Are
you ready to face the tax man?
A recent survey found that out of 3,200
Representative Offices (tax) audited in China, over one third
(1/3) had understated individual and corporate tax liabilities
of various forms over the year. The outcome - $8 million in extra
tax revenue when investigated by the tax bureau.1
The lesson - all companies in China are facing greater chances of
being audited by tax the taxation authorities.
Such is the rhetoric or the 'reality'
facing the business community in China at present. Some say justifiably
so, explaining - "if you are reaping profits from operating in
China, then you should pay tax according to the laws, thereby giving
something back to the community."
The taxation environment in China is
becoming increasingly stringent and many
companies are still operating illegally. This is extremely dangerous.
Not only have the tax authorities been given more powers and access
to more wide-ranging penalties, they are also gaining access to greater
information to discover such fraudulent activities and more resources
to investigate business activities.
Accounting to understate
profits may have worked well in the ill-regulated and fragmented tax
collection system of the past. However, recently
there has been a surge on auditing of transfer pricing agreements,
especially where foreign enterprises are party to the contract, offshore
interest payments are now being heavily scrutinized against the prevailing
(annual) commercial rate in the P.R.C (5.08%) with only this amount
deductible for tax purposes, and government departments are beginning
to work together to share information.
Many Foreign Invested Enterprises are,
however, operating legally and paying all taxes due. The majority
of companies use legitimate 'arms length' transfer pricing arrangements
to repatriate profits, enter into loan arrangements at commercial
rates and realise full profits in China, on which they pay taxes.
There are over 400,000 FIEs currently invested in China,which gives
the tax bureaus a lot of incentive to double
check.
The
delicate balancing act!
This Friday (8th November, 2002) the
Chinese government faces arguably the largest challenge in the past
54 years - the top three leaders are likely to step aside for a new
breed of politicians. Hu Jintao (proposed replacement to Jiang Zemin)
has assisted the government in balancing
the three represents (san ge dai biao), which include the Communist
Party's embrace of private businessmen, against the desire to maintain
a socialist-market economy.
At the same time, Li Peng's replacement is going to have to balance
China's legislative development and congress in light of WTO
commitments and internal expansionary policies. It
is at this political grassroots level where such balancing acts become
even more important for FIEs.
On a day-to-day basis, China is trying
to balance aggressive infrastructure and development projects with
a changing tax base and rapid economic policy development. Not only
are local and state tax departments under pressure to help build the
national public kitty, but their tax bases are being shifted and eroded
at the same time. A number of the major recent changes include:
- Falling
import duties in line with WTO commitments:
"Most Favoured Nations Import Duties" have fallen from
an average of 42% in 1992 to an average of 12% in 2002.2
WTO commitments will further reduce this and will begin to eat away
at the "General Customs Duties" - eroding an even larger
slice of the taxation pie.
- Cutting
back of preferential tax treatment policies:
With the development of the economy and improvements to the legal
system, the government is now trying to shift its tax incentives
from a geographical regime to an industry-oriented system, which
may better serve the interest of the whole economy. This has adversely
affected certain municipalities such as coastal cities which rely
on the tax policies to induce investment.
- A shift
of emphasis away from Business Tax (BT) to Value Added Tax (VAT):
The widening scope of VAT will
shift tax revenue away from BT, which is collected at local tax
bureaus, to VAT, which is collected at state tax bureaus. This will
create issues with budget allocations, especially for high-infrastructure
spending municipalities such as Beijing.
Statistics from the tax department indicate
tax avoidance of up to 50% in some areas.
To combat this a number of circulars have been issued by the State
Administration of Taxation (SAT) which are aimed at cracking down
on avoidance, increasing intensity on reviewing individual income
tax, and clamping down on various industry groups.
The reality
The fact that the SAT has openly targeted
foreign companies and high-income earners (above RMB 100,000 annual
salary) has certainly raised a bit of a stir within the expatriate
community in China. To back these government directives up, the SAT
has also been granted greater powers and information including:
- If a tax payer fails to complete
tax registration procedures, the tax bureau can request the Administration
Bureau of Industrial and Commercial ("ABIC") to cancel
the business license that was issued.
- The penalties applicable to underpaid
tax have changed. The old system provided for penalties up to 5
times the tax payable as well as late payment interest. The difficulty
with this system for the Government was that the tax authorities
were often negotiable on the penalty because of the burden of interest
chargeable, which was calculated at 0.2% per day (73% per annum).
The new
system provides for a penalty of above 50% to below 5 times tax
payable, as well as interest payable daily at 0.05% (18.25%
per annum). The new system provides for a minimum payable penalty,
which reduces local tax bureau discretion, and therefore tax payer
negotiability.
- Another significant
change relates to information exchange. Previously Government
bureaus operated independently with no legal requirement to share
information. Under the new rules the ABIC are required to inform
the tax bureau of new registrations and the tax bureau have an obligation
to inform ABIC should proper registration with them not take place.
- Additionally, the immigration
department is due to be linked with the tax bureau, which has rattled
the foreign communities more than any other change. In fact, the
legal representative of a corporate taxpayer or an individual taxpayer
with overdue tax liabilities, penalties and/or interest due
could be stopped from leaving the country.
Tax
is also a matter of good corporate governance ...
Companies in China must
be especially careful to be seen as being good corporate citizens
in the new tax environment. Not only are companies up for large penalties
if they break the law, but the tax authorities are now developing
a database to record companies' tax compliance history.Three
categories have been developed in which companies will be now classified.
This 'categorisation' of
enterprises involves input from tax bureaus, banks, government bodies
(e.g. Ministry of Finance), bureau of auditing, credit agencies, amongst
others.
Category
A - Companies who have demonstrated outstanding corporate
governance, especially in taxation. Such companies are provided
preferential treatment and basically left alone by the SAT.
Category
B - Companies which have demonstrated observance to corporate
governance standards and have generally abided by the rules and
regulations. Entities in this category are subject to "light"
supervision and audit inspections.
Category
C - Such companies have been found in breach of the law
and regulations. These companies are targeted by tax authorities
and are under heavy investigation for tax audits.
The process of categorisation is only
in its initial stages of implementation, but it does certainly indicate
initiative from the SAT and government to tighten
controls. As competition on the mainland grows and public information
bureaus develop, corporate citizenship will become an increasingly
important factor of successful business in China. An "Enron"
case is not likely to happen on the same scale in China in the near
future, but getting on the wrong side of the tax departments could
certainly have the same devastating results.
The
final word
For decades now taxation in China has
essentially been negotiable. Local municipalities were provided great
powers to offer tax incentives to foreign investors, and late/underpaid
taxes could be sorted out through negotiation. This certainly not
the case any more.
Tougher penalties,
targeting of foreign companies and a more integrated tax administration
system are certainly forcing many companies in China to reexamine
their books.
Many companies are now re-examining
their past years' statutory audits to ensure that they were
actually in compliance, regardless of signed auditor reports.
The new "Accounting
System for Business Enterprises" (applicable to all
FIEs in China as of January 1, 2002) has brought China closer into
line with International Accounting Standards (IAS) and strengthened
financial regulation. Firms need to adhere to these new rules and
to be more stringent in their financial diligence, documentation and
controls. Amongst other requirements, companies should ensure they
can prove inter-related party transactions
were conducted at 'arms length', costing of raw materials was 'fair'
and their accounting reports have been upgraded in line with the new
accounting requirements.
At present the tax department is somewhat
more understanding if companies volunteer information
and pay-back any underpaid/unpaid taxes. This period can act as a
window of opportunity to clear up any skeletons in the closet. It
should also be noted that the tax departments can go back 10 years
to check tax records and appropriate documentation.
Given the issues discussed above, there
is certainly "no time like the present" to sort out taxation
issues in China. The goverment is getting serious about tax ... and
peeling back the layers to find it.
Russell
Brown, Partner, Beijing.
Note:
1. China Prosperity Supervision Centre and CCTV China Economy Report
, 2002.
2: CPA Taxation Laws (shui fa), Economics
Science Press, Jingji kexue chu ban she, 2002.
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Special
Seminar Opportunity - "Accounting System for Business Enterprises"
LehmanBrown
China is pleased to announce a seminar to explain the inner
workings of the new "Accounting System for Business Enterprises".
The seminar will be held in Beijing from November 28th to 29th.
These
seminars present an opportunity for bookkeepers, accountants,
financial managers and directors, as well as other interested
parties, to get up to date on the changes and application of
the new Accounting System for Business Enterprises in China
which is mandatory for all companies in China from January 1,
2002. With the crackdown on taxation, especially for FIE companies,
currently underway this seminar is integral for anyone preparing,
interpreting or using financial statements in the P.R.C.
The
seminar will also cover certain topical business issues in China
at present including changes to taxation regulations, FOREX
regulations and other issues applicable to FIEs in China.
For
registration information visit: www.lehmanbrown.com/seminars.htm
or for phone registration call: Rachel Wan, Tel: (86 10)
8532 1720 today.
Space
is available for a maximum of 15 participants at the 2 day seminar,
so be sure to book early.
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