Editor's Note: In practice, tax authorities often issue risk alerts after comparing invoice amounts with tax returns and financial statements and finding that reported costs materially exceed the costs supported by invoices obtained. Does the absence of an invoice necessarily mean that a cost may not be deducted before tax? Drawing on the Enterprise Income Tax Law, the Individual Income Tax Law, and related rules, this article distinguishes the invoice-based deduction rule that generally applies under enterprise income tax from the actual-expense deduction rule for business income under individual income tax. It further examines Judgment (2024) Liao 10 Xing Zhong No. 174 and offers response strategies and compliance recommendations for such alerts, with a view to providing guidance for relevant market participants.

01 Case Overview

A is an individual industrial and commercial household engaged in the wholesale of building materials. A routinely purchases steel, cement, and other goods from manufacturers and resells them to construction sites and distributors, generating substantial freight volume. In one tax year, A reported costs and expenses of RMB 15 million. The tax authority, however, found that the purchase, freight, and other invoices obtained during that year totaled only RMB 13 million, leaving a difference of RMB 2 million. The RMB 2 million represented freight charges paid by A to individual truck owners. Because the truck owners did not issue invoices, A was unable to obtain freight invoices, but retained freight settlement statements, records of non-cash payments, information on carriers and vehicles, purchase and sales contracts, weighbridge tickets, inbound and outbound inventory records, and customer acknowledgements of receipt. The difference triggered a risk alert. The tax authority considered the RMB 2 million unsupported by lawful deduction vouchers and proposed to disallow it as a pre-tax deduction and require payment of additional tax. A therefore sought advice: where freight expenses were genuinely incurred but no invoices were obtained, must they be denied as pre-tax deductions solely for that reason? Answering this question requires distinguishing the two different sets of rules governing pre-tax deduction vouchers under enterprise income tax and under individual income tax on business income.

02 Different Taxpayers Are Subject to Different Rules on Pre-tax Deduction Vouchers

(I) Under Enterprise Income Tax, Invoices Are, as a Rule, the Primary Vouchers for Pre-tax Deductions

Where the taxpayer is a limited liability company, joint stock company, or another enterprise specified in the Enterprise Income Tax Law, the deduction of costs and expenses must first satisfy Article 8 of that Law: the expenditure must have actually been incurred, be related to the generation of income, and be reasonable in amount. Under Article 4 of the Administrative Measures for Pre-tax Deduction Vouchers for Enterprise Income Tax (State Taxation Administration Announcement [2018] No. 28), the corresponding pre-tax deduction vouchers must also meet the requirements of authenticity, legality, and relevance. As to the form of vouchers, Article 9 of Announcement No. 28 provides that, where an enterprise incurs domestic expenditure on a VAT-taxable item and the counterparty is a VAT taxpayer that has completed tax registration, an invoice, including one issued by a tax authority, shall serve as the pre-tax deduction voucher. Where the counterparty is an entity legally exempt from tax registration or an individual engaged in small-scale and sporadic business activities, the voucher may be an invoice issued by a tax authority, or a receipt voucher and internal voucher stating such information as the payee's identity, the expenditure item, and the amount. Articles 12 through 16 establish a sequential remedial regime for non-compliant invoices. Falsely issued invoices, improperly completed invoices, and other non-compliant invoices may not serve as pre-tax deduction vouchers. Where the expenditure is genuine and has actually been incurred, the enterprise must request the counterparty to reissue or replace the invoice before the end of the annual final settlement period. If reissuance or replacement is impossible for special reasons, such as the counterparty's deregistration, revocation, cancellation of its business license, or designation as an abnormal taxpayer, the enterprise may deduct the expenditure after substantiating its authenticity with proof that an invoice cannot be reissued, contracts or agreements, non-cash payment records, freight and inventory movement records, and other supporting materials. If the invoice is still not reissued after the prescribed period and the enterprise cannot provide the required materials, the expenditure may not be deducted in the year in which it was incurred.

It should be emphasized that the conditions for deducting uninvoiced expenses under enterprise income tax are quite stringent. Reissuance or replacement of invoices is often difficult because the counterparty refuses to cooperate or has been deregistered. The special remedial route is available only where reissuance is genuinely impossible and all legally required materials are provided. In practice, the circumstances in which other materials can truly replace an invoice for deduction purposes are therefore quite limited. This is precisely the important distinction between enterprise income tax and the actual-expense deduction rule for business income under individual income tax discussed below.

(II) For Business Income Subject to Individual Income Tax, Costs and Expenses Are Deducted Based on Actual Amounts

Article 1, paragraph 2, of the Enterprise Income Tax Law expressly provides: "Sole proprietorships and partnerships shall not be governed by this Law." Under Article 6 of the Individual Income Tax Law, income from production and business operations earned by individual industrial and commercial households, investors in sole proprietorships, and natural-person partners in partnerships is subject to individual income tax as "business income." Taxable income is the balance of gross income for each tax year after deducting costs, expenses, and losses. Taking individual industrial and commercial households as an example, Article 4 of the Measures for the Calculation of Individual Income Tax for Individual Industrial and Commercial Households identifies the proprietor as the individual income tax taxpayer. Article 7 defines taxable income as gross income minus costs, expenses, taxes, losses, other expenditures, and prior-year losses permitted to be carried forward. Articles 13 and 14 require deductible expenditures to be related to production and business activities, directly connected with the generation of income, and reasonable; they also distinguish revenue expenditure from capital expenditure and prohibit duplicate deductions. None of these provisions makes a compliant invoice the sole voucher for deducting costs and expenses.

The key point is that Article 3 of Announcement No. 28 limits its scope to resident and non-resident enterprises governed by the Enterprise Income Tax Law. Business income subject to individual income tax falls outside that scope. The current rules governing individual income tax on business income likewise do not establish a dedicated voucher-deduction and remedial regime equivalent to Announcement No. 28. Accordingly, a tax authority may not simply invoke Announcement No. 28 to disallow the costs of an individual industrial and commercial household merely because no invoice was obtained and the exceptional conditions under that Announcement were not met. In addition, Article 15, paragraph 3, of the Regulations for the Implementation of the Individual Income Tax Law provides that, where a person engaged in production or business activities fails to provide complete and accurate tax information and taxable income cannot be correctly calculated, the competent tax authority shall assess the taxable income or tax payable.

Overall, the deductibility of costs and expenses against business income turns on whether the expenditure was actually incurred, whether it was related to the generation of income, and whether the amount was reasonable. An invoice is only one form of evidence proving that a cost was genuinely incurred. Where the expenditure can be verified, it should be deducted according to the amount actually incurred. Returning to the example above, A is a taxpayer subject to individual income tax on business income. If the RMB 2 million in freight expenses was genuinely incurred and the contracts, transfer records, transport records, weighbridge tickets, acknowledgements of receipt, and settlement materials corroborate one another and form a complete chain of evidence, the tax authority may not infer that the freight cost did not exist solely because no invoice was obtained, by mechanically applying enterprise income tax rules by analogy.

03 Tax Authority Loses at Both Instances After Applying Enterprise Income Tax Rules to Disallow Uninvoiced Costs

The foregoing view is also supported by judicial practice. In Case (2024) Liao 10 Xing Zhong No. 174, Hongguang Furnace Materials Processing Plant, invested in by Mr. Li, was a sole proprietorship. It purchased ore from other localities and sold iron powder to customers elsewhere, requiring vehicle transportation for both purchases and sales. Mr. Li asserted that freight expenses exceeding RMB 9.36 million were actually incurred in 2020 and 2021, and submitted non-cash payment records, information on transport vehicles, inbound and outbound inventory materials, purchase and sales contracts, reconciliation statements, weighment slips, and accounting records. The tax authority refused to recognize the freight costs on the ground that compliant freight invoices had not been obtained and that the requirements for substitute materials under the Administrative Measures for Pre-tax Deduction Vouchers for Enterprise Income Tax were not satisfied, and it issued a tax treatment decision requiring additional tax. Mr. Li disagreed and, after administrative reconsideration, brought an action before the court.

At first instance, the Dengta City People's Court of Liaoning Province held that Hongguang Furnace Materials Processing Plant was a sole proprietorship and, under Article 1 of the Enterprise Income Tax Law, was not an enterprise income tax taxpayer. The tax authority nevertheless applied enterprise income tax rules in its treatment decision and used Announcement No. 28 by analogy as the basis for assessing additional tax. This constituted an erroneous application of law. The court therefore revoked both the tax treatment decision and the administrative reconsideration decision. The tax authority appealed. At second instance, the Liaoyang Intermediate People's Court of Liaoning Province likewise held that the Enterprise Income Tax Law did not apply to a sole proprietorship and that requiring additional tax by analogy to Announcement No. 28 constituted an erroneous application of law. Finding no error in the first-instance revocation, it dismissed the appeal and affirmed the original judgment.

It should be clarified that the courts revoked the challenged decisions on the ground of erroneous application of law; they did not directly determine on the merits that the entire amount of more than RMB 9.36 million in freight expenses had to be deducted. Without applying Announcement No. 28, how should the tax authority review genuine costs claimed by a sole proprietorship? The analysis must return to the actual-expense deduction rule discussed above. Whether costs and expenses are deductible depends on whether the expenditure was genuinely incurred, whether it was related to the generation of business income, and whether the amount was reasonable, rather than on the mere possession of an invoice. Thus, where contracts, fund flows, goods, transport records, and accounting materials corroborate one another, the expenditure should be deducted according to the amount actually incurred even in the absence of a compliant invoice; the cost may not mechanically be reduced to zero. Where tax information is genuinely incomplete and taxable income cannot be correctly calculated, the tax authority should make an assessment in accordance with law rather than disallow the costs by analogy to enterprise income tax rules. In sum, there is a sound legal basis for the proposition that business income subject to individual income tax follows the actual-expense deduction principle and that an invoice is not the sole voucher. The direction taken in this case is therefore worthy of approval.

04 Recommended Responses for Similar Taxpayers Receiving Tax Risk Alerts Concerning Costs and Expenses

First, identify the legal form of the business and the corresponding rules. Upon receiving a risk alert, a taxpayer should first determine whether it is subject to enterprise income tax or individual income tax. Companies are governed by enterprise income tax rules and Announcement No. 28, with the inquiry focusing on invoices, other vouchers, and remedial conditions; a one-person limited liability company is also an enterprise income tax taxpayer. Individual industrial and commercial households, investors in sole proprietorships, and natural-person partners in partnerships are governed by individual income tax rules. Their explanations should focus on the accurate calculation of business income and the supporting evidence, and the tax authority should not be permitted to apply enterprise income tax rules directly without a legal basis.

Second, reconcile item by item the difference between reported costs and invoice amounts. Invoice amounts do not equal costs for the current period. Purchase invoices may be recorded as inventory or fixed assets, while current-period costs may also arise from prior-year carryovers, wages, depreciation, and other items that do not require a current-period invoice. The business operator should break down the reported costs item by item: which items are supported by invoices; which are supported by internal vouchers, such as wages and depreciation; which involve small-scale and sporadic transactions; and which legally require an invoice that has not yet been obtained. This makes it possible to determine whether the difference reflects genuine expenditure, a timing difference between periods, or an actual overstatement of costs.

Third, establish a complete chain of evidence for genuine uninvoiced costs. Expenditures such as freight, loading and unloading charges, and temporary labor costs should be organized transaction by transaction. Relevant materials may include the counterparty's name, identity-card number, and contact information; contracts, orders, work orders, or settlement statements; non-cash payment records from banks or WeChat; information on transport vehicles, routes, cargo weight, and acknowledgements of receipt; inbound and outbound inventory records, weighbridge tickets, and acceptance vouchers; as well as accounting records and the basis for cost allocation. The more these materials corroborate one another, the more effectively they demonstrate that the expenditure was genuinely incurred and accurately quantified. In the Liaoyang tax case discussed above, Mr. Li likewise relied on this type of material to support his claim that the freight expenses were genuine.

If a tax authority disallows genuine costs solely because an invoice is missing, the taxpayer should promptly seek assistance from professional tax lawyers and protect its rights in accordance with law. At the same time, the basic compliance boundary must be observed. Where no genuine transaction exists and costs are falsely claimed or invoices are falsely issued, the expenditure will not only be non-deductible, but may also result in additional tax, late-payment surcharges, administrative penalties, or even criminal liability. Business operators should therefore continue, in their day-to-day operations, to obtain compliant invoices wherever possible and retain complete transaction records, thereby reducing tax risks at their source.