Tax system in mainland China is complicated by itself with various different types of taxes involved. Moreover, its laws, regulations, interpretations and practices are not always clear and consistent which may create various “tax traps” for unsuspecting foreign investors.

More Comprehensive Taxation Rules

With the issuance of the revised Tax Administration and Collection Law, tax authorities were granted with more authorities to access to taxpayers’ information and strengthen the tax collection measures by the following means:

1. Information sharing between tax bureaus and other government authorities is encouraged e.g. State or Local Administration of Industry and Commerce (“AIC” are required to regularly inform the tax authorities on new entities registrations or other changes in business registrations. Business licence can be cancelled by the AIC upon the request from the tax authorities if a taxpayer declines to perform tax registration.
2. Disclosure of all bank accounts details to the tax authorities in charge is mandatory. By doing so, the tax authorities are able to obtain access to the taxpayers’ bank accounts or even freeze the bank accounts of those non-compliance taxpayers. Penalties may also be imposed on banks for non-compliance.
3. Legal representatives of corporate taxpayers with unsettled tax and late payments may not be allowed to leave China.
4. Tax authorities would have the rights to announce the details of non-compliance taxpayers, including the names of the company and the legal representatives as well as the amount of underpaid taxes. This can impose significant reputation risks to the taxpayers.
5. Tax non-compliance would be subject to heavy penalties: 50-500% on the tax unpaid for taxpayers and 50-300% for withholding agent. In addition, late payment surcharge of 0.05% per day will also be imposed.

Common PRC Tax Non-Compliance Issues

The following are examples of tax issues uncovered in tax audits/investigations and are the main focus of PRC tax authorities:

Corporate Taxes

• Maintaining multiple sets of accounting records for tax reporting and management purposes;
• The use of offshore tax haven entities for booking profits overseas without proper justifications and substance;
• Making payments to non-residents which would have tax withholding obligations for the target company. Outward remittances in the form of royalties, interest, service fees to non-residents would be subject to both PRC withholding income tax and business tax;
• Adopting aggressive tax schemes or relying on verbal special arrangements/tax concessions with local authorities without any legal basis;
• Claiming fraudulent expenses deduction e.g. personal expenses of shareholders;
• Unsupportable transfer pricing policy is adopted to shift profits overseas or to related Chinese affiliates to which a lower income tax rate is applicable (Please refer to Transfer Pricing section below for details);
• Improper use of special VAT invoices or claiming excessive input VAT.

Transfer Pricing

Transfer pricing regulations in China are rapidly developing as the Chinese authorities target transfer pricing adjustments as a major source of tax revenues. Tax bureaux are becoming increasingly concerned with transfer pricing policies implemented by foreign investors in the PRC. These companies might manipulate their pricing strategies through related-party transactions and result in a loss of tax revenues.

Under the transfer pricing regulations, tax bureaux would have the right to make transfer pricing adjustments to enterprises in which they consider their profits levels to be unusually low when compared with third party comparable companies.

Foreign investment enterprises who have the following characteristics would be most vulnerable to transfer pricing audits:

• Large transaction amounts with associated enterprises;
• Long period of losses after operations;
• Small profits or losses for a long period, yet expansion in business;
• Transactions carried out with associated enterprises in tax haven jurisidictions;
• Profits lower than other companies within the group;
• Sudden drop in profits level after a tax holiday.

Transfer pricing adjustments would generally be made for three years. However, under special circumstances, this period may be extended to 10 years.

Since there are only limited levels of tax appeal in China and the burden of proof in transfer pricing disputes rests with taxpayers, proper documentation for transfer pricing policies are important. Advanced Pricing Agreement with tax authorities is also an effective measure to mitigate the future transfer pricing risk of PRC enterprises by ensuring that its future profits will be accepted as being reasonable by the mainland China tax authorities.

Individual Income Tax (“IIT”) on Expatriates

As an effort to clear up delinquent IIT and give a fresh start to all foreign investors, the State Administration of Taxation has effectively provided an amnesty over penalties under a circular, Guoshuifa [2004] No. 27 and subsequent issuance of another circular, Guo Shui Ban Han [2004] No. 364 to clarify the issues relating to the amnesty. The measures encouraged taxpayers to conduct self-inspections on their IIT filings of the previous years by waiving penalties for voluntary back-filing before the end of 2004.

Given the expiry of the IIT amnesty period, the stepping up of tax audits/investigations on IIT by tax authorities in different levels and locations would be expected. Those who fail to take advantage of this amnesty program probably would subject themselves to higher non-compliance risk in the future.

Some examples of common misunderstandings and improper practices leading to IIT under-reporting are as follows:

• The use of dual/multiple contracts to minimise IIT liabilities;
• It is an acceptable practice to report only a nominal salary;
• Reimbursement of expenses without valid PRC tax invoices;
• Remuneration paid/borne by overseas entities is exempted from IIT;
• Employer’s contributions made directly to pension plans, medical and insurance schemes, and social security are non-taxable;
• Stock options granted by overseas company would not be taxable in China.

Due to the special withholding agents provisions under the PRC tax laws, both the individuals as taxpayers and the employers as withholding agent would be separately subject to penalties and surcharges for failure to properly comply with the PRC IIT filings or withholding obligations. It is advisable that employers review the IIT positions of their employees and ensure that proper withholding obligations have been fulfilled. Tax non-compliance issues identified should be rectified in a proper manner.