In today’s China, financial compliance management is an integral part of business management. These obligations are complex and failure to comply can create a variety of legal risks that undermine the company’s operations, and can result in significant liability. In this article, we will cover these compliance requirements, related legal risks, and what to do about it, also presenting case studies of what other businesses have experienced.
Contents
Social Security Enrollment Non-compliance
Ineffective Financial Management Policies
Tax Receipt Mismanagement
In China, tax receipts are an important financial document that establishes your cost basis and is required for tax filings, which if not handled correctly can result in your being designated as out of compliance. Local management problems with tax receipts that can trigger an audit from the China tax office include falsification, incorrect usage, failure to include copies with tax filings, and can result in payment of back taxes, fines, and even criminal liability. Since China business accounting revolves around tax receipts, bad tax receipt management can cause inaccurate financial reporting. These risks can be mitigated by setting up a robust tax receipt management process so that they are correctly issued and recorded on the books.
Chinese law has detailed requirements for how a tax receipt must be issued and received that require strict compliance. You should have a designated tax receipt manager who oversees how tax receipts are issues, and enroll in an electronic tax receipt issuance service to minimize errors and reduce the cost of issuing them. Finally, find an attorney to conduct periodic compliance reviews, and to give financial staff trainings on the applicable legal requirements.
In one case reported in the news, a retailer’s management falsified tax receipts to claim improper deductions as part of a tax evasion scheme, which triggered a tax office audit resulting in large fines on top of back tax payments. The executives were charged with a crime and incarcerated. After that experience, the company’s owners sought a legal audit of their tax receipt governance processes and enhanced transparency.
Accountants and lawyers in China who speak English as a second language often call the tax receipt (zhuanyong fapiao) as a “special invoice” or if this is too confusing for clients, a “fapiao.” Actually, a fapiao is a receipt of taxes paid to the government and some taxpayers such as freelancers must get one printed at the tax office. Qualifying taxpayers can print them on government-issued forms which come pre-filled with some tax office data. To take an example from the China financial management from our friends at international company CBRE, there are four kinds of common payment records you need to keep track of in China that will be used in this kind of order:
Fukuan Tongzhi: an invoice, requesting payment from a customer, it has many different names in Mandarin Chinese.
Huidan: a bank’s payment confirmation, also called a remittance advice, serving as proof of payment.
Fapiao: a tax receipt, printed on tax office forms, proving that tax was paid and entitling the holder to claim tax deductions; has built-in anti-fraud features.
Xiaopiao: a point of sale or proof of sale receipt, typically used to claim refunds, but otherwise considered too high fraud risk for accounting, reimbursements, or tax.
Many accountants in China will instinctively recommend using these documents in an illegal way such as to evade taxes, without pointing out these practices are illegal and often subject of government crackdowns. To get reliable expert advice, CBL can help you find a lawyer with affordable rates.
Social Security Enrollment Non-compliance
The China Social Security Act requires company employees to be enrolled in a comprehensive social insurance system that covers retirement benefits, health insurance, unemployment insurance, worker’s compensation, maternity leave, and the provident housing fund. Consequently, employers who fail to make required contribution face employee lawsuits that can compel payment of overdue amounts. Social security noncompliance constitutes a large percent of employment law disputes in China. In addition to financial loss, they are damaging to the company’s reputation and will reduce employee loyalty.
To reduce your legal risks, audit to verify that your employment contracts clearly define the rights and obligations of the parties, and has clear provision for payment of social security and provident housing fund. The business should set up strong internal controls to ensure that monthly social security contributions are made in compliance with the law; periodically audit the contributions to avoid the possibility that the China tax office suspects you are deliberately evading taxes.
In one case, a medium sized business tried to reduce taxes by failing to pay social security contributions. The situation persisted for several years until the company was sued by an employee, leading to an arbitral award for the unpaid social security plus a late fee and damages for financial loss. Beyond just damaging employee morale, it caused serious damage to the company’s reputation and a rapid rise in turnover. The company deployed more effective human resources management processes and engaged professional human resources consultants to resolve the issue.
Delayed Financial Audits
A business entity in China must have accurate, complete and compliant financial information; routine audits can help identify financial irregularities, which drives business success. Financial mismanagement or negligence by company managers can complicate financial audits, which causes problems to accumulate until they culminate in a disaster. Management’s inability to access effective financial information undermines their decision-making ability and can harm the company’s performance and reputation. Make sure to use rigorous financial auditing for your China entity at least annually.
Larger or more complex organizations should consider engaging third party auditors to assure independence and objectivity; proactively address any financial reporting deficiencies they identify in order to prevent problems from multiplying.
A good practice is to set up internal auditing for your China operation, to ensure your financial reporting is accurate and reliable. Executives and board members should closely inspect the audit findings, as this will reduce legal risks. Overall, timely is beneficial for your risk mitigation, credibility in markets, and competitiveness.
In one case, a fast-growing real estate developer in China failed to do any audits for two consecutive years. To drive growth, the company frequently drew on its capital reserves, but undisciplined financial management resulted in it unexpectedly running out of funds. This situation continued until the company finally was unable to service its debts and defaulted.
Its bank required the company to undergo an audit, revealing its statement of assets and liabilities was inaccurate. The company was forced into a reorganization and implement a correction plan, and personal liability was imposed on the executives. Subsequently, this business changes its behavior and involved a third-party auditor to improve its financial management and auditing processes.
Theft of Funds
Misappropriation of funds for personal investment use or other non-business purposes by insiders is very common in China. This is very disruptive to the business and can cause cashflow to be inadequate, sometimes causing bankruptcy. Misappropriation can also lead to personal liability and criminal prosecution by Chinese authorities against any responsible person. To mitigate these risks, implement strong internal controls that provide financial transparency, and have robust internal approval procedures for financial transactions. Otherwise, you are likely to experience frequent funds misappropriation by insiders.
The management team should make sure rigorous financial controls are in place to validate all transactions, and large deals should obtain board of director approval. Institute internal audit processes to regularly review financial transactions with risk management policies. An independent board level financial oversight committee can further mitigate risks of theft, and take legal action if embezzlement occurs. Being proactive can ensure repeat incidents don’t occur.
In one case at a private sector company, a shareholder diverted corporate funds into the individual’s own real estate investments, disrupting cash flow and making it impossible to pay suppliers.
The problem was discovered when supplier relationships were damaged resulting in demands to make prepayments. Issues piled up, leading to a bankruptcy and reorganization, wherein the company’s financial controls and approvals were redone, and oversight rules were added to prevent fraud. In China, this kind of dishonesty commonly occur when approval processes and compliance systems are inadequate.
Ineffective Financial Management Policies
A China company needs a financial management policy addressing budgeting, financial controls, financial reports, and asset management. Otherwise, your China operation will likely be disorganized and vulnerable to cash flow disruptions or disappearing funds, which have knock-on effects of late or missed payments to employees or suppliers. Inaccurate financial statements will impair decision-making, heightening risks of fraud and theft, and risk of litigation against executives and financial staff.
Control these risks by setting up a financial management policy that covers all workflow steps. The policy should establish clear budgeting policies so that transactions are transparent and reasonable, using an approvals process to avoid unnecessary payments.
Ensure conformity to China’s GAAP so that financial reporting is precise and follows current requirements, and grows in sophistication along with the company. Buy modern accounting software tailored to the China market so that manual entry errors don’t occur. Schedule periodic audits to detect and correct financial management deficiencies.
In one case, a company lacking an effective financial management policy was unable to track where its money was going, because employees were stealing from the company. The company eventually became financially distressed, defaulting on its loans and unable to pay suppliers. A third-party audit pointed to several serious internal control deficiencies, and was forced to adopt better internal controls to increase cash flow transparency and financial decision-making processes.
Raising Capital Illegally
Unlawful capital raising schemes in China include practices such as fraudulent lending or unauthorized fund raising, and can have serious consequences such as regulatory enforcement, lawsuits, bankruptcy, and criminal liability. These incidents will also become public record, seriously damaging the company’s reputation, consumer perceptions, and investor relations.
Avoid these legal risks by ensuring compliance with Chinese financial regulation when obtaining financing, and work with financial institutions for loans and securities issuance, and conduct a risk assessment to ensure that the financing to mitigate risks associated with external financing.
Find a lawyer to review financing activities for Chinese law compliance, to eliminate risk of fund-raising law violations or illegal lending. Review financing contract provisions are unambiguous, with clearly delineated party obligations, to avoid litigation risk. The management team should have specialists analyze the legality of financing strategies.
In one case, a private sector company seeking to expand, raised 100 million CNY using an online kickstarter platform, but because they lacked regulatory approval, it constituted an illegal securities transaction. When the company’s exaggerated projections of future success failed to materialize, investors filed class action lawsuits successfully, imposing liability on the company, disrupting the company’s cash flow. The executives were criminally charged and sentenced and the company declared bankruptcy, which was devastating to their reputation. After its reorganization, the company’s new management team changed its financial planning process to closely follow China’s law.
Conclusion
A consequence of China’s legal reforms is that doing business now implies a variety of legal risks that require careful management, otherwise there can be significant legal, financial, and reputational consequences. In this article, we’ve learned that your China company needs an effective financial management policy, internal controls, and compliance management to ensure that Chinese regulatory requirements are met. Effective oversight is also necessary, so as appropriate engage third party audit firms to help correct deficiencies and control risks. Keep abreast of regulatory developments and be ready to change your strategy.
To make sure you are on the right track, CBL can help you find a lawyer with affordable rates.