Annual audit and compliance in China, and taxation in China are a necessary, but often complex, area for all companies registered in the country to understand. As well as monthly, quarterly or annual tax calculations and payments during the year, all companies must comply with a series of year-end requirements which are often more demanding than in their home countries.
- This article will explore:
- The annual year-end requirements in China and timetable for foreign companies
- Specific audit and compliance reports that need to be submitted
- Differences in the Chinese accounting system and the importance in year-end audit
- Our advice and suggestions for annual compliance
Annual requirements timetable
The financial year in China follows the calendar year, and the annual compliance procedures for companies start straight after the end of the year. They generally take until the end of June to complete.
The first step is the preparation of annual accounts and an audit report by a Chinese registered accountancy firm. A reconciliation of Corporate Income Tax (CIT) for the year is also carried out. The audit should be completed by the end of April and the tax reconciliation by the end of May. Many companies will also need to complete reports for Transfer Pricing, also by the end of May.
Running alongside this, with a completion date of the end of June, is the annual inspection process. This requires various filings to local government departments and is required for an ongoing business license in China.
Overall, the compliance process can be split into 5 steps- we will discuss each of these separately here:
- Annual audit – by end of April
- Tax reconciliation / Annual tax return (including Transfer Pricing Reports) – by end of May
- Annual inspection and reporting – by end of June
- Annual foreign exchange reconciliation (due date varies locally)
STEP 1 – ANNUAL AUDIT
Starting in January, and generally taking up to 4 months to complete, an annual audit needs to be carried out for the previous year’s activity. For a foreign company such as a WFOE, this needs to be prepared by a Chinese Certified Public Accounting (CPA) firm.
Standard reports that need to be produced as part of the audit include a full balance sheet, an income statement, and a cash flow statement. There are regional requirements which may require additional reports on top of these. For example, Shanghai local authorities require an additional taxable income adjustment sheet to be included.
Differences in Chinese Accounting Standards
Foreign companies should note that as well as using a Chinese CPA firm, accounts must be prepared in accordance with Chinese Accounting Standards (CAS). This will likely involve some restating of financial statements to meet the required standards.
Accounting standards in China underwent a major overhaul in 2006 to bring them more in line with international standards. Prior to that, accounting in China was very different! The accounting system was originally developed in a Communist system in which the state was the sole owner of property and industry. As such, accounting and reporting focussed much more on assets and inventory, rather than profit and loss, and debt. Clearly, in a market economy, and with foreign-owned participants, changes were helpful!
These new Chinese Accounting Standards, also known as Chinese Generally Accepted Accounting Principles (Chinese GAAP or PRC GAAP) are similar to the globally recognized International Financial Reporting Standards (IFRS) and also US GAAP, but there are a number of important differences.
Some of the key areas of difference to be aware of include:
- Chinese GAAP depreciation methods are different. CAS uses different valuation methods for fixed assets. IFRS allows valuation either by historical cost or by the revaluation of assets, whereas CAS insists on the historical cost principle.
- More detailed coverage of certain areas in IFRS. There are areas where IFRS has more detailed coverage that has been adopted by CAS. An often relevant example of this is employee benefits, where there are many more options permitted under IFRS than CAS, making the incorporation under CAS of some employee benefits packages difficult.
- Delays in the adoption of IFRS rules. There is often a delay period between the issuance of new rules under IFRS and their adoption into CAS. Any new rules are reviewed for appropriateness in China by the Ministry of Finance. Even if they are approved for inclusion, there is likely a period where the standards differ.
STEP 2 – ANNUAL TAX RETURN
Separate from the financial audit, companies must complete an annual Corporate Income Tax (CIT) reconciliation report. This is to ensure that tax has been correctly paid for the previous year. Besides, FDI China offers a free China’s tax compliance guide.
As CIT is calculated and reported on a monthly or quarterly basis, there can be inconsistencies with regards to total amounts paid over the year. There are differences between tax laws and accounting standards which mean the total tax liability can differ from the accounting book totals. The reconciliation report will determine these differences. As a result of the tax reconciliation, additional CIT may need to be paid, or a reimbursement made of CIT already paid.
Additionally, as part of tax reconciliation, Transfer Pricing Reports will have to be completed by most companies. These look at transactions between related parties and ensure appropriate taxation on these. This follows the generally applied “arms-length principle” meaning that transactions between associated companies should not be different from market rates/prices. The transfer pricing system in China underwent a significant overhaul in 2006 and the new regulations (documented in SAT Announcement no. 42) impose strict reporting and calculation requirements. These changes are very much in line with the government’s aim to reduce tax avoidance.
Companies need to prepare a statement about relevant inter-company/related parties, with detailed information on these companies. This is submitted along with the same timescale as the tax reconciliation, at the end of May. For companies with relevant transactions (with limits defined by SAT in Announcement 42), additional documentation is required (with differing submission deadlines). In summary, two major documents are needed:
- A “Master file” which provides an overview of the group’s policies and activities
- And a “Local file” which focuses on the Chinese company and transactions with other companies. This includes detailed company disclosures including a “Value Chain analysis” looking at the group’s activity.
Tax reconciliation is a requirement from the State Administration of Taxation (SAT) and locals tax bureaus will issue guidelines for this during the first couple of months of the year. Preparation would usually start in February, and the submission deadline is May 31st. Note however that subsequent processing and review by local taxation bureaus can carry on until the end of the year, and more information may be requested.
It may be possible for a company to complete reconciliations independently, although using an experienced agent is common. In many regions, however, there is a requirement to use a Chinese Certified Tax Agent to produce a CIT audit report in certain financial situations. For example, in Shanghai, a CIT audit report is required when a company has made a loss of more than 5 million RMB or has offset any losses from a previous year.
STEP 3 – ANNUAL REPORTING TO AIC
In parallel with the financial reporting, audit and tax reconciliations to be carried out, WFOEs must also report detailed company and financial information to the local government. Some of this is made public through AIC disclosure, but much of the financial information can be kept private.
This process is known as the Annual Reporting or Annual Inspection process and involves a number of submissions to the local State Administration for Industry and Commerce (AIC). Preparation for this generally starts from January, and the submission deadline for AIC is June 30th. The full submission is part of the requirements for business license renewal, and there can be strong penalties for failure to submit.
Information to be submitted as part of the Annual Report includes the following:
- Basic details of company and status
- Summary financial, tax and assets information
- Any equity investments
- Details of any company equity change, or shareholder contributions
For a fuller discussion of annual reporting requirements, see our article on preparing an Annual Inspection Report.
STEP 4 – FOREIGN EXCHANGE STATEMENT
Foreign exchange transaction in China is controlled by the government, through the State Administration for Foreign Exchange (SAFE). In the past, it was necessary to complete an audit/statement of all current foreign inflows and outflows. This had to be done using a CPA firm and was often combined with the annual audit, although the submission deadline to SAFE was later.
These requirements have changed in recent years and all that is required now is an annual registration with SAFE known as “Existing Right Registration.” This does not need a CPA audit and is a statement from the company regarding the current state of foreign investor’s equity. This is an important step as repeated failure to register can result in the removal of rights to carry out foreign exchange transactions.
Our advice for the annual compliance in China
At FDI China, we have helped companies through the annual audit and compliance process many times! We share here some of the more important things from our experience to bear in mind:
- Remember the differences between China GAAP and IFRS regulations. Although this is a task normally completed by a finance department or external accountant, it is still very important to bear in mind. The conversion process and frequently changing regulations can impact the audit timing and need to be allowed for. It is also vital to understand differences when combining or comparing statements with other accounts (e.g. company foreign owner).
- Beware of local differences in requirements and returns. It is very common in China for laws and regulations to differ between regions/cities. Whilst Company Law and compliance requirements are generally set at the State level, they are implemented and controlled regionally. There are often cases where regional authorities (AIC) ask for different inclusion in audit reports or make timetable amendments. A good local advisor or accountancy will be aware of this.
- The new (2016) Transfer Pricing Reports contain detailed information and can be complex to complete. For companies with relevant transactions and volumes, further guidance is likely required.
- Don’t underestimate the importance of compliance! Year-end audits and compliance in China are viewed very seriously. Failure or delay in completing any part of this can result in extra expenses, penalties, delays or refusal of ongoing business license. What’s more, companies will not be able to repatriate any profits or dividends until the audit is complete.
Start the audit as early as possible. The audit process can often bring up unexpected issues and challenges and certainly should not be left late to start. Many companies find advantages in even starting before the year-end. A preliminary audit in November / December will free up more time in the busy January / February period, and also allow more time to focus on other areas, such as company controls.
Taking into account all these changes and practical considerations, what is the minimum capital for WFOE setup in China?
Today much more than in the past, this is a practical consideration based on the plans and financial projections for the WFOE. The AIC will look at this, and it makes sense for the WFOE to plan capital levels with reference to this as well. In the absence of any over-riding circumstances, it is common to base this on the planned expenses for the first two years.
Taking this as a starting point, companies should also look at expected income or shareholder payments, as well as any planned expansion. Companies new to the China market would be well advised to use an accountant with experience in China for this. There are many differences to planning costs in China, such as an increased need for advance payment for the rental, stock, and even some salary costs. Besides that, there are further important considerations before opening a WFOE in China.
Remember is it important to set the capital level right at the start. If it is set too low, then any additional funding required will be taxed when injected (the level could be raised but this is difficult). And if it is set too high then it is likely that at some point money will be left idle in the capital account, instead of being put to use.