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Annual compliance

In advance of being able to distribute and repatriate profits, FIEs must complete annual compliance procedures, involving the following steps: producing a statutory annual audit report, making a CIT reconciliation report, and reporting to relevant government bureaus. These procedures are not only required by law, but are also a good opportunity to conduct an internal financial health check. The relevant procedures and key considerations vary slightly by region and entity type. Companies should either contact a service provider or the local government to achieve full compliance.

Step 1: Prepare an annual audit report

The annual compliance procedures start from the annual audit of the business. As mentioned in the first article, although the audit report is generally not required to be submitted in the compliance process for FIEs nowadays – companies only need to disclose whether they have done annual audit during annual reporting – most companies still conduct their audit on a yearly basis out of various considerations, and get the audit report ready before the end of April to meet the May 31 tax reconciliation deadline.

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The annual audit report for FIEs generally consists of a balance sheet, an income statement, a cash flow statement, a statement of change in equity, and a supplementary statement of financial indicators. To ensure that FIEs meet Chinese financial and accounting standards, the annual audit report should be conducted by qualified accounting firms and signed by two Certified Public Accountants (CPAs) registered in China.

To be noted, in the case where an annual report is required, the requirements for the report may vary by region. For instance, in Shanghai, companies must include a taxable income adjustment sheet in the audit report, which is not a necessary supplement in Hangzhou, Beijing, or Shenzhen.

Step 2: Conduct CIT reconciliation

Although the State Taxation Administration (STA) oversees all kinds of tax, only corporate income tax requires annual reconciliation to the tax bureau at the company level.

In China, CIT is paid on a monthly or quarterly basis in accordance with the figures shown in the accounting books of the company – companies are required to file CIT returns within 15 days from the end of the month or quarter. However, due to discrepancies between China’s accounting standards and tax laws, the actual CIT taxable income is usually different from the total profits shown in the accounting books.

As such, the STA requires companies to conduct annual CIT reconciliation within five months from the previous year’s year-end to determine if all tax liabilities have been met, and whether the company needs to pay supplementary tax or apply for a tax reimbursement.

All companies engaging in production and operation, including pilot production and operation, are required to go through this procedure, regardless of whether or not the company is under a tax deduction period, and whether or not the company makes profit. For companies maintaining branch offices in multiple locations and required to pay tax on a consolidated basis, there are special rules and requirements regarding CIT reconciliation procedures. Companies should pay special attention to the matter if they fall into this scope.

Generally, the Annual CIT Reconciliation Report must include adjustment sheets to bridge the discrepancies between tax laws and accounting standards among other documents. FIEs that conduct transactions with related parties should prepare an Annual Affiliated Transaction Report on transfer pricing issues as a supplementary document to the Annual CIT Reconciliation Report.

[tips title="Important Tip"]FIEs in certain regions might be required to prepare another separate CIT audit report by meeting certain conditions, which also vary from city to city.[/tips]

In the current trend of digitalization and business reform, annual CIT reconciliation can be conducted through online channels, under which companies can conveniently submit relevant information in the appointed system. This is specially recommended in the context of the COVID-19 pandemic. However, if companies cannot make online CIT reconciliation due to certain circumstances, they can still go to the tax bureau in person to submit relevant materials as required.

The deadline for conducting annual CIT reconciliation is May 31 every year, but the investigation of the tax compliance could last to the end of the year, and companies should be prepared to provide supporting documents upon demand from the tax bureau. Besides, where companies are unable to conduct CIT reconciliation within the stipulated deadline due to a force majeure event, such as where the company was quarantined due to COVID-19 control measures, they may apply for an extension. But they must submit a report to the tax bureau immediately upon cessation of the force majeure event. The tax bureaus shall investigate the facts and approve accordingly.

Every year around March, depending on the location, the local tax bureau will issue annual guidance on CIT reconciliation. FIEs are suggested to keep an eye on the guidance for any potential changes regarding the requirements and procedures.

Step 3: “Many-in-one” annual reporting

The third step of annual compliance is to conduct annual reporting to multiple government bureaus. Starting from 2020, with the new Foreign Investment Law coming into force, the annual reporting to the local Administration of Market Regulation (AMR, which previously was called Administration of Industry and Commerce or AIC) and the annual combinative reporting were merged into one “many-in-one” annual reporting, under which the FIEs can submit all relevant information at once through the National Credit Information Publicity system (www. gsxt.gov.cn).

The annual report submitted should cover the following information:

  • Basic information of the enterprise, including the contact information, the existence status of the enterprise, the
    business scope, the licensing situation, the staffing and salary information, the social insurance contributions, the IP situation, etc.
  • Investor profile, including information regarding the subscribed and paid in amount, time, ways of contribution, the actual controller of the investor, etc.
  • The name and URL of the website of the enterprise and of its online shops.
  • Equity change information of the equity transfer by the shareholders of a limited liability company.
  • Information relating to any investment by the enterprise to establish companies or purchase equity rights.
  • The balance sheet information of the enterprises, including total assets, total liabilities, total owner’s equity, etc.
  • Warranties and guarantees provided for other entities.
  • Information regarding the operation of the enterprise, including total imports and exports, total revenue, income from the main business, operational cost and expenses, R&D expenses, total tax payment, gross profit, net profit, profit distribution, etc.
  • Information regarding the credit and debt.
  • Tax breaks information if the enterprise enjoys preferential treatment for importing equipment.
  • Customs relevant information if the enterprise is subject to the administration of the customs.

Part of the information will be synced from the statistics maintained by other government bureaus, such as the social security bureau and tax bureau, automatically. Enterprises are required to prepare and submit other information online during the period between January 1 and June 30.

If the enterprise fails to submit the annual reporting information on time, it will be put into the Catalogue of Enterprises with Irregular Operations (Irregular Operations Catalogue), which is open to the public. Besides, the enterprise will also be put into the Irregular Operations Catalogue if fraudulent information or serious concealment are discovered by authorities in the random check following the annual reporting.

If the enterprise is listed in this Catalogue for three years in a row, there will be more serious consequences – the enterprise will be put into the Catalogue of Enterprises with Illegal and Dishonest Behaviors, which serves as a blacklist for future operations and investments.

The legal representative and the general manager of the blacklisted enterprise will be banned from taking the legal representative or general manager role in other enterprises for three years, and the blacklisted enterprise will be at a disadvantageous position in bidding, government procurement, licensing application, obtaining land, as well as making new investment in the future.

FIEs are suggested to pay attention to the deadlines and requirements, or make timely correction where incompliance happen, to avoid serious consequences.

For ROs, annual compliance procedures are simpler. They also need to prepare a statutory audit report and a tax reconciliation report, and then report to AMR between March 1 and June 30 every year. In certain cities, RO is also required to submit an existence certificate of headquarter during the annual compliance process.

Following the annual audit and completion of tax payment, a net profit figure can be derived.

[tips title="Important Tip"]The decision to repatriate and/or reinvest profit will depend on the current situation of the China-side FIE and its parent company abroad.[/tips]

However, not all profit can be repatriated or reinvested. A portion of the profit (at least 10 percent for WFOEs) must be placed in a reserve fund account, and treated as part of owner’s equity on the balance sheet. This account is capped when the amount of reserve funds equals 50 percent of the registered capital of the company. In addition, the investor may choose to allocate some of the remainder towards a staff bonus welfare fund or an expansion fund, although these are not mandatory for WFOEs.

The remaining net profit is available for redistribution. Following a resolution of the board of directors, an application form for the repatriation of funds can be submitted to the tax bureau to authorize the bank to disperse funds.

Pilot program of rolling annual reporting in selected cities

Starting from 2019, China has introduced the pilot program of rolling annual reporting in selected cities. Under the pilot program, the annual reporting is required to be done on a rolling basis, rather than by June 30.

First introduced in five cities – Liaoyuan (Jilin Province), Quzhou (Zhejiang Province), Yueyang (Hunan Province), Shenzhen (Guangdong Province), and Zhuhai (Guangdong Province) – enterprises are required to submit the annual reporting of the previous year within two months from the anniversary of its establishment. In 2019, enterprises subject to customs administration were excluded from the pilot program, which meant they still needed to follow the traditional reporting path and deadline. In 2020, FIEs have also been excluded from the pilot program.

In Hainan, starting from October 1, 2019, the rolling annual reporting system started to get implemented as well. Different from the system in the first five cities, enterprises in Hainan can choose any date as the annual reporting deadline. If they do not want to choose a different date, enterprises need to submit the annual report of the previous year within two months from the anniversary of their establishment. However, enterprises subject to customs administration, companies limited by shares, and FIEs are excluded from the rolling reporting system. Moreover, enterprises without business activities can apply to be dormant and are thus exempted from annual reporting. Hainan’s pilot program will end on December 31, 2021.

Although this pilot program seems quite unstable presently and FIEs are excluded from the pilot scope, the pilot program is more in line with international practices. There might be a possibility that the pilot program gets expanded to other cities. FIEs are suggested to follow up with future updates.

Due diligence

Broadly speaking, due diligence is a thorough review of a company so as to uncover any fraud, non-compliance, or other issues posing a risk to potential partners. Due diligence procedures, which can vary widely based on the intended business transaction and industry of the companies involved, are often split into legal, financial and operational due diligence. However, it can also include market, reputational and cultural considerations. A due diligence checklist in China is generally quite similar to those used elsewhere, likely including a review of:

  • Legal documents for company establishment and any additional government approvals and licenses;
  • Financial documents, including annual audits, tax returns, current financial statements and loans;
  • Documentation for real estate and land use rights (in China, land is owned by the state; an individual can merely purchase land use rights);
  • Documentation for intellectual property and hard assets;
  • Major contracts, distribution records, etc.;
  • Litigation history and outstanding litigation (if any); and
  • HR administration documents.

One of the key differentiating aspects of due diligence in China is the variety of issues commonly discovered in accounting books, from a company completely misrepresenting its financial situation to minor accounting errors that may come from misguided actions to help the company (i.e. by avoiding tax) or lack of knowledge. Some very common points to pay attention to in financial due diligence investigations in China include the following issues:

  • Two or more sets of financial accounts - many companies keep two or more sets of financial accounts so as to avoid tax, but this practice can also be used to cover up inappropriate financial behavior.
  • Revenue received “off the books” - underreporting of accounts receivable is often used to hide sales and reduce taxable income.
  • Employees paid “off the books” - employees are sometimes paid “off the books” so as to increase expenses and avoid paying taxes on labor salaries. This can result in high liabilities related to IIT and social security.
  • Phantom assets and contracts - the assets list on the books are often an overstatement or understatement of assets actually held. Assets are sometimes “mixed” with those of shareholders. Depending on the seriousness of infractions discovered in the course of an investigation (if any), it may be necessary to re-evaluate one’s dealings with the subject company.

Internal control and audit

Strong internal control systems and periodic audits are essential to preventing fraud when running a company in China. The following is a list of common types of fraud in China-based enterprises (including FIEs with less than adequate internal control systems), separated by department:

  • Payroll
    • Discrepancy between contract salary and payroll payments;
    • Deliberate over-accrual/unauthorized use of welfare benefits; and
    • Ghost employees (non-existent employees, whose salary is often sent to the bank account of another employee).
  • Supply Chain
    • Purchasing of overpriced raw materials due to relationship/inappropriate agreement between staff and supplier;
    • Improper disposal of scrap;
    • Fake VAT invoices; and
    • Poor inventory control.
  • Sales
    • Sale of goods at/below cost due to relationship/inappropriate agreement between sales staff and purchaser;
    • Payment of unauthorized sales commissions to employees or friends; and
    • Lack of competitive bidding process.

A key aspect of the Chinese legal environment is the use of official company seals, or “chops”, to legally authorize documentation (often in place of a signature). To safeguard against fraud, chops should not all be held by one person and steps should be taken to ensure that chops are not misused.

Depending on its business scope, a company may hold any number of chops, all for different purposes and used on different types of official documentation, including a company chop, financial chop, contract chop, customs chop, invoice chop, etc.

An internal audit ordered directly by company headquarters is the best way to evaluate the effectiveness of internal control systems and prevent fraud in a China-based entity. An internal audit engaged by the China-based entity and reporting only to that entity runs the risk that fraud discovered at the local level may not be reported to the overseas headquarters.

[faq title="FAQ: Annual accouting and audits in China" ui="accordion"]

How to prepare for an effective annual audit in China?

Whether an audit is effective or not makes a big difference in a company’s governance and development in the long run, though it is not easy to identify the audit effectiveness right after the process.

From the company’s perspective, an effective audit can help maintain its financial health and offer advice on how certain processes may be improved. To be more specific, an effective audit can:

  • ensure that financial statements of the company present a true and fair view of its financial situation;
  • reveal irregularities and suboptimal business practices;
  • identify risks in different functional areas; and
  • offer advice on improving internal

An effective audit should also complete to schedule and with minimal disruption to the company.

To achieve audit effectiveness, besides choosing a qualified audit firm, it is vital for companies to make preparations in advance, among others. An audit will be more meaningful for companies if auditors have adequate time to analyze accounts and evaluate control procedures, instead of being occupied with simple checks. This article is designed to provide some practical guidance based on our professional on-the-ground experiences.

What do companies need to prepare in general?

For companies, preparing for the annual audit goes beyond simply providing the accounts and ledgers. In general, companies can help to improve the audit effectiveness by taking the below measures:

Make a thorough inventory of the assets

Before the auditor conducts a spot check of the company’s assets in the substantive audit, companies are suggested to make a full-scale stocktake of the assets by themselves, to verify the existence and completeness of their assets. This is especially recommended if companies never check their assets on a regular basis.

Companies should arrange cash count, inventory count, and fixed assets inspection, among others. If obsolete inventory items, idling assets, and defective products are found during the check, they should let the auditors know and start to think about making impairment assessments.

The thorough stock take is suggested to be arranged as close to year-end as possible. Otherwise, companies may need to provide stock-in and stock-out information to roll back or roll forward to reconcile the actual stock take results and year-end accounting books.

Arrange confirmations

Bank confirmation is a primary focus in verifying the bank balance of the financial audit. Before the auditor’s investigation, companies are suggested to get relevant information ready in advance, including bank statements, bank reconciliations, bank balance, borrowings, guarantees, time deposits, bank mailing address, and contact number, etc. This will shorten the time spent at this stage and provide the auditor a good impression.

Besides bank confirmations, auditors may arrange confirmations for the current accounts to verify the existence and accuracy of the selected amounts, such as the related-party balances and transactions, trade receivables and payables, inventory on consignment, advancements to employees, etc. From the companies’ perspective, they are suggested to check accounts with current customers before the annual audit, if they didn’t do this regularly. This will save much time for their auditors.

Analyze recoverability of receivables (credit risks)

Credit risks analysis on financial assets often involves management’s judgment. While many companies find it difficult to conduct such an analysis, it is nevertheless essential to assess the recoverability of financial assets such as trade debtors.

Under the newly effective accounting standard on financial instruments, the expected credit loss model should be adopted when making the analysis. The accounts receivable aging analysis alone is no longer sufficient for impairment assessment of financial assets.

Companies should make clear accounting policies on what factors are to be taken into consideration when assessing credit risks, look for reasonable and supportable forward-looking information that is available to the management, and determine the risk of default.

If there are indeed such default risks based on companies’ self-evaluation, it will very likely be noticed and inquired by the auditor during the audit. Companies are suggested to think about how to justify the risks when being asked.

Prepare for expense checking

It’s important for companies to obtain and maintain tax-deductible expense vouchers, which, in China, mainly refer to VAT invoices. Companies are suggested to check and prepare relevant invoices and other documentation in advance. When the year-end approaches, for invoices that should have been but are not yet obtained, companies should try to see if there is any chance to get them ready before the financial audit. Should companies fail to obtain legitimate expense vouchers before filing the annual CIT returns, relevant expenses will become non-deductible for CIT purposes in the current year.

For outbound expenses paid to overseas vendors, relevant taxes must be withheld, or else such expenses will not be pre-tax deductible.

Besides obtaining VAT invoices and other legitimate tax-deductible vouchers, companies should also make full provision of the expenses in their accounting books, irrelevant of whether they have received the VAT invoice or not. All expenses should be properly recorded before the end of December.

Remember to bind your accounting vouchers and keep them tidy and organized. By making a good impression on the auditors, companies may expect fewer questions from the auditors.

Analyze profits and justify fluctuations

Companies should analyze their profit ratio in advance. In case significant changes are found for essential indicators, such as gross margin fluctuations or selling expenses increase, companies should have valid explanations to justify the fluctuations, as such irregulates will definitely be noticed by their auditors and lead to queries during the audit.

Make sure relevant staff are on duty

As introduced above, beyond providing documentation prior to the actual audit, companies should prepare for offering additional information and details behind the figures, which requires close support of all key staff during the audit.

Thus, companies should plan around the audit to ensure that all key finance and accounting staff and other key staff of the operational teams haven’t booked time off and have a general free schedule during the audit. Ideally, these staff should be available at any time when required.

What are the Corporate income tax (CIT) related preparations?

Under the current policy, companies decide whether they are qualified for certain CIT incentives based on their self-assessments. This simplifies the process for enjoying tax incentives but increases potential tax risks where there have been misjudgments. So, auditors generally will help to make CIT relevant evaluations in the annual audit, although they do not express an opinion in this regard.

From the companies’ perspective, they are suggested to prepare relevant sub-ledgers and gather and retain supporting documents for such items in advance. On the other hand, they are suggested to carefully examine if they have exhausted all possible tax reductions.

What are the additional preparations for the 2021 newly effective accounting standards?

Starting January 1, 2021, several new accounting standards have been applied to all entities that have adopted the Chinese Accounting Standards for Business Enterprises (CAS), including the CAS No.14 regarding revenue, CAS No.21 regarding leases, and accounting standards regarding financial instruments (CAS No.22, 23, 24, and 37).

The implementation of new accounting standards is likely to pose new challenges to the accounting work of relevant enterprises and could impact their daily business decisions, internal control, financial performance, and other aspects.

Companies that are obligated to adopt the new CAS but have not yet due to their insufficient understanding of the accounting standards or practical difficulties, should seek professional advice as early as possible to see how they can prepare.

Even companies that have adopted the new CAS will still need to prepare for the extra queries and documentation requirements from auditors regarding the implementation details of the new accounting standards.

For example, as a lessee, based on CAS No.21, your auditors may need you to provide the amortization table for lease liabilities and depreciation schedule for right-of-use assets. They may also ask you to explain and justify the discount rate you have been using and how do you calculate the implicit interest rate in the lease.

Are there any special considerations due to the COVID-19 pandemic?

Travel restrictions

Under China’s zero-tolerance approach in combating the COVID-19 pandemic, strict quarantine and travel restrictions are applied whenever there is an outbreak, which will be of comparatively high frequency during the audit season when the cold environment is more suitable for virus survival and transmission.

To prepare for this situation, companies are suggested to start the preliminary audit and formal audit as early as possible. Especially for those whose auditors are based in a different city from them, they should leave enough buffer time in case of sudden travel restrictions.

Business continuity

Despite the fact that the global economy is in recovery mode and uncertainty over COVID-19 is no longer the foremost economic concern to many executives, the pandemic has still taken a toll on businesses. Companies may suffer cash flow difficulties because it takes longer to collect the debt from the customers. The reliability of income and cash flow forecasts may become questionable due to unexpected developments associated with the pandemic in certain areas.

Under this situation, auditors will pay special attention to business continuity or “going concern” during the annual audit. Companies might be asked questions like “Have you assessed the impact of COVID-19?” “How did the management respond to the changing economic conditions”, etc. If significant, this information may even be disclosed in the financial reports of the company.

To prepare, companies should analyze in advance about:

  • if they have sufficient liquidity to remain solvent through the pandemic and beyond;
  • if they have any access to financial support from the parent company or a banking facility not yet utilized; or
  • if they are qualified for any government

Internal control and fraud

Besides the impact of domestic travel restrictions on annual audits, the travel restriction between China and the rest of the world may result in foreign general managers being stuck outside of China, which in turn will affect the implementation of the internal controls and cause disruption in the reporting line.

Moreover, the company management may have a greater incentive to override controls due to increased pressure on growth under COVID-19 or to correspond to changes in the business environment, such as inflation and supply chain disruption.

All these will lead to a higher risk of irregularities and fraud.

What is accounting digitalization?

Accounting digitalization, or tech-powered accounting solutions, means the use of information technology to optimize the finance and accounting processes. “Shift to digital” has been an emerging trend, especially since the outbreak of COVID-19.

Different from other preparations that are directly related to the annual audit and can be made right before the process, accounting digitalization is more like a long-term investment that has multiple benefits, including making the financial audit easier and more effective.

To be more specific, compared to traditional methods, finance, and accounting technology has advantages in efficient allocation of work hours, accurate accounting through real-time capture of information and computerized calculation, system integration with compliance/reporting mechanisms, and more optimal (rather than one-time) use of company data.

For example, a lot of information that needs to be prepared for the audit, such as how much money is owed to each vendor and what is the aging schedule/accounts receivable aging for each outstanding transaction, can be displayed on a searchable accounts payable list. This information itself is delivered from a specific module of the tech-powered accounting software, which in turn gets populated automatically from the digitalized expense management app.

Another example relates to fixed assets management. Important questions during audits include: What information does the company have about its fixed assets? How far have they depreciated? What is the nature of these assets? All this information will be pulled directly from the fixed assets module of the tech-powered accounting software and displayed on a fixed assets list.

At the very least, going digital results in most documentation being accessible online, saving auditors and executives from rifling through filing cabinets at the financial year-end. For companies that haven’t adopted the finance and accounting technology, they are well advised to think about it for the next year or plan for in the near future. Newer tech-enabled accounting solutions are no longer prohibitively expensive or difficult to use. For companies that use an accounting service provider and don’t have highly complex requirements in terms of processing or reporting, flexible platforms now exist, whose access is part of the services provided by accounting providers to smaller firms, sometimes with only minimal upfront setup fees.

How to get the most out of the annual audit?

An effective audit is beneficial to a company’s management and development in the long run. To pursue audit effectiveness, close collaboration between the auditor and the auditee is needed.

From the companies’ perspective, by conducting necessary self-checking, preparing needed accounting and tax documentation, analyzing core finance issues, and preparing for auditors’ inquiries in various aspects, they can not only help to minimize the disruption of the annual audit on their business operations but also enable a more comprehensive audit that can help senior management gauge the efficiency of the financial workings of their company.

In addition, to get the most out of the annual audit, companies are suggested to take the chance to improve their internal control and review related-party transactions. Especially for smaller companies that don’t have a designated team to handle the matters and don’t have separate internal control reviews and transfer pricing assessments, it is well advised to integrate these value-added reviews into the annual audit process.

Given this, auditors will likely increase the risk assessment level and come up with more inquiries, more tests of controls, and more substantive tests. Companies should be mentally prepared and get ready for collaborating with the auditors more closely for the additional inquiries and tests.

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