Editor’s Note: Recently, in its 2025 annual audit work report, the National Audit Office specially disclosed the findings of an audit investigation into the production and distribution of traditional Chinese medicine (TCM), identifying RMB 4.652 billion in problematic amounts. The issues involved inflated procurement costs for Chinese medicinal materials, fabricated selling expenses, “sales with kickbacks,” and the erosion of medical insurance funds, among others. Taking this as the point of entry, and against the backdrop of increasingly strict coordination among tax inspections, healthcare-sector rectification, and anti-commercial-bribery regulation, this article reviews the tax-related risks in the TCM production and distribution chain and the logic behind their formation, and puts forward compliance suggestions for TCM enterprises to prevent and control tax risks.

01 Signals of Stricter Enforcement Released by the Audit Report and Recent Regulatory Developments

On June 23, 2026, the National Audit Office released the Report on the Audit Work Concerning the Implementation of the 2025 Central Budget and Other Fiscal Revenues and Expenditures. In the section on audits of key livelihood-related funds, the report specifically disclosed the findings of an audit investigation into TCM production and distribution. The investigation covered 66 TCM production and distribution enterprises and 28 medical institutions across 10 provinces, involving RMB 21.591 billion in funds related to TCM purchases and sales, medical insurance settlement, and other matters, and identified RMB 4.652 billion in problematic amounts. According to the disclosures by the National Audit Office, the problems revealed by this TCM production and distribution audit were not confined to a single enterprise, tax type, or business link, but instead showed strong chain-like characteristics. They involved not only the authenticity of procurement costs for Chinese medicinal materials, but also the reasonableness of selling expenses, the extraction of funds for “sales with kickbacks,” and the erosion of medical insurance funds and policy dividends intended to support TCM at terminal medical institutions. Relevant risks have extended from drug pricing and medical insurance fund supervision to multiple areas, including invoice administration, cost aggregation, expense deduction, and fund flows.

At the same time, recent regulatory developments at multiple levels all point toward a stricter enforcement trend. On the tax administration side, the national tax work conference has listed falsely issued invoices as a key inspection area, maintaining a high-pressure stance on the serious investigation and handling of invoice-related violations. In the governance of the medical sector, the National Health Commission, together with 14 departments, issued documents to correct unhealthy practices in the medical industry, with kickbacks, rebates, improper transfers of benefits, and false promotional expenses remaining key targets of comprehensive governance. In the field of anti-commercial-bribery enforcement, regulatory pressure also remains high. Funds used for commercial bribery are often transferred out of enterprises through inflated procurement costs, fabricated promotion service fees, consulting fees, conference expenses, and similar arrangements, and then flow back through third-party entities or to designated recipients. If TCM enterprises use fabricated expenses, shell contract sales organizations (CSOs), or third-party promotion providers to extract funds and influence purchasing decisions of medical institutions, they may not only constitute commercial bribery but also trigger multidimensional tax risks involving enterprise income tax, value-added tax, and invoice violations. Overall, tax inspections, healthcare-sector rectification, anti-commercial-bribery regulation, and audit supervision are gradually moving toward coordinated enforcement. TCM enterprises are no longer facing only a single compliance challenge, but rather integrated risks that run through the entire production and distribution chain.

02 Tax-Related Risks in Production, Distribution, and Sales

The TCM industry chain is relatively long, generally covering the planting and purchase of Chinese medicinal materials, primary processing, processing of TCM decoction pieces, production of finished TCM products, commercial distribution, marketing promotion, and terminal sales. Tax risk identification for TCM enterprises cannot stop at the formal review of invoices. Instead, it should examine the procurement, distribution and promotion, and terminal sales links in depth and one by one.

(1) Production and procurement: multiple legal risks arising from inflated costs

The procurement of Chinese medicinal materials is a high-incidence area for tax risks among TCM enterprises. Unlike the procurement of ordinary industrial raw materials, the procurement of Chinese medicinal materials often involves multiple layers, such as farmers, cooperatives, purchasing and sales brokers, and primary processors. The transaction parties are scattered, procurement is highly seasonal, varieties and origins differ significantly, and the management of purchase vouchers is relatively difficult.

From the institutional background, under the current value-added tax (VAT) policies, agricultural producers are exempt from VAT when selling their self-produced agricultural products. To ensure the completeness of the VAT credit chain, tax policy allows the purchaser to issue agricultural product purchase invoices on its own and use them to claim input VAT credits. While this “self-issuance and self-crediting” arrangement reduces the tax burden in the circulation of agricultural products, it also provides room for manipulation by a small number of enterprises. Such enterprises may falsely issue agricultural product purchase invoices by fabricating farmer identities, fictitious purchase contracts, and invented quantities as well as inbound and outbound warehouse records, thereby inflating input VAT credits or procurement costs and reducing VAT or enterprise income tax liabilities. If input VAT has already been credited on this basis, the enterprise may also face input VAT transfer-out adjustments, administrative penalties for invoice violations, and even criminal risks related to the false issuance of invoices.

According to the National Audit Office report, the investigation found that, from 2016 to 2025, nine pharmaceutical enterprises collected personal information from more than 8,500 individuals, including their own employees, and falsely issued RMB 2.281 billion in agricultural product purchase invoices by fabricating farmer identities and purchase contracts. They used these invoices to inflate procurement costs for Chinese medicinal materials and lower taxable profits. Tax big-data analysis and horizontal comparisons within the same industry are major tools used by tax authorities to identify these risks. Circumstances such as abnormal procurement cost ratios, concentrated issuance of purchase invoices, mismatch between procurement timing and harvest seasons, highly similar supplier information, and closed-loop fund flows may trigger warnings in big-data risk-control models and lead to further on-site inspections, interviews, evidence collection, and tracing of fund flows.

(2) Distribution and promotion: fabricated expenses, fund reflux, and “sales with kickbacks”

To understand the tax-related risks in distribution and promotion, it is first necessary to grasp the structural impact of the Two-Invoice System. Before the Two-Invoice System was implemented, ex-factory drug prices were relatively low, and sales kickbacks, channel costs, and other expenditures could be absorbed across multiple distribution levels. After the system compressed distribution chains, ex-factory prices rose accordingly, and enterprises’ book profits and tax burdens increased at the same time. The costs of “sales with kickbacks” that were previously spread across multiple distribution levels were also concentrated in manufacturers and first-tier distributors. This is the background behind the surge in fabricated expenses and fund extraction in the distribution and promotion link.

After TCM products enter the distribution and promotion stage, enterprises usually incur marketing promotion fees, consulting service fees, academic conference expenses, and other expenditures. These expenses take diverse business forms, service results are not easy to quantify, and many third-party service providers are involved. As a result, they can easily become important channels for fabricating expenditures and extracting funds, and they are also the main breeding ground for “sales with kickbacks.” The so-called “sales with kickbacks” refers to the practice of influencing the purchasing choices of medical institutions, doctors, distributors, or other terminal parties through kickbacks, rebates, or other transfers of benefits. In essence, it constitutes unfair competition in the field of pharmaceutical purchases and sales, but in fiscal and tax treatment it is often disguised as false promotion service fees, consulting fees, conference expenses, and the like.

The National Audit Office report shows that, from 2018 to 2025, 26 pharmaceutical enterprises incurred RMB 4.378 billion in selling expenses, of which RMB 2.25 billion was paid to 462 third-party promotion providers despite the absence of a genuine business background or where only telephone promotion was conducted. The funds were then transferred back to the pharmaceutical enterprises or to their designated recipients. The essence of this model is to transfer funds out of the enterprise under the name of promotion services, and then achieve fund reflux or transfer through third-party entities. In practice, some third-party promotion providers are registered in tax-preferential regions and rely on fiscal rebates and assessed tax-rate policies to maintain low-cost operations. Once policies tighten, or where the relevant entities were originally established for the purpose of false invoicing, the risk of their absconding or becoming unreachable is relatively high. From a tax law perspective, whether promotion service fees, consulting fees, and conference expenses may be deducted before tax depends on whether the services were actually provided, whether the expenditure is related to the enterprise’s business operations, whether the amount is reasonable, and whether the results can be verified.

In practice, tax authorities usually focus on whether third-party service providers have genuine operational capabilities; whether service contracts are specific and clear; whether promotional activities were actually carried out and supported by process materials such as meeting minutes, sign-in sheets, image and video materials, and service deliverables; whether the expense amount matches the promotion scope, service content, and market price; and whether there are abnormal circumstances after payment, such as short-term split transfers or flows back to employees of the pharmaceutical enterprise, affiliated entities, or designated personal accounts. In addition, the fund flows of “sales with kickbacks” may also raise individual income tax issues at the terminal end. Medical institution personnel, distributors, or other relevant individuals who receive kickbacks should, in accordance with law, declare individual income tax on the additional income received.

(3) Terminal sales: the linked transmission of high-price procurement and tax risks

After TCM products enter medical institutions and other terminal scenarios, the relationships among drug purchase prices, medical insurance settlement, and promotional cooperation become more complex. The National Audit Office report disclosed that six medical institutions took advantage of the rule that sales of TCM decoction pieces may still be subject to a 25% purchase-price markup. In procurement, they “rejected lower prices and chose higher ones,” resulting in RMB 121 million in additional procurement spending, over RMB 30 million in additional markup income, and an increased burden of more than RMB 150 million on patients and medical insurance funds. Although this problem directly occurred at the medical institution end, it cannot be viewed separately from the tax risks of pharmaceutical enterprises.

Under current drug pricing policies, public medical institutions are, in principle, required to sell drugs at zero markup, while TCM decoction pieces still allow appropriate room for markup. The higher the purchase price, the higher the markup income, which may create distorted incentives for individual medical institutions to purchase at high prices. If pharmaceutical enterprises push up product prices by inflating costs and fabricating expenses, and then arrange benefit transfers through false promotion service fees, channel expenses, and similar means, a risk chain may emerge in which inflated drug prices, increased medical insurance burdens, and the extraction of enterprise funds overlap with one another. From a tax perspective, where there are clues of abnormal high-price procurement, abnormal promotional expenditures, or transfers of benefits at the terminal end, they may become an entry point for coordinated inspections by audit, medical insurance, market regulation, and tax authorities, and may in turn be transmitted back as tax risk points for pharmaceutical enterprises through reviews of expense authenticity.

03 Tax Compliance Suggestions for TCM Enterprises

The problems disclosed in the National Audit Office report show that tax compliance in the TCM industry cannot remain at a purely formal level. Enterprises should establish a full-chain compliance system and form a closed-loop management mechanism in high-risk scenarios.

(1) Strengthen transaction authenticity and evidence-chain management at the procurement source

TCM enterprises should focus on regulating the procurement of Chinese medicinal materials, especially where purchases are made from farmers, cooperatives, purchasing and sales brokers, Chinese medicinal materials markets, and primary processors. They should establish mechanisms for supplier admission, transaction-authenticity review, and retention of procurement materials, with emphasis on verifying suppliers’ operating capacity, farmers’ identities, planting areas, origin information, harvest seasons, and actual supply capacity. Around contracts, invoices, goods, funds, warehousing, quality inspection, and ledgers, enterprises should build a complete chain of evidence. Large-value procurement, cross-region procurement, concentrated invoice issuance, procurement outside harvest seasons, obviously abnormal prices, and inconsistency between the payee and the transaction party should be included in key review areas, so as to avoid the transmission of procurement-side inflated cost risks into invoice liabilities.

(2) Regulate full-process management of promotion services and establish entry and exit mechanisms for third-party service providers

For external service providers such as third-party promotion providers, consulting service agencies, and conference service agencies, TCM enterprises should establish admission review, whitelist management, and dynamic exit mechanisms. At the admission stage, enterprises should focus on reviewing the provider’s industrial and commercial registration, business scope, service experience, and actual performance capability. They should cooperate cautiously with entities that issue large-value invoices frequently shortly after establishment, whose business scope clearly does not match the service content, or that have affiliations with enterprise employees or distributors. Where service results cannot be verified, abnormal fund reflux exists, or the provider cooperates in supplying false materials, the enterprise should issue timely warnings, conduct reviews, and remove the provider. In terms of expense management, a full-life-cycle mechanism should be established, covering service initiation, contract signing, service execution, results acceptance, invoice acquisition, and pre-tax deduction. During the process, enterprises should retain materials such as meeting notices, participant lists, sign-in records, training materials, image and video materials, promotion plans, and implementation reports. Afterward, they should prepare results acceptance documents and compare the invoice content item by item with contract terms, service deliverables, and payment arrangements.

(3) Incorporate fund-flow reviews and anti-commercial-bribery compliance into the internal control system simultaneously

Using third-party promotion providers as an intermediate layer cannot cut off the path of tax investigation. What the National Audit Office report reveals is precisely that the existence of 462 promotion providers made fund flows more traceable. TCM enterprises should incorporate fund-flow reviews and anti-commercial-bribery compliance into their internal control systems at the same time. They should focus on identifying abnormal circumstances after service providers receive payments, such as large cash withdrawals over a short period, split transfers, transfers into personal accounts, reflux to the pharmaceutical enterprise, or flows to designated recipients. Where service providers have interest relationships with the enterprise’s business personnel, distributors, or medical institution personnel, where service deliverables are vague, or where fees are obviously higher than market levels, special reviews should be conducted. At the same time, tax compliance and anti-commercial-bribery reviews should be embedded into contract approval, expense reimbursement, supplier admission, promotional activity management, and payment approval procedures.

(4) Conduct regular tax health checks and graded risk responses

TCM enterprises should establish a regular tax health-check mechanism and periodically conduct self-inspections of procurement invoices, agricultural product purchase vouchers, promotion service fees, consulting fees, conference expenses, selling expenses, and fund flows of third-party service providers. For large-value procurement, large-value promotional expenses, and cooperation with abnormal service providers that occurred in historical periods, enterprises should conduct penetrating reviews based on invoices, contracts, payments, service deliverables, and fund flows. For general defects in vouchers, enterprises may supplement materials, improve ledgers, and regulate subsequent procedures. For matters where expense authenticity is insufficient or the transaction chain is incomplete, they should assess whether tax adjustments or proactive rectification are needed. For matters that may involve false invoicing, tax evasion, or criminal risks, they should rely on professional tax and legal service providers to conduct risk assessments, organize evidence, and prepare for dispute response in advance, so as to avoid further escalation of risks due to improper handling.

04 Conclusion

The problems in TCM production and distribution revealed by the National Audit Office work report appear on the surface to be distributed across different links, including procurement, promotion, and sales. In substance, however, they point to the interwoven and overlapping issues of insufficient transaction authenticity, distorted expense deduction, abnormal fund flows, and transfers of benefits. As tax big-data regulation, healthcare-sector rectification, anti-commercial-bribery enforcement, medical insurance fund supervision, and audit supervision continue to operate in coordination, the space for TCM enterprises to achieve merely formal compliance by relying on contracts, invoices, and payment vouchers is being compressed. Only by establishing a full-chain compliance system centered on business authenticity, complete evidence, clear fund flows, and traceable responsibility can enterprises effectively reduce tax administrative liabilities, tax-related criminal risks, and commercial-bribery risks under increasingly strict regulation, thereby achieving stable operations and long-term development.