Tax Risks in Medical Distribution and Compliance Recommendations

Original 叶永青余悦等金杜研究院

2024-08-28

Preface

Recently, the ongoing anti-corruption campaign in the healthcare industry across the nation has been increasingly intensified. The anti-corruption campaign primarily targets the distribution sector of medical industry, and medical companies are faced with the pressure of compliance system building and risk assessments with regard to medical distribution process. Against this backdrop, tax compliance, compared to the liabilities that may arise from non-compliant marketing practices, is often overlooked by medical companies and becomes a covert weakness in the entire medical compliance system.

In fact, the issues of "fake transactions" and "fake costs", etc., which are the focus of the recent anti-corruption campaign, are closely related to fictitious value-added tax (VAT) invoicing and tax evasion. These tax risks may impose heavy economic burdens and legal liabilities on enterprises. At present, some provinces have issued work plans on anti-corruption in the medical industry, explicitly stating that tax-related illegal activities are included within the scope of inspection. For example, Article 11 of the Notice on Issuing the Key Points for Rectifying Misconduct in the Field of Pharmaceutical Procurement and Sales and Medical Services in Shanghai for the Year 2023 mentions that "…any tax-related illegal activities discovered in the field of medical procurement and sales shall be investigated and inspected in accordance with laws and regulations, and online-related illegal and irregular activities shall be rectified and purified."

In the context that regulators conduct comprehensive investigations using diversified legal tools in the ongoing anti-corruption campaign, the possibilities of tax compliance risks and other legal compliance risks may mutually become the fuse.

This article focuses on the tax compliance issues in the medical distribution sector, analyze the tax administrative and criminal liability risks that medical companies may involve, and provide recommendations for the improvement of tax compliance to managing the relevant risks.

Hidden Risks of Tax Compliance in Distribution Practices

1.Common Tax Risks Under Different Sales Models

Currently, in the distribution sector of pharmaceuticals and medical devices, there are mainly two sales models, including self-operated sales by medical companies and third-party marketing such as outsourced Contract Sales Organizations (CSO). Under different sales models, medical companies may face tax risks such as fictitious invoicing and tax evasion.

（1）Self-Operated Sales

Under the self-operated sales model, for various reasons, medical companies may carry out "rebate sales" in various names or forms, or illegally deliver benefits to medical institutions or medical staff through payment of consulting fees, intellectual property fees, etc., that are difficult to verify. To deduct corresponding kickbacks, commissions, and other expenses before tax, some medical companies may record unrelated or even fictitious invoices in the accounting book.

In addition, some medical companies may pay the "sales" expenses advanced by sales personnel by providing reimbursement, and sales personnel may submit non-compliant invoices or vouchers for non-compliant reimbursement.

（2）Third-Party Sales Including Outsourced CSO

On the one hand, limited by the current market development status and industry environment, some CSOs often have difficulty in clearly defining the real services they provide to medical companies. Some medical companies with a lack of compliance awareness or only achieving "formalistic compliance" may organize training sessions, academic conferences, and other forms of nominal promotional services through CSOs or other meeting organizing institutions, and pay high service fees, consulting fees, sponsorship fees. They may use invoices based on "fake transactions", "fake conferences", and "fake donations" issued by CSOs and other organizations for tax deductions.

On the other hand, due to the chain attribute of VAT risks, even if medical companies do not intentionally violate tax laws, they may be affected by the upstream tax risks of non-compliant CSOs. For example, if a CSO uses fictitious invoices to illicitly transfer funds, it can easily cause a chain reaction, leading to further investigation by tax authorities, implicating the medical companies that received the invoices. Additionally, some CSOs may split transactions through a large number of shell companies, illegally enjoy tax benefits for small taxpayers and small and micro enterprises, and require medical companies to sign service contracts with different shell companies, possibly resulting in inconsistencies between the actual service provider and the invoicing party.

Whether it is self-operated sales or an outsourced CSO model, if medical companies utilize the aforementioned invoices obtained or reimbursed by sales personnel for pre-tax deductions, they may trigger tax legal risks associated with accepting fictitiously issued VAT invoices or evading taxes. In general terms, once this type of tax risk is triggered, medical companies may not only face the direct economic consequences of paying underpaid taxes, late payment penalties, and administrative fines, but may also face criminal penalties against the company and the relevant criminal liability of the responsible individuals. Additionally, they may be restricted in various aspects such as bidding and procurement of pharmaceutical products and devices, company credit record, etc., due to a reduction in their tax credit rating and the initiation of joint punitive measures, thus being unable to carry out normal business activities. The economic consequences and legal liabilities that these risks may bring to the company will be specifically introduced in the second part of this article.

2.Practical Factors Triggering Tax Risks

The medical industry has been a key focus of tax inspection for many years. Combining the current anti-corruption campaign in the healthcare industry with increasingly strict and precise tax collection measures, we tend to believe that under the current background, the possibility of the tax compliance risks in the aforementioned medical distribution practices being actually triggered is relatively significant.

On the one hand, the regulatory focus in the current anti-corruption campaign among pharmaceutical companies mainly targets fake transactions and reimbursement of various fictitious expenses. As mentioned earlier, these "fake transactions" and "fake costs" themselves may directly constitute tax violations.

The current anti-corruption campaign is characterized by employing various means and involving compound legal responsibilities. Multiple regulatory departments, including tax authorities, have joined, making the methods of investigation and evidence collection more diverse and in-depth. It also makes it easier for the veneer of "formalistic compliance" to be penetrated, thereby exposing more substantive illegal acts. The foreseeable triggers of tax risks include but are not limited to:

Tax authorities actively using tax inspection and other tax legal means to carry out a comprehensive investigation;
Other regulatory departments, when investigating "fake transactions", "fake costs", and "fake conferences", will transfer related clues to the tax authorities;
Disciplinary inspection and supervision departments will transfer the tax violation clues discovered or voluntarily disclosed by the investigated persons to strive for meritorious performance to the tax authorities during the process of investigating bribery issues;
Disclosure to the stock exchange and Securities Regulatory Commission regarding sales expenses, leading to the formation of publicly available potential tax violation clues that catch the attention of tax authorities;
Regulatory departments and disciplinary inspection and supervision departments transfer potential tax violation clues to the public security authorities' economic investigation departments, allowing related tax risks to enter directly into the criminal investigation process.

On the other hand, with the continuous advancement of the "Phase IV of the Golden Tax Project" and the in-depth application of big data tax governance, as well as the electronification of invoices across all fields, sectors, and elements, the tax monitoring system for medical companies and their upstream and downstream related entities has become more complete, and supervision will be more precise. Through means such as penetration checks into transaction flow and capital flow, control of supplier qualifications and tax credit information, and big data monitoring of financial and tax indicators such as sales expenses, the issues mentioned earlier, such as whether the actual service provider is consistent with the invoicing party, the authenticity of transactions, and the existence of fictitious invoices, will be subject to more precise and effective monitoring.

The Impact of Accepting Fictitious Invoices/Tax Evasion on the Business Operations of Medical Companies

1.Direct Economic Consequences and Legal Liabilities: Underpaid Tax Payments, Late Payment Penalties, and Administrative or Criminal Penalties

For medical companies that accept and use fictitious invoices for tax deduction, if there is evidence to prove that the medical company knowingly accepted fictitious invoices from CSO or other invoicing parties in circumstances where the transactions were not genuine, the following economic consequences and legal liabilities may arise:

Payment of Underpaid Corporate Income Tax: Due to expenses that have not actually occurred, expenditures unrelated to income, or receipt of non-compliant invoices (including fictitiously issued VAT invoices), the corresponding costs and expenses cannot be deducted before the corporate income tax. The commonly applicable corporate income tax rates are 25% or 15%;
Transfer out Input VAT: Due to the receipt of fictitiously issued VAT invoices, input VAT transferring out is required. If the fictitious invoice is a service invoice, the applicable VAT rate is 6%;
Late-payment Surcharges: Due to the historical nature of costs and expenses listed and input VAT credited, late-payment surcharges need to be paid, annualized at 18.25%;
Administrative Fines Related to Fictitious Invoicing: If determined to have accepted fictitious VAT invoices, corresponding administrative fines may be incurred, usually up to RMB 500,000;
Administrative Fines Related to Tax Evasion: If the company is determined to have evaded taxes, administrative fines ranging from 0.5 to 5 times the amount of underpaid VAT and income tax may arise (there may be theoretical and practical disputes concerning the penalties for tax evasion and fictitious invoicing);
Potential Criminal Risk: If determined to have committed crimes such as fictitious issuance of special VAT invoices, fictitious issuance of regular VAT invoices, or tax evasion, the company and related individuals may face criminal liabilities;
Administrative Fines for Failure to Fulfill Tax Withholding Obligations: In addition to the liabilities arising from the inability to list or deduct invoices affecting their own tax obligations, depending on the specific nature of the transactions, the company may also be determined to have failed to fulfill the withholding obligations towards doctors, sales personnel, etc., resulting in administrative fines ranging from 0.5 to 3 times of the under-withheld tax amount.

Even if medical companies did not subjectively engage in invoice fraud through entities like CSOs, they could still be implicated due to the tax non-compliance of these invoicing entities. Combined with inadequate tax compliance risk management on their own part, there is a possibility of being unable to fully verify the authenticity of invoices corresponding to actual marketing transactions. According to the provisions of the Circular of the State Taxation Administration ("STA") on the Settlement for the Taxpayers Obtaining in Good Faith the Fictitious Special Invoice of VAT (Guo Shui Fa [2000] No.187), in this situation, medical companies may be considered as obtaining in good faith the fictitious special invoice of VAT. While they may be exempt from administrative penalties and late payment surcharges, the corresponding input VAT amount should still be transferred out. Additionally, in cases where invoices cannot be timely reissued, replaced, or proven as irreplaceable, there may also be a requirement to pay corporate income tax. It's worth noting that the determination of "good faith" in this context is contentious in tax practice, generally requiring companies to prove that they have fulfilled their reasonable and prudent due diligence obligations.

Furthermore, due to the impact of non-compliant CSOs issuing abnormal invoices, according to the provisions of the Announcement of the STA on Matters Concerning the Administration of Abnormal VAT Vouchers for Deduction (Announcement [2019] No.38 of the STA), when the value or proportion of abnormal vouchers received exceeds a certain threshold, the invoices issued by medical companies that have received these abnormal vouchers will also be included in the scope of abnormal vouchers by the tax system. This will inevitably severely affect the normal business collaboration between medical companies and downstream retail and medical institutions.

2.Reduction in Tax Credit Rating and Joint Punitive Measures: Impact on Normal Business Operations

According to Article 6 of the Measures for the Disclosure of Information on Parties with Serious Tax-Related Illegal and Dishonest Acts (Order No. 54 of the STA), tax authorities can designate enterprises that engage in "parties with serious tax-related illegal and dishonest acts", such as issuing fictitious invoices or evading taxes exceeding a certain amount or proportion, as "the subjects with tax-related serious illegal and dishonest acts", and publicly disclose information on such cases. At the same time, according to the provisions of the Measures for Tax Credit Administration (for Trial Implementation) (Announcement No. 40 [2014] of the STA) and other regulations, if an enterprise is involved in corresponding serious tax-related illegal and dishonest acts, it will be directly determined its tax crediting rating as Grade D and publicly disclosed.

After being determined of its tax crediting rating as Grade D, the most direct impact on the enterprise's operations is that issuing invoices will be restricted. When the enterprise needs to issue invoices to external parties, it may have to provide business information to the tax authorities on a transaction-by-transaction basis and obtain approval before issuing the invoices. Simultaneously, the tax authorities will place the enterprise under close monitoring, leading to increased frequency of supervision inspections, enhanced export tax refund audits, and stricter penalties for tax violations. Grade D taxpayers are ineligible for various preferential policies and tax facilitation measures, including refunds of excess input VAT credits. Additionally, the effects of Grade D grading are interconnected; individuals responsible for a Grade D taxpayer or other enterprises they operate or are registered for will also be directly determined as Grade D.

The impact of a Grade D an enterprise can last for a considerable period. Grade D is normally retained for two years, and Grade A cannot be awarded in the third year. Although regulations provide some paths for credit restoration for Grade D taxpayers, the conditions for restoration are stringent and typically cannot be met within 12 months.

Apart from this, tax authorities will also report information to other relevant departments and they will impose joint punishments on enterprises with serious tax-related illegal and dishonest acts According to the Memorandum of Understanding on Taking Joint Disciplinary Actions against the Parties in the Major Cases on Tax Law Violations ( Fa Fai Cai Jing, No. 2798 [2016]), tax authorities will regularly provide the information regarding the major cases of tax violations and parties concerned for the departments and entities signing this Memorandum, and publicly disclosed for public consulting. Upon receiving the relevant list, these departments will impose joint punishments, including strict control over the issuance of production permits, legal limitations on issuing corporate bonds, and legal prohibition from participating in government procurement activities, based on the stipulations in the memorandum. These measures will have a significant adverse impact on the enterprise's business and development. In practice, instances of banks reducing or refusing loans to enterprises due to their Grade D tax credit are common.

3.Impact on Medical Companies' Participation in Public Procurement

In addition to facing penalties and legal responsibilities for tax violations, medical companies can also lose numerous business opportunities due to these violations. On one hand, this is because the violation information will be publicly disclosed on various important platforms such as the National Enterprise Information Publication System and tax department websites, adversely affecting the company's reputation. On the other hand, the National Healthcare Security Administration and centralized procurement institutions for pharmaceuticals and medical consumables may restrict or prohibit non-compliant medical companies from participating in government procurement activities, affecting their bidding procurement opportunities.

Specifically, according to documents such as The Provisions on the Good Operating Practice for the Credit Evaluation of Medicine Pricing and Bidding Procurement (2020 Edition) (Yi Bao Jia Cai Zhong Xin Han [2020] No.24), the Guiding Opinions of the National Healthcare Security Administration on Establishing the Credit Evaluation System for Medicine Pricing and Bidding Procurement (Yi Bao Fa [2020] No.34), and the Discretion Benchmark for Credit Rating of Medicine Pricing and Bidding Procurement (2020 Edition) (Yi Bao Jia Cai Zhong Xin Han [2020] No.25) and other documents, medical companies that have "acquired fictitious VAT invoicing (excluding those obtained in good faith)" are included in the list of items under management. Based on the amount of tax involved, these companies will be classified into levels of creditworthiness such as "ordinary", "medium", "serious", and "very serious". Corresponding measures will be taken, including written reminders and admonishments, risk information notifications to purchasers via centralized procurement platforms, restricting or suspending the listing of related pharmaceuticals or medical consumables, limiting or suspending the procurement of related pharmaceuticals or medical consumables, and disclosing the information of non-compliance.

Recommendations for Strengthening Tax Compliance and Risk Control in the Medical Distribution Sector

In the short term, in the midst of the current anti-corruption campaign, medical companies that have historical tax compliance risks or significant deficiencies in tax compliance management should prioritize self-examination. Medical companies can focus on evaluating the authenticity and compliance of pre-tax deductions for various types of sales expenses and VAT credit vouchers. If the self-examination is initiated by the competent tax authorities in the current situation, medical companies shall be more prudent in the examination process.

Based on the different circumstances reflected in the self-examination, proactive measures are recommended to be taken in a timely manner to avoid further escalation of liabilities and to seek to mitigate or exempt penalties:

If non-compliance risks are discovered, such as accepting fictitious invoices or unreasonable sales expense deductions, medical companies can, after assessing the risks thoroughly, pay the underpaid taxes and late payment surcharges when necessary in an appropriate manner;
For expenditures that are genuine and legal but lack sufficient evidence, supporting documents and explanations should be promptly provided;
It is recommended to consider engaging third-party professional institutions to assist in the self-examination and actively communicate with the competent tax authorities about the self-examination results, the proposed tax payments and the interpretation of relevant tax law and regulation for such payments (if applicable).

In the long term, as the medical industry remains a focal point of tax supervision, there is a considerable journey ahead for building a systemic tax compliance framework. Following the self-examination, medical companies can gradually establish and enhance a tax compliance management system according to their findings. They should continue to control and reduce tax-related risks based on regulatory requirements and improve the overall compliance level of the company. We suggest that the establishment and enhancement of relevant tax compliance systems can be approached from the following aspects:

Supplier Audit: Medical companies should strengthen the review of suppliers' business and qualification compliance, paying attention to their tax status, tax credit ratings, and other tax-related information. As previously mentioned, the phenomenon of some CSOs illegally obtaining tax benefits by splitting contract subjects is relatively common. This may lead to a situation where compliant medical companies, even if they have engaged in genuine promotional marketing transactions with CSOs, may still have the invoices deemed fictitious because the invoicing party is different from the actual service providing entity. Therefore, in the supplier management review process, caution should be exercised against the situation where the supplier's actual business situation does not match the transactions with the medical companies, or where the invoicing entity does not match the actual service-providing entity.
Contract Review: Medical companies should focus on whether the services and deliverables specified in the contracts are fulfilled and delivered as agreed. When payments are made to personal accounts, particular attention should be given, and a rigorous review should be conducted to ensure the existence of contractual basis and whether the services defined in the contract are real, reasonable, and have actually been provided.
Invoice Review: Before using special VAT invoices issued by CSOs for tax deduction, medical companies should pay special attention to whether existing documents can prove the authenticity of the services stated on the invoice. A comprehensive review should be conducted by considering factors such as whether the invoice issuer matches the contracting party/service provider and the recipient, and whether the invoice issuer has actually provided the relevant services.
Fund Audit: For payments to CSOs for services, as mentioned above, a comprehensive audit should be performed to verify the authenticity of the related services. For reimbursements to sales personnel, standardized reimbursement management systems should be developed and properly implemented. Taking the example of organizing academic promotion conferences, thorough audits of internal approval documents, budget allocation, payment items, payment amounts, invoice compliance, and on-site conference materials (such as attendance sheets, conference materials, photos, etc.) should be carried out before making payments.
Record Retention: Medical companies should establish a comprehensive record-keeping system, archiving supplier profile information, transaction contracts, invoices, fund flows, and foundational materials related to transactions to prove the authenticity of the transactions.

Conclusion

In the context of intensified anti-corruption in the healthcare industry, the significance of compliance in creating value becomes apparent. This is also a critical period for medical companies to conduct tax compliance rectification, thoroughly assess risks, improve tax compliance management systems, and advance sustainable development.

Against the backdrop of anti-corruption campaign, medical companies can enhance their compliance systems, thereby creating long-term value in terms of corporate reputation and compliance management. This will facilitate their healthy development within the new industry order that emerges after stringent regulatory measures eliminate non-compliant practices. Therefore, it is essential for medical companies to timely assess and address tax compliance risks with the support of professional institutions, resolving issues at an earlier stage and promptly establishing and reinforcing their enterprise tax compliance management systems.

Authors

Ye Yongqing (Bill)

Partner