Editor's Note: Splitting the income of a single business operation among multiple affiliated small entities so that each separately qualifies as a small and low-profit enterprise and enjoys a lower tax rate has become a common way of breaking up a business to claim tax preferences in recent years. Taking as its starting point a case involving a chain automotive service brand that split store income to claim enterprise income tax benefits, this article applies the 'reasonable commercial purpose' criteria set out by the State Taxation Administration in its Questions and Answers on Issues Concerning Micro and Small Enterprises Improperly Claiming Tax Preferential Policies. It examines whether additional tax should be assessed, whether the conduct may be characterized as tax evasion, and what compliance measures businesses should take when establishing separate entities, with a view to providing guidance for relevant market participants.

01 Case Background

Company A Automotive Service Management Co., Ltd. is the operating headquarters of a chain automotive service brand and is registered in City A. The brand expanded through a 'small and dense' neighborhood-store model and, over several years, established more than one hundred stores in multiple cities, principally providing car washing, quick repair, and routine maintenance services. For business registration purposes, each store was separately incorporated as an independent limited liability company, completed its own tax registration, maintained separate accounts, and filed tax returns independently. Staffing at each store was relatively lean, typically consisting of only two employees: one locally hired store employee and one store manager assigned by headquarters. The headquarters management team had approximately ten members, each responsible for around ten stores. Brand operations, store systems, service pricing, procurement of supplies, membership management, and centralized cash management were all arranged uniformly by headquarters.

With respect to income and profit arrangements, each store had annual taxable income below RMB 3 million, and its number of employees and total assets also met the criteria for a small and low-profit enterprise. Each store therefore separately claimed the enterprise income tax preference for small and low-profit enterprises, under which 25% of taxable income was included in the tax base and enterprise income tax was then levied at a 20% rate, producing an effective tax rate of only 5%. For value-added tax purposes, each store, as a small-scale taxpayer, truthfully reported and paid VAT on its income locally, with no underpayment. The dispute therefore centers on enterprise income tax. All stores were owned by Company A. In one year, the stores simultaneously distributed their profits to Company A as dividends. The large dividend distributions made at the same time by more than one hundred small entities to the same shareholder triggered a tax-risk alert.

The tax authority took the view that the more than one hundred stores lacked substantive independent operations and had been artificially divided into multiple taxable entities so that income that should have been centrally accounted for was dispersed among the stores, enabling them to improperly claim the preferential treatment for small and low-profit enterprises and thereby underpay enterprise income tax. On this basis, the tax authority proposed to reassess enterprise income tax on the income after reversing the split, impose late-payment surcharges, characterize the conduct as tax evasion, and levy a fine. Should additional tax be assessed in this case, and does the conduct constitute tax evasion? These questions are examined below.

02 Whether the Store-Splitting Arrangement Had a Reasonable Commercial Purpose

The key to resolving the above dispute is whether the business model at issue had economic substance and served a reasonable commercial purpose. Article 47 of the Enterprise Income Tax Law provides that where an enterprise implements an arrangement that lacks a reasonable commercial purpose and thereby reduces its taxable revenue or taxable income, the tax authority may make an adjustment using a reasonable method. Article 120 of the Regulations for the Implementation of the Enterprise Income Tax Law further provides that an arrangement 'without a reasonable commercial purpose' refers to an arrangement whose principal purpose is to reduce, exempt, or defer the payment of tax. In recent years, review of 'reasonable commercial purpose' has also extended to other taxes. Article 8 of the Individual Income Tax Law, as amended in 2018, and Article 53 of the Regulations for the Implementation of the Value-Added Tax Law, effective in 2026, both establish adjustment rules for arrangements lacking a reasonable commercial purpose. In February 2026, the State Taxation Administration, in its Questions and Answers on Issues Concerning Micro and Small Enterprises Improperly Claiming Tax Preferential Policies, set out in a relatively systematic manner three criteria for determining whether a split arrangement has a 'reasonable commercial purpose': whether the motive is reasonable, whether the business is genuine, and whether the transactions are conducted on an arm's-length basis. It also provided positive and negative lists for reference.

First, consider whether the motive is reasonable. A reasonable split should be consistent with industry practice and the enterprise's development strategy, and should produce tangible benefits such as improved management efficiency or stronger market competitiveness, rather than being undertaken solely or primarily to reduce, exempt, or defer tax. An unreasonable split, by contrast, has tax reduction as its sole or principal purpose: the enterprise's overall operating scale and business structure remain substantially unchanged before and after the split, and the arrangement merely enables income to be subject to a lower tax rate or to qualify for preferential treatment.

Second, consider whether the business is genuine. Entities created through a reasonable split should have independent production or operating capacity and complete business processes. Their organization, assets, business activities, and finances should be mutually independent; they should be able to provide complete records of business negotiations, contracts and agreements, and evidence of performance; and there should be no sharing of assets, commingling of personnel, or centralized control over decision-making. Each entity's income should correspond to its actual business activities. By contrast, an unreasonable split often involves 'multiple licenses at one address': the registered address is a virtual office or is shared with another entity, there are no actual operating personnel or traces of business activity, and the premises contain only a small amount of office equipment without any genuine operations.

Third, consider whether the transactions are conducted on an arm's-length basis. Transactions among entities resulting from a reasonable split should follow the arm's-length principle. The prices of goods sold and fees charged for services should be consistent with comparable market transactions, and supporting materials such as third-party quotations or industry pricing data should be available. An unreasonable split, by contrast, often shifts profits through low-price sales, free services, or similar arrangements in order to reduce the overall tax burden.

Under the positive and negative lists, a split undertaken to meet genuine business needs will generally be recognized as having a reasonable commercial purpose. Positive examples include separating independently operated business segments such as R&D, production, and sales; isolating businesses with different levels of risk; expanding regionally by establishing independently accounted entities in different locations; and arrangements involving asset divestitures and reorganizations, family succession, or employee equity incentives. Negative examples focus on homogeneous splitting characterized by commingled personnel, premises, and assets, such as 'multiple entities at one address' or 'multiple entities controlled by one person'; shell entities with no actual business that merely serve as vehicles for booking income; and splitting a large transaction into smaller contracts to avoid a statutory threshold. It should be emphasized that these criteria and lists serve as guidance and reference points for tax authorities. Enterprises may use them to conduct routine self-assessments and identify compliance boundaries, but the final characterization of any individual case still depends on its specific facts and evidence.

Applied to this case, the stores appear to have a reasonable commercial purpose. Each store has genuine business premises, actual employees and customers, and real operating revenue. Formally, each is also an independent legal person, maintains separate accounts, and files tax returns independently; none is merely a shell used to book income. The brand's 'small and dense' neighborhood-store expansion across multiple cities is itself a genuine model of regional expansion and chain operation, rather than a collection of homogeneous entities temporarily assembled to dilute operating scale and claim tax preferences. The fact that pricing, cashiering, membership programs, procurement, and cash management are centrally controlled by headquarters reflects a common chain-business practice of using a unified brand and system to achieve economies of scale and management efficiency. This is consistent with the positive indicators of 'improved management efficiency and stronger market competitiveness' under the 'reasonable motive' criterion. Centralized management alone should therefore not justify a conclusion that the sole or principal purpose of the arrangement was to reduce tax. Accordingly, each store met the conditions for a small and low-profit enterprise and should have been entitled to claim the preference separately; no additional tax adjustment should be made on that basis.

03 Why a Tax Adjustment, Even If Required, Should Not Constitute Tax Evasion

Even assuming that the tax authority rejects the above position and concludes that the structure lacks a reasonable commercial purpose and must be adjusted, the proper course should be to assess additional tax rather than characterize the conduct as tax evasion. Such adjustments generally take one of two forms. First, a special tax adjustment may be made under Article 47 of the Enterprise Income Tax Law, with additional tax and interest imposed. Second, under Article 35(6) of the Tax Collection and Administration Law, where the declared tax base is obviously low without a justifiable reason, the tax authority may determine the amount of tax payable and, applying the principle of substance over form, treat the affiliated entities as a single taxpayer for consolidated calculation. The rejection of a split arrangement therefore does not automatically amount to tax evasion. In this case, even if the structure is ultimately not accepted, the constituent elements of tax evasion are still not satisfied, for the following reasons.

First, the accounts objectively correspond to the actual business, and there was no tax-evasion conduct such as concealing income. The methods of tax evasion listed in Article 63 of the Tax Collection and Administration Law are limited to forging, altering, concealing, or destroying without authorization accounting books or bookkeeping vouchers; overstating expenditures or failing to record or understating income in the accounting books; refusing to file a tax return after being ordered by the tax authority to do so; or filing a false tax return, thereby failing to pay or underpaying tax. Here, each store was openly and genuinely established as an independent legal person, with actual premises, personnel, customers, and revenue. Each kept accounts, issued invoices, and truthfully reported the income it actually received, and the accounting records were consistent with actual operations. There were no off-book receipts, no dual sets of accounts, and no concealment of income in private bank accounts. The alleged 'underpayment' did not arise because any store underreported its own income, but because the tax authority considered that all stores should be combined and taxed as a single entity. That issue concerns the independence of the operating entities and the characterization of the business structure and belongs within the analysis of reasonable commercial purpose and anti-avoidance rules; it is not the same as the statutory methods of tax evasion.

Second, there was no subjective intent to evade tax. A finding of tax evasion requires not only objectively evasive conduct and resulting harmful consequences, but also a subjective intent on the part of the taxpayer to evade its tax obligations, and the burden of proving that intent lies with the tax authority. An underpayment made without such intent should not be characterized as tax evasion. Here, based on its understanding of the preferential policies for small enterprises, the company openly established the stores and truthfully filed returns for each of them, placing the entire structure in full view and registering it with the tax authorities. Such an openly implemented arrangement is fundamentally different, in terms of subjective state of mind, from concealment or deception. Even if the structure is ultimately rejected, that would show only that the company misunderstood the policy or designed the structure incorrectly; it would not, by itself, be sufficient to prove an intent to evade tax. The tax authority's evidence on subjective intent would therefore be difficult to regard as sufficient.

Third, the boundary between tax avoidance and tax evasion must be observed. Where an arrangement is formally lawful but lacks a reasonable commercial purpose, the legal response is a tax adjustment, not a fine or criminal liability. If every rejected structure were automatically treated as tax evasion, the distinction between avoidance and evasion would be blurred and the anti-avoidance adjustment regime would be rendered largely meaningless. In practice, many cases involving income splitting to improperly claim small-enterprise tax benefits have indeed been characterized as tax evasion. The reason, however, is that in the cases publicly disclosed by tax authorities, the splitting arrangement was often accompanied by additional methods such as establishing shell entities, concealing income, receiving off-book payments, or maintaining two sets of accounts. Those additional facts supported findings of tax evasion, tax recovery, late-payment surcharges, and fines. In the absence of such concealment or deception, conclusions from those cases should not simply be transplanted to a different factual setting.

04 Compliance Priorities and Risk Prevention for Separately Established Entities

In practice, splitting income to claim tax preferences has become a focus of tax inspections. Recently, tax authorities in multiple regions have publicized a number of cases in which businesses split income to improperly obtain tax benefits for micro and small enterprises, covering industries such as medical aesthetics, health management, and internet technology. A common technique is to control the operating scale of each individual entity so that it qualifies for preferences such as VAT exemptions for small-scale taxpayers or enterprise income tax benefits for small and low-profit enterprises. The room for claiming preferences through such splitting can be expected to narrow further. The following recommendations address the tax risks that may arise from establishing separate entities.

First, structures should be designed on the basis of a genuine commercial purpose, and operational independence should be implemented in substance. Before establishing branches or affiliated entities, an enterprise should assess the substantive necessity of the arrangement against the positive and negative lists published by the State Taxation Administration. Arrangements serving regional expansion, independent operation by franchisees, separation of business segments, or risk isolation generally have a sound compliance basis, whereas shell entities established solely to dilute operating scale and claim preferences are typical negative cases. Once the structure is implemented, the entities should remain independent in terms of personnel and social insurance, assets and equipment, business processes, and financial accounts. Inter-entity transactions should follow the arm's-length principle and be priced independently, and the enterprise should fully retain shareholders' resolutions, feasibility analyses, evidence of business premises, and other supporting materials demonstrating actual operations.

Second, major tax matters should be communicated with and confirmed by the competent tax authority in advance. The bulk establishment of entities, concentrated dividend distributions, restructuring, and cross-region relocations are often high-risk events. Before implementation, enterprises should communicate item by item with the competent tax authority regarding applicable policies, tax calculation methods, attribution of income, and filing materials, seek a relatively clear administrative position, and retain records of such communications and relevant explanations. Proactive communication in advance can both reduce disputes arising from policy misunderstandings and serve as evidence of good-faith compliance in any subsequent examination.

Third, existing structures should be subject to systematic self-review. Enterprises should review, item by item, historically established separate entities, threshold management, related-party invoicing, concentrated dividend distributions, and similar matters. Using the three criteria and the positive and negative lists discussed above, they should focus on whether each entity conducts genuine operations, whether personnel or assets are commingled, whether income has been fully and truthfully reported, and whether the evidentiary chain is complete. Particular attention should be paid to entities operating near eligibility thresholds or with concentrated related-party invoicing. Where problems are identified, they should be corrected proactively at an early stage; where necessary, enterprises should engage professional advisers to conduct a tax health check and resolve potential risks before a tax inspection begins.

Fourth, enterprises should take seriously the inspection risks created by data-driven tax administration and engage professional support at an early stage. Current tax big-data risk-control systems can flag suspicious entities based on individual indicators or combinations of indicators, including related appointments, similarity of invoiced items, concentration of registrations, proximity to eligibility thresholds, and related-party invoicing. Tax authorities in some regions have also developed a 'risk model for micro and small enterprises receiving related-party invoices near the eligibility threshold' to identify such risks. Enterprises are advised to engage professional tax lawyers upon receiving a risk alert or at the outset of an inspection, assert their positions in accordance with law, submit adequate evidence, and seek to resolve risks before the dispute escalates.