelled by the Shanghai tax bureau, after months of speculation. Effective from August 1, 2021, the new measure requires companies to do a more thorough audit of its accounts and special value-added tax invoices (‘VAT fapiao) to work out its taxable income.
This new ruling will stop enterprises from taking advantage of more informal audit methods to reduce the amount of taxable income. Many are considering the possibility of relocating to other regions where the policy is still valid.
Companies, including sole proprietors and partnerships registered as general taxpayers, will have to switch to the ‘levying upon audit’ method (‘audit method’).
Before this new ruling was made effective, in Shanghai corporate income tax was levied in one of two ways: ‘Levy upon assessment’ – where tax authorities assess the taxable income based on the average industry profit margin by looking at several company indicators, and ‘Levy upon audit’ – where tax authorities conduct an annual audit of the company’s accounts to determine its taxable income.
The standard CIT rate in China is 25 percent, with a reduced 15 percent CIT rate awarded to companies engaged in certain strategic and high-tech industries and/or set up in certain development zones.
A company meets the criteria for designation as a “high-tech enterprise”, when it is in a high-tech field supported by the state, is engaging in continuous R&D and the transformation of technological achievements into tangible products, and owning the intellectual property rights to its core technologies in China.
Companies that could not keep accurate accounts of all their income and expenditures because of the lack of VAT fapiao, have been the main beneficiaries of the old assessment method for CIT.
On the other hand, the assessment method could be used as a form of punishment against companies without accounts or with unreliable accounts, as the method ignores the possibility that a company may be making a loss, and by extension that they could be eligible for CIT exemption.
This method turned out to be easily exploited, leading it to be widely regarded as a ‘tax privilege policy’.
A potential tax loophole surfaced, allowing companies to reduce their taxable income through large-scale transfers of shares or property. As these transfers can only be taxed at the industry rate, regardless of how much income they generate (in China, capital gains are not taxed separately, but included within the corporate income tax), leading to a discrepancy in the taxable income.
Companies can also erroneously report their main business items or fail to report when there is a significant change in their business scope, resulting in a deemed taxable income that is below the lower limits of the overall industry.
When information is reported in good faith, this system is unlikely to produce a highly accurate assessment of the actual taxable income, which means that there is a considerable risk that the tax collected is less than the income tax payable calculated based on accounting profit.
In China, there are two categories of taxpayers: general taxpayers and small-scale taxpayers. The change of assessment method will only affect general taxpayers (sole proprietor and partnership companies registered as general taxpayers).
Small-scale enterprises are also known as ‘small and micro enterprises’ (a company with an annual taxable income below RMB 3 million (US$ 464,410) and assets worth less than RMB 50 million (US$ 7.74 million) and can be eligible for tax cuts.
It is still uncertain whether small-scale enterprises will be affected by the changes. However, Shanghai has suspended the registration of new enterprises opting for the assessment method since the beginning of 2021, and it is still unclear whether they will reopen registration for small-scale taxpayers by the beginning of the next tax year.
Even if registration to the assessment method is reopened to small-scale companies, there is a possibility that they will have to go through increasingly rigorous processes when being assessed and meet higher requirements for eligibility.
Firms that previously depended on the assessment method for CIT levy will have to either deregister after settling their current taxes, or default to the audit method. This will require them to go through a complex income reporting and audit procedure.
However, as only one method for levying CIT can be chosen every year, companies that have already registered with the assessment method will likely not have to switch to the audit method until January 1, 2022.
To comply with the audit method, foreign-invested companies are required to submit a series of reports to the State Taxation Administration (STA) each year, including an annual audit report and a CIT reconciliation report for tax returns.
Since the Shanghai tax authorities announced the suspension of the assessment method, other provinces, including Shandong, Sichuan, and Jiangxi, have done the same.
In June of this year, the Guizhou Province tax bureau issued a statement detailing the tightening of restrictions for the use of the assessment method. Meanwhile, the tax bureau of Hangzhou, the provincial capital of Zhejiang Province, announced that taxpayers who report quotas or VAT fapiao amounts over a certain threshold will default to the audit method for CIT levies.
It seems that China is planning on eliminating the assessment method entirely, or at the very least, place stronger restrictions and barriers of entry for companies that wish to use it.
However, this method of tax exemption remains an important tool for local governments to attract investment to development zones. It is likely that there will still be some areas in China that continue permitting this type of tax reporting method.
Regions that offer the assessment method may also increasingly issue caveats, such as eligible industries, upper limits on fapiao amounts, and limits on scopes of business, among other restrictions, and subject companies that choose this method to random inspections and other auditing measures.
The tax system in China will continue to be updated to accommodate the country’s financial and economic development. In the coming years, more measures to demand a higher level of compliance and crack downs on tax avoidance practices could be expected.