"In any market, especially one as competitive the Chinese market, the % margin spent on tax makes an enormous difference to a company's bottom line, and therefore to their ability to grow and invest"
By Andy Clayton.
The Chinese market is not only famous for being “bigger that you can understand", but also "more competitive than you can imagine".
Competition in China is cut throat and can often seem rigged in favour of the local companies in China. Some advantages of Chinese companies, such as better customer understanding, or stronger abilities at cultivating relationships, are hard to learn quickly. But there is one area of 'advantage' that is not hard to throw open the door on: gaming the tax system in China. In any market, especially one as competitive the Chinese market, the % margin spent on tax makes an enormous difference to a company's bottom line, and therefore to their ability to grow, invest, attract investment, and ultimately enrich shareholders. Local companies in China are past masters at the tricks used to gain a margin advantage over less flexible foreign competitors in China.
Here, we throw the door open on the world that many local Chinese companies operate in. In the heart of the system sits something that needs to be fully understood: Fapiao.
1. The Worlds most significant, yet least understood traded paper
Not many outside of China realise this, but there is a paper currency - a commodity - that forms a core part of transactions in an economy that still accounts for more than a third of global economic growth. It involves transaction of paper in exchange for payment; is actively traded on both grey and black markets; and by individuals and companies. They are called ‘fapiao'. They are printed VAT Invoices, though comparisons can be misleading, so we will simply call them what they are - fapiao.
2. What is a 'Fapiao'?
Every company in China, when registering with the Chinese Tax Bureau, must purchase a special printing machine. This machine connects to the Tax Bureau in China, and every time that a company receives a payment, they are supposed to print fapiao from this machine. This ensures that the Tax Bureau is aware of the full income of every company in China.
3. Why do Fapiao's exist?
Fapiao are the Chinese Tax Bureau's main instrument of control over tax collection. In the UK and other Western markets, companies issue their own commercial invoices, then declare their books at the end of the year, on pain of a thorough audit. In China it happens the other way round - control at the point of transaction is tight, due to the physical issuance of the paper invoices ('fapiao'), whereas the year end audit is closer to a rubber stamping exercise. As long as company headline figures, particularly around profit and corporation tax, look acceptable, local Chinese companies are not held to much scrutiny on the details (although supervision at this stage of the process is gradually tightening up).
The consequences of this system are multifarious, and it often leads to confusion amongst foreign companies in China as many Chinese counterparts get involved in the following practices:
- 2 Prices: with Fapiao and without
Particularly when dealing with smaller Chinese companies, there are often two prices available for the purchase of goods or services - one including fapiao, and a lower one without. To British ears this sounds suspicious, but given the constraints of the tax system in China then you can start to understand the logic behind this practice.
In many cases, such as dealing with freelancers or small companies with limited fapiao, there may be no fapiao on offer at all, as only a company can be tax registered. This creates a significant headache. Not only does it reduce VAT that can be reclaimed on issuing sales fapiao, but it also increases the profitability of the company (because of the missing cost fapiao), leading to a ruinous corporation tax bill.
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Paying into Company Accounts and Personal Accounts
For companies that cannot or do not issue fapiao, the question then arises of how they receive money for the sale of goods or services in China. Fapiao are not the only point of control for the Chinese Tax Bureaus. The company's bank account is of course open to scrutiny, and all transactions therein are by default taken to be company revenue or cost transactions.
Many local companies in China therefore require alternative accounts to receive funds for which fapiao have not been issued. Personal accounts are commonly used for this purpose. General Managers of Foreign Companies in China are usually highly uncomfortable with this kind of arrangement, but in China it is still common to have to make payments to personal accounts.
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Running 2 Sets of Books
" the audited books are the sum total of sales fapiao issued, minus the total of all the cost fapiao they have been able to collect, regardless of provenance, and bear little relation to the true profitability of the company. "
With multiple streams of income and cost, both 'on book' and 'off book', this makes company accounting irreconcilable. The only way these companies in China can square this circle is to run multiple sets of books - the 'real' management accounts, and the accounts presented for audit at year end.
Managers of companies worldwide are familiar with the concept of 'getting the books ready for year-end', which typically involves tying up loose ends, confirming the nature of transactions, and allocating costs and income to the correct accounts. This requires a degree of skill wherever you are operating. However, nothing compares to the fiction that are the audited books of many Chinese companies.
Simply put, the audited books are the sum total of sales fapiao issued, minus the total of all the cost fapiao they have been able to collect, regardless of provenance, and bear little relation to the true profitability of the company. Hence, the rush to bring in fapiao for costs (and sometimes at any cost - see final point on fake fapiao below)
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Stretching the Directors Loan Book
There is a means of moving money between company and personal accounts, which is an important conduit in the structure outlined above, and that is the director's loan account.
If you check the balance sheet of any company in China, one oddity you may notice is wild swings in the Directors Loan account. This is because it is used as the means for getting money on and off the books. At any given time, many companies in China are either busy finding ways to repay loans to the Directors account, if they are able to obtain a surplus of cost fapiao; or paying money back in from the account, in the event that they have off-books income.
Many bosses of Chinese SMEs have a keen eye for this number, and will select deals in part based on whether it helps them with their Directors Loan balance issue.
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Split Compensation Structures for Employees
It is common practice amongst many Chinese SMEs to set up employee compensation structures as a mix of 'base' and 'reimbursement' pay. The purpose of this is to minimise the declared salary of the employee for both social security and income tax purposes. Ultimately, the cost to the company is reduced, thereby giving them a significant advantage, enabling them to undercut those who are fully compliant when quoting for a job. The argument to employees is that it increases their take home pay, which is compelling when there is often little value seen in payments to social security service.
This then puts the employee (or the Company, if they have agreed to cover it) in the position of having to 'procure' fapiao. Staff in China often obsessively hoard taxi bills, restaurant bills, even getting VAT invoices from the weekly shop, all to hand in as the 'cost' portion of their salary.
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Applying for an Increase of Fapiao
The fapiao blank stock - the 'empties' to be printed on - have to be purchased from the local Chinese Tax Bureau. Incredibly, this requires a special application purchase, especially to increase the value of the fapiao allowed to be issued. This situation can lead to companies not being able to issue fapiao, therefore take payment, and therefore pay tax, because the Chinese Tax Bureau refuses to issue more stock!
So, Chinese finance managers up and down the country carefully manage their fapiao stock, and have to be fully aware of upcoming surges in income and prepare accordingly.
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Negotiating over Fapiao
" Few companies in China would make a payment until a fapiao (or at least scanned copy thereof) has been received"
The China business environment tends to have a lower level of trust than the UK, US or European economies. Actual exchange of payment for fapiao is a source of much negotiation and choreography. Few companies in China would make a payment until a fapiao (or at least scanned copy thereof) has been received. As Chinese VAT is paid monthly, and corporation tax in China quarterly, the cost of insufficient fapiao can quickly rack up.
Larger companies will often insist on painful payment terms, sometimes requiring several months after receipt of fapiao before making payment. This can be incredibly challenging for the supplier in China, as the income of the transaction is already declared to the Chinese Tax Bureau, regardless of whether funds have been received or not.
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Chasing Fapiao
It is astonishing the time and effort bosses of Chinese companies have to put in to the chasing and acquisition of fapiao. Given the margins involved, these are often negotiations at the highest level. Many meetings and dinners between Chinese CEOs revolve around this topic. Many Chinese companies will have suppliers they regularly use as much because of the ability to issue extra fapiao, as because of their product or price.
This creates an elaborate supply chain of connections. Certain industries, such as restaurants, take large volumes of cash, and therefore can end up with surplus sales fapiao, and then may sit at the bottom of a complex fapiao food chain.
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Fake Fapiao
A level below this, there is a huge black market for the supply of fapiao. Many street corners in China are adorned with name cards for the vendors of fapiao. A large proportion of the spam SMSs received around China are for this purpose too. This is an area trodden with great caution. Many of these fapiao are issued by 'suitcase companies' set up hastily and shut down equally fast, existing briefly only for the purpose of maximum fapiao production. Fapiao are traceable, so when the suitcase company gets shut down, the Tax Bureau in China follows the trail to all the companies found using them, which leads to big trouble.
In the past fake fapiao were used much more commonly, so the practice is still ingrained with many Chinese finance managers as acceptable. We have come across numerous foreign companies in China where, unbeknownst to them, their internal finance team were procuring fake fapiao, with initial un-benign consequences, which came back to haunt them later on.
The distinction of 'fake' fapiao is quite blurred though. For example, paying an existing supplier a few extra % for surplus fapiao often happens, but would not be considered 'fake', even though that would not happen in the UK. These days, as a general rule, companies would generally only obtain fapiao from companies with whom they could prove some kind of trading relationship.
4. Countless Shades of Grey
A friend of ours, a local Chinese, recently completed a phd on the Chinese tax system. His comprehensive study attempted to catalogue the full range of taxes companies operating in China are bound to pay. His astonishing result showed that, if a Company operating in China were to pay all taxes legally due, these would total 112% of revenue. That's right, for every RMB 100 of sales a company makes, they technically owe The State RMB 112, (so why bother starting?).
In reality, only a proportion of these taxes are actually collected, but the fact is no-one in China is fully compliant. This explains a lot of the local practices described in this article. Like it or not, there are often only countless shades of grey.
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Andy Clayton is CEO of LNP China. LNP China offer an easy and secure solution for companies from overseas to thrive when doing business in China by managing all back-office operations, which allows firms to operate and trade in China without having to go through the time, cost, and risk of setting up and running their own company. Since 2007, LNP China have supported over £25 million of exports for their clients in China.