The collection of corporate income tax in Shanghai is no longer based on a general income assessment, but on an audit. The new regulation, which will come into effect on August 1, 2021, will prevent companies from using casual audit methods to reduce the amount of taxable income, causing many to de-register from the tax office and relocate to regions in to which the directive still applies.
On July 27, 2021, the Shanghai Tax Bureau confirmed rumors that the city would abolish the long-standing corporate tax collection (CIT) method (hereinafter referred to as the “assessment method”). This requires that companies, including sole proprietorships and partnerships, act as general taxpayersto switch to the “collection on audit” (“audit method”) method, which requires a much more thorough examination of a company’s accounting and special VAT invoices (“VAT fapiao”) in order to determine taxable income.
According to the news, many companies that have made use of this policy have rushed to deregister from the Shanghai Tax Office before the policy is repealed on the 1st from this tax policy in other parts of the country and who exactly will adhere to the CIT assessment method got to.
In this article, we look at some of the reasons for taking this step and what it means for the future of Chinese tax laws and what to do if you own a business that benefits from this policy.
Why Shanghai Abolished the Corporate Income Tax Method
In some places in China, including Shanghai prior to this ruling, corporate tax is levied in two ways:
- “Tax on assessment” – where the tax authorities set taxable income based on the average profit margin in the industry using a range of business indicators, such as volume of production and sales, and then collect the applicable CIT rate.
- “Filed On Audit” – when the tax authorities conduct an annual audit of the company’s financial statements to determine its taxable income and then collect the applicable CIT rate.
The standard CIT rate in China is 25 percent, with a reduced CIT rate of 15 percent for companies that participate in certain strategic and High-tech industries and / or set up in specific development zones.
Corporate tax rates in China
|default||25 percent||N / A|
|Reduced for “small businesses”||20 percent CIT on 12.5 percent of taxable income for companies with annual profits of RMB 1 million (US $ 154,825) and below; 20 percent CIT rate on 50 percent of taxable income for companies with annual profits over RMB 1 million and under RMB 3 million ($ 464,410).||A company with annual taxable income of less than 3 million RMB ($ 464,410), fewer than 300 employees, and total assets of less than 50 million RMB ($ 7.74 million).|
|Reduced for certain high-tech companies||15 percent||A company that meets the criteria for being a high-tech company, including being in a government-sponsored high-tech field, continuing research and development and transforming technological advances into tangible products, and owning the intellectual property rights to its core technologies in China.|
The valuation method for the CIT has proven to be very beneficial for companies that cannot accurately record all of their income and expenses, for example due to expenses that cannot be covered by VAT Fapiao and which therefore cannot be deducted from taxable income.
On the other hand, the valuation method can also be used as a form of punishment for companies with no or unreliable accounts, as the method ignores the possibility that a company may make a loss and thus also qualify for CIT exemption.
However, this method has been found to be a rather blunt and easy-to-use tool, which has led to it being widely viewed as a “tax break policy”.
A potential tax loophole that this creates is that corporations can reduce their taxable income through large-scale stock or property transfers. Since these transfers can only be taxed at the industry rate, regardless of the amount of their income (in China, capital gains are not included separately but are included in corporate income tax), this leads to a mismatch in taxable income.
Businesses may also falsely report their primary business positions or fail to report if their business volume changes significantly, resulting in taxable income that is below the industry floor.
And even if information is reported in good faith, this system is unlikely to provide a very accurate estimate of actual taxable income, which means there is a significant risk that the tax collected will be lower than that based on the calculated Income tax payable on the balance sheet profit.
Who is affected by this change?
The CIT assessment method has been withdrawn for both sole proprietorships and partnerships that are registered as general taxpayers. There are two categories of taxpayers in China: general taxpayers and small taxpayers.
Small businesses are also referred to as “small and micro-businesses,” which for tax purposes are referred to as businesses that have annual taxable income of less than 3 million RMB ($ 464,410), employ fewer than 300 people, and have total net worth have less than RMB 50 million ($ 7.74 million) worth. Companies that meet these requirements can take advantage of tax cuts, a measure designed to encourage the development of small and micro businesses.
The abolition of the assessment method has so far only been extended to general taxpayers; It is therefore still uncertain whether small businesses will be affected. However, as mentioned earlier, Shanghai has suspended registration of new companies that choose the assessment method since early 2021 and it is still unclear whether they will reopen registration to small taxpayers at the beginning of the next tax year.
Even if the registration is reopened for the Small Business Assessment Method, there is a high likelihood that they will have to go through increasingly stringent assessment processes and meet higher eligibility requirements.
In addition, the CIT levy assessment methodology is generally more widely used by smaller, younger businesses without sophisticated accounting systems, and many companies are switching to the CIT levy assessment methodology as they grow and mature.
Compliance with the test method for the CIT surcharge
With this change, companies that previously relied on the assessment method for the CIT-surcharge will either have to deregister after paying their current taxes or use the verification method. This requires them to go through a complex income reporting and auditing process.
However, since only one method for collecting the CIT can be selected each year, companies that have already registered with the assessment method will probably not have to switch to the test method until January 1, 2022.
In order to comply with the audit methodology, overseas companies are required to submit a number of reports to the State Tax Administration (STA) each year, including an annual audit report and a CIT reconciliation report on tax returns, as well as additional reports to a number of government agencies. Read our article on Auditing and Tax Compliance for a Step by step instructions to carry out annual audits in China.
Limitations of the new policy
The abolition of the CIT tax assessment method will not completely hamper tax avoidance practices while the method is still legal in other regions of China. In the course of the news from Shanghai, numerous articles appeared on the Internet, in which it is discussed where in the country the valuation method is still allowed and how companies in Shanghai can benefit from it.
Some companies can also opt out and register new companies in a structure that allows them to report lower taxable income.
The future of corporate tax in China
In retrospect, the abolition of the valuation method has been a long time coming. In early 2021, Shanghai announced that it would be suspending new applicants for the assessment method, and in early July city officials suspended the method entirely – a move that was quickly repeated in various provinces, including Shandong, Sichuan, and Jiangxi.
Other cities and provinces in China have also tightened or eliminated restrictions on the use of the assessment method. In June this year, the Guizhou Provincial Tax Bureau issued a statement detailing the tightening of restrictions on the use of the valuation method. Meanwhile, the Tax Bureau of Hangzhou, provincial capital of Zhejiang Province, announced earlier this year that taxpayers who report quotas or VAT fapiao amounts above a certain threshold will default to the CIT tax assessment method.
China’s STA has also supported reforms of the tax and tax system and the taxation of private or sole proprietorship.
It seems, therefore, that China is well on its way to completely abolishing the valuation method, or at least introducing significantly stricter restrictions and entry barriers for companies that wish to use it.
However, this method of tax exemption remains an important tool for local governments to attract investment in development areas within their jurisdiction. It is therefore likely that there will still be some areas in China that will continue to allow this type of tax reporting method, even as the areas that offer it become increasingly scarce.
Locations that allow the assessment method may also have increasing reservations, such as eligible industries, limits on fapiao amounts, and restrictions on business size, and companies that choose this method may undergo random inspections and other audits.
As China’s financial system develops and matures, lawmakers will continue to update the tax system to keep up with the current market situation, tighten regulations and close loopholes. We expect more action to be taken in the coming years to demand higher levels of tax compliance and crackdown on tax avoidance practices.
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