Maybe your company is one of the lucky ones that the tax authorities have asked not to pay tax by the due date and agree to waive all late payment surcharges. Probably not! Nowadays, the tax bureaux in China operate more or less like private enterprises. They have a set target revenue to meet each year against which their performance is measured.
We have seen a significant increase in the number of tax investigation cases being carried out by the Chinese tax authorities toward the last quarter of 1998. Their aim is to collect revenue from foreign investment enterprises (FIEs) and representative offices of foreign enterprises to meet their revenue goal. Actually, some of the tax bureaux have been restructured so that more resources can be allocated to the tax investigation team.
What can a corporate taxpayer do to minimise its chance of being audited? And, if audited, how can it minimise the amount of levy and interest/penalties that may be assessed and imposed?
Reasons for tax investigation
First, a taxpayer should know the reason and scope of a tax investigation in order to plan the right course of action. Second, a tax-payer should understand the general procedures of a tax investigation in order to know the appropriate time to start the negotiation process. Finally, some precautionary measures may be taken by the taxpayer to reduce the risk of being investigated.
There may be different reasons for each tax investigation and the taxpayer should always understand the reasons behind the investigation in order to plan a course of action. The reasons might include:
Regular tax examination of accounts
This refers to routine examination of accounting records by the tax authorities. Generally, the tax authorities would not conduct an examination while the FIE is in a loss position or enjoying tax exemption holiday (i.e. the first two profit-making years). The examination is usually deferred until after the third year of the five-year tax holiday period. For regular examination, the tax authorities normally review all revenue and expense items without any specific focus.
No tax registration in the past
The tax authorities may view failure to perform tax registration as a tax evasion and impose surcharges on any underpaid taxes. We have seen a case where an FIE had a liaison office in another location and failed to perform tax registration there. The tax authorities of that location had treated the FIE as a tax evader and performed a detailed audit on that office.
Target/focus tax investigation cases
Sometimes the tax authorities may identify for tax investigation a certain target group of taxpayers, such as banks or representative offices of foreign enterprises. In other cases, the investigations may focus on a certain type of tax, such as value-added tax, business tax or withholding taxes. In the target/focus investigation, a taxpayer should cooperate with the tax authorities and provide all relevant information requested in order to shorten the duration of the investigation. If the tax authorities cannot find any underpaid taxes, the case can be closed quickly.
This is the worst scenario of the investigation and is often initiated by a disgruntled employee. In an informer case, the odds are against the taxpayer as the tax authorities probably know more details than the management themselves. Accordingly, the taxpayer should be as cooperative as possible. In informer cases, the tax authorities normally perform a detailed investigation on certain areas. There is a strong likelihood that the tax authorities would impose heavy penalties and surcharges on underpaid taxes discovered during the investigation. Although it is difficult to negotiate for a complete waiver of the penalties and surcharges, a reduction may be possible.
Consequence of other tax investigation cases Occasionally, tax investigation may be triggered by another investigation case. We have seen cases where the tax authorities performed a tax investigation on an enterprise and subsequently performed tax investigations on a FIE which had transactions with that enterprise.
Scope of tax investigation
The taxpayer should understand the scope of the tax investigation so that only relevant information is disclosed to the tax authorities. Generally, the scope of the tax investigation includes the following subjects:
VAT is a gold mine for the tax authorities since most FIEs are in a loss position. The tax authorities can simply check VAT special invoices received by the FIE for input VAT claim and not accept claims where the VAT invoices are not issued in accordance with the law (for example, where the numeric number is different from the Chinese character amount). Quite often FIEs may neglect to transfer out the input VAT associated with inventory written-off or abnormal losses to cost of goods sold. For FIEs in the consumer products industry, the focus is normally on deemed sales, such as gifts of self-produced goods. We have seen cases where an FIE had not paid VAT on promotional gifts given to customers and subsequently were assessed underpaid VAT plus penalties/surcharges.
The tax authorities generally review business tax paid on service income, interest income, rental and other income to ensure its compliance. For expense payments made abroad, the focus is whether business tax had been withheld for services rendered within China.
Enterprise income tax
While most FIEs are in a loss position, the focus in the enterprise income tax area is more towards transfer pricing adjustments and support of expense claims. Therefore, it is important for FIEs to ensure their transfer prices with related parties are justifiable and supported by documentation. The tax authorities may disallow expense claims where there is no proper invoices for the expenses.
The focus is on payments made overseas. The burden of proof rests on the taxpayer if no withholding is performed on some items. Although the taxes normally should have been borne by the overseas recipients, the tax authorities will require the taxpayer to pay the withholding tax since the payer under the law has the responsibilities to withhold such taxes.
Individual income tax (IIT)
The State Administration of Taxation has recently issued a set of procedures regarding special purpose tax inspection on IIT compliance. According to the procedures, all local tax bureaux should conduct special purpose tax inspections on IIT compliance target groups, which would include expatriates working in China and foreign individuals frequently travelling to work in China.
It is common to put expatriates on off-shore payroll and have their expenses charged back to an FIE. The tax authorities are educated and know to compare the amount of chargeback with that reported on the expatriate's tax return. The FIE should generally prepare a reconciliation schedule to identify items which are not taxable for Chinese IIT purposes and supported by documentation. For example, if the FIE identifies that the non-taxable portion is related to reimbursements of rental expenses, this would need to be supported by valid Chinese unified invoices.
Other local taxes and levies
Some local taxes and levies are calculated with reference to the amount of turnover or turnover tax payable, such as VAT or business tax. If there is any additional assessment on the turnover or turnover tax payable, the local taxes and levies could automatically be assessed as well.
Lately, we have seen that the tax authorities have been more aggressive in levying stamp duty on purchase and sales orders. This is the easiest area for the tax authorities to identify and assess tax as they can simply obtain sales and purchase amounts from financial statements.
The general procedures of tax investigation are as follows:
-The tax authorities issue a notice to the taxpayer, but in some cases there may be no notice, such as an informer case. In practice, the notice is often served with a telephone call.
-The tax officers visit the FIE and review all relevant accounting records, supporting contracts and documents.
-After reviewing the records and documents, the case officer issues a preliminary opinion of his/her findings. Sometimes, it may be possible to obtain a verbal preliminary opinion from the case officer before he/she puts the opinion into writing. If a verbal opinion can be obtained, it may signalthe correct time to start the negotiation with the case officer.
-After the preliminary; opinion .has been issued by the case officer, the taxpayer should negotiate with the case officer' or other tax officials or a higher-rank officer for the amount of underpaid tax as well as any penalties and surcharges.
-After negotiation, the taxpayer and the tax officials agree on the final settlement of the case. But sometimes there may be no agreement on the settlement.
-A final tax investigation report is issued to the taxpayer. The report may be based on a prior agreement or, if no such agreement is reached, based on the tax official's own opinion.
-A final demand note is issued for payment of the underpaid taxes plus penalties and surcharges.
-If the taxpayer is not happy with the settlement of the case, it may appeal to the senior level of the tax authorities. However, the taxpayer must make sure to pay the taxes and penalties/surcharges prior to making an appeal to the senior tax authorities.
A taxpayer may take some precautionary measures to reduce the risk of being audited and the impact of the investigation.
-The taxpayer can decide to perform a self-assessment or examination of its tax compliance. This is to ensure that it has correctly complied with the relevant tax laws and regulations.
-The taxpayer should have a policy in place for withholding taxes, such as business tax, enterprise income tax and IIT, on payments made to entities located overseas.
-A detailed tax compliance review, or health check, should be performed by tax specialists on the tax compliance status of the taxpayer in China. The health check could serve as a means to identify potential issues and to provide recommendation for course of actions.
-In order to be well prepared for any tax investigation, the taxpayer should keep proper detailed documentation and records of all revenue and expense items.
-The finance officer of the taxpayer should develop and maintain a good relationship with the local tax authorities so that it would be easier to start the negotiation with the tax officials during a tax investigation process.
During the tax investigation process, it is recommended that the taxpayer should identify or nominate a person or several staff to deal with the tax officers. This is to prevent any incorrect, inconsistent or unnecessary information being given to the tax officer.
Written by Matthew Wong, Tax Partner, and Diana fen, Senior Tax Manager, PricewaterhouseCoopers in Shanghai.
The above information is not intended to be comprehensive or final. It is only for the reader's reference. Professional tax and legal advice is strongly recommended if you or your company is involved in a tax investigation.