If Financial Interpretation No. 48—the new accounting rule forcing companies to estimate the validity of their tax strategies—is keeping you up at night, imagine what it’s doing to your friends, colleagues and neighbors who work with Chinese companies.

Enacted by the Financial Accounting Standards Board at the start of this year, the unpopular rule specifically requires companies to disclose how certain or uncertain they are that their tax positions will pass muster with local taxing authorities, and then book a liability proportionate to that certainty.

The problem for Chinese companies listed on U.S. exchanges: Almost every tax position in China is uncertain. In a recent note, PricewaterhouseCoopers outlined some of the potential tax problems a Chinese company could face in China and offered up analysis on what these mean for Chinese companies that must prepare filings for U.S. regulators.

Tax incentives were at the top of that list. For years, Chinese authorities at the national, provincial and local levels have provided tax breaks for foreign companies; indeed, many Chinese companies in the United States are incorporated outside of China so they are deemed foreign by Chinese regulators and consequently entitled to the tax breaks. Invariably, these incentives are modified or simply being declared unlawful. In many cases, the officials who granted the break were acting outside their authority.

The central government recently passed a law ending reduced income taxes for foreign corporations—broadly taking them from 15 to 25 percent—but no one really knows how the new law will be applied. It is not clear how long foreign companies will be grandfathered and which ones will be entitled to new incentives.

“The law is in place, but a lot of clarification needs to be made,” says Suzanne Wat, a partner at PWC in Hong Kong. “That won't happen until the latter part of the year.”

Wat

“Under FIN 48 companies need to calculate how much these rates will be revalued,” she adds. “That will be a challenge. They are going to have to make some tough decisions.”

Currently, more than 100 Chinese companies trade in the United States. Most of them have achieved this status through a reverse merger, where they acquire a U.S. shell company for stock, leaving the home market company as a wholly owned subsidiary of a U.S. public company (which itself is majority owned, after the transaction, by the former controlling shareholders of the Chinese company).

These companies are not the giant state-controlled corporations that have achieved a New York listing. They usually have less than $100 million in sales, short histories, tiny market capitalizations and dubious business prospects. The shells they acquire are usually no better, either companies simply set up by promoters for this type of transaction, or the remnants of dead real estate developers, biotech failures or Internet startups that never thrived. They generally trade on the OTC Bulletin Board or on the Pink Sheets. Many are barely liquid.

Already, these companies have had trouble complying with Sarbanes-Oxley. Some wonder how they will be able to handle FIN 48. More than a few of these companies have had difficulty even meeting the most basic of SEC regulations.

Towne

“Can they comply? Are they going to comply?” asks Gerald Towne, a tax attorney at the law firm Thelen Reid Brown Raysman & Steiner. “What are the options? What are the auditors going to do? Are they going to be able to sign off on the financials?”

Accounting experts believe that these tax breaks are at risk not only because the breaks may be unlawful, but also because the companies may have been operating beyond the scope of the breaks being offered.

Manufacturers, for example, may be undertaking too much trading relative to the amount of product they are making. Foreign companies may be operating outside a designated special economic zone. They may be conducting business on a scale not permitted in the original agreement. Or they may be applying a head office tax rate to branch offices that are not qualified for that rate.

“The law is in place, but a lot of clarification needs to be made. That won't happen until the latter part of the year.”

— Suzanne Wat, PWC Hong Kong

PWC warns that even if companies win the blessing of the proper Chinese tax authorities for the tax positions they take, they must evaluate whether the views from those officials could change over time, and should make their own determination as to whether the tax incentive will last no matter what the government says. “Permanent establishment risk”—that is, the risk that a Hong Kong business will build up its operations in mainland China that it becomes subject to taxation in both jurisdictions—is also a threat, according to accountants.

But perhaps the most significant risk is that of transfer pricing (the sale of goods from one division to another, under one corporate umbrella). Recent tax legislation in China indicates that the government is seeking to improve its understanding of transfer pricing, develop better relevant regulations, and upgrade enforcement and compliance with respect to transfer pricing. PWC notes that even for the most honest and transparent of companies, transfer pricing issues in China can be complex due to the nature and structure of the China export market.

PWC says that export toll and contract manufacturing can be particularly troublesome. The former suffers from a disparity between the declared customs value for imported materials and the cost booked for these materials, while the latter uses cost-plus margins, a practice that tax authorities are likely to challenge. The deductibility of intercompany charges also needs careful examination, and a discussion with the relevant Chinese tax bureau to confirm deductibility is often necessary.

According to PWC, China is a “document intensive environment,” and companies operating there must have their papers in order. Failure to do so may result in an adjustment to taxation that is both negative and permanent. Companies operating in China also need to assess non-income taxes properly, since they may change as income tax rates are modified, and this must be properly reflected on the books.

Penalties in China can reach 500 percent of the tax due, and the statute of limitations can run five years in cases where the underpayment is above 100,000 renminbi ($12,953).

Chinese companies trading in the United States are already starting to note FIN 48 in their SEC disclosure documents. For example, China BAK Battery, a battery maker that reverse-merged in 2005 with a Nevada-incorporated coffee company, has a paragraph in a 10-Q filed Feb. 2 saying that FIN 48 is effective for it from Oct. 1, 2006, and that the company is currently evaluating the effect of the interpretation on its accounts.

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