Levy of corporate income tax in Shanghai will no longer be based on a general assessment of a company’s income, but rather than an audit of accounts. The new ruling, effective from August 1, 2021, stops companies from taking advantage of loose audit methods to reduce the amount of taxable income, leaving many scrambling to deregister from the tax bureau and seeking to relocate to regions where the policy still stands.
On July 27, 2021, the Shanghai tax bureau confirmed rumors that the city would cancel the long-standing ‘levying upon assessment’ method for corporate income tax (CIT) collection (hereafter referred to as the ‘assessment method’). This will require companies, including sole proprietors and partnerships registered as general taxpayers, to switch to the ‘levying upon audit’ method (‘audit method’), which requires a much more thorough audit of a company’s accounts and special value-added tax invoices (‘VAT fapiao) to work out its taxable income.
In the wake of the news, many companies that took advantage of this policy rushed to deregister from the Shanghai tax bureau before the policy cancellation officially took effect on August 1. A flurry of articles has also appeared online discussing what options companies have to continue benefiting from this tax policy in other parts of the country, and who exactly will have to comply with the audit method for CIT levies.
In this article, we look at some of the reasons behind this move and what it means for the future of China’s tax laws, as well as what to do if you own a company that benefited from this policy.
Why Shanghai has cancelled the assessment method for corporate income tax
In some places in China, including in Shanghai prior to this ruling, corporate income tax is levied in one of two ways:
- ‘Levy upon assessment’ – where tax authorities make an assessment of the taxable income based on the average industry profit margin by looking at a number of company indicators, such as production and sales volume, and then levy the applicable CIT rate.
- ‘Levy upon audit’ – where tax authorities conduct an annual audit of the company’s accounts to determine its taxable income, and then levy the applicable CIT rate.
The standard CIT rate in China is 25 percent, with a reduced 15 percent CIT rate awarded to companies engaged in certain strategic and high-tech industries and/or set up in certain development zones.
Corporate Income Tax Rates in China
|Reduced for ‘small-scale enterprises’
||20 percent CIT levied on 12.5 percent of taxable income for companies with an annual profit of RMB 1 million (US$154,825) and below; 20 percent CIT rate levied on 50 percent of taxable income for companies with an annual profit above RMB 1 million and below RMB 3 million (US$464,410).
||A company with an annual taxable income below RMB 3 million (US$464,410), under 300 employees, total assets worth less than RMB 50 million (US$7.74 million).
|Reduced for specified high-tech companies
||A company that meets the criteria for designation as a “high-tech enterprise”, which include being in a high-tech field supported by the state, engaging in continuous R&D and the transformation of technological achievements into tangible products, and owning the intellectual property rights to its core technologies in China.
The assessment method for CIT has been highly beneficial for companies that cannot keep accurate accounts of all their income and expenditures, due to, for example, having expenditures that cannot be backed by VAT fapiao, which therefore cannot be deducted from the taxable income.
On the other hand, the assessment method can also be used as a form of punishment against companies without accounts or with unreliable accounts, as the method ignores the possibility that a company may be making a loss, and by extension that they could be eligible for CIT exemption.
However, it has become clear that this method is a rather blunt instrument, and one that is easy to exploit, leading it to be widely regarded as a ‘tax privilege policy’.
One potential tax loophole that this creates is enabling companies to reduce their taxable income through large-scale transfers of shares or property. As these transfers can only be taxed at the industry rate, regardless of how much income they generate (in China, capital gains are not taxed separately, but included within the corporate income tax), leading to a discrepancy in the taxable income.
Companies can also erroneously report their main business items or fail to report when there is a significant change in their business scope, resulting in a deemed taxable income that is below the lower limits of the overall industry.
And of course, even when information is reported in good faith, this system is unlikely to produce a highly accurate assessment of the actual taxable income, which means that there is a considerable risk that the tax collected is less than the income tax payable calculated based on accounting profit.
Who will be affected by this change?
The assessment method of CIT has been withdrawn for both sole proprietor and partnership companies registered as general taxpayers. In China, there are two categories of taxpayers: general taxpayers and small-scale taxpayers.
Small-scale enterprises are also known as ‘small and micro enterprises’, which for tax purposes is designated as a company that has an annual taxable income below RMB 3 million (US$ 464,410), employ under 300 staff members, and have total assets worth less than RMB 50 million (US$ 7.74 million). Companies that meet these requirements can be eligible for tax cuts, a measure put in place to foster the development of small and micro-enterprises.
The cancellation of the assessment method has thus far only been extended to general taxpayers; therefore, it is still uncertain whether small-scale enterprises will be affected. However, as previously mentioned, Shanghai has suspended the registration of new enterprises opting for the assessment method since the beginning of 2021, and it is still unclear whether they will reopen registration for small-scale taxpayers by the beginning of the next tax year.
Even if registration to the assessment method is reopened to small-scale companies, there is a high chance they will have to go through increasingly rigorous processes when being assessed and meet higher requirements for eligibility.
In addition, the assessment method for CIT levies has generally been more commonly used by smaller, younger companies without fully developed accounting systems, and many companies transfer to the audit method for CIT levies when they grow bigger and more mature.
How to comply with the audit method for CIT levy
With this change, companies that previously relied on the assessment method for CIT levy will have to either deregister after settling their current taxes, or default to the audit method. This will require them to go through a complex income reporting and audit procedure.
However, as only one method for levying CIT can be chosen every year, companies that have already registered with the assessment method will likely not have to switch to the audit method until January 1, 2022.
To comply with the audit method, foreign-invested companies are required to submit a series of reports to the State Taxation Administration (STA) each year, including an annual audit report and a CIT reconciliation report for tax returns, as well as additional reporting to a number of government bureaus. See our article on audit and tax compliance for a step-by-step guide to conducting annual audits in China.
Limitations of the new policy
The scrapping of the assessment method for CIT tax will not entirely hinder tax avoidance practices as long as this method is still permitted in other regions in China. In the wake of the news from Shanghai, numerous articles appeared online discussing where in the country the assessment method is still permitted, and how companies in Shanghai can benefit from them.
Some companies may also deregister and register new companies in a structure that will allow them to report a lower taxable income.
The future of corporate tax levy in China
With the benefit of hindsight, the cancellation of the assessment method has been a long time coming. At the beginning of 2021, Shanghai announced that it would suspend new applicants to the assessment method, and earlier in July, the city’s officials fully suspended the use of the method – a move that was swiftly replicated in various provinces, including Shandong, Sichuan, and Jiangxi.
Other cities and provinces in China have also tightened restrictions related to the use of the assessment method or gotten rid of it entirely. In June of this year, the Guizhou Province tax bureau issued a statement detailing the tightening of restrictions for the use of the assessment method. Meanwhile, the tax bureau of Hangzhou, the provincial capital of Zhejiang Province, announced earlier this year that taxpayers who report quotas or VAT fapiao amounts over a certain threshold will default to the audit method for CIT levies.
China’s STA has also supported reforms to the taxation and fiscal system and of the management of taxation of privately or individually owned businesses.
It appears, therefore, that China is on course to eradicate the assessment method entirely, or at the very least, place much tighter restrictions and barriers of entry for companies that wish to use it.
However, this method of tax exemption remains an important tool for local governments to attract investment to development zones within their jurisdictions. It is therefore likely that there will still be some areas in China that continue permitting this type of tax reporting method, even if the areas offering it become increasingly scarce.
Places that allow the assessment method may also increasingly issue caveats, such as eligible industries, upper limits on fapiao amounts, and limits on scopes of business, among other restrictions, and subject companies that choose this method to random inspections and other auditing measures.
As China’s financial system develops and matures, legislators will continue to update the tax system to keep up with the current market situation, seek to tighten regulations, and close loopholes. We expect to see more measures taken to demand a higher level of compliance with tax regulations and crack downs on tax avoidance practices in the coming years.
China Briefing is written and produced by Dezan Shira & Associates. The practice assists foreign investors into China and has done so since 1992 through offices in Beijing, Tianjin, Dalian, Qingdao, Shanghai, Hangzhou, Ningbo, Suzhou, Guangzhou, Dongguan, Zhongshan, Shenzhen, and Hong Kong. Please contact the firm for assistance in China at firstname.lastname@example.org.
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