Dr Kuang-Hua Lin

There is no lack of creativity when it comes to fraudsters within Chinese companies. Accounting departments unwittingly sign off millions passed off as legitimate expenses via falsified hotel bills. Frequently, German managing directors are liable – even if they know nothing about the practices. The only way to stamp them out is to carry out regular checks.

Booming business in China does not only offer opportunities for German companies, but also opens the way to hitherto unknown risks. Liability cases have already arisen in the context of import–export activities with China, even where companies do not have their own local subsidiaries. For some products, an authorization is required – this is especially true for so-called dual-use goods. In this case, German authorities must approve the export and the Chinese authorities the import. The most frequent pitfall in this regard concerns encryption hardware which, in China, is subject to strict authorization – at the risk of severe penalties. This includes not just dongles, routers with encryption functions, but also various kinds of machines. More and more German machine-builders are using hardware encryption in order to protect their programming, but without declaring this fact when they export their goods to China. Another common problem is false declarations concerning product specifications to enable importers to fraudulently obtain import privileges for China. Indeed, a number of business travellers from Germany have already been imprisoned in China for allegedly supporting customs and tax evasion, simply because product specifications were out by a few centimetres. Furthermore, Chinese anti-monopoly laws do not only apply to domestic companies and consumer goods: all German companies that prescribe a minimum recommended sales price for their dealers and distributors in China are at risk of investigations and penalties.

Combining operative business and liability

Additional risks and liability cases arise for owners of subsidiaries in China. Many Germans let themselves be registered with the relevant Chinese authorities – for example as a “legal representative”. As such, they have similar duties and responsibilities as the managing director of a private limited company in Germany. However, due to a lack of language skills, most Germans will not be in a position to control operational details on the ground in China on their own. They will often have to blindly trust their Chinese employees, while remaining personally liable, however. In addition, since the penalties in China are higher than in Germany, the person actually leading the operative business locally (typically the Chinese general manager) should be registered as the legal representative with the authorities. In this way, the same person is in charge of operations and liable in the case of any problems. It should be remembered that, in practice, the legal representative is liable for:

Tax evasion (Article 201, Chinese criminal law: prison sentence of up to seven years)

Evading income-tax payments and social-security contributions by underdeclaring employee salaries to the authorities is so widespread in China that many financial officers do this even without being requested to do so by the management. Moreover, tax benefits are often applied for in an unjustified way, in particular by claiming “high-tech status”, which means that a company only has to pay 15% instead of 25% corporate income tax. If the prerequisites are not fulfilled, such an unjustified tax benefit resembles tax evasion. It is therefore highly advisable to hand over all bookkeeping – or, at the very least, the monthly controls of the calculation and payment of social-security contributions and taxes – to a trustworthy external service-provider, preferably one against whom any necessary action can be taken in Germany.

Serious occupational accidents (Article 135, Chinese criminal law: prison sentence of up to seven years)

If someone dies as a result of an occupational accident or, say, a fire in a factory, the Chinese authorities like to put the responsible persons into prison. Legal representatives of companies can only protect themselves from this fate by complying with all the rules and regulations regarding manufacturing safety. Since the regulations in China change on almost a monthly basis, adhering to them all is a real challenge. It is therefore very much advisable to appoint a state-licensed production safety officer in each factory. This person is responsible for compliance with all regulations regarding manufacturing safety and occupational safety, and shall also be liable for any incidents in these domains.

Bribery in business transactions (Article 164, Chinese penal law: prison sentence of up to ten years)

Since the very recent convictions of five top managers from GlaxoSmithKline China – each of whom was sentenced to between two and four years’ imprisonment – the Western world has become far more aware of how seriously bribery and corruption is taken in China. It is unfortunately not enough to have internal rules (such as an employee handbook, a code of conduct and compliance regulations) in place against active and passive corruption. Employers must also ensure that these rules are enforced. For instance, it is common practice to charge unjustified entertainment and hotel invoices to the employer. Restaurants and hotels often have a large stock of unused official receipts that they sell to people in need of expense receipts. In order to monitor expenses, employees’ claim documents should include the official receipts (fapiao) and the purpose of the expenditure (specifying the names of the customers with whom they dined, for instance) and should be personally signed. Another common practice is to purchase credit tickets issued by supermarkets. Purchasers and other contact persons of customers receive these as “presents” on important holidays. They not only receive a fapiao for those credit tickets but can even request that the receipts be marked as being for stationery, computer accessories or the like. This then does not restrict what the recipient may later actually buy with the credit. Some Chinese general managers also set up illicit funds for bribery or for lining their own pockets by deducting hotel costs incurred for German guests in China that the guests in question actually paid themselves. By submitting a fapiao, managers are “reimbursed” for these hotel costs and can do whatever they like with the money.

Internal auditing: the most important monitoring tool

The liabilities and risks in doing business in China are therefore numerous and varied, and are often difficult to grasp for Germans owing to the language barrier and a number of Chinese particularities. It is therefore advisable to conduct a detailed internal audit of Chinese subsidiaries at least once every two years in order to detect and prevent any potential problems or risks.

The most common problems detected during such an audit are:

• Payments of unusually high commission for agents (above 50% of turnover) and commission payments to agents against hotel receipts instead of their sales invoices.
• High cash payments to their own employees – supposedly to be forwarded to service-providers – but without contracts and valid sales invoices.
• Evasion of income tax for expatriates and Chinese management staff via the “conversion” of salaries to expenses accounts. In one extreme case, a Chinese managing director had his entire income, amounting to 1.2 million yuan (approximately €157,400), paid to him entirely against expense receipts that had been collected, without paying a single cent of income tax or social-security contributions.
• Many expense receipts submitted by German expatriates and Chinese senior managers have obviously been “purchased”, as in the case where a Chinese managing director made claims for several hotel receipts, each amounting to more than 10,000 yuan, and which had all been issued on the same day by the same hotel.
• No depreciation with regard to overdue receivables and bad debts, so that the company can post more profit and the managing director can receive a higher bonus.
• Non-compliance with the terms of payment and customer credit limits stipulated by the head office in Germany. However, the SAP system matches head-office specifications in order to conceal the breach of regulations.

All the irregularities cited above are examples of problems that were not identified by external auditors. It is important to remember that internal audits only make sense if they are conducted by trustworthy external service-providers who are aware of the tricks commonly used in China.

Published in: Asia Bridge, 12:2014

Image source: Andrey Popov, shutterstock.com