Why a “Tax Health Check” is important in China
By Maarten Roos and Michael Liu
Background
The official launch of the Golden Tax System Phase IV, an upgraded version of the Golden Tax System Phase III, is about to be implemented in China. The new system will not only monitor the business process of the taxation system as its former version did, but it will also monitor “non-tax” business. This means that in the near future, the Chinese tax authorities will achieve the transition from “tax management by invoices“ to “tax management by numbers”.
Under the tighter monitoring of this new and powerful tax system, companies will have to become more transparent and are more likely to be exposed to potential tax risks, which can lead to severe penalties. In response, companies are strongly recommended to perform a “tax health check” to ensure they are in good shape.
Definition and Purpose of a “Tax Health Check”
A tax health check is a review of all tax-related matters of a business entity, intended to identify potential weaknesses or risks arising from errors or omissions in the business records and accounting systems, as well as identifying potential tax liabilities. It reports on whether the entity is complying with tax laws and regulations, and is often triggered by the following:
- Investigation of the tax authorities
A tax health check can prepare a team for an upcoming investigation by local tax authorities, and can prepare a company in case such an investigation is initiated in future. In this context, the tax health check may focus on resolving issues that the tax office would otherwise raise.
- Internal control
A tax health check can guide entities to conduct a tax scan on internal control processes in terms of tax matters. A well-functioning tax internal control process (either manual or automatic) can build a solid basis for the company to take proactive strategies to manage tax risks.
- Mergers & Acquisitions
A tax health check is often executed in preparation for or as part of a tax due diligence for an acquisition project. The tax status of an entity is one of the most important factors taken into consideration when potential investors make acquisition decisions. Therefore, a tax health check can help to identify issues that should be resolved prior to the due diligence, or as part of the due diligence to properly inform potential inventors about the current situation and avoid them overemphasizing any potential tax liabilities of the target company.
- Clarity
To provide the business entity with a reasonable level of comfort in affirming that local tax returns will not contain any inappropriate statements and/or estimations.
The Scope of a “Tax Health Check”
A health check review normally focuses on the following types of China taxes that a foreign-invested enterprise is subject to:
| Corporate income tax | Real estate tax |
| Withholding tax | Stamp duty |
| Value-added tax | Individual income tax for employees |
| Consumption tax | Land appreciation tax (where applicable) |
| Customs duty |
Examples
Corporate income tax (CIT) is one of the most common taxes in business operations. Based on our experience, two kinds of mistakes are commonly made when companies file their CIT reports.
- There are certain types of activities that do not seem to be a sales activity in terms of business but should nonetheless be deemed as a sales activity in terms of tax regulation. Companies can easily miss out on reporting the related revenue when they file CIT reports. To give an example, a company may use its inventory or other assets as a physical reward to employees. This must be reported as revenue when companies file the CIT report.
- Not all kinds of costs and expenses can be (fully) deducted when calculating taxable income. For example, when a company makes a loan agreement with its parent company, the related interest expense may not be fully deducted due to limitations on interest rates set by tax regulations.
Withholding tax normally occurs when companies distribute dividends to shareholders outside China or when they make non-trade payments such as loan interest, royalty fees, consulting fees etc. to companies abroad. We often see companies failing to withhold tax when they make such payments, especially when their bank does not require a record of taxes paid as part of the bank’s approval process.
Conclusion
The Chinese market is rapidly growing with tremendous business opportunities for foreign investors and their Chinese subsidiaries. While seeking to advance their business into the Chinese market, it is also crucial and difficult for companies to work out solutions for tax compliance purposes in China.
A “tax health check” is an extremely effective tool to give a company or its (foreign) shareholders a clear overview of the tax situation in China and what steps could be taken for optimization and compliance.
R&P is a full-service law firm; our tax department supports foreign clients and their Chinese subsidiaries on tax-relates issues in China. Many clients outsource their administrative and compliance functions to R&P's affiliate Acclime China, which provides a full range of services including custodian of stamps and licenses, treasury, payroll, and accounting + tax filing assistance. For more information, please contact Gina Chen ([email protected]) or Maarten Roos ([email protected]).