Compliance is China’s latest Hot Topic.

Until recently, many Western managers accepted that some flexibility on legal issues was needed to thrive in the complex Chinese legal environment. Practices to strengthen relationships such as luxurious dinners and karaoke evenings, sponsored travel, red-pocket money and the like, have often been regarded as part of the local culture: the best – and in some cases the only – way to get things done. Just as paying out part of salaries and bonuses against fapiao (legal invoices), thereby reducing the burden of individual income tax (IIT), was seen as a good way to stay financially competitive.

But reality has set in. On the one hand, China is sending a clear message that incompliance will not be tolerated, for example with the GSK scandal (CNY 3 billion in bribes), with Chinese officials at every level (tigers and flies) under arrest, with an active Public Security Bureau seeking to expel foreigners who do not have the right papers, with dawn raids by tax officers and the labor department, and with increase customs checks. On the other hand, foreign governments such as those of the UK (UK Bribery Act), the US (FCPA) and Canada (CFPOA) are increasingly pursuing and penalizing corrupt practices of their foreign subsidiaries, including those in China. We are even seeing managers of Chinese subsidiaries being expelled to appear in investigation hearings in their home country.

Are foreign companies being singled out in China? This is certainly the general impression, and in specific industries it is becoming next to impossible for foreign businesses to remain competitive. In practice though, foreign-invested companies (and their foreign managers) have always had a tougher time to stay under the radar. Large companies such as GSK are juicy targets to set the example, and many international businesses are sensitive to bad press. Moreover, there is no doubt that the Chinese government’s current anti-corruption campaign is actually targeting Chinese officialdom. Conclusions are already being drawn on the lasting impact of this campaign on the business environment, which in the long run should benefit Chinese and foreign businesses alike.

For international companies the lessons are clear: whether you are a large multinational or a small- to medium-sized business, to operate successfully in China a high level of compliance must be pursued. Here some typical issues that companies should watch out for:

Employment Taxes

Many companies traditionally sought to save on the cost of individual income taxes and social insurance contributions, by paying part of salaries (and bonuses!) as reimbursementsagainst valid legal invoices (fapiao). However, an employee complaint to the Labor Department or local tax officer may be sufficient to trigger an inspection, which could result in back-payments as well as late-fees and fines. If the amounts of evaded taxes are large enough, these practices could even lead to criminal liability (though this is not common).

Corporate Taxes

Recently, some companies were pursued by a local district tax office in Shanghai for failure to pay withholding taxes on intercompany expenses booked in the previous year. Tax offices are improving their systems and many are becoming more assertive at initiating inspections and monitoring compliance. Campaigns focusing on certain kinds of activities (in 2014: affiliated party transactions) are causing havoc to companies that do not strictly play by the rules.

Tax Evasion and Bribery (Commercial and Official)

Some companies manage to receive income off the books, and then use some of these funds to pay illegal commissions (kickbacks) to promote sales, win projects or obtain licenses. Not only does this practice expose the company and its managers to liability for accounting fraud and tax evasion, but it can also result in administrative, civil and criminal liabilities for commercial or official bribery under PRC laws. Even in industries where such practices are common, foreign businesses in particular may be the first to get caught – with life-altering consequences for the business and the involved managers.

Business Scope Restrictions

China continues to restrict foreign investment in certain sectors, or subjects businesses to special licenses that are difficult to obtain. Examples in the service industry are recruitment (joint ventures only, unless the investor is CEPA qualified), labor dispatch (license difficult to obtain), legal services (closed to foreign investment), accounting and auditing (joint ventures only), as well as certain forms of education (subject to restrictions or licensing). Many foreign investors avoid such restrictions by establishing a general consultancy WFOE. But this exposes the business, and could lead to fines and even revocation of the business license. As part of a long-term strategy, foreign investors should also consider alternatives such as making the extra effort to obtain the required licenses, relocating to a pilot area that allows this business (e.g. the Shanghai Free Trade Zone), using a VIE (Variable Interest Entity) structure or entering into a joint venture with a local partner.

By Maarten Roos & Robin Tabbers