As an important financial and tax policy to encourage technological innovation and implement the innovation-driven development strategy, the Enterprise Income Tax Law has clarified this policy in the form of law since 2008, and its scope of application has been broadened and the deduction ratio has been improved, which has become a preferential policy widely applied by enterprises. At the same time, the R&D activity itself is characterized by strong professionalism and high barriers, and there are many risks in the process of industry-finance convergence in the application of deduction for R&D expenses. In this paper, we will analyze the common tax-related risks in practice from the audit cases related to deduction for R&D expenses for the enterprises to check themselves and prevent risks.

I. Improper application of additional deduction for R&D expenses by a number of enterprises, characterized as tax evasion and fined

(I) Scope of application of the policy of additional deduction for research and development expenses and cost aggregation

Article 30 of the Enterprise Income Tax Law stipulates that the research and development expenses incurred by an enterprise in developing new technologies, new products and new processes may be deducted when calculating taxable income. This provision defines the policy of additional deduction of research and development expenses in the form of law. Subsequently, the Ministry of Finance (MOF), State Administration of Taxation (SAT), Ministry of Science and Technology (MOST) and other departments issued a series of policies to clarify the definition of R&D activities, the percentage of additional deduction, and the provisions on the aggregation of R&D expenses, and continuously adjusted the scope of the industry and the percentage of deduction. 

In March 2023, the Ministry of Finance ("MOF") and the State Administration of Taxation ("SAT") issued the Announcement on Further Improving the Policy of Adding Deductions for R&D Expenses before Tax (Announcement No. 7 of the MOF and the SAT of 2023, hereinafter referred to as the "Announcement No. 7"). The Announcement No. 7 has further increased the preferential treatment by increasing the percentage of deduction from 75% to 100% for all enterprises of the eligible industries. ratio from 75% to 100% and implemented as an institutional arrangement on a long-term basis.

According to the "Notice of the Ministry of Finance, State Administration of Taxation and Ministry of Science and Technology on Improving the Policy of Pre-tax Deduction of Research and Development Expenses" (Cai Shui [2015] No. 119, hereinafter referred to as "No. 119"), the R&D expenses that are permitted to be deducted include personnel and labor expenses, direct input expenses, depreciation expenses and amortization of intangible assets, Costs related to experiments and other related costs.

(II) Many enterprises have improperly applied the additional deduction for R&D expenses, and there are many tax-related risks.

No. 119 clarifies that R&D activities refer to the systematic activities with clear objectives carried out continuously by enterprises to acquire new knowledge of science and technology, creatively utilize new knowledge of science and technology, or substantially improve technology, products (services), and processes. From the R & D project management, personnel arrangements, R & D cost collection, to data retention for inspection, R & D cost deduction policy in all aspects of the need to pay attention to the key points, if the enterprise fails to identify the risks, it is very likely to trigger the risk of tax adjustments, which will lead to late fees, fines, affect the qualification of high-tech enterprises recognized as an unfavorable consequence of the improperly handled, or even lead to criminal risk.

The author found that in practice, many enterprises have been subject to tax audits due to improper application of deduction for R&D expenses, and in addition to adjusting the taxable income, paying back taxes and charging late fees, some enterprises have also been characterized as tax evasion and fined for making false tax declarations, and some enterprises have been fined due to fictitious transactions and fictitious R&D projects. Some enterprises are at risk of false invoicing due to fictitious transactions and fictitious R&D projects.

II. Common Tax Risks of Deduction of R&D Expenses

(I) Exclusion from the scope of application of the policy of additional deduction for R&D expenses

1. Scope of industries not subject to R&D cost deduction

Circular 119 specifies the scope of industries that are not applicable to the deduction of R&D expenses in the form of a reverse list, including the tobacco manufacturing industry, the accommodation and catering industry, the wholesale and retail industry, the real estate industry, the leasing and business services industry, the entertainment industry, and other industries specified by the Ministry of Finance and the State Administration of Taxation (SAT). The industries herein are based on the National Economic Industry Classification and Codes (GB/4754-2011) and updated accordingly (now the National Economic Industry Classification and Codes (GB/4754-2017)).

The Announcement on Issues Relating to the Policy of Pre-tax Deduction of Research and Development Expenses of Enterprises (State Administration of Taxation Announcement No. 97 of 2015) further stipulates the criteria for determining the industries on the Negative List, i.e., with the business of the industries listed in the foregoing as the main business, and with the income from the main business in the year in which the research and development expenses are incurred accounting for more than 50% (inclusive) of the balance of the enterprise's income based on the total amount of revenue minus the income that is not subject to taxation and the investment income. Enterprises should pay attention to the tax differences when determining whether they belong to the list of negative industries, so as to avoid incorrectly applying the policy of additional deduction for R&D expenses due to accounting errors.

2. Activities not subject to R&D expense deduction

Circular 119 stipulates that activities such as routine upgrading of products (services), direct application of scientific research results (e.g., direct adoption of publicly available new processes, materials, devices, products, services, or knowledge, etc.), technical support activities for customers after commercialization, and repetitive or simple changes in existing products, services, technologies, materials, or processes cannot be subject to the policy of additional deduction of R&D expenses. Enterprises should fully understand what is the 119th R & D activities, clear R & D activities and other similar activities of the border, to avoid the application of the wrong tax-related risks.

3. Authorized levy can not be applied to the policy of additional deduction of R&D expenses.

Circular 119 makes it clear that the additional deduction for R&D expenses is applicable to resident enterprises with sound accounting, implementation of checking and collection of accounts, and the ability to accurately collect R&D expenses, and should not be applied to enterprises with approved collection of accounts.

(II) Failure to differentiate between the labor costs of part-time personnel

A Decision on Administrative Penalty published by Huangshi Inspection Bureau of Hubei Province shows that a pharmaceutical and chemical enterprise did not allocate the labor hours consumed by part-time R&D personnel engaged in R&D activities and production and operation activities when listing the salaries of R&D personnel, and included all of their salaries in R&D expenses and enjoyed the additional deduction of more than RMB 1.2 million. The Audit Bureau adjusted the taxable income and imposed a fine of 10,000 RMB for "fabricating false tax basis".

In the Announcement on Issues Relating to the Scope of Collection of Pre-Tax Deductions for R&D Expenses (SAT Announcement No. 40 of 2017, hereinafter referred to as "Circular No. 40"), it is clearly stipulated in the regulations on personnel labor costs that if the personnel who are directly engaged in R&D activities are also engaged in non-R&D activities, the enterprise shall make necessary records of the personnel activities and record the actual expenses incurred by the personnel. The enterprise shall make necessary records of the activities of its personnel and allocate the relevant expenses actually incurred between R&D expenses and production and operation expenses according to a reasonable method such as the proportion of actual working hours, and shall not deduct any unallocated expenses. Therefore, if there are part-time personnel engaged in R&D activities, the enterprise should make relevant records and reasonably allocate the portion attributable to R&D expenses to avoid the risk of tax adjustment due to improper application.

(III) Exceeding the scope of R&D expenses to enjoy additional deduction

According to an Administrative Penalty Decision published by Chaozhou Inspection Bureau in Guangdong, a food enterprise listed "ice cream" and "pineapple nectar" in the R&D expenditure account, which were not related to production and operation, and declared the R&D expenses as additional deduction, resulting in the underpayment of EIT of about 320,000 RMB. The Audit Bureau recognized its behavior as "making false tax declaration", which constituted tax evasion and imposed a fine of 50% of the underpaid tax.

Circular 119 stipulates that the R&D expenses that are allowed to be deducted include personnel and labor costs, direct input costs, depreciation costs, amortization of intangible assets, costs related to experiments, and other related costs. Over-scoping the expenses to be grouped into R&D expenses and enjoying the additional deduction will lead to the risk of tax adjustment and qualitative tax evasion.

(IV) Special income should be offset against deductible R&D expenses

A recent "Administrative Penalty Decision" contains a metal protective materials enterprises will be the R & D generated waste pulp as waste pulp sales, not the waste pulp income offset R & D expenses, requiring enterprises to adjust taxable income and characterized as tax evasion, a penalty of 50% of the underpaid tax.

Article 7 of the No. 40 stipulates that enterprises to obtain the R & D process of the formation of scraps, defective products and other special income, in the calculation of recognized income in the year of deduction of R & D expenses, should be from the pooled R & D expenses deducted from the special income, less than the deduction of R & D expenses deducted according to the calculation of zero.

(V) Deduction of other related expenses exceeding the scope and limits

No. 40 stipulates that other related expenses that can be deducted refer to other expenses directly related to R&D activities.No. 40 at the same time positively enumerates the types of other expenses, and there is no underlining clause, the enterprise in the collection of other expenses, should be checked against the expenses incurred whether they belong to the types stipulated in No. 40.

In terms of the deduction ratio, the total amount of other related expenses shall not exceed 10% of the total amount of R&D expenses that can be deducted. The Announcement on Issues Relating to the Further Implementation of the Policy of Additional Deduction of R&D Expenses (SAT Announcement No. 28 of 2021) further stipulates that, if an enterprise carries out a number of R&D activities at the same time in a tax year, the limit of "other related expenses" shall be changed from the original limit of calculating "other related expenses" according to each R&D project to a unified one. Instead of calculating the limit of "other related expenses" separately for each R&D project, the limit of "other related expenses" is calculated uniformly for all R&D projects.

III. How can enterprises prevent the risk of applying the policy of additional deduction for R&D expenses?

(I) Improve the standardization of accounting and management

No. 119 of the enterprise to enjoy the R & D costs plus deduction put forward the accounting and management requirements, enterprises should enjoy the deduction of R & D costs according to the R & D project to set up auxiliary accounts, accurate accounting for the year can be added to the actual amount of R & D costs incurred. If it is not possible to accurately distinguish between R&D expenses and production and operation expenses, no additional deduction shall be applied.

Enterprises in the R & D activities, should do a good job of industry and finance convergence, accurately distinguish between the R & D costs incurred whether the R & D costs belong to the scope of the R & D expenses plus deduction, the relevant costs can be accurate and reasonable collection, to avoid being adjusted by the tax, bringing the risk of paying back taxes, late fees and even qualitative tax evasion.

(II) Pay attention to the difference in caliber between the deduction of R&D expenses and the recognition of high-tech enterprises.

In the calculation of high-tech enterprise certification and R&D expense deduction, there is a difference in the caliber of R&D expenses. Taking "other related expenses" as an example, compared with the standard of high-tech enterprise certification, the scope of other related expenses that can enjoy the deduction of R&D expenses is wider, and the proportion is different, see the comparison in the table below. Therefore, no matter in the recognition of high-tech enterprises or in the accounting of R&D cost deduction, enterprises should accurately differentiate between different caliber of cost collection and correctly apply the corresponding policies.

(III) Retaining the information for checking of R&D expenses deduction

Deduction of R&D expenses is based on the levy and management method of "real occurrence, self-identification, declaration and enjoyment, and retention of relevant information for inspection". A penalty decision published by the Jilin City Audit Bureau shows that the enterprise was fined RMB 11,000 for "failing to keep the research and development project plan, resolution documents, cost allocation instructions, R&D expenditure auxiliary accounts and other information for inspection", and adding deduction for R&D expenditures that did not comply with the regulations, and fabricating a false tax basis. Enterprises should retain information such as research and development project plan, personnel engaged in research and development activities and cost allocation instructions for instruments, equipment and intangible assets used in research and development activities, auxiliary accounts for research and development expenditures and summary tables, etc., in order to cooperate with the tax authorities in the subsequent management and inspection.