Shanghai A foreign company was established in 2018, engaging in the production and sales of automotive components, with its headquarter located in Europe. The five directors of the A foreign company are all held concurrently by foreign executives from the HQ and are not resident in China. As the HQ has great trust in the general manager of Shanghai foreign company, the general manager is fully responsible for and handles the daily business management of the foreign company.

Although the annual sales volume of the A foreign company has been increasing since its establishment, the A foreign company continues to suffer losses, and its registered capital of EUR 5,000,000 has been completely exhausted four years after its establishment. In September 2022, the chairman of the A foreign company received a notice from the China tax administration, which involved tax evasion and required the chairman to accept an investigation. The HQ was very shocked and decided to entrust Dongjin to conduct an internal audit of the A foreign company and cooperate with the tax administration to accept the investigation.

After the comprehensive and in-depth audit, Dongjin found that the general manager had colluded with the financial manager employed by the HQ to fabricate various expenses and use the falsely issued invoices to reimburse and record them. Due to the clear facts and conclusive evidence of tax violations, the chairman, as the legal representative, had to reluctantly accept a huge penalty from the China tax administration.

Through investigation, Dongjin also found that the A foreign company did not establish a management system for contract seals, and there was no third-party supervision. The general manager was free to use the seal at any time. Therefore, the general manager arranged for the main raw material procurement and outsourcing services of the A foreign company to be provided by companies established by his relatives and friends as suppliers, and the contract price is significantly higher than the market price. He also signed several guarantee contracts in the name of the A foreign company. Although the headquarter of the A foreign company directly dismissed the general manager and the financial manager, reported the case to the public security organization to pursue their personal responsibilities, and also filed a lawsuit in the court, the huge losses have been difficult to recover, and there are even unpredictable guarantee liabilities to bear.

Dongjin Remind:

It is recommended that the headquarter of foreign companies establish a legal and fiscal risk monitoring system for foreign companies in China, hire an independent third-party professional institution to review various contracts in advance, establish a management system for company seals, and conduct regular fiscal and tax internal audits to avoid executives losing control and causing huge penalties and losses to foreign companies.

Mike Chang

Partner

mikechang@shanghaiinvest.com