Legal Compliance Fraud and Risk Management in 2021

The People´s Republic of China has reported better than expected financial results for the year 2020 and a sharp rebound in China’s manufacturing in recent months as the country has been able to effectively control the spread of Covid-19. Chinese exports surged at the fastest pace in almost three years with manufacturers continuing to keep pace with overseas orders and capitalize on coronavirus restrictions elsewhere in the world.

While most foreign investors also report good business and profitability in China business, they still face a number of new challenges in addition to known legal compliance and fraud prevention issues. In this blog, we examine the key Legal Compliance issues faced by foreign invested companies in the coming year 2021 and, how to navigate through some thorny strategical, operational, and financial and remedies available.

I. Legal compliance officers be aware of situation

For the entire year 2020, China has effectively restricted foreign executive’s travel to China in order to stabilize the country and further prevent Covid-19 outbreaks. When much of the work force has been forced to stay at home away from the usual office stations it creates risk. Such travel bans have allowed a number of legal compliance issues among foreign invested companies to occur.

The lack of corporate leaders means lack of control, and as a result, legal compliance issues occur. These problems are opening-up opportunities for fraud and embezzlement. Legal Compliance Officers are well advised to look at a variety of new issues in 2020 Supervisor reports as working from home will continue in 2021 and beyond. Face-to-face meetings have now been changed to online meeting which together with financial pressures and understaffing are creating real challenges for internal control mechanisms, supply chain screening and fraud prevention.

In China, an often-reported problem has been unauthorized purchasing from third parties or selecting closely related parties as suppliers without going through proper tendering processes. Bribes and internal commission structures have been built into supply chains and in some cases purchasing has been directed to substandard products. Full and effective screening without the possibility to meet the suppliers and persons involved is a challenge when simultaneously companies are lowering their personnel thus creating opportunity for unethical acts.

Unfortunately, many foreign invested companies still try to manage Corporate Control and Supervision by remote control from their country head offices or by using their own local staff. Instead they should be engaging third party experienced Legal Compliance Offices and Supervisors present in China
to perform such specialized duties independently for and on behalf of the Company on field. Remote supervision is not effective in China, companies and supervisors must be present physically to inspect work and ensure no fraud or wrongdoing is committed.

II. Financial control, internal inspection and due care

Legal Compliance Officers are well advised to work closely with internal and external financial controllers and launch a variety of preventative measures to fight forgery, embezzlement, and fraud. Companies have reported various instances where travel costs have been fabricated and fake receipts have been included in the company’s bookkeeping. Cash Management Officers are requested to scrutinize all internal reporting issues and where possible double- check all authorized travel and costs thereof. As the old adage says, measure twice, cut once.

Foreign invested companies under restructuring are especially at risk for the issues mentioned. When restructuring, companies have to exercise extra care when making changes in the company to avoid company cash going into the wrong hands. To name a few common and often overlooked examples:

Simple tasks like the rental of new office premises might include under table payments to respective negotiation parties, or sometimes, dismissed personnel might receive extra payments or even salaries after their dismissal.

Moreover, warehouses, sales records and inventories shall be kept under strict observation in order to avoid theft and loss of company properties at these times of much reduced supervision and human-to-human interaction.

III. Corporate withholding and individual income tax risks for extended China periods

Given the current problems with leaving China due to covid-19, it should be noted many companies may run into additional taxation problems due to this. This is because China has limits on how long foreign employees can stay in China without being subject to Chinese tax burden (183 days).

In accordance with the Chinese taxation regime, foreign invested companies are requested to monitor their foreign personnel stay in China. In the event that a person has stayed in China more than 183 days, thus becoming subject to China IIT taxes rules, the company might be liable for filing such report to tax authorities and withhold relevant tax payments from China derived income.

Foreign invested companies are advised to monitor their foreign executives stay in China and make pre-assessment of such tax residence statuses by calculating their number of days in China during a tax year.

On the other hand, as a positive, foreign executives who left to their home countries at early stages of Covid-19 pandemic and have not been able to return to China, might escape from China tax resident status and, therefore, are not liable in China for individual income tax payments for the year 2020 and on-going 2021 tax period.

IV. China credit worthiness, blacklisting, and taxation credit evaluation risks

The Chinese government has during the last few years enacted a series of strict measures to regulate corporate behavior in mainland China, which are targeted to clean-up corporate actions, eliminate dishonest reporting and prevent tax avoidance.

These measures are known as the Corporate social responsibility (CSR) measures, and companies can be “blacklisted” if they do not adhere to such measures.

Being blacklisted means it is difficult to do business with government, tax scrutiny and audits are common, and other companies may not want to do business with you until you are removed from the blacklist.

How it works

In the year 2020 the CSR measures have been refined and expanded: for example, a mechanism to evaluate corporate credit worthiness and classification of taxpayers in various categories has been created. Corporations are nowadays awarded five classification groups depending on their corporate social credit scores and points generated. Foreign invested companies are well advised to report timely and correctly
their annual returns and monthly tax declaration in order to avoid being blacklisted. Once you are either ranked down on the credit scores there is a risk of being blacklisted and there is a lowering of tax credit worthiness classification status.
This means there is more tax scrutiny at tax audits and tax inspection exercises for a company.

V. New Chinese Accounting Standars and changes to Financial Reporting

Chief Financial Officers of foreign invested companies should also take notice that the year 2021 will introduce new Chinese Accounting Standards for Business Enterprises, some companies have already complied so check with financial departments.

Financial statements are required to add a variety of new detailed features in the balance sheets like the introduction of contract assets and contract liabilities, and explanations and
regulations on timing of revenue.

For example:
* Recognition of contract revenue is now on transfer of control, previously it was on the transfer of significant risks and rewards. So simply, the revenue can only be recognized
when the customer can use the product and gain almost all the economic benefits from it.
* Revenue will be recognized based on performance over time or at a point in time which means performance obligations must be stipulated in the contract.
* New frameworks for recognizing specific transactions.

This will cause extended legal compliance and risk assessment work for the company’s financial departments. So best make sure staff are up to date, and if not, seek expertise. Despite the inconvenience, the silver-lining for business is that it will also provide greater transparency for partnerships and investors.

VI. Profit repatriation and inter-company agreements

Foreign Investors should be aware that profit repatriation from China is allowed only after and upon all procedures for Annual Returns and tax compliance are fully completed. Profits are generally allowed to be remitted to home countries once a year after providing evidence of legal compliance, payment of Corporate Income Tax and profit repatriation taxes as defined in Double Taxation Agreement of respective countries and regions in questions.

As many foreign investors have seen profit repatriation from China can be a difficult and time-consuming task. Therefore, in order to minimize profit repatriation risks from the People´s Republic of China. intelligent companies have employed a variety of tax optimization and cash flow management tools in their business architecture and corporate format.

Below are present some of the Titles of the Inter-Company Agreements, that can be used as part of the incorporation documentation:

BOX – Inter-Company Agreement

Agreement for Internal Loans

Agreement for Company Set up Cost Reimbursement Agreement for Production Start-up Support Services Agreement for Technology Transfer Services Agreement for Patent Licensing

Agreement for Source Code and Trademark Licensing

Agreement for Sales Support Services

If you would like to learn more, these blogs are published every week in the lead-up and after the Fintrade-Mercer Pandas Go Olympics Business Cafe, held through the Management Institute of Finland on January 28th of December. The Business Café will be free to attend and is accessible through webinar and will discuss China opportunities, Pandas Go Olympics, and help you with your China knowledge and training.

Stay tuned to learn more.

Jari E. Vepsäläinen

CHAIRMAN FINTRADE-MERCER GROUP. THE PEOPLE´S UNIVERSITY OF CHINA, BEIJING