When Proof Isn’t Enough: Documenting and Defending Service Fee Deductions in China
Highlights - Chinese tax audits are intensifying scrutiny on service fee deductions. Even third-party payments require detailed proof that services occurred, and classification must match reality. Recent cases show that documentation gaps can lead to costly tax adjustments.
Background
Recent Chinese tax audit cases highlight an emphasis in enforcement around service fee deductions for enterprise income tax (EIT) purposes. Contrary to common assumptions, having a signed service contract and a valid VAT invoice does not automatically secure EIT deductibility. Tax authorities now focus on two key themes: (1) whether the services were actually received, and (2) whether the nature of the services is consistent with the taxpayer's claimed classification.
This heightened scrutiny applies equally to third-party transactions and intercompany service arrangements, with a particular focus on broadly defined categories such as consulting services, where both the scope of work and the appropriate tax classification are often ambiguous and subject to interpretation by the tax authorities.
Verifying the Occurrence and the Nature of Services
A recent investigation by the Tax Investigation Bureau in Fujian province provides an example of current enforcement trends. In this case, a domestic enterprise taxpayer was required to submit a wide range of evidence to prove the occurrence of certain consulting services it had paid for. Required documentation included service contracts detailing scope and deliverables, payment records, internal justifications, and service outputs such as project deliverables, reports, and communication records. The audit emphasized that these materials must be maintained contemporaneously, not reconstructed after the fact.
This case underscores that even third-party payments are now closely reviewed for income tax deduction. The burden lies with the taxpayer to prove not only that payment was made, but also that the transaction involved legitimate, necessary business services that were actually performed.
Even if a service is confirmed to have been performed, tax authorities may still challenge its characterization and reclassify it into a category subject to deduction limits. In a recent case in Zhejiang province, fees labeled as “consulting” were reclassified as advertising expenses after the tax bureau reviewed the service outputs, which included brand strategy and customer outreach, and found that the contract and documentation failed to clearly differentiate the work from marketing activities. As a result, a 15% revenue cap on deductibility was applied. This case underscores the importance of ensuring that the documented nature of a service aligns with its intended tax treatment.
Reminders
The recent cases reinforce two themes in current tax enforcement: proving that services were genuinely rendered, and ensuring their classification is aligned with the economic substance of the activity. These are not background concerns and are central to determining the deductibility of service fee payments. These issues are scrutinized before any transfer pricing consideration becomes relevant, if the services transaction is with a related party.
Taxpayers must ensure they build and preserve a coherent, contemporaneous documentary trail for all material service arrangements. This may include detailed contracts, communication records, and outputs (e.g., review, acceptance, application, etc.). Particular caution is needed for service categories that border on advertising, or commissions, etc., which may trigger EIT deduction caps.
As audit practices continue to evolve, focusing on these practical documentation and classification issues is essential for mitigating risk. The burden of proof lies with the taxpayer validating these facts through well-structured supporting documents assembled at the time of the transaction, not afterwards.
