We often receive calls from foreign business owners who are trying to introduce financial controls into their business in reaction to some unusual activity related to cash transactions by their local business partner or managers. Hindsight never fails them as they realize the risks they unknowingly exposed themselves to by not having introduce such controls earlier. In the case of one business owner, the activities of their business partner implicated them in tax evasion, a crime that carries significant individual penalty in China.
This individual in particular came to Axel Standard looking for accounting software to remedy their problem, but they approached us when it was too late. Their initial capital had already been depleted, without any record of what it was spent on. Their business partner used a common defense that their actions were in line with most small businesses in China.
Whether you do business in china with the help of a local business partner or have observed some of the common business practices, you will have notice that proper handling of financial transactions is rare, especially when it comes to recording cash transactions. Perhaps you scanned a personal WeChat QR code to pay for goods, or you were told that a fapiao was not available, both are common examples of the business owner may be engaging in tax evasion.
More severe examples exist, such as purchasing input fapiao’s in order to reduce corporate profits, thus paying less corporate income tax. However, with the introduction of China’s Golden Tax III tax reform agenda, such activities are becoming riskier and already carry serious repercussions for the business owners.
This article outlines some simple practices for any foreign business owner to protect themselves from such activities while simultaneously improving the financial information available to them to better run their business in China.
Cash transactions / Paperless business
Cash transactions, or paperless business, refers to financial transactions that do not get recorded on the books, therefor do not incur any value-added-taxes. Trying to lower one’s VAT paid is an all too common practice in China. Low level suppliers often offer clients a small discount if they forfeit an input fapiao or refuse one altogether. Without input fapiao’s to be deducted against output fapiao’s, the client ends up paying a higher net VAT amount on their end. This practice is often extended to employee salaries, paying a portion of the salary in cash, thus avoiding individual income tax (IIT) and social security costs, while making up the difference in cash.
Paying for goods and services in cash and forfeiting an input fapiao only makes sense if the business is accepting cash payments for their own sales, thus avoiding any financial records altogether. It should not surprise anyone that this kind of activity is not tolerated by the tax authorities.
Read more about how to better manage fapiao’s and avoid overpaying on your taxes.
When we spoke to the business owner which mentioned earlier, they shared the response from their business partner when pressed about recording revenue which they were certain was coming in.
“We don’t need to book any revenue since we don’t have any expenditure.”
-Local Business Partner
This individual had been complacent to their business partner paying bills in cash. When it came time to reconcile their transactions for an accurate financial state of their business, it was impossible due to the actions of their business partner.
It had even got to the point where the business owners had lost track of their initial investment. It was evident from the company bank account that the seed investment had already been spent, without any record of what it was spent on.
Avoiding profits
In the case of many Chinese small businesses, the business owners or managers aims to reduce profits as much as possible to avoid 25% corporate income tax, a highly illegal practice. To hide any profits the business might have made from tax authorities and any business partners, the use of “fake” input fapiao’s for services which were never received are used to deduct any profit the company might have made. The cash is then spent freely or pocketed by the persons involved.
It cannot be overstated that this kind of activity is highly illegal and can results in heavy fines, revocation of business license and even imprisonment of the individuals involved. The individual who approached us to implement transparency into their businesses financial reporting feared that they was unknowingly an accomplice to their business partner’s tax evasion.
Risks associated with business activity
The tax evasion practices we discussed are all too wide spread amongst businesses in China and cutting down on such activities nationwide is the one of the main focus’ of China’s tax reform. Some of the baseline indicators that put businesses at risk for a tax audit include;
If selected for a tax audit, the business must produce the supporting documents in addition to that which is required for compliance to prove that the tax amount paid is correct. Even if the business did not engage in any tax evasion activities, this can carry significant cost to the business in the case a detailed set of books has not been kept.
Beyond the risks of attracting the attention of tax authorities through your actions, those who engage in cash transactions or paperless business run the risk of a disgruntled employee with knowledge of your business activities notifying the tax authorities of your illegal activates. This puts you at a significant disadvantage when running your business on a day-to-day basis.
Golden Tax 3 (金税三)
The Golden Tax III (GTS 3) is the third iteration of an electronic tax system developed originally in 1990, the third of which went into full effect in 2017. The GTS 3 increasingly scrutinizes individual tax returns and implements measures of IIT filings that fight corporate tax avoidance. With it comes a new policy giving Chinese tax authorities the ability to demand the individual bank records of the business owners or managing directors bank account if suspected the individuals account has been used to evade taxes.
With the involvement of individuals bank accounts and consequential linking of WeChat and bank accounts and the ease of reconciling those transactions electronically, the most commonly used methods of engaging in cash transactions for small businesses are becoming increasingly risky. In case of an audit, it becomes very difficult to explain the large business transactions being conducted via an individual’s bank account and scrutinizes any other individual income they might have.
Solutions
Hindsight provides a clear view of the risks that business owners do expose themselves to when they do not properly maintain their finances. Avoiding such risks altogether always involves some pre-emptive actions on the part of the business owners.
Some simple pre-emptive actions that any business owner can implement are;
1. Implement clear corporate governance guidelines via a shareholders agreement before any capital injection – We recommend that you include provision such as; requiring all cash transactions to be processed through the company bank account to ensure the consistency, reliability and accuracy of financial data, requiring monthly/quarterly financial reporting to management, and mandating all business owners have viewing access to company bank accounts. You can also mandate the use of accounting software for all sales/bills paid by the company.
2. Hiring an independent accountant – to monitor business transactions and remain impartial to any one business owner or manager in financial reporting. The role of a CFO is to implement internal control procedures to maintain the integrity of not only financial reporting but entire business processes that involve company assets. Virtual or share CFO services are available and offer these benefits at the fraction of the cost of in-house CFO’s.
Read more about simple internal control mechanisms to protect your most important assets.
3. Using adequate accounting software – By mandating the use of adequate accounting software it makes significantly more difficult for any one person to engage in tax evasion. When used correctly, software provides a means of transparency to all business owners and simplifies processes such as; tracking shareholder equity, monitoring cashflow, and compliance in the event of an audit. Axel Standard recommends Megi Cloud Accounting systems for most small business applications.
The benefits of implementing adequate financial control into a business go far beyond avoiding the risks and consequences outlines in this article. Financial control provides business owners valuable information on the current state of their business for important financial decision making, capital raising, management decisions and can prevent fraud.
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