In China, receiving a visit from the Tax Authorities is never a pleasant surprise. Even well-intentioned and honest businesses can get penalized for unqualified fapiaos, missing supporting documents, and simple mistakes made by employees. 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 contain many of these hidden tax risks caused by negligence or simply by poor quality accounting.
These risks are very likely to get realized during tax audits. A poorly kept set of books not only creates additional tax liabilities for the business if audited but also makes responding to tax officers request for additional documentation time consuming 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.
To avoid these repercussions, following PRC GAAP and tax regulations is fundamental. By knowing what can trigger a tax auditing, business owners can take the necessary precautions to minimize the likelihood of receiving unwanted attention from the tax authorities.
SCENARIO 1 – Getting reported to the tax authorities
In China, a good relationship can get you a meeting with the right people while a bad one can be damaging to your business. One example of this is being reported to the tax authorities with or without substantiated cause.
Avoiding such a scenario is the best option. Unhappy business partners, disgruntled employees, minority shareholders, and even clients make up your most likely delinquents. Even when there is a lack of any substantial wrongdoing, a tip from one of these individuals could trigger unwelcomed attention from the tax authorities.
It’s important that managers and business owners are careful to ensure that all of their business dealings with their employees, clients and partners is clearly laid out in the terms of their contracts. Secondly, termination of these contracts should be done not only in full compliance with the terms of the contract and applicable laws, but also with appropriate concessions to avoid creating potential liabilities for your business.
Such tax risks cannot be managed by finance personnel entirely. Reducing this risk often requires making changes to the company culture. This means educating your staff on how to handle unsuccessful client relationships, how to terminate contracts and implementing the right policies for your human resources.
SCENARIO 2 – Red flags in your financial reports
Under China’s “Golden Tax III” big data, Chinese tax authorities are able to systematically and efficiently spot any potential fraudulent behavior through the financial reports submitted by a company. Tax reports, financial reports, fapiao information, social security filing, customs clearance, business registration and many other documents are integrated into a unified system. For instance, if the system recognizes a miss-match of gross salary between individual income tax (IIT) declaration report and corporate income tax (CIT) declaration report, this creates an alert with tax authorities to investigate.
Repeated and/or consistent abnormalities in financial figures will increasingly attract the attention of the tax authorities. With every subsequent alert, your business will likely need to produce supporting documents or risk an audit.
Most of the common fraudulent activities which business in China engage in to minimize their tax liability are easily spotted through big data. We explain in a separate article exactly how Chinas Big Data Tax Plan exposes fraud efficiently and with incredible accuracy.
SCENARIO 3 – Applying for a tax refund
In China, applying for a tax refund is not as straight forward as you might think. Applying for a tax refund for overpaid CIT or VAT is going to require a tax audit of your business unless the amount is very small. A portion of amount claimed back might be offset by any hidden tax risks exposed during the tax audit.
Corporate Income Taxes are paid quarterly based on estimated profits followed by an annual tax clearance based on the actual profits at year end. If you overpay your corporate income tax for the financial year you might find yourself evaluating whether to take the risks associated with applying for a tax refund and being audited. Tax planning and proper financial controlling are the best ways to minimize the costs associated with claiming back overpaid taxes at year end.
SCENARIO 4 – Legal entity deregistration
Deregistering a company in China requires a full-scope tax audit to ensure 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, so expect them to be thorough. 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 contains significant tax risks that result from poor quality bookkeeping.
Learn how to diagnose your tax risk by looking at your balance sheet. 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.
How to protect against a tax audit
Avoiding a tax audit altogether is simply the best way to minimize the costs associated with compliance in China. 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 the scope of the audit increased from the past 1 year to up to the past 5 years or more.
Your financial department should be aware of those possible scenarios and guide you towards better financial choices. To do this, the finance professional must be involved inside your business. Traditional outsourced accountants do not have the necessary skills or resources to perform this role, leading to the many tax risks associated with an unexpected audit.
For most businesses, a virtual CFO is a cost-effective way to structure the financial function of your business. Virtual CFO’s are senior financial professionals that use cloud accounting technologies to achieve the necessary visibility of sales, purchasing, business expenses and other functions to work inside your business, as opposed to as an outsider. This allows them to efficiently perform the role of a traditional CFO at a fraction of the price.
