Editor’s Note:In recent years, tax administration concerning the application of preferential tax policies for small and low-profit enterprises has become increasingly precise. Whether an enterprise may continue to enjoy such incentives depends not only on whether it meets the three eligibility criteria—annual taxable income, number of employees, and total assets—but may also be affected by the compliance of transaction documentation and tax risks involving upstream suppliers. Drawing on publicly available cases, this article reviews common forms of fraudulent claims and erroneous applications of the incentives, examines disputes over cost deductibility and eligibility for small and low-profit enterprise incentives arising from irregular upstream invoices, and offers corresponding compliance recommendations.

01 More Targeted Administration of Tax Incentives for Small and Low-Profit Enterprises

On July 28, 2026, the State Council Information Office held a thematic press conference in its series on “Getting the 15th Five-Year Plan Off to a Good Start.” According to information released at the conference, during the first half of 2026, tax authorities nationwide investigated and handled various tax-related violations in accordance with the law, recovering RMB 180.6 billion in tax revenue losses, representing a year-on-year increase of 20.8%. Among these cases, more than 3,200 enterprises were found to have fraudulently claimed or improperly benefited from tax incentives, resulting in RMB 12 billion in additional taxes assessed and recovered. These figures indicate that, while ensuring that eligible taxpayers may lawfully benefit from tax incentives, preventing the fraudulent or improper use of such incentives has become an important focus of current tax administration.

Corporate income tax incentives for small and low-profit enterprises are an important policy measure supporting the development of small business entities. Under the current rules, an enterprise may qualify as a small and low-profit enterprise if it operates in an industry that is neither restricted nor prohibited by the State, has annual taxable income of no more than RMB 3 million, employs no more than 300 persons, and has total assets of no more than RMB 50 million. A qualifying enterprise is subject to corporate income tax on 25% of its taxable income at a rate of 20%, resulting in an effective tax burden of 5%. In addition, eligible small and low-profit enterprises may benefit from reductions under the “six taxes and two surcharges” policy. These incentives help reduce enterprises’ tax and fee burdens and strengthen the resilience and growth capacity of small business entities. In recent years, however, the tax authorities have publicized a number of tax evasion cases involving fraudulent claims for such incentives. Tax-related violations involving the abuse of preferential tax policies have increasingly been characterized by concealed methods and complex transaction chains.

Against this backdrop, the administration of tax incentives for small and low-profit enterprises has become more precise in risk identification, more comprehensive in the scope of review, and more focused on the substance of business operations. On February 25, 2026, the Department of Policies and Legislation of the State Taxation Administration issued the Questions and Answers on the Improper Enjoyment of Tax Incentives by Small and Micro Enterprises. With respect to income splitting, the document sets out assessment criteria covering the reasonableness of business motives, the authenticity of business activities, and the arm’s-length nature of transactions. It also uses positive and negative lists to illustrate typical circumstances in which a reasonable commercial purpose is, or is not, considered to exist, thereby providing more specific guidance for distinguishing legitimate business restructuring from improper arrangements designed to obtain tax incentives.

In tax administration practice, the tax authorities generally monitor risks by focusing on indicators close to the eligibility thresholds for small and low-profit enterprise incentives and conduct further reviews once potential risks are identified. More specifically, by leveraging tax big data, the authorities focus on annual taxable income, number of employees, and total assets, and cross-check corporate income tax returns, individual income tax withholding information, value-added tax returns and input VAT credits, as well as invoice, fund-flow, and business-operation data. They also identify anomalies by reference to industry characteristics and data from comparable enterprises in the same region. Enterprises presenting concentrated risk indicators may also be subject to on-site inspections, during which the authorities may review accounting records, bookkeeping vouchers, contracts, invoices, and supporting documents relating to contract performance, in order to verify whether revenue recognition, cost and expense deductions, and eligibility indicators are consistent with the enterprise’s actual operations. This reflects a gradual shift in the administration of small and low-profit enterprise incentives from the review of isolated tax return data to a comprehensive examination of filing information, transaction documentation, and business substance.

02 Risks in Applying Tax Incentives for Small and Low-Profit Enterprises Arising from an Enterprise’s Own Conduct

(I) Fraudulent Claims for Tax Incentives

1. Artificially Reducing Annual Taxable Income

Recent publicly available cases show that some enterprises have sought to keep their annual taxable income below RMB 3 million by inflating deductible expenses, understating revenue, or improperly splitting income, thereby creating the appearance that they meet the eligibility criteria for small and low-profit enterprises. On the deduction side, some enterprises have obtained falsely issued invoices without any underlying genuine transactions or recorded fictitious costs and expenses, such as consulting fees and salaries, in their accounting books in order to reduce taxable income. Others have created the appearance of genuine transactions by entering into sham contracts, fabricating service arrangements, making duplicate settlements, or arranging for funds to be returned. Where the expenses claimed clearly deviate from normal industry practices and are unsupported by evidence of actual performance, they may be treated as fictitious costs. On the revenue side, common practices include receiving business proceeds through the personal bank accounts of shareholders or employees, or through third-party payment channels, without issuing invoices, recording the income, or declaring it for tax purposes; maintaining two sets of books to understate unbilled revenue; and deferring revenue that already meets the recognition criteria to the following tax year. Some enterprises have also repeatedly amended their tax returns in order to keep annual taxable income close to, but below, the RMB 3 million threshold over an extended period.

In addition, some enterprises have established shell individual businesses, affiliated enterprises, or multiple subsidiaries to distribute income that originally belonged to a single operating entity among several entities, enabling each of them to appear separately eligible for small and low-profit enterprise incentives. Whether such splitting constitutes an improper arrangement for obtaining tax incentives depends primarily on whether it has a reasonable commercial purpose and whether each entity maintains independent personnel, assets, financial systems, and business processes. Where several entities are centrally managed by the same de facto controller, with a high degree of commingling in personnel, premises, customers, and funds, and merely perform separate functions such as receiving payments, issuing invoices, or dispersing income, the arrangement may be regarded as a scheme to fraudulently claim tax incentives by fragmenting a single business into multiple entities.

Overall, although the above practices take different forms, they are essentially aimed at reducing annual taxable income by understating revenue or overstating deductions. Where it is established that an enterprise has filed a false tax return through deception or concealment, resulting in an underpayment of tax, the tax authorities will recover the unpaid tax, impose late-payment surcharges, and levy penalties in accordance with the law. Where the case involves suspected criminal conduct, such as the false issuance of invoices, it may also be referred to the public security authorities for further investigation.

2. Falsely Reporting the Number of Employees

Where an enterprise’s actual number of employees exceeds 300, some enterprises deliberately omit employees who have established employment relationships with the enterprise or workers engaged through labor dispatch arrangements. Others report a headcount on their tax returns that is materially lower than the actual figure, thereby creating the appearance that they satisfy the eligibility criteria for small and low-profit enterprises. In practice, the tax authorities generally cross-check the number of employees reported by an enterprise against individual income tax withholding records and social insurance contribution data. Where significant discrepancies exist and the enterprise cannot provide a reasonable explanation, it may be found to have fraudulently claimed tax incentives through false reporting.

3. Artificially Understating Total Assets

To keep total assets below RMB 50 million, some enterprises deliberately fail to calculate the annual average in accordance with the prescribed quarterly-average method. Instead, they select data from particular dates when asset balances are lower or artificially adjust opening and closing balances for individual quarters in order to understate the amount reported. In practice, some enterprises also understate total assets by improperly mixing asset and liability accounts, offsetting accounts receivable and other receivables against accounts payable and other payables, recording negative balances in asset accounts, or keeping assets that they actually control and use off the books. These practices create the appearance that the enterprise satisfies the eligibility criteria for small and low-profit enterprise incentives.

(II) Erroneous Application of Tax Incentives for Small and Low-Profit Enterprises

Unlike fraudulent claims, erroneous application generally does not involve a subjective intent to underpay taxes through deception or concealment. It usually occurs where an enterprise enjoys tax incentives despite failing to meet the applicable conditions because of an incorrect assessment of its legal status, a misunderstanding of policy requirements, inaccurate calculation of eligibility indicators, or errors in tax filing. Common situations include treating a branch without independent legal-person status as a separate entity for purposes of determining eligibility; failing to calculate the number of employees and total assets based on the prescribed annual average of quarterly figures; omitting workers engaged through labor dispatch arrangements; and continuing to file as a small and low-profit enterprise after its annual taxable income exceeds RMB 3 million following annual corporate income tax reconciliation or a tax adjustment.

03 Corporate Income Tax Treatment and Eligibility Disputes Arising from Abnormal Upstream Invoices

The fraudulent and erroneous applications discussed above primarily arise from an enterprise’s own handling of eligibility requirements or tax-filing matters. In practice, however, risks may also originate from a transaction counterparty. Where an upstream supplier absconds and becomes unreachable or is determined to have issued false invoices, invoices obtained by the downstream purchaser may be classified as abnormal tax deduction vouchers or otherwise become subject to further scrutiny. Where the tax authorities disallow the relevant costs and expenses for corporate income tax purposes, they may either make a specific tax adjustment or place the enterprise under an assessment-based collection method. The method adopted will directly affect the enterprise’s annual taxable income and, consequently, whether it remains eligible for the corporate income tax incentives available to small and low-profit enterprises. In the author’s view, whether expenditures supported by irregular vouchers may be deducted for corporate income tax purposes should still be determined by reference to the authenticity of the underlying transactions, the relevance and reasonableness of the expenditures, and whether the supporting vouchers can be lawfully supplemented or corrected. This article, however, focuses on how taxable income should be determined, and eligibility for the incentives reassessed, after the tax authorities ultimately disallow the relevant costs and expenses.

(I) Where the Authenticity of the Underlying Transactions Cannot Be Substantiated, the Relevant Costs Are Subject to an Upward Tax Adjustment

Where an enterprise is unable to substantiate that the transactions and expenditures underlying irregular vouchers actually occurred, the tax authorities will generally make an upward tax adjustment to the disputed costs and expenses. China Taxation News reported a relevant case involving Company C in Guigang, Guangxi, which was principally engaged in the wholesale of medical devices and had previously enjoyed corporate income tax incentives for small and low-profit enterprises. During a tax review, the tax authorities found that some of the company’s procurement expenses were supported only by handwritten receipts and warehouse entry records. The company had also frequently recorded technical service fees and consulting fees that were inconsistent with its business model, but was unable to provide service contracts, payment records, or other documentation substantiating that the relevant transactions had actually occurred. Company C subsequently made upward tax adjustments to the relevant costs and expenses. Following the adjustments, its annual taxable income exceeded RMB 3 million, and it therefore ceased to qualify as a small and low-profit enterprise. In the absence of any other applicable corporate income tax incentives, the company paid additional corporate income tax at the statutory rate of 25%, together with late-payment surcharges. The case did not involve assessment-based collection. Rather, the tax authorities made specific adjustments to particular costs and expenses while retaining the accounts-based collection method. The application of the 25% tax rate was the consequence of reassessing the company’s eligibility for the preferential treatment based on its adjusted annual taxable income.

(II) Where the Underlying Transactions Can Be Substantiated but Compliant Deduction Vouchers Cannot Be Obtained, Assessment-Based Collection May Apply in Accordance with Law

Where an enterprise can substantiate that the relevant transactions actually occurred and can accurately account for its total revenue, but the relevant expenditures are disallowed for tax purposes because compliant deduction vouchers cannot be obtained, the tax authorities may assess and collect corporate income tax in accordance with the law. Under the Measures for the Assessment-Based Collection of Corporate Income Tax (Trial), assessment-based collection may apply where an enterprise has established accounting books but its supporting documentation for costs, revenue, or expenses is incomplete, making an accounts-based audit impracticable. Specifically, where the enterprise’s total revenue can be verified but its total costs and expenses cannot be accurately calculated or verified, a deemed taxable income rate shall be determined, and taxable income shall be calculated using the formula “taxable revenue × deemed taxable income rate.” Where the annual taxable income determined under this method does not exceed RMB 3 million and the enterprise also satisfies the other applicable conditions relating to the number of employees, total assets, and industry restrictions, it may continue to qualify for the corporate income tax incentives available to small and low-profit enterprises. Where the assessed taxable income exceeds RMB 3 million, the enterprise will no longer satisfy the eligibility requirements. Accordingly, under this assessment-based collection approach, the central issue is whether the deemed taxable income rate determined by the tax authorities is reasonable.

The Measures for the Assessment-Based Collection of Corporate Income Tax (Trial) prescribe ranges of deemed taxable income rates for different industries. In the author’s view, however, these standards were formulated some time ago, and the industry classifications are relatively broad. For certain low-margin industries, even the lower end of the prescribed range may produce a deemed taxable income rate that is significantly higher than the enterprise’s actual profit margin or the normal profit level within the industry. In such circumstances, the enterprise may argue for an assessment based on the actual tax burden of comparable local enterprises or for the use of another reasonable method, such as determining taxable income by reference to business revenue, costs plus reasonable expenses and profit, or raw-material consumption, so that the assessed result does not materially depart from the enterprise’s actual profitability.

04 Compliance Recommendations for Applying Tax Incentives for Small and Low-Profit Enterprises

(I) Ensuring Genuine Business Operations and Entity Independence

Where an enterprise needs to separate its operations for legitimate business reasons, such as specialized management, risk segregation, or regional expansion, the arrangement should be based on genuine commercial needs. Before implementation, the enterprise should formulate a restructuring plan aligned with its development strategy and retain internal resolutions, development plans, and other supporting materials to demonstrate the commercial purpose of the arrangement. Each entity created through the restructuring should maintain relatively independent organizational structures, personnel, assets, business operations, and financial systems. Its business registration and tax registration information should also be consistent with its actual operations. Enterprises should avoid establishing shell entities whose sole functions are to receive payments, issue invoices, or split revenue. Transactions between related entities should comply with the arm’s-length principle. Transaction terms should be determined by reference to fair market prices, and supporting materials such as pricing documentation, transaction records, and evidence of contractual performance should be properly retained. Enterprises should avoid using non-arm’s-length pricing or artificially shifting revenue, costs, or profits in order to keep relevant indicators below the eligibility thresholds for preferential tax treatment.

(II) Standardizing Tax and Financial Accounting and Record Retention

Each operating entity should maintain separate accounting books and independently account for its revenue, costs, expenses, and profits. It should accurately calculate its annual taxable income, number of employees, and total assets, and promptly reassess its eligibility for preferential tax treatment after filing provisional corporate income tax returns, completing the annual corporate income tax filing, or submitting amended returns. Where the applicable policy is unclear or an eligibility indicator is close to the relevant threshold, the enterprise should communicate with the competent tax authority in a timely manner. If it discovers that an incentive has been applied in error, it should promptly amend the relevant tax return and pay any additional tax due. In its day-to-day operations, the enterprise should standardize the management of fund receipts and payments and invoices, and properly retain contracts, payment records, and evidence of actual performance. The contractual arrangements, fund flows, invoice flows, and flows of goods or services should be capable of corroborating one another. Supporting documents required for the application of tax incentives should also be classified, archived, and properly retained for the prescribed period.

(III) Strengthening Risk Response and Tax Dispute Resolution

Enterprises may establish a tax risk early-warning mechanism by integrating financial, invoice, employment, and fund-flow data. Particular attention should be paid to unusual changes in the three eligibility indicators and to the operating status of transaction counterparties. Upon discovering irregularities in upstream invoices or receiving a risk alert from the tax authorities, an enterprise should promptly verify the authenticity of the underlying transactions. Where invoices can be reissued or replaced, the enterprise should complete the correction without delay. Where correction is impossible for objective reasons, it should promptly compile documentation capable of substantiating the genuine transactions and the expenditures actually incurred. Where disputes arise over the deductibility of costs and expenses, assessment-based collection, the deemed taxable income rate, or eligibility for preferential tax treatment, the enterprise should communicate fully with the tax authorities on the basis of the relevant business facts, supporting evidence, and applicable policy provisions. It should also exercise its rights to make representations, present a defense, and seek legal remedies in accordance with the law. Where necessary, professional advisers may be engaged to assist in properly resolving the tax dispute.