According to PRC Company Law and other relevant regulations, all foreign-invested enterprises in China, including Wholly Foreign Owned Enterprises, Joint Ventures, Foreign Invested Commercial Companies and Representative Offices, are required to comply with statutory annual audit and other compliance processes.
All foreign-invested enterprises are required to hire external accounting firms to conduct an annual audit of the company’s financial reports. The audit report must be signed by a China-qualified Certified Public Accountant.
The objective of a statutory audit is to ensure that companies meet Chinese financial and accounting standards, including proper use of Chinese GAAP.
All accounting documents, books and statements prepared by a foreign-invested enterprise must be in Chinese. Foreign businesses have the option to write them concurrently in English or other foreign languages.
Foreign-invested enterprises in China can distribute and repatriate their profits or dividends back to their home country only after completion of their annual statutory audit and settlement of all tax liabilities
What are the key areas in an annual audit?
For Joint Ventures, Wholly Foreign Owned Enterprises and Foreign Invested Commercial Companies, accounts related to purchases and sales are usually the most vulnerable areas in a statutory annual audit, and so more time would typically be spent reviewing these accounts and ensuring that the accounting data is genuine and accurate.
This is done by comparing the transactions with the corresponding contracts, invoices, orders, and inventory changes.
In addition, it is quite common for foreign-invested enterprises new to China to conduct most of their transactions with affiliated companies overseas. For example, they would import from their foreign parent company and sell the products domestically, or export products purchased from China to their overseas affiliates.
These transactions can raise issues in transfer pricing and bring the foreign company into non-compliance with the Chinese tax bureau.
For Representative Offices, attention will be paid more to expense accounts and financial statements, because daily business operations are relatively simple compared to other types of foreign-invested enterprises.
Why is the annual audit important to foreign-invested enterprises?
Foreign-invested enterprises can distribute and repatriate their profits or dividends back to their home country only after completion of their annual statutory audits and settlement of all relevant tax liabilities. Failure to comply with the annual audit and compliance may result in extra expenses, penalties, or even revocation of business licenses.
When foreign-invested enterprises initially began setting up in China, many were not familiar with Chinese accounting standards and tax rules. This resulted in incorrect accounting treatments or tax filings becoming common, especially among small and medium-sized foreign businesses.
The statutory annual audit is a good opportunity to enhance a company’s internal control systems. Through the annual audit process, auditors will help find mistakes in business operations, help foreign-invested enterprises improve their financial reports in accordance with Chinese accounting standards, and ensure that accounting data is presented appropriately.
What are the new and revised corporate accounting standards?
The financial statements of foreign-invested enterprises are governed by China’s Generally Accepted Accounting Principles, which are based on two standards: the Accounting Standards for Business Enterprises (ASBEs) and Accounting Standards for Small Business Enterprises (ASSBEs).
For most enterprises established in China, ASBEs are generally adopted, which are similar in structure to US GAAP and IFRS.
A number of updates to China’s accounting standards [CAS] were released in 2014. The following are the most recent amendments to those standards.
Corporate Accounting Standard [no. 2] – Long-term Equity Investments
This standard now doesn’t apply to equity investments as defined in the standard on financial instruments. One of the major changes is that the financial statement no longer needs to show what proportion of shares the investor holds in its participation or subsidiary. This will instead be entered under capital reserves – a departure from international practice.
The new rules change the calculation method for transactions between related or jointly managed companies. The norms for disclosure of information on subsidiaries, related or jointly managed companies have been moved under Corporate Accounting Standard 41.
The requirements for the audit report vary by region. In Shanghai, companies must include a taxable income adjustment sheet in the audit report, which is not necessary in Hangzhou, Beijing, or Shenzhen
Corporate Accounting Standard [no. 9] – Employee Remuneration
This new standard clarifies that payments for short-term work are included and expands the definition for it. The amendment now also adds the benefits received after the termination of the employment contract.
Corporate Accounting Standard [no. 33] – Consolidated Financial Statements
The amendment introduced a new definition of the term ‘control’. Control was previously defined as the investor having the power to determine financial and operational policy and obtaining a benefit from the investee’s business activities.
Now, control means that the investor has the ability to participate in the investee’s operations to earn a variable return, and has the influence to affect the amount in the returns it receives. The investee’s activities need to be related to the return that the investor receives.
The ability to participate can take the form of equity shares or derivatives thereof; the right to appoint or dismiss directors; and to make corporate decisions. These criteria allow for a more objective assessment, and take into consideration the way that the investor set up and designed the participation.
Corporate Accounting Standard [no. 39] – Fair Value Measurement
A new set of rules for the determination of fair value was also released in 2014. They apply, among other entries, to inventory, share-based payments, leases, asset impairment and employee remuneration.
Corporate Accounting Standard [no. 40] – Joint Arrangements
A joint arrangement is one where two or more participants jointly control an enterprise. Neither party may by itself control the enterprise.
There can be two types: a joint venture company (合营企业) and joint operation (共同经营).
A joint arrangement is classified as a joint venture company when a separate legal entity is created. Where the participants share in the assets and liabilities of the joint arrangement, such as in a partnership, it is termed a joint operation.
What are the steps for completing the annual compliance requirements?
There are four steps that foreign-invested enterprises in China should follow.
Step 1: Prepare Audit Report. The requirements for the audit report 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.
Usually, accounting firms start preparing an annual audit report in January, right after the company has closed the previous year’s accounts. The audit procedure takes about two months, and the audit report should be completed before the end of April in order to meet the May 31 tax reconciliation deadline.
Step 2: Prepare Corporate Income Tax Reconciliation. In China, Corporate Income Tax is paid on a monthly or quarterly basis, in accordance with the figures shown in the accounting books. Companies are required to file CIT returns within 15 days from the end of the month or quarter.
However, due to discrepancies between the accounting standards and tax laws in China, the actual CIT taxable income is usually different from the total profits shown in the accounting books. The CIT calculation should be in compliance with tax law, not the accounting standards.
Foreign-invested enterprises in China are required to undergo an annual cooperative inspection jointly conducted by several governmental departments of the State Council
As such, the State Administration of Taxation requires companies to submit an Annual CIT Reconciliation Report 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.
Generally, the Annual CIT Reconciliation Report must include adjustment sheets to bridge the discrepancies between tax laws and accounting standards.
Foreign-invested enterprises that conduct frequent transactions with related parties should also prepare an Annual Affiliated Transaction Report on transfer pricing issues as a supplementary document to the Annual CIT Reconciliation Report.
For companies declaring losses of more than RMB5 million, an audit report conducted by an external accounting firm is required to be attached to the CIT Reconciliation Report.
Local tax bureaus release a guideline on CIT reconciliation every year around March. Taxpayers should carefully study the guideline because the specific requirements can differ by both year and region.
Step 3: Annual Inspection. Foreign-invested enterprises in China are required to undergo an annual cooperative inspection jointly conducted by several governmental departments of the State Council. These inspections are designed to ensure that foreign-invested enterprises conducting businesses in China are fulfilling the legal commitments they make to each of the departments.
Each year from March to the end of June, the annual inspection is jointly hosted by the following governmental departments:
- Ministry of Commerce
- Ministry of Finance
- Administration of Industry and Commerce
- State Administration of Taxation
- State Administration of Foreign Exchange
- Statistical Bureau
Certain parts of the cooperative annual inspection are just a formality, with the first 90% of annual compliance work involving annual reporting package preparation, and the last 10% involving submission at a one-stop service location where all relevant government departments check and approve the annual reporting package.
Note that the annual inspection required by the State Administration of Taxation is only a review of the tax registration certificate, and is different from the CIT Reconciliation.
The inspections by the Administration of Industry and Commerce and State Administration of Foreign Exchange (see below) are usually more complicated and may require additional separate procedures being conducted.
Regional variances also exist. Wholly Foreign Owned Enterprises with branches should pay special attention to ensuring that their branches also undergo annual inspection.
The relevant documents required for the annual inspection are:
- Annual inspection report
- Audit report issued by external accounting firm
- Financial statements of the previous year
- Certificate of approval for Foreign-Invested Enterprises
- Business license
- Capital verification report
- Industry-specific license or permit
- Financial registration certificate
- Tax registration certificate
- Other forms or documentation required by relevant government departments
Step 4: Profit Repatriation. Companies distributing profits should complete the reconciliation procedure in advance to leave sufficient time for shareholder companies to prepare for Corporate Income Tax compliance before the May 31 deadline.
The submission of additional documents may also be required. In Shanghai, for example, a company should apply for a Letter of Notice for Profit Distribution of Domestic Enterprise issued by the local tax bureau after finalizing its CIT reconciliation. The company receiving the profits will need to attach this letter to its own CIT reconciliation report.
About the Author
Dezan Shira & Associates, a specialist foreign direct investment practice that provides advisory services to multinationals investing in emerging Asia. This story is based on two articles first published in China Briefing, and was reedited for clarity and conciseness. For further details or to contact the firm, please visit www.dezshira.com.
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