Internal Control and Audit in China

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 foreign-invested entities with less than adequate internal control systems), separated by department:

• Payroll
  • The discrepancy between contract salary and payroll payments.
  • Deliberate over-accrual/unauthorized use of welfare benefits.
  • 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.
  • 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.
  • Lack of a 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.

China has various nuanced annual audit procedures that foreign invested commercial enterprises (FICE) will have to follow in order to achieve full compliance. Here, we provide a step-by-step guide to these procedures, including general requirements, key considerations, and materials to be prepared, with notes on regional differences and tips from experienced accountants and auditors.

For WFOEs, JVs, and FICEs, achieving annual compliance can be a long and complicated process. The work primarily involves producing a statutory annual audit report, a corporate income tax (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 a statutory annual audit report

The statutory annual audit report consists of a balance sheet, an income statement and a cash flow statement. To ensure that foreign-invested companies meet Chinese financial and accounting standards, including proper use of China's generally accepted accounting principles, the annual audit report must be conducted by external licensed accounting firms and signed by a certified public accountant (CPA) registered in China for compliance purposes.

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. 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 report (annual tax returns)

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 State Administration of Taxation (SAT) 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.

Every year around March, depending on the area, the local tax bureau will issue annual guidance on CIT reconciliation. The annual CIT reconciliation report is examined by the tax bureau to see if all tax liabilities have been fulfilled under tax law. Adjustments in financial statements caused by discrepancies between Tax Law and accounting standards are also required to be included in the annual CIT reconciliation report. Foreign invested enterprises (FIE) that additionally conduct frequent 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.

Moreover, FIEs in certain regions need to engage a certified tax agent firm in China to prepare another separate CIT audit report. In Beijing, this requirement applies to firms that meet the following conditions:

• Yearly sales revenues exceed RMB 30 million;
• Carrying over last year's losses to deduct this year's income; or,
• Yearly losses exceed RMB 100,000.

In Shanghai, the CIT audit report is needed when:

• Taxpayers who have made a loss (current year loss) of more than RMB 5 million;
• Taxpayers who have offset losses carried forward from previous years.

The deadline for submitting the CIT reconciliation report to the tax bureau 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.

Step 3: Annual reporting to Administration of Industry and Commerce (AIC)

According to the "Interim Regulations for the Publicity of Corporate Information", each year from January 1 to June 30, all FIEs should submit an annual report for the previous fiscal year to the relevant AIC. This should be done through the corporate credit and information publicity system.

The annual report submitted should cover the following information:

• The mailing address, postcode, telephone number, and email address of the enterprise;
• Information regarding the existence status of the enterprise;
• Information relating to any investment by the enterprise to establish companies or purchase equity rights;
• Information regarding the subscribed and paid in amount, time, and ways of the contribution of the shareholders or promoters thereof, in the case that the enterprise is a limited liability company or a company limited by shares;
• Equity change information of the equity transfer by the shareholders of a limited liability company;
• The name and URL of the website of the enterprise and of its online shops;
• Information of the number of business practitioners, total assets, total liabilities, warranties and guarantees provided for other entities, total owner's equity, total revenue, income from the main business, gross profit, net profit, and total tax; and,
• Information regarding custom annual reporting of enterprises subject to the administration of the Customs.

Step 4: Annual combinative reporting to MOFCOM, MOF, SAT, AQSIQ, NBS and SAFE

FIEs in China have been required to undergo an Annual Combinative Inspection jointly conducted by several governmental departments since 1998. However, pursuant to a Notice jointly released by Ministry of Commerce (MOFCOM), Ministry of Finance (MOF), AIC, SAT, State Administration of Foreign Exchange (SAFE), and National Bureau of Statistics of China (NBS) in 2014, the annual combinative inspection has now been replaced by an annual combinative reporting system. Unlike the annual inspection, annual reporting entails that relevant government bureaus take on the role of supervisors rather than judges. They no longer have the right to disapprove reports that are submitted, even if they think the reports are unqualified – they can only suggest that the FIEs make modifications. Accordingly, relevant government bureaus no longer affix any seals on a report.

With this new rule implemented, the annual compliance requirements for FIEs have become much more manageable. All information can be submitted online, and paper materials are no longer required.

The deadline for this combinative report is subject to yearly variance. In 2017, the deadline was delayed to July 15. And in 2018, the reporting period is from April 1 to June 30.

For Representative Offices (RO), annual compliance procedures are simpler. While ROs are exempt from annual exchange reconciliation and combinative reporting, they still need to prepare a statutory audit report, a tax reconciliation report, and then report to AIC.

Step 1: Prepare statutory annual audit report

Similar to the annual audit for JVs, WFOEs, and FICEs, the annual audit report for ROs should also be prepared by external licensed accounting firms and signed by a CPA registered in China. When doing the annual audit works, auditors should pay special attention to the following factors:

• Bank statements, cash, staff, and individual income tax (IIT): The balance on the bank book should be the same as that stated in the bank statement. If not, a bank reconciliation should be prepared to verify the differences. The balance on the account should be the same as the cash contained in the cash box. The auditors will perform a cash count during their fieldwork. Employment of staff has to be registered in accordance with the relevant regulations (local employees registered with Foreign Enterprise Service Company (FESCO) and valid work permits for expatriate staff), and IIT correctly assessed and filed.
• Expenses report: Audit fees, salaries, rentals, utilities, FESCO fees, and any expenses belonging to the calendar fiscal year should be properly accrued with contracts or agreements as support. The total salary of the chief representative, whether paid offshore or locally, has to be included in the expenses. If employees are involved in overseas social security plans, these payments have to be included in the expenses report. Expenses paid on behalf of the head office may also be required to be recorded.
• Taxable income: On February 20, 2010, the SAT issued "Provisional Measures on Administration of Tax Collection for Resident Representative Offices of Foreign Enterprises" (Guo Shui Fa [2010] No. 18, hereinafter "Circular No. 18"), which addresses the question of how ROs of foreign enterprises in mainland China file and pay PRC taxes. The Circular explicitly stipulates that ROs must pay CIT on their deemed taxable income, as well as VAT and consumption tax when it is applicable and will be required to assess CIT liability using the deemed profit method, cost-plus method, or actual revenue method. Among these three methods, the cost-plus method is most commonly used to calculate deemed taxable income, since the other two methods require ROs to submit numerous supporting documents.

All expenses incurred by or related to the RO must be included in office expenses to calculate the deemed taxable revenue. Expenses include rent, transportation, telephone, salary, office purchases, and entertainment, regardless of whether these are paid from the RO or directly from its head office. The total salary of the chief representative should be included in the RO's expenses.

Step 2: Annual tax filing

The responsibility for tax filing in China is with the taxpayer. The tax bureau does not send out tax returns; the taxpayer has to collect and file tax forms according to relevant regulations. The tax authority additionally requires that accounting records and ledgers be set up and kept properly and that the details of the accounting system be filed.

The annual tax reconciliation is finished through the online filing wholly. ROs usually will need to submit the annual taxation consolidation report to the tax bureau by the end of May each year, but regional variations may exist. If the audited taxes due are found to be different from the taxes paid by the RO, the RO shall discuss the variation with the tax bureau. For foreign companies that suspect this might occur, it is wise to hold preemptive discussions with tax advisors prior to audit submission.

Step 3: Annual reporting to AIC

ROs are required to submit an annual report between March 1 and June 30 every year providing information on the legal status and standing information of the foreign enterprise, ongoing business activities of the RO, and an audit report. The registration authorities will issue an RMB 10,000 to RMB 30,000 penalty if the RO fails to provide these reports on time, and an RMB 20,000 to RMB 200,000 penalty if the report includes false information. Fraud may also lead to license revocation.

During the annual reporting process, the following documents should be provided in paper or online:

• Annual report (the template will be distributed by AIC around March);
• Business registration certificate;
• Audit report; and,
• Proof of information on the legal status and standing of the headquarters overseas.

The Canadian Trade Commissioner Service in China recommends that readers seek professional advice regarding their particular circumstances. This publication should not be relied on as a substitute for such professional advice. The Government of Canada does not guarantee the accuracy of any of the information contained on this page. Readers should independently verify the accuracy and reliability of the information. 

Content on this page is provided in part by Dezan Shira & Associates a pan-Asia, multi-disciplinary professional services firm, providing legal, tax, and operational advisory to international corporate investors.