Q&A on SMEs' Improper Use of Preferential Tax Policies

Criteria

Splitting with Reasonable Commercial Purposes

(Positive List)

Splitting without Reasonable Commercial Purposes

(Negative List)

Whether the motivation is reasonable

It conforms with industry practices and is consistent with the enterprise's strategic developmental objectives, and generates practical benefits, including improved management efficiency and enhanced market competitiveness, rather than being driven primarily or solely by the desire to reduce, exempt, or defer tax obligations.

The primary or sole purpose is to reduce taxes, with no material change in the overall business scale or operational structure before and after the split. The only effect of splitting is to make the operating income eligible for a lower tax rate or tax incentives.

Whether the business transaction is authentic

It shall have independent production and operating capacity and a complete business process, including independence in organization, assets, business operations, and finance, and be able to provide comprehensive documentation such as negotiation records, contracts, and performance evidence, without asset sharing, staff overlap, or centralized decision-making and control, and revenue misalignment with the actual business activities.

It frequently has multiple business licenses registered at the same address. The registered address is often a virtual office or a common location, where there are no actual personnel or traces of business activities. Only a limited number of office supplies are kept on site, and no substantive business operations are conducted.

Whether the transaction is fair

It shall be conducted under the arm's length principle, with goods prices and service fees matching those prevailing in comparable market transactions. Evidentiary materials, including third-party quotations and industry fair market data, shall be provided.

Profit transfer is conducted through underselling, free-of-charge services, and other methods, to lower the overall tax burden.

Main types

1. Demerger of business segments. For the purpose of achieving refined management, facilitating specialized operations, and sharpening the focus on core business activities, the company splits its business segments (e.g., R&D, production, sales, and services) into independent legal entities. Each has its own organizational structure, staff, and business scope, aiming to improve management efficiency and boost market competitiveness. For instance, a home appliance manufacturer spins off its R&D segment relating to smart home into an independent subsidiary to drive technological innovation and expand its market presence.

2. Splitting the isolation of risks. To prevent the spillover effects of operational risks, business segments at different risk levels are separated into independent legal entities to achieve business isolation. This also constitutes a special case of demerger of business segments. For example, A logistics firm separates its hazardous materials transportation operations from its conventional freight services by establishing distinct corporate entities, preventing risks arising from a single business segment from adversely affecting its overall operational performance. Similarly, a manufacturing enterprise may separate its research and development function into an independent subsidiary, thereby diversifying the risk of unsuccessful R&D outcomes.

3. Regional footprint split. To pursue market expansion or to take advantage of region-specific policies (excluding preferential tax policies), a company incorporates subsidiaries in various regions and attributes the revenue generated in each region to the corresponding subsidiary. For example, Stores located in various geographical regions are registered as independent operating entities with separate accounting and management. Each entity is responsible for business activities within its region, thereby streamlining management processes, reducing administrative costs, and enhancing overall management effectiveness.

4. Asset spin-off and restructuring. To streamline its asset structure, enhance asset operation efficiency, or satisfy specific regulatory requirements, a company spins off certain assets (together with related business operations and personnel) to form an independent legal entity, which shall maintain separate accounting for its operating income, achieve professional asset management and efficient utilization, and reinforce the focus on core assets, thus fulfilling the compliance requirements of listed companies or specific transaction needs.

5. Family business succession and equity incentive spin-off. A family business may transfer some of its operations or assets to entities set up by family members or key employees through a legal equity structure, with the purpose of generational transition or implementing equity incentive plans for key employees. This practice is designed to clarify the ownership structure and motivate core employees, thereby supporting the sustainable and healthy development of the above family business.

1) Entity splitting. By establishing affiliated enterprises, individual businesses, or even shell companies, a single operating entity splits its economic activities across multiple entities. After keeping the scale of each entity below the applicable limits, the operating entity can secure access to corresponding tax incentives. It can be implemented in two forms as follows:

First, split an integrated entity into homogeneous entities. Multiple entities with highly homogeneous business scopes are established under the same controlling entity. On paper, each entity appears to operate independently, but in reality, their staff, premises, and assets are heavily intertwined, which is evidenced by multiple business licenses registered at the same address or multiple entities controlled by a single individual.

Second, establish multiple shell entities. The same de facto controller uses his/her identity, and those of family members, employees, and other related persons, to register multiple affiliated enterprises or individual businesses, all of which operate in the same type of business. The overall business is artificially fragmented across these entities, which lack any genuine business substance and exist merely as tools to split income.

2) Contract splitting. Through artificially created transaction layers, contract splitting, or other similar arrangements, a single business transaction of large amounts or long-term duration is broken down into multiple independent contracts of shorter time intervals and smaller amounts (usually below the VAT exemption threshold or the preferential tax threshold for SMEs), or profits are allocated through intermediary entities.