Managing Tax Compliance Risks in China: Fraudulent Invoicing and Misuse of Tax Incentives

Companies in China must manage VAT invoices and tax incentives carefully to avoid compliance risks. Strong tax risk management and internal controls are essential to minimize liabilities and ensure regulatory compliance.

Recent case reviews of Chinese enterprises have highlighted two critical tax risk areas: fraudulent value-added tax (VAT) invoicing and improper application of tax incentives. As China’s tax authorities enhance compliance enforcement and adopt more sophisticated mechanisms such as the Golden Tax System Phase IV, these risks are becoming more easily detectable. Companies must implement stringent internal controls to mitigate exposure and ensure compliance.

Case 1: Fraudulent VAT invoicing exceeding RMB 753 million

Since early 2023, the Ningbo Audit Bureau uncovered fraudulent activities in a large construction project. The investigation revealed forged design company seals and falsified design change notices, indicating irregularities in bidding and labor procurement.

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Further inquiries by the Ningbo Economic Investigation Department traced substantial fund transfers from a Ningbo engineering consulting firm to four labor dispatch companies. These firms retained a 1.8 percent fee before transferring the remaining funds to personal accounts linked to the consulting firm. Through extensive data analysis and multi-regional evidence collection, authorities discovered that these four companies had issued 5,075 false invoices to 755 entities, totaling more than RMB 753 million (US$104 million).

Recently, the Ningbo Yinzhou District People’s Court sentenced six defendants to prison terms ranging from two to four years and seven months. All illicit gains were confiscated and transferred to the state treasury.

Analysis and recommendations

Invoices are the backbone of financial reporting and directly impact accounting integrity. A significant number of corporate financial fraud cases involve fraudulent invoicing. Recognizing this, China’s State Council has reinforced its “penalty and prevention” strategy, introducing stricter oversight through coordinated regulatory opinions issued by six government agencies.

Fraudulent VAT invoicing typically involves issuing or accepting invoices for non-existent transactions to inflate reported income. Article 21 of China’s Invoice Management Measures explicitly prohibits issuing or receiving invoices unrelated to actual business activities.

Authorities often identify false invoicing through financial inconsistencies, such as discrepancies in procurement and sales contracts, mismatches between production capacity and energy consumption, or deviations in logistics costs. For example, if a company reports steel consumption exceeding its inventory and procurement levels, or if its utility usage does not align with reported production capacity, these may signal fraudulent activities.

To mitigate risk, businesses must establish robust tax compliance frameworks incorporating tax declaration processes, transaction audits, strategic tax planning, and internal reporting mechanisms. Leveraging advanced information systems for compliance monitoring can further enhance transparency and reduce exposure to tax fraud.

Case 2: Misapplication of tax incentives

On November 2, 2024, a publicly listed company announced that it had been ordered to repay back taxes and late fees due to non-eligibility for the Western China tax incentive. The company’s financial statements for 2019 revealed that its primary business income accounted for less than 70 percent of its total revenue, a key criterion for qualifying for the tax benefit. Consequently, the company was required to pay RMB 6.4 million (US$890,000) in back taxes and RMB 5.16 million in late fees, amounting to a total liability of RMB 11.565 million (US$1.6 million).

Analysis and recommendations

The Western China tax incentive allows qualifying enterprises to benefit from a reduced 15 percent corporate income tax rate. To be eligible, a company’s principal business must align with specified industries and generate at least 70 percent of its total revenue. This policy aims to promote investment and industrial growth in western China.

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The company’s failure to meet these criteria underscores a fundamental compliance gap. To avoid similar tax risks, businesses must conduct thorough assessments of policy requirements before claiming tax benefits. Tax incentive applications must adhere to both substantive and procedural legal standards, as incorrect filings can lead to significant financial liabilities.

Companies with complex structures and multiple subsidiaries should reinforce their internal tax control mechanisms, continuously updating compliance procedures to reflect evolving regulations. By maintaining detailed financial records and ensuring eligibility verification, businesses can mitigate the risk of penalties and back taxes.

Conclusion

Companies operating in China must exercise vigilance when managing VAT invoices and applying for tax incentives, as missteps can result in significant compliance risks. Establishing a robust tax risk management framework and strengthening internal controls are essential for mitigating exposure to tax-related liabilities. By aligning corporate financial strategies with China’s evolving tax regulations, businesses can navigate compliance challenges more effectively and minimize financial risks.

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