Mainland audit issues Q&As value-added tax

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1 Mainland audit issues Q&As value-added tax The Questions and Answers (Q&As) below are developed by the Working Group on Mainland Audit Issues of the HKSA Auditing and Assurance Standards Committee (AASC) to raise practising members awareness of the common audit issues that may be encountered by auditors in the audits of the financial statements of Mainland enterprises that are prepared under HKGAAP framework. They should be read in the light of Statements of Auditing Standards. This set of Q&As addresses some of the common issues relating to valueadded tax (VAT) in the Mainland, including some useful background information about VAT, the more common questions to be considered in the planning process and the practical procedures that may be applied by the auditors in ascertaining the amount of input VAT. VAT is a complicated area and the Working Group will seek to address other common issues on the subject in future Q&As. The Working Group welcomes your comments and feedback, which should be sent to commentletters@hksa.org.hk, for the attention of Stephen Chan, Technical Director (Ethics & Assurance) & Head of Standards & Technical Department Coordination. The Q&As are intended for general guidance only. The HKSA, the AASC and the Working Group on Mainland Audit Issues DO NOT accept any responsibility or liability, and DISCLAIM all responsibility and liability, in respect of the Q&As and any consequences that may arise from any person acting or refraining from action as a result of any materials in the Q&As. Q1: What background information on VAT is useful to auditors in auditing the financial statements of Mainland enterprises? A1: VAT is a kind of turnover tax levied on the value added in the course of importation, production, distribution and retailing of goods. The general tax rate is 17 per cent but necessities such as agricultural and utility items are taxed at 13 per cent. Export goods are exempted from VAT. VAT is the major source of fiscal revenue for the Government of the People s Republic of China. The Provisional Regulations of the People s Republic of China on Valueadded Tax (!"#$%&'( ), which is currently effective in the Mainland was promulgated by the State Council in December 1993 and came into effect in January VAT invoices (!"#$) are issued by the seller to the buyer upon the sale of goods for the purpose of calculating the output VAT payable/input VAT creditable for the seller/ buyer. The collection of VAT is based on invoicing control and VAT invoices are the irreplaceable documents required for the crediting of input VAT. VAT registration is required for an enterprise to qualify as an ordinary VAT taxpayer (!" ) which can issue VAT invoices. The registration procedures are as follows: I. The enterprise must submit a written application together with the following documents: a) Tax registration certificate; b) Business licence; c) Certificates issued by the relevant Finance Bureaus held by in-house personnel of Finance function (!!"#$%&'()*!); d) Ownership or lease agreements on real estates for registered office and places of production / operation; e) Relevant contracts (e.g. joint venture agreement) and articles of association; f) Evidence on opening of bank account for tax payment; and g) Other relevant documents requested by the tax authorities. II. The tax authorities will then conduct a preliminary examination on the application report and relevant documents submitted. On approval of the application, an Application Recognition Form of VAT General Taxpayer (!"#!"#$%will be issued to the enterprise. The form will further request the completion of the following information: a) Date of commencement of business; b) Scope, mode and address of operations; c) Book-keeping conditions to assess the ability to accurately report on output and input tax figures; and d) Organisation structure of personnel in Finance function. III. The enterprise has to complete the Application Recognition Form of VAT General Taxpayer and pass it to the tax authorities with the above documents for final examination. VAT is calculated and the amount payable is the difference between the output VAT collected on sales less the input VAT paid on purchases/ expenses. It is payable on a monthly basis and a taxpayer has to pay within ten days after each month end. Special rules are in place however in respect of the refund of input VAT for exporters. Under Guoshuifa ( ) [1993] No.157, it is illegal to issue a VAT invoice where no taxable transaction has actually occurred. In accordance with Guoshuifa [1997] No.134, fraudulent VAT invoices are defined as those issued 60

2 by a party other than the seller or in a location other than the selling place. Pursuant to Guoshuifa [2000] No.187, even though there is a genuine business transaction, the buyer is not allowed to claim any input VAT credit on the VAT invoice obtained from the seller via improper channel. In addition, a buyer in good faith will only have the previously claimed input VAT disallowed in this respect without any penalty or surcharge if the following criteria are satisfied: There is no tax evasion on the part of the buyer and no evidence suggesting that the buyer is aware of the case in which the seller has obtained the invoices via improper channels. The invoices: (a) are issued by the seller in the province it resides; (b) bear the name of the seller with its official chop; (c) state the quantity and price of goods; and (d) have all shown details matching with the actual transactions. If the tax bureau alleges that a taxpayer has used improper VAT invoices and the taxpayer fails to prove that it is a good faith buyer, a penalty and surcharge could be imposed. It is the taxpayer who bears the burden of proof in any tax dispute or investigation. Anti-forgery measures on VAT invoices are currently being developed by the Mainland tax authorities. The Golden Tax Project (!) is being developed to aim at the installation of a nationwide computer network to match input VAT claims against the corresponding output. On its completion, taxpayers and tax officials can verify the invoices received via their own anti-fraud invoicing control machines (terminal port of the Golden Tax System) while the tax authorities can monitor all VAT invoices issued throughout the Mainland. In accordance with Guoshuifa [2000] No.183, all VAT taxpayers must issue computerised invoices under the VAT Anti-forgery Tax Control System (!" #$ ) instead of hand-written ones by the end of 2002 to facilitate the implementation. However, it is being noted that hand-written invoices are still prevalent in some remote regions at present. More than Rmb1 billion is expected to be spent over the next five years to further integrate around eight software platforms across a countrywide network. The whole system is expected to complete by Q2: What are the more common questions that auditors ask in obtaining an understanding of the accounting and internal control systems for VAT administration in audit planning and developing an appropriate audit approach? A2: Some of the more common questions are: a) VAT registration Has the company performed proper registration as a VAT taxpayer? Has the company obtained approval from the relevant local tax bureaus if it sells in other mainland locations b) VAT accounting system What are the main control procedures over the invoicing system? Does the company have a separate VAT accounting system which complies with the VAT Accounting Treatment Regulations (!"#$)? Is there a nominated person responsible for the VAT accounting records? Does the company keep a register of VAT invoices and are those invoices kept in a safe place to which only designated people have access? Who is responsible for checking the validity of input VAT invoices and has the staff been trained to do so? c) VAT returns Are all returns submitted on time and accepted? Is input VAT related to domestic sales segregated from input VAT related to export sales in the return and how? Has any non-recoverable input VAT been identified? Has the tax bureau made any adjustments on the returns? d) Others Are there any sales made below market values? Are there any deemed sales for VAT purposes (e.g. transfer of goods between branches or offices)? Do the figures for output and input VAT appear reasonable with taxable sales and purchases? Has the company ever been subject to VAT investigation by the local tax bureau? If yes, what was the result? Is there proper accounting treatment and disclosure on VAT balances? Q3: What are the practical procedures that auditors can apply to ascertain the amount of input VAT recoverable, and in particular the authenticity of VAT invoices? A3: Currently, buyers have to submit VAT invoices to the tax bureau for certification within 90 days after receipt. The certification process involves number matching and is the condition for valid input VAT claims at present. However, the credit claims can still be disallowed if the conditions mentioned in Q1 are not satisfied in subsequent tax investigations, if any. Telephone hotlines are available in the relevant local tax bureaus for checking the authenticity of VAT invoices. This service is provided in every region throughout the Mainland. The phone numbers can be found in the respective websites of the relevant tax bureaus. For instance, the hotline for Beijing is and those for 62

3 Shanghai and Shenzhen are and respectively. However, verbal confirmation cannot replace the above formal certification process to make the claims effective. This is often used as a preliminary check on receipt of invoices of material amounts. All input VAT invoices have to go through the certification process set out above to make any subsequent claims effective. The actual payment of a claim would involve a two-stage approval process: (i) the approval of the amount of a claim; and (ii) the approval of the payment of the claim. Payment of a claim does not automatically follow the approval of the amount of the claim and auditors should be aware of this process. In addition to making reviews on any history of failed VAT claims and the related reasons, auditors can perform analytical procedures to assess the reasonableness of input VAT, which should be the product of applicable tax rate and purchases in ideal situations. Discrepancies may arise if there is timing difference between the receipt of goods and invoices. Attention should be paid to proper accruals on VAT when sales are recognised. Guoshuifa [2002] No. 7 and No. 11 stipulate the details for export refunds. There is a noncreditable/non-refundable portion in those input VAT claims (NCNR VAT). NCNR VAT is determined as equal to (VAT rate - VAT refund rate) x (FOB value of exports - value of bonded imported raw materials). The range of the difference between VAT rate and VAT refund rate is around 4 percent to 6 percent and this irrecoverable item should be expensed in the income statement. This applies to most trading goods and is a nationwide requirement. MAY 2004 THE HONG KONG ACCOUNTANT 63

4 The Hong Kong Society of Accountants China Tax Conference 2003 The PRC Legal and Taxation Subcommittee of the Society organised the 2003 China Tax Conference in December With the supports of the senior officials of the PRC State Administration of Taxation (SAT), the Inland Revenue Department and the Trade and Industry Department of the Hong Kong SAR Government, the conference was held sucessfully and well received by the members of the Society. The China Tax Conference 2003 was conducted through four panel discussions by the speakers as follows. The major issues discussed during the four panels of the 2003 China Tax Conference are summarised as follows: Latest development of the PRC tax, VAT refund for export and tax rule changes The PRC tax regime has been constantly evolving and the second panel covered 1. Latest development of the PRC tax, VAT refund for export and tax rule changes Chairman: Mr Alfred Shum, partner, Ernst & Young Mr Zhang Zhiyong, director-general, International Taxation Department, State Administration of Taxation (SAT), PRC Mr Ma Lin, director-general, Import and Export Taxation Department, SAT, PRC 2. Tax issues on merger and acquisition, and individual income tax for Hong Kong individuals working in the Mainland Chairman: Mr Peter Kung, partner, KPMG Mr Zhang Zhiyong, director-general, International Taxation Department, SAT, PRC Mr Patrick Kwok, executive director, Henderson Land Development Company Limited Mrs Chan Wong Yee-hing, acting assistant commissioner of Inland Revenue, Inland Revenue Department, HKSAR Government 3. Taxation of specialised industries & financial services in China Chairman: Mr Joseph Fu, partner, Ernst & Young (partner of Deloitte Touche Tohmatsu at the time of the conference) Mr Zhang Zhiyong, director-general, International Taxation Department, SAT, PRC Ms Sue Cuthbertson, director, Pacific Tax, Credit Suisse First Boston Mr Phillip Wong, director for Taxation, Asia Pacific, Nortel Networks (Asia) Ltd. 4. Import goods & setting up service companies in China under Closer Economic Partnership Arrangement (CEPA) and the related tax issues Chairman: Mrs Petrina Tam, partner, PricewaterhouseCoopers Mr Zhang Zhiyong, director-general, International Taxation Department, SAT, PRC Ms Carol Yuen Sui-wai, assistant director-general of Trade and Industry Department, HKSAR Government Mr David CW Hui, chairman, A-Fontane Group Limited Mr Tse Kwok Leung, senior economist, Bank of China (Hong Kong) the most recent developments of the PRC tax regime relevant to foreign investors. Tax reform There has been a long discussion about the unification of the two sets of Enterprise Income Tax (EIT) laws that are applicable to domestic enterprises and foreign enterprises and foreign investment enterprises respectively. The latest income tax rate under the unified EIT laws is expected to be in the range of 24 per cent to 27 per cent. The tax incentives (e.g. tax holiday, tax refund on re-investment, etc) currently available to foreign investors are likely to be replaced by new tax incentives which are designed to drive the economic development in special areas (e.g. the midwest region, the northern provinces, etc) and the growth of designated industries (e.g. hi-tech, agriculture, infrastructure, etc) in China. Another area of the tax reform is on the existing VAT regime. It is expected that the VAT regime would be transformed from the existing production type system to a consumption type system under which input VAT paid on machinery, equipment and other fixed assets purchased by enterprises can be credited against output VAT. Advance Pricing Agreement The SAT has recently released a draft version of the long awaited Application Procedures for Advance Pricing Agreement among Related Parties (Draft APA Application Procedures) to the public and the tax practitioners for comment. The Draft APA Application Procedures were issued to standardise the APA administrative procedures. The provisions in the Draft APA Application Procedures generally follow the OCED guidelines. Under the Draft APA Application Procedures, the application and implementation of APA would be under the following stages: 1. Review and evaluation stage 2. Negotiation stage 64

5 3. Drafting and signing of APA 4. Monitoring VAT refund for exports On 13 October 2003, the Ministry of Finance (MOF) and the SAT jointly issued Cai Shui [2003] 222 to revise the VAT refund rates of different types of goods with effect from 1 January The category with reduction of the VAT refund rate is the most relevant part to foreign investors: 1. For goods with a refund rate currently at 17 per cent or 15 per cent, the rate will be reduced to 13 per cent; 2. For goods with both a VAT charging rate and refund rate currently at 13 per cent, the refund rate will be reduced to 11 per cent; 3. For certain types of goods, the rate will be reduced to 11 per cent (e.g. gasoline), 8 per cent (e.g. unwrought aluminium) or even to 5 per cent (e.g. coke and semi-coke). With the implementation of Cai Shui [2003] 222, there will be additional VAT costs to PRC enterprises (both domestic and foreign invested) with respect to their export sales. Tax rule changes As there is an increasing trend toward restructuring in China, the SAT has issued different tax circulars to clarify the tax treatments on relevant transactions. In order to strengthen tax administration, the SAT has also issued circulars to further clarify the taxation basis of a foreign representative office and tax treatments on inter-company transactions of Chinese Holding Companies. Moreover, new rules have been promulgated to strengthen tax administration and collection. Tax issues on merger and acquisition, and individual income tax for Hong Kong individuals working in the Mainland The panel covered two common topics concerned by foreign investors doing business in China: Corporate restructuring In recent years, many foreign investors have been actively restructuring their investments in China, involving mergers and de-mergers. It would be worthwhile to re-visit the existing regulations governing the tax treatments in this regard. In a merger or acquisition situation, a new (or remaining) foreign investment enterprise (FIE) would take up all the debts and liabilities of the merging entities either through transfer of business or transfer of equity. Under both scenarios, there would be continuation of business and thus, the tax losses of the pre-merger FIEs should be available to the new (or remaining entity) for future utilisation. Thus, tax losses from premerger entities can continue to be carried forward by the merged entity for the remaining years within the five-year statutory limitation under the existing PRC tax regulations. The Hong Kong Inland Revenue Department has issued a new guideline (which has been endorsed by the SAT) regarding the cross-border personal tax issues for Hong Kong residents working in Mainland China and the HKSAR. The existing tax provisions for M&A activities mainly focus on the PRC income tax treatments. In terms of turnover tax treatments, the existing tax regulations are rather less comprehensive. Not all business tax and value-added tax treatments under a merger or demerger situations are specifically addressed. Therefore, a tax ruling request would be necessary in order to manage the tax exposure under most merger and de-merger transactions. Individual Income Tax (IIT) For PRC IIT purposes, under the existing PRC IIT regulations and the Arrangement between the Mainland of China and the HKSAR for Avoidance of Double Taxation (the Arrangement ), a resident of Hong Kong who is working in China can be exempt from IIT provided the following conditions are met: 1. The Individual would not spend more than 183 days during a calendar year in the mainland; and 2. The compensation of the individual is neither paid by a mainland employer nor borne by any permanent establishment in the PRC. In case where the above conditions are not met, a Hong Kong resident would be subject to PRC IIT to the extent of his/ her mainland sourced income provided the individual has not resided in the mainland for more than five full years. One full year means that the individual has stayed in the PRC for 365 days in a calendar year. Any temporary exit out of the PRC for a period of not exceeding 30 days in one time or less than 90 days in aggregate during the year is ignored in computing the number of days of physical presence. For Hong Kong salaries tax purposes, tax is levied on a territorial basis under which only income from an office or an employment arising in or derived from Hong Kong would be subject to Hong Kong salaries tax. For individuals who are required to perform some ad-hoc duties in Hong Kong, he/she would be exempt from Hong Kong salaries tax provided he/she can qualify for the 60-day rule exemption. The Hong Kong Inland Revenue Department has issued a new guideline (which has been endorsed by the SAT) regarding the cross-border personal tax MAY 2004 THE HONG KONG ACCOUNTANT 65

6 In recent years, many foreign investors have been actively restructuring their investments in China, involving mergers and de-mergers. issues for Hong Kong residents working in Mainland China and the HKSAR. Before the issuance of the new guideline, it had been the practice for the counting method on the taxable thresholds (i.e. 90-day or 183-day) to count either the day of arrival or the day of departure but not both. Under the new guideline, it clearly stipulated that the days of physical presence method should be adopted (that is, any part of a day including days of arrival and days of departure) in counting the 183-day taxable threshold under the Arrangement. This new method will have a significant impact for Hong Kong frequent travelers who will trigger the 183-day taxable threshold more easily than before. Taxation of specialised industries & financial services in China The first part of this panel discussion mainly focused on the general scheme of taxation in China and relevant issues regarding Corporate Income Tax, Business Tax and Valued-added Tax. In the second part of the discussion, the panel speakers shared their experiences in two specialised industries. Under the existing tax regime in the PRC, there are tax incentives specifically designed to encourage the development in manufacturing industries, particularly for those related to hi-tech. For example, foreign invested production enterprises may be eligible for a reduced Corporate Income Tax rate, tax holidays, tax refund on reinvestment, etc. For hitech enterprises, there are super tax deduction (i.e. 150 per cent) for R&D costs, extended tax holiday, etc. It is important to note that generally tax incentives are not automatically given to taxpayers. Instead, the eligibility of tax incentives should be approved by the in-charge tax bureaus on a case-bycase basis. Another industry covered by the panel speakers was the financial services industry. The focus of this sub-section was Business Tax and Corporate Income Tax treatments on different types of income under the respective transactions, e.g. interest income derived by a foreign bank in the PRC by sub-lending its funds to non-prc customers, underwriting services, interest swap, etc. Import goods & setting up service companies in China under Closer Economic Partnership Arrangement (CEPA) and the related tax issues The governments of the People s Republic of China and the Hong Kong Special Administrative Region signed the CEPA and its Six Annexes on 29 June 2003 and 29 September 2003, respectively, to strengthen trade and investment cooperation between the Mainland and Hong Kong by lifting customs tariffs, liberalising market access and relaxing investment restrictions. Trade in goods Effective 1 January 2004, the Mainland agreed to apply Zero import tariff rates on exports of goods with Hong Kong as the Country of Origin for 273 categories of products. The Mainland has also agreed to apply zero import tariffs on other products by 1 January 2006, upon applications by local manufacturers for other codes maintained on the China s tariff system and meeting the CEPA Country of Origin rules. Trade in services Hong Kong Companies engaged in 18 sectors will benefit in terms of additional market access or removal of specific restrictions in the Mainland market. They include management consultancy, exhibitions and conventions, advertising, legal, accounting, medical and dental services, real estate and construction, transportation, distribution, logistics, forwarding, storage, tourism, audiovisual, banking, securities and insurance. In order to enjoy the preferential treatments granted under CEPA, Hong Kong Companies should meet the criteria of Hong Kong Service Suppliers as stipulated under the CEPA. Trade and investment facilitation Both sides agree on promoting cooperation in seven areas, namely, trade and investment promotion, customs clearance facilitation, commodity inspection and quarantine, food safety, quality and standardisation, electronic business, transparency in laws and regulations, cooperation of small and medium enterprises, and cooperation in the Chinese medicine industry. In order to capitalise on the benefits offered under CEPA, it is very important for both international and Hong Kong companies to re-evaluate their investment strategies in China. For example, both Hong Kong and overseas manufacturers must assess the overall cost of having their productions located in Hong Kong, which could out-weigh the saving in tariffs. On the other hand, in order to set up a service company under CEPA, Hong Kong companies must ensure they can meet both the criteria of Hong Kong Service Suppliers together with the PRC entry requirements of the relevant service sector. DANNY PO AND ANDREW CHOY, PRICEWATERHOUSECOOPERS 66