Representative Office Risks and Audits in China

January 13, 2010 Posted by China Briefing Reading Time: 4 minutes

Jan. 13 – Representative offices in China undergo a different type of audit process than WFOEs, FICEs and JVs as they are not limited liability legal entities in their own right. The audit concentrates on balancing income from head office remittances and the expenses and taxes due by the RO. Annual license reviews are also different for an RO.

Representative audits
If you are a representative office in China (expenses-based taxpayers), the following issues should be considered:

Cash – are bank statements and bank reconciliation correct?
Foreign currency issues – is the transaction rate entered correctly?
Fixed assets purchasing – has this been recorded into expenses? If not, has it been approved by the tax authority?
Fixed asset disposal gain/loss – is this recorded into expenses?
Funds from the parent company – are these consistent with the parent company’s records?
Interest income/expenses – have they been identified in the expenses report correctly?
Expatriate individual income tax – for high level management, such as the chief representative, has the IIT calculation and pertinent rate been correctly assessed?
Audit fees – have the audit fees been accrued and separately entered? Are they listed in the expenses report?
Rental expenses – have the rental expenses been accrued and separately entered? Are they listed in the expenses report?
Employer contributions to overseas social security plans – if employees are involved in overseas social security plans, has these payment has been included into the expenses report?
Expenses paid on behalf of the head office – the local tax bureau may require such expenses to be recorded into the expenses report
BT and CIT payments – these tax payments should be excluded from expenses report
Stamp duty – is the RO subject to stamp duty?
Unofficial invoices – has the RO received unofficial invoices (non VAT) as part of its expenses? If so this can be subject to tax penalties
Business licenses and related administrative matters – the annual renewal of all licenses such as registration certificate, tax licenses and so on
Local employees registered with FESCO and valid work permits for expatriate staff – has all this been completed in accordance with the pertinent regulations?

Costs and risks of under-declaring
It is a widespread practice for ROs whose activities are taxed through actual and deemed-income methods to receive offshore part if not the majority of the service income (this practice is however illegal!), and thus avoid declaring huge amount of revenues in China subject to the local enterprise income tax rate of 25 percent. Without doubt, it is hard for the Chinese government to locate hidden funds outside China, even more so if the holding company is structured in a tax haven or use nominee shareholders. Still the Chinese government has the authority to track your ultimate shareholders and ask for explanations or penalties in the worse cases.

Many ROs would use the cost-plus assessment method for tax and it is thus immediately apparent the fact that if you spend (or officially declare) less then you will end up paying less taxes in the end.

These malpractices are common everywhere in the country. Chinese authorities are more and more aware of this and it may happen that local withdrawals above a certain amount need to be supported by declarations and signatures at the related bank.

If you do not officially declare all your expenses through the RO account or have separate funds to finance the local activities, then firstly, you are not in compliance, and secondly, you run the risk of staff turning this against you when they are dismissed or leave the company (blackmailing and threats to disclose malpractices to local authorities are common in order to seek own financial gains). Local staff may even manipulate the company records to ensure it is not in compliance – in order to hold leverage against you in the event of any disciplinary action being taken against them at a later stage. It is relatively common.

No government likes tax evasion and China is no exception to the rule. The penalties for late payments, non-payment and other transgressions (naivety is no excuse) can be severe – often up to five times the amount due, plus the original liability. In cases of blatant evasion, businesses can have their licenses withdrawn and assets seized.

With increased inter-government bureau cooperation, information sharing activities and checks initiated by individual tip offs, the likelihood of falling into the taxman’s hands is high.

If your representative office has been operating out of compliance as shown, it is important that this is corrected immediately. The State Administration of Tax has the right to levy fines of up to seven times any taxes due, plus the original amount, if taxes have not been paid on time. There can also be issues with having the RO license suspended.

A quick check by experienced personnel can ascertain the level of competency that your local China RO has been operating under.

Dezan Shira & Associates regional staff include qualified tax inspectors who have the right to enter into dialogue with the local tax bureau to negotiate over late payment or incorrect filing matters. Should you require assistance with RO audit or suspect you may have operational or tax problems with it, please contact Sabrina Zhang, the national tax partner for Dezan Shira & Associates at tax@dezshira.com for assistance.

Also available from China Briefing is the technical guide, “Setting Up Representative Offices in China.” Written with assistance by Dezan Shira & Associates, it is now in its third edition and may be purchased from our bookstore in both hard copy and PDF versions.