China’s fast growth has helped to produce one of the world’s most difficult and challenging tax environments. The country’s tax system and regulations are changing constantly to meet the demands of its rapidly expanding economy, while its tax authorities are under mounting pressure to generate tax revenue. In this environment, businesses are confronting more tax investigations and audits, more assessments and more frequent application of penalties.
As David Ling explains, companies need to meet these challenges by taking a proactive approach to potential tax disputes and controversy and by being well prepared to respond to tax audits or assessments.
In China, the incidence of tax investigations and disputes appears to be rising. What’s driving this increase?
Since 2008, the pace of tax law reform has quickened as China’s central government seeks to adopt best international practices in taxation law. While such modernization is welcome, companies and tax authorities alike are challenged to keep up with these complex changes, and interpretations of new tax laws may vary among tax authorities at different levels and in different locations. A second factor causing the increase in tax investigations and assessments are the intense demands on tax authorities to increase revenues, especially at the local level.
Other contributing factors include increased awareness of tax avoidance, greater cooperation among tax authorities globally, the application of new technologies in tax investigations, and the deployment of a national reporting system throughout all levels of central and local tax authorities. Strong audit and investigation bureaus are now in place in all tax authority levels, and a Large Enterprise Division has been created to directly manage tax compliance and enforcement for selected large enterprises.
What should companies in China do to prepare themselves for a tax audit?
Every company will get audited by a tax authority at some point, whether by the State Administration of Taxation (SAT) or a local tax authority, and many of these audits will result in a tax assessment and penalty.
The best ways to prepare to meet the challenges of a tax audit and possibly minimize any tax assessment or penalties are to have sound internal control systems and to know your tax risk factors. You should also undertake regular “tax health checks” to help ensure that you:
- identify and quantify the potential impact of non-compliance and other risk factors
- identify recommended tax treatment changes
- improve any identified tax internal control weaknesses.
Companies should seek to understand the tax authorities’ technical positions and enforcement approach, and plan their dealings accordingly. Establishing good working relationships with the tax authorities is critical. Negotiations with the tax authority can be effective in encouraging more favourable determinations, for example, on the scope of the audit, the finding and the penalties.
When a company disagrees with tax authority’s finding and/or assessment, what options does the company have to resolve the dispute?
Taxpayers have the option to settle the audit findings with tax authorities at the field level to avoid dispute. Once both sides have agreed on the audit findings, the taxes are then paid, mistakes are corrected and the investigation ends. This option usually results the best outcome for taxpayers.
However, where a taxpayer disagrees with the audit findings and negotiation with the tax authorities is not successful, the taxpayer may attempt to resolve the dispute through the lengthier administration review process. This step must be followed before the commencement of any judicial proceedings, and taxpayers must pay the taxes raised on assessment before the administrative review process can begin. The application for review must be submitted within 60 days of the decision, and the review should be completed within four months. Although administrative reviews are intended to be independent, in reality, these decisions are often influenced by the original ruling tax authority or they are approved by the upper tax authority. As a result, the outcome of the administrative review process may not be in the taxpayer’s favor.
What steps are being taken to provide more guidance, consistency and certainty for taxpayers in China?
China is seeking to align tax authority interpretations and improve consistency across regions. Businesses are being encouraged to enhance their levels of voluntary compliance. To this end, the SAT has proposed to introduce a system of advance rulings for enterprise taxpayers in China. The SAT is also pilot-testing tax compliance agreements with taxpayers to encourage them to establish effective internal control systems in exchange for less scrutiny from tax authorities.
What specific improvements are being made in the area of transfer pricing policy and administration?
Since revamped transfer pricing regulations (Circular 2) were issued in 2009, Chinese tax authorities have become increasingly active in enforcing transfer pricing matters. They run an aggressive transfer pricing audit program, supplemented with a maturing APA program. Recently, they are focusing more on the day-to-day administration and advance management of taxpayers’ transfer pricing issues. This focus has led to informal, pre-audit assessments by tax authorities. In these cases, the taxpayer can elect to make adjustments to its taxable income, although these adjustments may not be eligible for double tax relief.
Based on statistics in the SAT’s 2012 APA annual report (PDF 1.5 Mb) more taxpayers in China are seeking tax certainty by pursuing an APA. In order to be eligible for the APA program, applicants must have over 40 million renminbi (RMB) in annual related party transactions, and they must have prepared and/or submitted annual filing and contemporaneous documentation in accordance with the Chinese transfer pricing regulations.
The rising volume of APA applications has lengthened the amount of time needed to complete an APA. Chinese tax authorities say they plan to recruit and train a larger pool of tax officers with transfer pricing expertise to support the APA program, thereby alleviating the current bottleneck.
Given the current tax audit environment in China, it seems that companies would do well to seek advice of local tax professionals.
When doing business in China, local professional tax advice is a must. For example, tax professionals in China are well positioned to conduct an independent “health check”, as described above, to identify potential compliance deficiencies and communicate with the tax authorities to help forestall an adverse assessment. In the event of a tax appeal, local advisers can help establish a smooth communication channel with the tax auditor and help raise the issue to a more senior level or even with SAT to better understand the technical positions and possible resolutions.
In short, engaging a global firm with a strong network of local advisers in China can help ensure your tax affairs are in good shape in each location while ensuring your overall tax obligations are managed with coordination and efficiency.
David is the Partner in Charge of KPMG’s Northern China tax practice as well as the Tax Dispute Resolution and Controversy practice leader in China. He has 20 years of experience in China tax planning and negotiating with counterparties. He specializes in advising foreign companies on establishing and maintaining operations in China, including investment holding companies, foreign-invested trading companies and manufacturing companies in China.
David has extensive knowledge of the China’s Customs regulations, foreign exchange control policies, and other regulatory matters affecting foreign investment in China. He has developed long-time relationships with various PRC authorities at both central and local levels, and he has helped many foreign companies secure favorable advance tax and other rulings.
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