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EX-31.1 - CERTIFICATION OF THE CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 - China Xuefeng Environmental Engineering Inc.exh31_1.htm
EX-32.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 - China Xuefeng Environmental Engineering Inc.exh32_2.htm
EX-32.1 - CERTIFICATION OF THE CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 - China Xuefeng Environmental Engineering Inc.exh32_1.htm
EX-31.2 - CERTIFICATION OF THE CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 - China Xuefeng Environmental Engineering Inc.exh31_2.htm


 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
 
(Mark One)
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended May 31, 2016

or
 
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from _____________ to _____________

Commission File No. 333-175483
 
China Xuefeng Environmental Engineering Inc.
 (Exact name of registrant as specified in its charter)

Nevada
99-0364975
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
 
 
229 Tongda Avenue
Economic and Technological Development Zone,
Suqian, Jiangsu Province, P.R. China 223800
(Address of principal executive offices) (Zip Code)

+86 (527) 8437-0508
(Registrant's telephone number, including area code)

Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
 
Securities registered under Section 12(b) of the Exchange Act:
 
 
Title of each class:
Name of each exchange on which registered:
None
None
 
Securities registered under Section 12(g) of the Exchange Act:
None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes   No 
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes   No 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes   No 
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes   No 
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference Part III of this Form 10-K or any amendment to this Form 10-K. 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer
Accelerated filer
 
 
 
 
Non-accelerated filer
Smaller reporting company
(Do not check if a smaller reporting company)
 
 
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x
 
State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant's most recently completed second fiscal quarter: $216,164,672.
 
As of August 30, 2016, the registrant had 55,200,000 shares of common stock, par value $0.001 per share, issued and outstanding.
 
Documents Incorporated by Reference: None.

TABLE OF CONTENTS
 
PART I
  Page
 
 
 
Item 1.
Business
 1
 
 
 
Item 1A.
Risk Factors
 10
 
 
 
Item 1B.
Unresolved Staff Comments
 21
 
 
 
Item 2.
Properties
 21
 
 
 
Item 3.
Legal Proceedings
 22
 
 
 
Item 4.
Mine Safety Disclosures
 22
 
 
 
PART II
 
 
 
 
Item 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 22
 
 
 
Item 6.
Selected Financial Data
 23
 
 
 
Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operations
 23
 
 
 
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
 33
 
 
 
Item 8.
Financial Statements and Supplementary Data
 33
 
 
 
Item 9.
Changes in and Disagreements With Accountants On Accounting and Financial Disclosure
 68
 
 
 
Item 9A.
Controls and Procedures
 68
 
 
 
Item 9B.
Other Information
 68
 
 
 
PART III
 
 
 
 
Item 10.
Directors, Executive Officers and Corporate Governance
 69
 
 
 
Item 11.
Executive Compensation
 72
 
 
 
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
 73
 
 
 
Item 13.
Certain Relationships and Related Transactions, and Director Independence
 74
 
 
 
Item 14.
Principal Accounting Fees and Services
 74
 
 
 
PART IV
 
 
 
 
Item 15.
Exhibits, Financial Statement Schedules
 75
 
 
 
SIGNATURES
 77
 
 

 
CERTAIN USAGE OF TERMS
 
 
PART I
 
Item 1.  Business

Except as otherwise indicated by the context, references in this report to "we," "us," "our," "our Company," or "the Company" are to the combined business of China Xuefeng Environmental Engineering Inc.

Overview
 
We are in the business of providing services to optimize garbage-recycling processes. We utilize our patented technology of "comprehensive and harmless garbage-processing equipment," to upgrade software systems and reconstruct hardware for our clients, and therefore expand the sorting scope and capacity of our clients' garbage recycling equipment. We conduct our operations through our controlled consolidated affiliate Jiangsu Xuefeng Environmental Protection Science and Technology Co., Ltd. ("Jiangsu Xuefeng"). Jiangsu Xuefeng was incorporated under the laws of the People's Republic of China ("PRC") on December 14, 2007.

Our Corporate History and Background
 
We were incorporated in the state of Nevada on March 30, 2011. We were initially formed to engage in the business of clothing distribution.  Since our inception and until the acquisition of Inclusion Business Limited (BVI), we were a development stage company without significant assets or any revenue.
 
Acquisition of Inclusion

On November 27, 2012, we completed a reverse acquisition transaction through a share exchange with Inclusion Business Limited (BVI) ("Inclusion") and its stockholders (the "Inclusion Stockholders"), whereby we acquired 100% of the issued and outstanding capital stock of Inclusion and in exchange we issued 7,895,000 shares of our common stock (pre-Forward Split), or 76.65% of our issued and outstanding capital stock as of and immediately after the consummation of the reverse acquisition, to the Inclusion Stockholders. As a result of the reverse acquisition, Inclusion became our wholly-owned subsidiary and the former Inclusion Stockholders became our controlling stockholders. The share exchange transaction has been treated as a reverse acquisition, with Inclusion as the acquirer and the Company as the acquired party for accounting purposes.

Prior to the closing of the reverse acquisition, the Company's prior shareholder, Mr. Zhenxing Liu, surrendered 7,895,000 shares of the common stock of the Company. Mr. Zhenxing Liu did not receive any consideration from the Company for accounting purposes. However, Mr. Zhenxing Liu may be deemed to have received consideration from the increase in the value of 250,000 shares held by Mr. Zhenxing Liu as a result of the reverse acquisition. Mr. Zhenxing Liu purchased 8,145,000 shares at approximately $0.007 per share at the time when the Company was considered a shell and kept 250,000 shares after the surrender. On November 30, 2012, at the closing of the reverse acquisition, the stockholder's equity increased to $5,194,728. Accordingly, the value of the 250,000 shares held by Mr. Zhenxing Liu appreciated to approximately $124,673. Other than such appreciation in the value of his shares, Mr. Zhenxing Liu did not receive any other consideration in connection with the reverse acquisition.

As a result of our acquisition of Inclusion, we now own all of the issued and outstanding capital stock of Lotus International Holdings Limited ("Lotus"), which in turn owns all of the issued and outstanding capital stock of Baichuang Information Consulting (Shenzhen) Co. Ltd ("Baichuang Consulting"). In addition, we effectively and substantially control Jiangsu Xuefeng through a series of captive agreements with Baichuang Consulting.

Subsequent to the closing of the Exchange Agreement, we conduct our operations through our controlled consolidated affiliate Jiangsu Xuefeng. Jiangsu Xuefeng is primarily engaged in providing improvement and upgrading services of garbage recycling processing technology and equipment.

Name Change and Forward Split

On November 27, 2012, the Company filed a certificate of amendment to its articles of incorporation to change its name from "NYC Moda Inc" to "China Xuefeng Environmental Engineering Inc" and to effect a 4-for-1 forward stock split of its outstanding shares of common stock.  The name change went effective on December 14, 2012 and the forward split went effective on December 17, 2012, upon the approval of Financial Industry Regulatory Authority, Inc. (FINRA). Upon the effectiveness of the forward split, the number of outstanding shares of the Company's common stock increased from 10,300,000 to 41,200,000 shares, and the number of authorized shares of common stock remained 75,000,000 shares. The effect of the forward split was applied retroactively to the Company's consolidated financial statements for the periods presented.
1

  
Contractual Arrangements with our Controlled Consolidated Affiliate and its Shareholders
 
On October 17, 2012, prior to the reverse acquisition transaction, Baichuang Consulting and Jiangsu Xuefeng and its shareholders Li Yuan and Yi Yuan entered into a series of agreements known as variable interest agreements (the "VIE Agreements") pursuant to which Jiangsu Xuefeng became Baichuang Consulting's contractually controlled affiliate. The VIE Agreements included:
 
(1)
an Exclusive Technical Service and Business Consulting Agreement between Baichuang Consulting and Jiangsu Xuefeng pursuant to which Baichuang Consulting is to provide technical support and consulting services to Jiangsu Xuefeng in exchange for (i) 95% of the total annual net profit of Jiangsu Xuefeng plus (ii) RMB100,000 per month (approximately U.S.$16,000).
 
 
(2)
a Call Option Agreement among Li Yuan and Yi Yuan (together referred to as "Jiangsu Xuefeng Shareholders"), and Baichuang Consulting under which the  Jiangsu Xuefeng Shareholders have granted to Baichuang Consulting the irrevocable right and option to acquire all of the equity interests in Jiangsu Xuefeng to the extent permitted by PRC law. If PRC law limits the percentage of Jiangsu Xuefeng that Baichuang Consulting may purchase at any time, then Baichuang Consulting may repeatedly exercise its option in such increments as may be allowed by PRC law. The exercise price of the option is RMB1.00 ($0.16) or any lower price permitted by PRC law. The Jiangsu Xuefeng Shareholders agreed to refrain from taking certain actions which might harm the value of Jiangsu Xuefeng or Baichuang Consulting's option;
 
 
(3)
a Proxy Agreement by Li Yuan and Yi Yuan pursuant to which they each authorize Baichuang Consulting to designate someone to exercise all of their shareholder decision rights with respect to Jiangsu Xuefeng; and
 
 
(4)
a Share Pledge Agreement among Li Yuan and Yi Yuan, Jiangsu Xuefeng, and Baichuang Consulting under which the Jiangsu Xuefeng Shareholders agree to pledge all of their equity in Jiangsu Xuefeng to Baichuang Consulting to guarantee Jiangsu Xuefeng's and its shareholders' performance of their obligations under the Exclusive Technical Service and Business Consulting Agreement, the Call Option Agreement and the Proxy Agreement.
  
The VIE Agreements with our Chinese affiliate and its shareholders, which relate to critical aspects of our operations, may not be as effective in providing operational control as direct ownership. In addition, these arrangements may be difficult and costly to enforce under PRC law. See "Risk Factors - Risks Relating to the VIE Agreements."
 
The foregoing description of the terms of the Exclusive Technical Service and Business Consulting Agreement, the Call Option Agreement, the Proxy Agreement and the Share Pledge Agreement is qualified in its entirety by reference to the provisions of the agreements filed as Exhibits 10.1, 10.2, 10.3 and 10.4 to this report, respectively, which are incorporated by reference herein.
 
See "Related Party Transactions" for further information on our contractual arrangements with these parties.
2


After the exchange, our current organizational structure after giving effect to the name change is as follows:
 
 
Inclusion was established in the British Virgin Islands on August 9, 2012.  Lotus was established in Hong Kong on May 2, 2012 to serve as an intermediate holding company with authorized shares of 10,000 at HK$1.00 per share. Baichuang Consulting was established by Lotus as a wholly foreign owned enterprise (the "WFOE") in the PRC on September 5, 2012.  Jiangsu Xuefeng, our operating consolidated affiliate, was established in the PRC on December 14, 2007. The local government of the PRC issued a certificate of approval of the foreign ownership of Baichuang Consulting by Lotus, a Hong Kong entity on September 5, 2012.

Recent Acquisition of Linyi Xuefeng

On August 2016, the Company entered into an agreement to acquire 100% interest of Linyi County Xuefeng Renewable Resources Utilization Technology Co., Ltd ("Linyi Xuefeng"), a privately-held company owned by our CEO and Chairman of the Board, Yuan Li. Pursuant to the transfer agreement, the specific transfer price is based upon the net asset amount in Linyi Xuefeng's audit report as of May 31, 2016. The Company will pay thirty percent of the transfer price with cash and seventy percent of the transfer price by issuing additional shares for the acquisition. From the date of the execution of the agreement through the period when Mr. Li Yuan and the Company complete all obligations of performing the agreement, Mr. Li Yuan shall not transfer any assets of Linyi Xuefeng under any circumstances.

Upon acquisition, Linyi Xuefeng will become a wholly-owned subsidiary of the Company. The acquisition will be accounted for as a business combination.
 
Our Services

As the urbanization in China progresses, the amount of household garbage increases. The processing capability of current garbage processing equipment in China cannot typically satisfy the increasing demands. We expand the garbage sorting scope and capacity of our clients' garbage processing equipment, by installing the various systems that embody the patented technology of "comprehensive and harmless garbage-processing equipment" into the client's garbage processing equipment and reconstructing their hardware, to provide upgrades and improvement to their equipment.
3


The patented technology of "harmless and comprehensive garbage processing equipment" helps to achieve high and stable garbage processing capacity, which uses a Distribution Control System (DCS) to realize mechanical automation for the comprehensive garbage treatment. The core technology is to organically integrate the anaerobic digestion and aerobic fermentation garbage process, degrade and transform the organic matter of domestic waste, effectively sort out the garbage and recycle all kinds of materials, to eventually realize the true waste resource utilization and harmless utilization, with its resource utilization and harmless utilization rate approaching 100%. The resource recovery products, biogas, can not only be used for meeting the needs of the plant itself, but also for outer supply, which greatly improves the efficiency of garbage processing of customer's equipment, decreases production cost, and increases the recovery return of garbage processing.

The comprehensive and harmless garbage processing equipment is comprised of a waste digestion pretreatment system, methane gas power generation system, sorting processing system, bricklaying building system, leachate treatment system, DCS (distribution control system), XFET-5 ecological and water-saving toilets and excrement comprehensive processing system and various material collection systems. The equipment technology is designed and manufactured based on the complicated situation of the household garbage in China. According to the features of various garbage, the equipment utilizes the wind-force, gravity, magnetic, shape, etc. to process the garbage by the combined way of machine selecting, winnowing, magnetic separation, automatic cutting, smashing and other technological processes. The equipment has large processing capacity and can run all day. The stand-alone equipment can process 500 tons to 1000 tons of garbage per day. It can sort and process complicated municipal solid waste, leaving no pollution and no residue, reaching the"3 without" standard of no waste gas, no waste water and no waste residue.

After we complete the internal system upgrade and hardware equipment improvement of the garbage equipment, we deliver the upgraded equipment to the customers. The customers will conduct inspection and performance testing to the upgraded equipment no more than one month pursuant to the contract to inspect whether the internal control system and the hardware structure can operate steadily and achieve the garbage process features. The inspection includes the following: whether the quality of the equipment and accessories after improvement can match the patented technology and process various kinds of garbage, whether the various garbage systems can process automatically, and whether the daily garbage processing capacity reaches the standard of the contract. If during the performance testing period, all the performance index can fulfill the requirements of the contract are achieved, it would be deemed that we have fully executed the agreement.
 
Prior to the first service agreement in April 2012, we did not conduct any business activities except for the preparation of the business and the development of the clients, etc. When we complete the upgrading service for the client, we go through the acceptance check and commissioning of the company in accordance with the contract, to make sure that the service provided met the requirements of the clients. After that, we are not subject to any additional service. The revenue we generated belongs to the service class income, with the main cost being the salaries of the staff and the leasing fees for the patent, whereas the hardware and software equipment, as well as the material used in the upgrading are the responsibility of the clients.

Until August 31, 2012, the main revenue of Jiangsu Xuefeng was generated from providing improvement and upgrading services to garbage recycling processing plants. On August 5, 2012, Jiangsu Xuefeng entered into a license agreement with Li Yuan, one of its stockholders for the use of a patent on garbage recycling processing technology, a Utility Model Patent of Comprehensive and Harmless Garbage Processing Equipment, issued by the State Intellectual Property Office (SIPO) on July 7, 2010 and valid for ten years (Patent Number: ZL 2009 2 0232893.7).  The patent is owned by our Chief Executive Officer, Mr. Li Yuan.  Although the license commenced on September 1, 2012 and expired in August 2017, Mr. Li Yuan has agreed to allow the company continue to use the patent under the same terms and conditions.  Jiangsu Xuefeng expanded its business model from the sole service of providing upgrading to waste processing plants to also providing patent licensing based on its newly acquired use right of the patent technology.  We use the patent technology to help the clients to upgrade their internal system or reconstruct the hardware equipment we have, the Company has of the garbage processing equipment so that the equipment performance could reach the standard of our patent technology. After the upgrade and reconstruction, the patent technology will continue to be used in their equipment and we allow the clients to continue using the patent technology in their equipment for patent licensing revenue. License agreements will be offered to clients for a limited period of three to five years, within which period, the client shall pay patent royalties yearly to Jiangsu Xuefeng for their use of the equipment containing the patent technology. 
4

 
Therefore, under the new business model, Jiangsu Xuefeng generates its revenues from two sources: improvement and upgrading services of garbage processing equipment and patent licensing for the use of the upgraded technology.
 
For the year ended May 31, 2016, sales from improvement and upgrading services and patent licensing were $2,907,422 and $4,079,769, respectively. For the year ended May 31, 2015, sales from improvement and upgrading services and patent licensing were $3,481,780 and $3,514,320, respectively.   For the year ended May 31, 2014, sales from improvement and upgrading services and patent licensing were $1,464,300 and $3,245,865, respectively.  
 
Products and Facilities
 
We provide equipment improvement and upgrading service and license the patented technology to our customers. We also sell or lease garbage-processing units equipped with our patented technology.
 
We mainly incorporate and install the patented technology into garbage processing equipment's internal control and operation systems to achieve the requested processing capacity. During the internal system upgrading process, if any hardware equipment, such as the machine parts, is required to be reconstructed, the customers are responsible for the hardware purchase while we provide guided and assisted installation.

In addition, as our customers continue to use the equipment embodying the patented technology, they pay us a fee for the use of the patented technology.
 
We hope to construct our own garbage processing plant to process various environmental wastes.

Customers

None of the customers individually accounted for more than 10% of the Company's revenue during the year ended May 31, 2016 and 2015, respectively.
 
The following table sets forth our major customers for the year ended May 31, 2014:

Customers
Sales
 (US Dollar)
 
% of
Total
Revenue
 
 
 
 
Gaoyou Zhujia Household Garbage Process Co., Ltd
 
$
732,150
     
15.54
%
Tianjin Yongtai Household Garbage Process Co., Ltd
 
$
707,745
     
15.03
%
Linxiang Municipal Garbage Process Co., Ltd
 
$
634,530
     
13.47
%
 
Our Industry
 
In the description below we rely on certain information and statistics regarding our industry and the economy in China from the reports published by National Bureau of Statistics of China and the PRC Ministry of Environmental Protection.  We have no reason to believe that the information and statistics we cite are not accurate.
 
The Chinese industry of garbage processing is highly fragmented and in a very early-stage of development. Benefiting from a series of encouraging and supportive policies on garbage processing formulated by the Chinese government, the urban garbage processing industry has been in rapid development. The current market is primarily dominated by small regional companies, like Jiangsu Xuefeng, which account for approximately 90% of all environmental protection enterprises in China.
 
The volume of solid waste generated by industrial companies directly correlates to the industrial rate of utilization of natural resources and is expected to grow by over 10% per year according to the National Bureau of Statistics of China. In addition, according to estimates from the PRC Ministry of Environmental Protection, the production of industrial waste was approximately 3.25 billion tons in 2013, excluding approximately 31.57 million tons of hazardous industrial waste.
5

 
According to the Opinions on Further the Municipal Solid Waste Processing Service issued by the Chinese government, the harmless garbage processing rate will reach over 80% by 2015.  This anticipated increase creates a strong incentive for companies to improve their garbage processing capability.  Thus, the Chinese garbage processing industry has significant potential for growth both in areas of equipment marketing and equipment upgrading and improvement.
 
Nationwide Innocuous Disposal Facilities MSW Facilities Construction Planning (2011-2015) ("Planning"), recently passed by the Chinese government, has gone into the implementation phase. In accordance with the Planning, the aggregate investment in the items of the Planning will reach RMB 260Billion Yuan (approximately US $41 billion).
 
According to the Environmental Protection Equipment "Twelfth Five-Year" Development Planning, the yearly growth rate of the environmental protection industry gross output during the Twelfth Five-Year period is 20% and will reach 500 billion yuan (approximately US $79 billion) by 2015.
 
Thus, recently issued policies reducing the cost of Jiangsu Xuefeng operations, and anticipated future industrial policies of the Chinese government show the Chinese government's encouragement and support for the long term development of the environmental waste processing industry, setting the stage for a larger market place for the environmental protection equipment upgrading and improvement business.
 
Competition

Competitive Advantages
 
The industry for environmental protection equipment upgrading and improvement in China, being in its early stage, creates a great amount of business opportunities. We believe that, with our services and products that are supported by the patented technology and gradually gaining its market acceptance, we are well positioned to take advantage of the opportunities presented in this industry.
 
Competitive Disadvantages
 
While we saw gross profit margins of 43%, 95% and 92% for the years of 2016, 2015 and 2014, respectively, we are uncertain that our high gross profit margins are sustainable if we have to commit to substantive research and development activities when the Chinese government adopts higher standards for environmental protection technologies and when the cost of our services become substantially higher.
 
Our Growth Strategy
 
As industrial development continues its rapid increase in growth, the demand for the Company service should also increase rapidly.  The Company hopes to seize the opportunity to use industrial growth of both large and medium-size enterprises, establishing cooperative relationships with high-quality customers by fully using its advantages in waste processing technology providing customers with improved environmental solutions and larger scale processing capability.
 
The Company will further develop the equipment upgrading business. Jiangsu Xuefeng will make the best use of its patented technology of comprehensive and harmless garbage processing equipment to carry on the improvement and upgrading service for Chinese clients. In addition, patent license agreements will be offered to clients for a limited period of three to five years, within which period, the client shall pay patent royalties yearly to Jiangsu Xuefeng for their use of the equipment containing the patent technology thus providing the Company with an additional source of revenue.
 
The Company hopes to establish an equipment manufacturing and sales center. While continuing to provide equipment upgrading services, Jiangsu Xuefeng intends to establish a garbage processing equipment manufacturing and sales center to meet the anticipated market needs for Chinese garbage processing equipment, gradually branching further into the Chinese garbage processing equipment market and improving the Company's revenue.
 
The Company plans to also undertake technical cooperation with key domestic and foreign R&D institutions and industry partners. Keeping abreast of domestic and foreign technical developments, the Company plans to make use of international and domestic newly advanced technology in comprehensive garbage processing with high daily processing capacity. The Company plans to constantly expand marketing channels and increase its market shares.
6


Markets, Sales and Distribution
 
Currently, our marketing and sales efforts largely rely on word of mouth among our existing clients.
 
Intellectual Property
 
The Company acquired the license of the patent technology of comprehensive and harmless garbage processing equipment" that passed the ISO9001:2008 International Quality Management System Certification through the Patent Licensing Service Agreement signed with our Chairman, Chief Executive Officer and a shareholder, Li Yuan. The Licensing Agreement commenced on September 1, 2012 with a monthly payment to Li Yuan of approximately $12,600 (RMB 80,000).  Although the Licensing Agreement expired in July 2017. Mr. Li Yuan has agreed to continue licensing our company the use of the patent under the same terms and conditions.  Provision 42 of the Patent Law of the People's Republic Of China (as amended in 2008) provides that "the time limit of patent for invention is twenty years, the time limit of patent of utility models and design patent is ten years, both of which are calculated from the date of application". Company has received Utility Model Patent Certificate and Certificate of Patent for Invention, from the State Intellectual Property Office of the People's Republic of China. Patent right of comprehensive disposal equipment for waste processing was terminated on July, 2009 due to the expiration of the protection period. We no longer enjoy the exclusive patent right to that technology. However, because patent for our waste sorting treatment technology was granted in July 2009 and its time limit is 20 years, we could license the use of the patent to other company until July 2029.
 
Comprehensive and Harmless Garbage Processing Equipment is a Utility Model Patent issued by the State Intellectual Property Office (SIPO) on July 7, 2010 and valid for ten years (Patent Number: ZL 2009 2 0232893.7). It is owned by with our Chairman.  This patented technology is for the treatment of complex municipal solid waste including sorting and classification, leaving almost no pollution and no residue.
   
Regulation
 
Because our operating affiliate Jiangsu Xuefeng is located in the PRC, our business is regulated by the national and local laws of the PRC. We believe our conduct of business complies with existing PRC laws, rules and regulations.

Environmental Law
 
Jiangsu Xuefeng is subject to China's national Environmental Protection Law, which was enacted on December 26, 1989, as well as a number of other national and local laws and regulations governing landfills, air, water, and noise pollution and establishing pollutant discharge standards for wastewater.
 
On July 1, 2004, the PRC central government adopted the Measures for the Administration of Permit for Operation of Dangerous Wastes (the "Measures"). The Measures are intended to strengthen supervision and administration of activities relating to the collection, storage and disposal of dangerous wastes, and preventing dangerous wastes from polluting the environment.
 
Both the PRC Ministry of Environment Protection and local bureaus of environmental protection, license and regulate companies engaged in waste disposal and treatment in China. The requirements for licensing have become more stringent, with applicants having to demonstrate a sufficient operating history and a number of professional technicians, as well as comply with national and local environmental standards. The licensing process is also very time consuming and requires lengthy lead times.
7


General Regulation of Businesses
 
We believe we are in material compliance with all applicable labor and safety laws and regulations in the PRC, including the PRC Labor Contract Law, the PRC Production Safety Law, the PRC Regulation for Insurance for Labor Injury, the PRC Unemployment Insurance Law, the PRC Provisional Insurance Measures for Maternity of Employees, PRC Interim Provisions on Registration of Social Insurance, PRC Interim Regulation on the Collection and Payment of Social Insurance Premiums and other related regulations, rules and provisions issued by the relevant governmental authorities from time to time, for our operations in the PRC.
 
According to the PRC Labor Contract Law, we are required to enter into labor contracts with our employees. We are required to pay no less than local minimum wages to our employees. We are also required to provide employees with labor safety and sanitation conditions meeting PRC government laws and regulations and carry out regular health examinations of our employees engaged in hazardous occupations.
 
Foreign Currency Exchange
 
The principal regulation governing foreign currency exchange in China is the Foreign Currency Administration Rules (1996), as amended (2008). Under these Rules, RMB is freely convertible for current account items, such as trade and service-related foreign exchange transactions, but not for capital account items, such as direct investment, loan or investment in securities outside China unless the prior approval of, and/or registration with, the State Administration of Foreign Exchange of the People's Republic of China, or SAFE, or its local counterparts (as the case may be) is obtained.
  
Pursuant to the Foreign Currency Administration Rules, foreign invested enterprises, or FIEs, in China may purchase foreign currency without the approval of SAFE for trade and service-related foreign exchange transactions by providing commercial documents evidencing these transactions. They may also retain foreign exchange (subject to a cap approved by SAFE) to satisfy foreign exchange liabilities or to pay dividends. In addition, if a foreign company acquires a company in China, the acquired company will also become an FIE. However, the relevant PRC government authorities may limit or eliminate the ability of FIEs to purchase and retain foreign currencies in the future. In addition, foreign exchange transactions for direct investment, loan and investment in securities outside China are still subject to limitations and require approvals from, and/or registration with, SAFE.

Regulation of Income Taxes
 
On March 16, 2007, the National People's Congress of China passed the Enterprise Income Tax Law, or the EIT Law, and its implementing rules, both of which became effective on January 1, 2008. The EIT Law and its implementing rules impose a unified EIT rate of 25.0% on all domestic-invested enterprises and FIEs, unless they qualify under certain limited exceptions.
  
Under the EIT Law, companies designated as High- and New-Technology Enterprises may enjoy a reduced national EIT rate of 15%. The Administrative Measures for Assessment of High-New Tech Enterprises and Catalogue of High/New Tech Domains Strongly Supported by the State (2008), jointly issued by the Ministry of Science and Technology and the Ministry of Finance and State Administration of Taxation set forth general guidelines regarding criteria as well as application procedures for qualification as a High- and New-Tech Enterprise under the EIT Law.
 
In addition to the changes to the current tax structure, under the EIT Law, an enterprise established outside of China with "de facto management bodies" within China is considered a resident enterprise and will normally be subject to an EIT of 25% on its global income. The implementing rules define the term "de facto management bodies" as "an establishment that exercises, in substance, overall management and control over the production, business, personnel, accounting, etc., of a Chinese enterprise." If the PRC tax authorities subsequently determine that we should be classified as a resident enterprise, then our organization's global income will be subject to PRC income tax of 25%. For detailed discussion of PRC tax issues related to resident enterprise status, see "Risk Factors – Risks Related to Our Business – Under the EIT Law, we may be classified as a 'resident enterprise' of China. Such classification will likely result in unfavorable tax consequences to us and our non-PRC stockholders."
 
Our future effective income tax rate depends on various factors, such as tax legislation, the geographic composition of our pre-tax income and non-tax deductible expenses incurred. Our management carefully monitors these legal developments and will timely adjust our effective income tax rate when necessary.
8

 
Dividend Distribution
 
Under applicable PRC regulations, FIEs in China may pay dividends only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. In addition, a FIE in China is required to set aside at least 10.0% of its after-tax profit based on PRC accounting standards each year to a general reserve until the cumulative amount of such reserve reaches 50.0% of its registered capital. These reserves are not distributable as cash dividends. The board of directors of a FIE has the discretion to allocate a portion of its after-tax profits to staff welfare and bonus funds, which may not be distributed to equity owners except in the event of liquidation.
 
The EIT Law and its implementing rules generally provide that a 10% withholding tax applies to China-sourced income derived by non-resident enterprises for PRC enterprise income tax purposes unless the jurisdiction of incorporation of such enterprises' shareholder has a tax treaty with China that provides for a different withholding arrangement. Baichuang Consulting is considered a FIE and is directly held by our subsidiary in Hong Kong, Lotus. According to a 2006 tax treaty between the Mainland and Hong Kong, dividends payable by an FIE in China to the company in Hong Kong who directly holds at least 25% of the equity interests in the FIE will be subject to a no more than 5% withholding tax. We expect that such 5% withholding tax will apply to dividends paid to Lotus by Baichuang Consulting, but this treatment will depend on our status as a non-resident enterprise.    

PRC M&A Rule, Circular 75 and Circular 638

On August 8, 2006, six Chinese government agencies, namely, the Ministry of Commerce, or MOFCOM, the State Administration for Industry and Commerce, or SAIC, the China Securities Regulatory Commission, or CSRC, the State Administration of Foreign Exchange, or SAFE, the State Assets Supervision and Administration Commission, or SASAC, and the State Administration for Taxation, or SAT, jointly issued the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, referred to as the "New M&A Rules", which became effective on September 8, 2006. The New M&A Rules purport, among other things, to require offshore "special purpose vehicles," that are (1) formed for the purpose of overseas listing of the equity interests of Chinese companies via acquisition and (2) are controlled directly or indirectly by Chinese companies and/or Chinese individuals, to obtain the approval of the CSRC prior to the listing and trading of their securities on overseas stock exchanges. Based on our understanding of current Chinese Laws and pursuant to a legal opinion issued by Jilin Changchun Law Firm dated October 17, 2012, (i) Baichuang Consulting was incorporated by a foreign investor and therefore has no Chinese shareholders; (ii) the share exchange between Inclusion and the Company,  is between two offshore companies and is not deemed as a transaction to acquire equity or assets of a "Chinese domestic company" as defined under the New M&A Rules and (ii) no provision in the New M&A Rules clearly classifies the contractual arrangements between Baichuang Consulting and Jiangsu Xuefeng as a type of transaction falling within the New M&A Rules.
 
The SAFE issued a public notice in October 2005, or the Circular 75, requiring Chinese residents to register with the local SAFE branch before establishing or controlling any company outside of China for the purpose of capital financing with assets or equity of Chinese companies, referred to in the Circular 75 as special purpose vehicles, or SPVs. Chinese residents who are shareholders of SPVs established before November 1, 2005 were required to register with the local SAFE branch before June 30, 2006. Further, Chinese residents are required to file amendments to their registrations with the local SAFE branch if their SPVs undergo a material event involving changes in capital, such as changes in share capital, mergers and acquisitions, share transfers or exchanges, spin-off transactions or long-term equity or debt investments.
 
Pursuant to the Circular 698, where a foreign investor transfers the equity interests of a Chinese resident enterprise indirectly via disposing of the equity interests of an overseas holding company, which we refer to as an Indirect Transfer, and such overseas holding company is located in a tax jurisdiction that: (i) has an effective tax rate less than 12.5% or (ii) does not tax foreign income of its residents, the foreign investor shall report such Indirect Transfer to the competent tax authority of the Chinese resident enterprise. The Chinese tax authority will examine the true nature of the Indirect Transfer, and if the tax authority considers that the foreign investor has adopted an abusive arrangement in order to avoid Chinese tax, they will disregard the existence of the overseas holding company and re-characterize the Indirect Transfer and as a result, gains derived from such Indirect Transfer may be subject to Chinese withholding tax at the rate of up to 10%. Circular 698 also provides that, where a non-Chinese resident enterprise transfers its equity interests in a Chinese resident enterprise to its related parties at a price lower than the fair market value, the competent tax authority has the power to make a reasonable adjustment to the taxable income of the transaction.
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Insurance
 
Insurance companies in China offer limited business insurance products. While business interruption insurance is available to a limited extent in China, we have determined that the risks of interruption, cost of such insurance and the difficulties associated with acquiring such insurance on commercially reasonable terms make it impractical for us to have such insurance. As a result, we could face losses from the interruption of our business as summarized under "Risk Factors – Risks Related to Our Business – We do not carry business interruption insurance so we could incur unrecoverable losses if our business is interrupted."
 
Our Employees
 
As of August 30, 2016, we had a total of 32 employees. The Company employs a highly qualified team of technically trained personnel. Among the Company's employees, 11 employees have environmental assessment engineering degrees and 10 employees have ecological and environmental protection planning qualifications.  This team provides support for clients. 
Item 1A.       Risk Factors
 
An investment in our common stock involves a high degree of risk. You should carefully consider the risks described below, together with all of the other information included in this report, before making an investment decision. If any of the following risks actually occurs, our business, financial condition or results of operations could suffer. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment.
 
Risks Related to Our Business

Our failure to effectively compete in the waste processing market may have a material adverse effect on our growth prospects and our ability to generate revenue.

We currently compete primarily on the basis of our ability to secure contracts with waste processing companies, and local government entities in the Jiangsu Province, China and surrounding areas for the updating of waste processing equipment.  The Company is embarking on an area of growth in licensing the use of our licensed patented technology used in these updates and plans to establish our own waste processing centers.  There can be no assurance that we will be able to complete such expansion without losses or that our competitors will not develop at a faster rate and offer more favorable arrangements to our current and future customers. We expect that we will be required to continue to invest in research and development and building our waste treatment and disposal infrastructure.

Our competitors include both domestic companies and international companies operating in the waste processing industry in China. Some of these competitors have significantly greater financial and marketing resources and name recognition than that of our Company at this point. As the Chinese government continues to support and encourage the development of the environmentally sound waste processing industry, more domestic and international competitors may enter the market. We believe that the Chinese market for our services is subject to intense regional competition, with a relatively limited number of large competitors. While the Company effectively competes in our current focus of updating waste processing equipment for centers in our primary regional market of Jiangsu Province and surrounding areas, our reach outside this primary market and beyond our current focus has yet to be tested and we will necessarily face new competitors in the other geographic markets into which we plan to expand. If the Chinese government continues to emphasize the spending on environmental protection and continues to allocate funds to our industry, the number of our competitors throughout China, both domestic and foreign companies, will likely increase, so we cannot assure you that we will be able to compete successfully against any new or existing competitors, or against any new technologies our competitors may develop or implement.  All of these competitive factors could have a material adverse effect on our revenues, profitability and growth prospects.
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The waste processing industry is highly regulated and our business depends on governmental permits and certifications to operate our business, the loss of any of which would have a material adverse impact on our business.
 
Only those companies that have been granted operating licenses issued by the PRC central and local governments are permitted to engage in the industrial waste treatment and disposal business in China. Our company is currently fully licensed to carry out our core business of updating and improving waste processing equipment, however, creation of our own waste processing center in the future will require new licenses for which we will apply. The central and local governments of the PRC impose strict requirements on companies regarding the technology which must be employed and the qualifications and training of management employees which must be maintained. While we possess the necessary permits and certifications to operate our business, our regulatory approvals authorizing our operations and activities are subject to periodic review, reassessment and renewal by Chinese authorities.  Standards of compliance necessary to pass such reviews change from time to time and differ from jurisdiction to jurisdiction, leading to a degree of uncertainty. If our licenses and permits are revoked, substantially modified or not renewed or if additional permits, business licenses or approvals that may become necessary in connection with our business are not granted or are delayed, we may suffer adverse consequences. As a result, the termination or suspension of our licenses to operate would have a material adverse impact on our revenue and business.
 
If we fail to introduce new products or services or our existing products and services do not meet the requirements of our customers, we may not gain or may lose market share.

Our continued growth is dependent upon our ability to generate increased revenue from our existing customers, obtain new customers and raise capital from outside sources. While our current technology is at the forefront of industry developments, in order to maintain that advantage we will need to continue to pursue innovative solutions to meet our customers' needs. We believe that in order to continue to capture additional market share and generate additional revenue, we will have to raise more capital to fund the construction and installation of new facilities and to obtain additional equipment to collect, process and dispose of industrial waste and recycle waste for our existing and future customers. We anticipate that such funding will be provided through a variety of sources including bank loans, equity financing and net cash flow generated from operations.
 
In the future we may be unable to obtain the necessary financing for our capital requirements on a timely basis or on acceptable terms, which may prevent or delay the planned expansion of our service offerings. Our failure to provide new products or services may prevent us from retaining customers or gaining new customers, which may adversely affect our financial position, competitive position, growth and profitability. Our ability to obtain acceptable financing at any time may depend on a number of factors, including, our financial condition and results of operations; the condition of the PRC economy, the industrial waste treatment industry in the PRC, and conditions in relevant financial markets in the United States, PRC and elsewhere in the world.

The rapid expansion of our business could strain our resources and adversely affect our ability to effectively control and manage our growth.

If our business and markets grow and develop as planned, it will be necessary for us to finance and manage expansion in an efficient manner. We may face challenges in managing our waste processing equipment updating business over an expanded geographical area as well as managing expanded service offerings, including, among other things, waste processing services and patent licensing. Such eventualities will increase demands on our existing management, workforce and facilities. Failure to satisfy such increased demands could interrupt or adversely affect our operations and cause administrative inefficiencies.

Waste processing operations can be hazardous and may subject us to civil liabilities as a result of hazards posed by such operations.

Waste processing operations are subject to potential hazards incident to the gathering, processing and storage of industrial hazardous waste such as explosions, product spills, leaks, emissions and fires. These hazards can cause personal injury and loss of life, severe damage to and destruction of property and equipment, and pollution or other environmental damage, and may result in the curtailment or suspension of operations at the affected facility. Consequently, we may face civil liabilities in the ordinary course of our business as we update the equipment which performs this process at clients' waste processing plants and as we branch into our own waste processing business. As the environmental protection industry in China is developing, there is no comprehensive insurance available to cover environmental liabilities. Although we have not faced any civil liabilities in the ordinary course of our waste processing equipment updating operations, there is no assurance that we will not face such liabilities in the future. If such liabilities occur in the future, they may have a material adverse effect on our results of operations, financial condition and business prospects.
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Our success depends on our management team and other key personnel, the loss of any of whom could disrupt our business operations and have a material adverse effect on our financial condition, operating results and growth prospects.

Our success to date has been largely due to the contributions of our current management team, especially Chairman Li Yuan. The continued success of our business is very much dependent on the experience of the members of our management team and the goodwill that they have developed in the industry to date. As a result, our continued success is dependent, to a large extent, on our ability to retain the services of our management team and key personnel. The loss of the services of any of our management team or key personnel due to resignation, retirement, illness or otherwise without suitable replacement or the inability to attract and retain qualified personnel would have a material adverse effect on our operations and may reduce our profitability and the return on your investment. We do not currently maintain key man insurance covering our key personnel.
 
If we fail to adequately protect or enforce our intellectual property rights, we may be exposed to intellectual property infringement and the value of our intellectual property rights could diminish.
 
If we need to initiate litigation or administrative proceedings to enforce or protect our intellectual property rights, such actions may be costly and may divert management attention as well as expend other resources which could otherwise have been devoted to our business. An adverse determination in any such litigation could impair our intellectual property rights and may harm our business, prospects and reputation. In addition, historically, implementation of PRC intellectual property-related laws has been lacking, primarily because of ambiguities in the PRC laws and difficulties in enforcement. Accordingly, intellectual property rights and confidentiality protections in China may not be as effective as in the United States or other countries, which increases the risk that we may not be able to adequately protect our intellectual property. Given the relative unpredictability of China's legal system and potential difficulties enforcing a court judgment in China, there is no guarantee that we would be able to halt any unauthorized use of our intellectual property through litigation which may cause us to lose our competitive advantage and adversely affect our business and profitability.

We may face claims for infringement of third-party intellectual property rights.

We may face claims from third parties with respect to the infringement of any intellectual property rights owned by such third parties. There is no assurance that third parties will not assert claims to our processes, technologies and systems. In such an event, we may need to acquire licenses to, or to contest the validity of, issued or pending patents or claims of third parties. There can be no assurance that any license acquired under such patents would be made available to us on acceptable terms, if at all, or that we would prevail in any such contest. In addition, we would incur substantial costs and spend substantial amounts of time in defending ourselves in or contesting suits brought against us for alleged infringement of another party's patent rights. As such, our operations and business may be adversely affected by such civil actions. We rely on trade secrets, technology and know-how. There can be no assurance that other parties may not obtain knowledge of our trade secrets and processes, technology and systems. Should these events occur, our business would be affected and our profitability affected.

A significant portion of our revenue is dependent on our improvement and upgrading business.  As our improvement and upgrading business has become dependent on only a limited few customers, such dependency may have a material adverse effect on our business, operating results and financial condition.
 
Our improvement and upgrading business greatly relies on our ability to maintain and continue to develop our customer base. Our improvement and upgrading business generated revenue from four customers for the fiscal year ended May 31, 2016. Should any of our current customers cease to require the use of our service, and if we are unable to grow our customer base on a timely basis, our operations, revenue and profitability could be materially and adversely affected.
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BOT (Build-Operate-Transfer) projects that we may be awarded could be adversely affected by cost overruns, project delays and/or incorrect estimation of project costs.

The Company is establishing its own waste processing centers as an extension of its current business.  However, any future BOT projects we may be awarded will require us to incur high up-front expenditures.  Therefore, it is important that we manage such projects efficiently in terms of time, procurement of materials and allocation of resources. If our initial cost estimates are incorrect or delays occur in a project resulting in cost overruns, the profitability of that project could be adversely affected. Cost overruns due to additional rectification work and delays in completion of projects or delivery of waste to our new processing centers would adversely affect our profitability. We may also face potential liability from legal suits brought against us by our government customers for causing loss due to any delay in completing a project. In addition, we may also face potential liability from legal suits brought against us by our customers who have suffered loss due to such mismanagement or mistakes. This would also adversely affect our profitability and financial position.
Substantially all of our business operations are concentrated in Jiangsu and surrounding areas, and expose us to regional economic or market declines.
 
Substantially all of our revenues are generated from Jiangsu, China. Our current customer base is comprised of companies located in Jiangsu and surrounding areas. As a result, any adverse economic developments in Jiangsu could affect regional waste generation rates and demand for waste processing services which we plan to provide in the future or waste processing equipment upgrades which we currently provide to waste processing centers in Jiangsu. In addition, adverse market developments caused by increased waste disposal capacity from our competitors in this region could adversely affect waste disposal pricing. While one of our main growth strategies is to expand into other geographic markets in China, the occurrence of any adverse economic developments in Jiangsu and surrounding areas could have a material adverse effect on our business, financial condition and growth prospects.
 
We are subject to risks relating to expanding into other geographic markets in China outside of our principal market of Jiangsu.
 
To take advantage of industrialization outside of Jiangsu and to expand our service offerings to other geographic markets, we plan to establish centers for waste processing both within Jiangsu and expanding into other areas of the country. We intend to build and operate waste treatment facilities gradually.

Expansion into new geographic markets will require us to comply with rules and regulations of the applicable local government, and to address certain business issues particular to each market depending on the development and demand of customers within that market. As a result, there may be a significant period of time before any facility that we construct develops a consistent revenue stream. Accordingly, any delays or interruptions in implementing our expansion strategy or our business operations outside of Jiangsu may have a material adverse effect on our growth prospects, profitability and financial condition.

Relaxed enforcement of PRC environmental laws and governmental approvals and non-compliance by new and existing customers could have an adverse effect on our business, financial condition and growth prospects.

Companies operating in the waste treatment and disposal industry are subject to China's national Environmental Protection Law as well as a number of other national and local laws and regulations governing air, water, noise pollution and establishing pollutant discharge standards. In addition, such companies are subject to stringent licensing and certification requirements imposed by the PRC Ministry of Environmental Protection and the provincial environmental bureaus, which has created high barriers to entry for potential market participants.  However, the urbanization and industrialization from China's rapid economic growth has created an increased need for waste treatment services from solid waste disposal to sewage and sludge treatment. In order to help meet the demand for such services, the central government may not strictly enforce the compliance with environmental laws and relax certain conditions to gaining governmental licensing and approvals.  If such an event were to occur, there would be more competitors to our business operations and customers may turn to less expensive competitors for their waste disposal needs, which in turn, would have an adverse effect on our business, financial condition and grow prospects.
13


 Fluctuations in exchange rates could adversely affect our business and the value of our securities

The value of our common stock will be indirectly affected by the foreign exchange rate between U.S. dollars and the RMB and between those currencies and other currencies in which our sales may be denominated. Appreciation or depreciation in the value of the RMB relative to the U.S. dollar would affect our financial results reported in U.S. dollar terms without giving effect to any underlying change in our business or results of operations. Fluctuations in the exchange rate will also affect the relative value of any dividend we issue that will be exchanged into U.S. dollars as well as earnings from, and the value of, any U.S. dollar-denominated investments we make in the future.
 
Since July 2005, the RMB is no longer pegged to the U.S. dollar. Although the People's Bank of China regularly intervenes in the foreign exchange market to prevent significant short-term fluctuations in the exchange rate, the RMB may appreciate or depreciate significantly in value against the U.S. dollar in the medium to long term. Moreover, it is possible that in the future PRC authorities may lift restrictions on fluctuations in the RMB exchange rate and lessen intervention in the foreign exchange market. In August 2015, the PRC Government devalued its currency by approximately 3%.
 
Very limited hedging transactions are available in China to reduce our exposure to exchange rate fluctuations. To date, we have not entered into any hedging transactions. While we may enter into hedging transactions in the future, the availability and effectiveness of these transactions may be limited, and we may not be able to successfully hedge our exposure at all. In addition, our foreign currency exchange losses may be magnified by PRC exchange control regulations that restrict our ability to convert RMB into foreign currencies.

Under the EIT Law, we may be classified as a 'resident enterprise' of China

Under the New Income Tax Law, enterprises established outside the PRC whose "de facto management bodies" are located in the PRC are considered "resident enterprises" and their global income will generally be subject to the uniform 25% enterprise income tax rate. On December 6, 2007, the PRC State Council promulgated the Implementation Regulations on the New Income Tax Law (the "Implementation Regulations"), which define "de facto management bodies" as bodies that have material and overall management control over the business, personnel, accounts and properties of an enterprise. In addition, a recent circular issued by the State Administration of Taxation on April 22, 2009 provides that a foreign enterprise controlled by a PRC company or a PRC company group will be classified as a "resident enterprise" with its "de facto management bodies" located within the PRC if the following requirements are satisfied:
 
(i)    
the senior management and core management departments in charge of its daily operations function mainly in the PRC;
 
 
(ii)     
its financial and human resources decisions are subject to determination or approval by persons or bodies in the PRC;
 
 
(iii)      
its major assets, accounting books, company seals, and minutes and files of its board and shareholders' meetings are located or kept in the PRC; and
 
 
(iv)       
more than half of the enterprise's directors or senior management with voting rights reside in the PRC.
 
Because the EIT Law, its implementing rules and the recent circular are relatively new, no official interpretation or application of this new "resident enterprise" classification is available. Therefore, it is unclear how tax authorities will determine tax residency based on the facts of each case.
14


If the PRC tax authorities determine that we are a "resident enterprise" for PRC enterprise income tax purposes, a number of unfavorable PRC tax consequences could follow. First, we may be subject to the enterprise income tax at a rate of 25% on our worldwide taxable income as well as PRC enterprise income tax reporting obligations. In our case, this would mean that non-China source income would be subject to PRC enterprise income tax at a rate of 25%. Second, although under the EIT Law and its implementing rules dividends paid to us from our PRC subsidiary would qualify as "tax-exempt income," we cannot guarantee that such dividends will not be subject to a 10% withholding tax, as the PRC foreign exchange control authorities, which enforce the withholding tax, have not yet issued guidance with respect to the processing of outbound remittances to entities that are treated as resident enterprises for PRC enterprise income tax purposes. Finally, it is possible that future guidance issued with respect to the new "resident enterprise" classification could result in a situation in which a 10% withholding tax is imposed on dividends we pay to our non-PRC stockholders and with respect to gains derived by our non-PRC stockholders from transferring our shares.
 
We do not carry business interruption insurance so we could incur unrecoverable losses if our business is interrupted

We are subject to risk inherent to our business, including equipment failure, theft, natural disasters, industrial accidents, labor disturbances, business interruptions, property damage, product liability, personal injury and death. We do not carry any business interruption insurance or third-party liability insurance or other insurance to cover risks associated with our business. As a result, if we suffer losses, damages or liabilities, including those caused by natural disasters or other events beyond our control and we are unable to make a claim against a third party, we will be required to bear all such losses from our own funds, which could have a material adverse effect on our business, financial condition and results of operations.

We will incur increased costs as a result of operating as a public company, and our management will be required to devote substantial time to new compliance initiatives.

As a public company, we will incur significant legal, accounting and other expenses that we did not incur as a private company. We will be subject to the reporting and other requirements of the Securities Exchange Act of 1934, as amended, or the Exchange Act, the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, and the Dodd-Frank Wall Street Reform and Protection Act. These rules and regulations will require, among other things, that we file annual, quarterly and current reports with respect to our business and financial condition and establish and maintain effective disclosure and financial controls and corporate governance practices. We expect these rules and regulations to substantially increase our legal and financial compliance costs and to make some activities more time-consuming and costly. Our management and other personnel will need to devote a substantial amount of time to these compliance initiatives.

We qualify as an "emerging growth company" under the jobs act of 2012
 
We are an "emerging growth company," as defined in the JOBS Act, and, for as long as we continue to be an "emerging growth company," we may choose to take advantage of exemptions from various reporting requirements applicable to other public companies but not to "emerging growth companies," including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved. We could be an "emerging growth company" for up to five years, or until the earliest of (i) the last day of the first fiscal year in which our annual gross revenues exceed $1 billion, (ii) the date that we become a "large accelerated filer" as defined in Rule 12b-2 under the Exchange Act, which would occur if the market value of our Common Stock that is held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter, or (iii) the date on which we have issued more than $1 billion in non-convertible debt during the preceding three year period.
 
In addition, Section 107 of the JOBS Act also provides that an "emerging growth company" can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. In other words, an "emerging growth company" can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected to use the extended transition period provided above and therefore our financial statements may not be comparable to companies that comply with public company effective dates.
 
Because of the exemptions from various reporting requirements provided to us as an "emerging growth company," we may be less attractive to investors and it may be difficult for us to raise additional capital as and when we need it. Investors may be unable to compare our business with other companies in our industry if they believe that our reports are not as transparent as other companies in our industry. If we are unable to raise additional capital as and when we need it, our financial condition and results of operations may be materially and adversely affected. 
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Risks Related to Doing Business in the PRC

We face the risk that changes in the policies of the PRC government could have a significant impact upon the business we may be able to conduct in the PRC and the profitability of such business.

The PRC's economy is in a transition from a planned economy to a market oriented economy subject to five-year and annual plans adopted by the central government that set national economic development goals. Policies of the PRC government can have significant effects on the economic conditions of the PRC. The PRC government has confirmed that economic development will follow the model of a market economy. Under this direction, we believe that the PRC will continue to strengthen its economic and trading relationships with foreign countries and business development in the PRC will follow market forces. While we believe that this trend will continue, we cannot assure you that this will be the case. A change in policies by the PRC government could adversely affect our interests by, among other factors: changes in laws, regulations or the interpretation thereof, confiscatory taxation, restrictions on currency conversion, imports or sources of supplies, or the expropriation or nationalization of private enterprises. Although the PRC government has been pursuing economic reform policies for more than two decades, we cannot assure you that the government will continue to pursue such policies or that such policies may not be significantly altered, especially in the event of a change in leadership, social or political disruption, or other circumstances affecting the PRC's political, economic and social environment.
 
Introduction of new laws or changes to existing laws by the PRC government may adversely affect our business.

The PRC legal system is a codified legal system made up of written laws, regulations, circulars, administrative directives and internal guidelines. Unlike common law jurisdictions like the U.S., decided cases (which may be taken as reference) do not form part of the legal structure of the PRC and thus have no binding effect on subsequent cases with similar issues and fact patterns. Furthermore, in line with its transformation from a centrally-planned economy to a more free market-oriented economy, the PRC government is still in the process of developing a comprehensive set of laws and regulations. As the legal system in the PRC is still evolving, laws and regulations or the interpretation of the same may be subject to further changes. For example, the PRC government may impose restrictions on the amount of service fees that may be payable by municipal governments to wastewater and sludge treatment service providers. Also, the PRC central and municipal governments may impose more stringent environmental regulations which would affect our ability to comply with, or our costs to comply with, such regulations. Such changes, if implemented, may adversely affect our business operations and may reduce our profitability.

The PRC laws and regulations governing our current business operations are sometimes vague and uncertain. Any changes in such PRC laws and regulations may have a material adverse effect on our business.
 
There are substantial uncertainties regarding the interpretation and application of PRC laws and regulations, including, but not limited to, the laws and regulations governing our business, or the enforcement and performance of our arrangements with customers in the event of the imposition of statutory liens, death, bankruptcy and criminal proceedings. We are required to comply with PRC laws and regulations. These laws and regulations are sometimes vague and may be subject to future changes, and their official interpretation and enforcement may involve substantial uncertainty. The effectiveness of newly enacted laws, regulations or amendments may be delayed, resulting in detrimental reliance by foreign investors. New laws and regulations that affect existing and proposed future businesses may also be applied retroactively. We cannot predict what effect the interpretation of existing or new PRC laws or regulations may have on our operations, financial condition, and business prospects. 
16

 
A slowdown or other adverse developments in the PRC economy or other major economies all over the world may have a material adverse effect on our customers' demand for our services and our business. A slowdown in the economic growth in the PRC has recently occurred.
 
All of our revenues are currently generated in the PRC where all of our business operations are conducted. Because there are signs that the growth of PRC economy has slowed down over the last few years, we cannot assure you that such growth will continue. Moreover, China enjoys an export-oriented economy and it relies on external demand. The industrial waste treatment industry in the PRC is relatively new and growing, but we do not know how sensitive we are to a slowdown in economic growth or other adverse changes in the PRC economy which may affect demand for our products and services. A slowdown in overall economic growth, an economic downturn or recession or other adverse economic developments in the PRC or other major economies all over the world may materially reduce the demand for our products and services, which could have a material adverse effect on our business. 

Inflation in the PRC could negatively affect our profitability and growth.
 
While the PRC economy has experienced rapid growth, such growth has been uneven among various sectors of the economy and in different geographical areas of the country. Rapid economic growth can lead to growth in the money supply and rising inflation. In order to control inflation in the past, the PRC government has imposed controls on bank credits, limits on loans for fixed assets and restrictions on state bank lending. Such an austere policy can lead to a slowing of economic growth, which may have an adverse effect on our business operations and financial condition.

Governmental control of currency conversion may affect the value of your investment.

The PRC government imposes controls on the convertibility of Renminbi, or RMB, into foreign currencies and, in certain cases, the remittance of currency out of the PRC. We receive all of our revenues in RMB, which is currently not a freely convertible currency. Shortages in the availability of foreign currency may restrict our ability to remit sufficient foreign currency to pay expenses and dividends, or otherwise satisfy foreign currency dominated obligations. Under existing PRC foreign exchange regulations, payments of current account items, including profit distributions, interest payments and expenditures from the transaction, can be made in foreign currencies without prior approval from the PRC State Administration of Foreign Exchange, or SAFE, by complying with certain procedural requirements. However, approval from appropriate governmental authorities is required where RMB is to be converted into foreign currency and remitted out of the PRC to pay capital expenses such as the repayment of bank loans denominated in foreign currencies.
 
The PRC government also may at its discretion restrict access in the future to foreign currencies for current account transactions. If the foreign exchange control system prevents us from obtaining sufficient foreign currency to satisfy our currency demands, we may not be able to pay certain of our expenses as they come due.
 
The fluctuation of RMB may materially and adversely affect your investment.

The value of the RMB against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in the PRC's political and economic conditions. As we rely entirely on revenues earned in the PRC, any significant revaluation of RMB may materially and adversely affect our cash flows, revenues and financial condition. For example, to the extent that we need to convert U.S. dollars we receive from an offering of our securities into RMB for our operations, appreciation of the RMB against the U.S. dollar could cause the RMB equivalent of U.S. dollars to be reduced and therefore could have a material adverse effect on our business, financial condition and results of operations. Conversely, if we decide to convert our RMB into U.S. dollars for the purpose of making dividend payments on our common stock or for other business purposes and the U.S. dollar appreciates against the RMB, the U.S. dollar equivalent of the RMB we convert would be reduced. In addition, the depreciation of significant U.S. dollar denominated assets could result in a change to our operations and a reduction in the value of these assets. In August 2015, the PRC government devalued the currency by approximately 3%. The impact of this devaluation is not currently determinable.
17

  
Because our principal assets are located outside of the United States and all of our directors and all our officers reside outside of the United States, it may be difficult for you to enforce your rights based on U.S. Federal Securities Laws against us and our officers and directors or to enforce a judgment of a United States court against us or our officers and directors in the PRC.

All of our directors and officers reside outside of the United States. In addition, substantially all of our assets are located outside of the United States. It may therefore be difficult for investors in the United States to enforce their legal rights based on the civil liability provisions of the U.S. Federal securities laws against us in the courts of either the U.S. or the PRC and, even if civil judgments are obtained in U.S. courts, to enforce such judgments in PRC courts. Further, it is unclear if extradition treaties now in effect between the United States and the PRC would permit effective enforcement against us or our officers and directors of criminal penalties, under the U.S. Federal securities laws or otherwise.

Adverse changes in economic and political policies of the PRC government could have a material adverse effect on the overall economic growth of China, which could adversely affect our business.

Substantially all of our business operations are conducted in China. Accordingly, our results of operations, financial condition and prospects are subject to a significant degree to economic, political and legal developments in China. China's economy differs from the economies of most developed countries in many respects, including with respect to the amount of government involvement, level of development, growth rate, and control of foreign exchange and allocation of resources.

Since the adoption of the "open door policy" in 1978 and the "socialist market economy" in 1993, the PRC government has been reforming and is expected to continue to reform its economic and political systems. Any changes in the political or economic policy of the PRC government may lead to changes in the laws and regulations or the interpretation of the same, as well as changes in the foreign exchange regulations, taxation and import and export restrictions, which may in turn adversely affect our financial performance. While the current policy of the PRC government seems to be one of imposing economic reform policies to encourage foreign investments and greater economic decentralization, there is no assurance that such a policy will continue to prevail in the future.

While the PRC economy has experienced significant growth in the past 30 years, growth has been uneven across different regions and among various economic sectors of China. The PRC government has implemented various measures to encourage economic development and guide the allocation of resources. Some of these measures benefit the overall PRC economy, but may also have a negative effect on us. For example, our financial condition and results of operations may be adversely affected by government control over capital investments or changes in tax regulations that are applicable to us. Since early 2004, the PRC government has implemented certain measures to control the pace of economic growth. Such measures may cause a decrease in the level of economic activity in China, including the manufacturing output of our customers, which, in turn, could adversely affect our results of operations, financial condition and business prospects. The growth rate of the PRC economy has recently beguns to slowdown.

Failure to comply with the U.S. Foreign Corrupt Practices Act and Chinese anti-corruption laws could subject us to penalties and other adverse consequences.

We are required to comply with China's anti-corruption laws and the United States Foreign Corrupt Practices Act, which generally prohibits U.S. companies from engaging in bribery or other prohibited payments to foreign officials for the purpose of obtaining or retaining business. In addition, we are required to maintain records that accurately and fairly represent our transactions and have an adequate system of internal accounting controls. Foreign companies, including some of our competitors, are not subject to these prohibitions. Corruption, extortion, bribery, pay-offs, theft and other fraudulent practices occur from time-to-time in mainland China. If our competitors engage in these practices, they may receive preferential treatment from some companies, giving our competitors an advantage in securing business or from government officials who might give them priority in obtaining new licenses, which would put us at a disadvantage. Although we inform our personnel that such practices are illegal, we cannot assure you that our employees or other agents will not engage in such conduct for which we might be held responsible. If our employees or other agents are found to have engaged in such practices, we could suffer severe penalties and other consequences that may have a material adverse effect on our business, financial condition and results of operations. In addition, our brand and reputation, our sales activities or the price of our ordinary shares could be adversely affected if we become the target of any negative publicity as a result of actions taken by our employees or other agents.
18

 
We do not have liability business interruption, litigation or natural disaster insurance.

The insurance industry in China is still at an early stage of development. In particular PRC insurance companies offer limited business products. As a result, we do not have any business liability, disruption insurance or any other forms of insurance coverage for our operations in China. Any potential liability, business interruption, litigation or natural disaster may result in our business incurring substantial costs and the diversion of resources.

Restrictions under PRC law on our PRC subsidiary's ability to make dividends and other distributions could materially and adversely affect our ability to grow, make investments or complete acquisitions that could benefit our business, pay dividends to you, and otherwise fund and conduct our businesses.

Substantially all of our revenues are earned by our PRC subsidiary. However, PRC regulations restrict the ability of our PRC subsidiary to make dividend and other payments to its offshore parent company. PRC legal restrictions permit payments of dividend by our PRC subsidiary only out of its accumulated after-tax profits, if any, determined in accordance with PRC accounting standards and regulations. Our PRC subsidiary is also required under PRC laws and regulations to allocate at least 10% of our annual after-tax profits determined in accordance with PRC GAAP to a statutory general reserve fund until the amounts in said fund reaches 50% of our registered capital. Allocations to these statutory reserve funds can only be used for specific purposes and are not transferable to us in the form of loans, advances or cash dividends. Any limitations on the ability of our PRC subsidiary to transfer funds to us could materially and adversely limit our ability to grow, make investments or acquisitions that could be beneficial to our business, pay dividends and otherwise fund and conduct our business. 
 
Failure to comply with PRC regulations relating to the Foreign Exchange Registration for Oversea Investment and Return Investment by PRC resident.

In October 2005, SAFE issued the Notice on Relevant Issues in the Foreign Exchange Control over Financing and Return Investment Through Special Purpose Companies by Residents Inside China, generally referred to as Circular 75, which required PRC residents to register with the local SAFE branch before establishing or acquiring control over an offshore special purpose company, or SPV, for the purpose of engaging in an equity financing outside of China on the strength of domestic PRC assets originally held by those residents. Internal implementing guidelines issued by SAFE, which became public in June 2007 (known as Notice 106), expanded the reach of Circular 75 by (1) purporting to cover the establishment or acquisition of control by PRC residents of offshore entities which merely acquire "control" over domestic companies or assets, even in the absence of legal ownership; (2) adding requirements relating to the source of the PRC resident's funds used to establish or acquire the offshore entity; covering the use of existing offshore entities for offshore financings; (3) purporting to cover situations in which an offshore SPV establishes a new subsidiary in China or acquires an unrelated company or unrelated assets in China; and (4) making the domestic affiliate of the SPV responsible for the accuracy of certain documents which must be filed in connection with any such registration, notably, the business plan which describes the overseas financing and the use of proceeds.  Amendments to registrations made under Circular 75 are required in connection with any increase or decrease of capital, transfer of shares, mergers and acquisitions, equity investment or creation of any security interest in any assets located in China to guarantee offshore obligations, and Notice 106 makes the offshore SPV jointly responsible for these filings. In the case of an SPV which was established, and which acquired a related domestic company or assets, before the implementation date of Circular 75, a retroactive SAFE registration was required to have been completed before March 31, 2006; this date was subsequently extended indefinitely by Notice 106, which also required that the registrant establish that all foreign exchange transactions undertaken by the SPV and its affiliates were in compliance with applicable laws and regulations.  Failure to comply with the requirements of Circular 75, as applied by SAFE in accordance with Notice 106, may result in fines and other penalties under PRC laws for evasion of applicable foreign exchange restrictions. Any such failure could also result in the SPV's affiliates being impeded or prevented from distributing their profits and the proceeds from any reduction in capital, share transfer or liquidation to the SPV, or from engaging in other transfers of funds into or out of China.
19

 
We have advised our shareholders who are PRC residents, as defined in Circular 75, to register with the relevant branch of SAFE, as currently required, in connection with their equity interests in us and our acquisitions of equity interests in our PRC subsidiary and affiliate. However, we cannot provide any assurances that their existing registrations have fully complied with, and they have made all necessary amendments to their registration to fully comply with, all applicable registrations or approvals required by Circular 75. Moreover, because of uncertainty over how Circular 75 will be interpreted and implemented, and how or whether SAFE will apply it to us, we cannot predict how it will affect our business operations or future strategies. For example, our present and prospective PRC subsidiary's and affiliate's ability to conduct foreign exchange activities, such as the remittance of dividends and foreign currency-denominated borrowings, may be subject to compliance with Circular 75 by our PRC resident beneficial holders. In addition, such PRC residents may not always be able to complete the necessary registration procedures required by Circular 75. We also have little control over either our present or prospective direct or indirect shareholders or the outcome of such registration procedures. A failure by our PRC resident beneficial holders or future PRC resident shareholders to comply with Circular 75, if SAFE requires it, could subject these PRC resident beneficial holders to fines or legal sanctions, restrict our overseas or cross-border investment activities, limit our subsidiary's and affiliate's ability to make distributions or pay dividends or affect our ownership structure, which could adversely affect our business and prospects.
 
Risks Related to Our VIE Agreements
 
The PRC government may determine that the VIE Agreements are not in compliance with applicable PRC laws, rules and regulations.
 
Baichuang Consulting provides support and consulting services to Jiangsu Xuefeng pursuant to the VIE Contractual Agreements.  Almost all economic benefits and risks arising from Jiangsu Xuefeng's operations are transferred to Baichuang Consulting under these agreements.  Details of the VIE Agreements are set out in "DESCRIPTION OF BUSINESS – Contractual Arrangements with our Controlled Affiliate and its Shareholders" above.
 
There are risks involved with the operation of our business in reliance on the VIE Agreements, including the risk that the VIE Agreements may be determined by PRC regulators or courts to be unenforceable.  Our PRC counsel has provided a legal opinion that the VIE Agreements are binding and enforceable under PRC law, but has further advised that if the VIE Agreements were for any reason determined to be in breach of any existing or future PRC laws or regulations, the relevant regulatory authorities would have broad discretion in dealing with such breach, including:
 
      ●
imposing economic penalties;
 
      ●
discontinuing or restricting the operations of Baichuang Consulting or Jiangsu Xuefeng;
 
      ●
imposing conditions or requirements in respect of the VIE Agreements with which Baichuang Consulting or Jiangsu Xuefeng may not be able to comply;
 
      ●
requiring our company to restructure the relevant ownership structure or operations;
 
      ●
taking other regulatory or enforcement actions that could adversely affect our company's business; and
 
      ●
revoking the business licenses and/or the licenses or certificates of Jiangsu Xuefeng, and/or voiding the VIE Agreements.
 
Any of these actions could adversely affect our ability to manage, operate and gain the financial benefits of Jiangsu Xuefeng, which would have a material adverse impact on our business, financial condition and results of operations.
 
Our ability to control Jiangsu Xuefeng under the VIE Agreements may not be as effective as direct ownership.
 
We conduct our business in the PRC and currently generate virtually all of our revenues through the VIE Agreements. Our plans for future growth are based substantially on growing the operations of Jiangsu Xuefeng.  However, the VIE Agreements may not be as effective in providing us with control over Jiangsu Xuefeng as direct ownership.  The VIE Agreements do not provide us with day-to-day control over the operations of Jiangsu Xuefeng.  Under the current VIE arrangements, as a legal matter, if Jiangsu Xuefeng fails to perform its obligations under these contractual arrangements, we may have to (i) incur substantial costs and resources to enforce such arrangements, and (ii) rely on legal remedies under PRC law, which we cannot be sure would be effective. Therefore, if we are unable to effectively control Jiangsu Xuefeng, it may have an adverse effect on our ability to achieve our business objectives and grow our revenues.
20

 
As the VIE Agreements are governed by PRC law, we would be required to rely on PRC law to enforce our rights and remedies under them; PRC law may not provide us with the same rights and remedies as are available in contractual disputes governed by the laws of other jurisdictions.
 
The VIE Agreements are governed by PRC law and provide for the resolution of disputes through the jurisdiction of the courts in the PRC.  If Jiangsu Xuefeng or its shareholders fail to perform the obligations under the VIE Agreements, we would be required to resort to legal remedies available under PRC law, including seeking specific performance or injunctive relief, or claiming damages. We cannot be sure that such remedies would provide us with effective means of causing Jiangsu Xuefeng or its shareholders to meet their obligations, or recovering any losses or damages as a result of non-performance. Further, the legal environment in China is not as developed as in other jurisdictions. Uncertainties in the application of various laws, rules, regulations or policies in PRC legal system could limit our liability to enforce the VIE Agreements and protect our interests.
 
The payment arrangement under the VIE Agreements may be challenged by the PRC tax authorities.
 
We generate our revenues through the payments we receive pursuant to the VIE Agreements. Currently, all of our operations reside in the VIE which is required to pay our wholly owned subsidiary, Baichuang Consulting 95% of their earnings, as defined, plus a monthly consulting fee of RMB 100,000(approximately U.S.$16,000).  We could face adverse tax consequences if the PRC tax authorities determine that the VIE Agreements were not entered into based on arm's length negotiations. For example, PRC tax authorities may adjust our income and expenses for PRC tax purposes which could result in our being subject to higher taxes, or cause other adverse financial consequences.
 
Item 1B.   Unresolved Staff Comments

On August 1, 2016, the Company became aware of a comment letter dated March 9, 2016 and subsequent notices March 31, 2016, April 19, 2016 from the Securities and Exchange Commission (the "SEC") Division of Corporation Finance regarding its Annual Report on Form 10-K for the fiscal year ended May 31, 2015 and Quarterly Reports on Form 10-Q for the quarters ended August 31, 2015 and November 30, 2015. In general, the unresolved staff comments relate to specific nature of our services and products, along with the methodologies underlying the revenue recognition policy of these services and products. While these comments have not been considered resolved as of the date hereof, we have filed with the SEC a correspondence to the comment letter. Additionally, we have incorporated into this annual report additional disclosures that we believe are responsive to the SEC's comments.

Item 2.   Properties

The Company leases office space under a one-year operating lease from an unrelated third party, which expired on March 31, 2016.  The lease required the Company to prepay the rental for one year of $6,784 (RMB 44,664).  The related prepayments of $0, $6,078 and $6,078 are included in prepaid expenses on the consolidated balance sheets as of May 31, 2016, 2015 and 2014, respectively.  The lease provides for renewal options but the Company ceased the lease.  Rent expense for the year ended May 31, 2016, 2015 and 2014 was $5,818, $7,267 and $7,267, respectively.

The Company entered into a new lease agreement with an unrelated third party for new office space, which commenced on April 1, 2016 and expires on March 31, 2019.  The lease requires the Company to prepay the semi-annual rental of $3,645 (RMB 24,000). The lease provides for renewal options.

Future minimum payments for the years ending May 31 are as follows:
 
Year Ending
   
May 31,
 
Amount
 
     
2017
 
$
7,503
 
2018
   
7,503
 
2019
   
6,288
 
         
   
$
21,294
 
 
21

Item 3.   Legal Proceedings
 
There are no actions, suits, proceedings, inquiries or investigation before or by any court, public board, government agency, self-regulatory organization or body pending or, to the knowledge of the executive officers of our company or any of our subsidiaries, threatened against or affecting our company, our common stock, any of our subsidiaries or of our companies or our subsidiaries' officers or directors in their capacities as such, in which an adverse decision could have a material adverse effect.
 
Item 4.  Mine Safety Disclosures

Not applicable 
 
  
PART II
 
Item 5.  Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
 
Market Information

Our common stock has been quoted on the OTCQB since May 9, 2012. Our initial symbol was "NYCM". In January 2013, our symbol was changed to "CXEE". The following table sets forth the range of the quarterly high and low bid price information for the past two fiscal years as reported by the OTCQB.
 
 
 
 
High Bid* ($)
   
Low Bid* ($)
 
2016
 
   
 
 
 
   
 
March 1, 2016 – May 31, 2016
   
4.51
     
3.00
 
December 1, 2015 – February 29, 2016
   
4.39
     
4.25
 
September 1, 2015 – November 30, 2015
   
4.38
     
3.92
 
June 1, 2015 – August 31, 2015
   
3.93
     
3.86
 
 
               
2015
               
 
               
March 1, 2015 – May 31, 2015
   
3.92
     
3.89
 
December 1, 2014 – February 28, 2015
   
3.93
     
3.88
 
September 1, 2014 – November 30, 2014
   
3.92
     
3.71
 
June 1, 2014 – August 31, 2014
   
3.71
     
3.68
 
 
* The quotations of the closing prices reflect inter-dealer prices, without retail mark-up, markdown or commission, and may not necessarily represent actual transactions.

The market price of our common stock is subject to significant fluctuations in response to variations in our quarterly operating results, general trends in the market, and other factors, over many of which we have little or no control. In addition, broad market fluctuations, as well as general economic, business and political conditions, may adversely affect the market for our common stock, regardless of our actual or projected performance.
 
Holders
 
As of August 10, 2015, we estimate that there were approximately 1,225 stockholders of record of our common stock. This figure does not take into account those shareholders whose certificates are held in the name of broker-dealers or other nominees.
 
 Dividends
 
Any future decisions regarding dividends will be made by our board of directors. We currently intend to retain and use any future earnings for the development and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. Our board of directors has complete discretion on whether to pay dividends, subject to the approval of our stockholders. Even if our board of directors decides to pay dividends, the form, frequency and amount will depend upon our future operations and earnings, and capital requirements, general financial conditions, contractual restrictions, government restrictions and other factors that the board of directors may deem relevant.
22

 
PRC regulations restrict the ability of our PRC subsidiary to make dividend and other payments to its offshore parent company. PRC legal restrictions permit payments of dividends by our PRC subsidiary only out of its accumulated after-tax profits, if any, determined in accordance with PRC accounting standards and regulations. Our PRC subsidiary is also required under PRC laws and regulations to allocate at least 10% of our annual after-tax profits determined in accordance with PRC GAAP to a statutory general reserve fund until the amounts in said fund reaches 50% of our registered capital. Allocations to these statutory reserve funds can only be used for specific purposes and are not transferable to us in the form of loans, advances or cash dividends. Please refer to the section "Risk Factors — Risks Related to Doing Business in the PRC" beginning on page 16.
 
Furthermore, our present PRC subsidiaries' ability to conduct foreign exchange activities, such as the remittance of dividends and foreign currency-denominated borrowings, may be subject to compliance with Circular 75 by our PRC resident beneficial holders. A failure by our PRC resident beneficial holders or future PRC resident stockholders to comply with Circular 75, if SAFE requires it, could limit our subsidiaries' ability to make distributions or pay dividends or affect our ownership structure, which could adversely affect our business and prospects. Rer to "Risk Factors — Risks Related to Doing Business in the PRC" beginning on page 16.
 
Recent Sales of Unregistered Securities

There were no unregistered sales of the Company's equity securities during the fiscal year ended May 31, 2016, that were not otherwise disclosed in a Quarterly Report on Form 10-Q or a Current Report on Form 8-K.

Item 6.   Selected Financial Data
 
 
 
 
Fiscal Year
Ended
May 31,
2016
   
Fiscal Year
Ended
May 31,
2015
   
Fiscal Year
 Ended
May 31,
2014
   
Fiscal Year
Ended
May 31,
2013
   
Fiscal Year
Ended
May 31,
2012
 
 Revenue
 
$
22,187,094
   
$
6,996,100
   
$
4,710,165
   
$
5,426,435
   
$
314,248
 
 Net income attributable to common stockholders
 
$
3,951,924
   
$
4,382,498
   
$
2,806,120
   
$
3,208,482
   
$
63,514
 
 Earnings per common share
 
$
0.10
   
$
0.08
   
$
0.05
   
$
0.07
   
$
0.00
 
 Total Assets
 
$
35,297,419
   
$
26,488,007
   
$
20,750,926
   
$
17,602,633
   
$
4,964,549
 
 Long Term Obligations
 
$
2,794,868
   
$
-
   
$
-
   
$
-
   
$
-
 
 Cash Dividends Declared Per Common Share
 
$
0.00
   
$
0.00
   
$
0.00
   
$
0.00
   
$
0.00
 
 

Item 7.  Management's Discussion and Analysis of Financial Condition and Results of Operations
 
This Management's Discussion and Analysis of Financial Condition and Results of Operations is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity, and certain other factors that may affect our future results.  The following discussion and analysis should be read in conjunction with our audited consolidated financial statements and the accompanying notes thereto included in "Item 8. Financial Statements and Supplementary Data."
23




This annual report on Form 10-K contains or may contain forward-looking statements (collectively the "Filings") and information that are based upon beliefs of, and information currently available to, the Company's management as well as estimates and assumptions made by Company's management. Readers are cautioned not to place undue reliance on these forward-looking statements, which are only predictions and speak only as of the date hereof. When used in the filings, the words "anticipate," "believe," "estimate," "expect," "future," "intend," "plan," or the negative of these terms and similar expressions as they relate to the Company or the Company's management identify forward-looking statements. Such statements reflect the current view of the Company with respect to future events and are subject to risks, uncertainties, assumptions, and other factors. Should one or more of these risks or uncertainties materialize, or should the underlying assumptions prove incorrect, actual results may differ significantly from those anticipated, believed, estimated, expected, intended, or planned.

Although the Company believes that the expectations reflected in the forward-looking statements are reasonable, the Company cannot guarantee future results, levels of activity, performance, or achievements. Except as required by applicable law, including the securities laws of the United States, the Company does not intend to update any of the forward-looking statements to conform these statements to actual results.

Our financial statements are prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). These accounting principles require us to make certain estimates, judgments, and assumptions. We believe that the estimates, judgments, and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments, and assumptions are made. These estimates, judgments, and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenues and expenses during the periods presented. Our financial statements would be affected to the extent there are material differences between these estimates and actual results. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management's judgment in its application. There are also areas in which management's judgment in selecting any available alternative would not produce a materially different result. The following discussion should be read in conjunction with our consolidated financial statements and notes thereto appearing elsewhere in this report.

For discussion of factors that we believe could cause our actual results to differ materially from expected and historical results see "Item 1A — Risk Factors" beginning on page 10.

 

Overview 
We are in the business of providing equipment and upgrade services to optimize garbage-recycling processes. We sell and lease comprehensive and environmental-friendly garbage recycling equipment. We also utilize our licensed patented technology of "comprehensive and harmless garbage-processing equipment" to upgrade software systems and reconstruct hardware for our clients and therefore expand the sorting scope and capacity of our clients' garbage recycling equipment. We also have manufactured and sell or lease garbage-processing equipment commencing during the twelve months ended May 31, 2016. We conduct our operations through our controlled consolidated affiliate Jiangsu Xuefeng Environmental Protection Science and Technology Co., Ltd. ("Jiangsu Xuefeng")
Our Services
With the development of the urbanization in China, the amount of household garbage is growing, whereas the processing capability of garbage processing equipment cannot satisfy the increasing amount of garbage. In order to improve the processing equipment of garbage processing plants, we provide upgrades and improvements to the software systems and hardware equipment by installing various systems of our licensed patented technology "comprehensive and harmless garbage-processing equipment" into customers' equipment, and reconstruct the hardware to expand the garbage sorting scope and capacity of their equipment.
24


The comprehensive and harmless garbage processing equipment that we sell or lease is comprised of a waste digestion pretreatment system, methane gas power generation system, sorting processing system, bricklaying building system, leachate treatment system, DCS (distribution control system), XFET-5 ecological and water-saving toilets and excrement comprehensive processing system and various material collection systems. The equipment technology is designed and manufactured based on the complicated situation of the household garbage in China. According to the features of various garbage, the equipment utilizes the wind-force, gravity, magnetic, shape, etc. to process the garbage by the combined way of machine selecting, winnowing, magnetic separation, automatic cutting, smashing and other technological processes. The equipment has large processing capacity and can run all day. The stand-alone equipment can process 500 to 1000 tons of garbage per day. It can sort and process complicated municipal solid waste, leaving almost no pollution and no residue, reaching the "3 without" standard of no waste gas, no waste water and no waste residue.
The licensed patented technology of "harmless and comprehensive garbage processing equipment" provided by Jiangsu Xuefeng to its customers has a high garbage processing capacity and stable operation capacity. It is the first modern system equipment in China to use DCS (Distributed Control System) centralized control, by which mechanical automation will be realized for the comprehensive treatment of life garbage. Its core technology is to organically integrate the anaerobic digestion and aerobic fermentation garbage process, degrade and transform the organic matter of domestic waste, effectively sort out the garbage and recycle all kinds of materials, to eventually realize the true waste resource utilization and harmless utilization rate, approaching 100%. The resource recovery products, biogas, can not only be used for meeting the needs of the plant itself, but also for sale outside the company, which greatly improves the efficiency of the garbage processing equipment, decreases production costs, and increases the recovery return of garbage processing.
After we sell or lease the equipment or complete the internal system upgrade and hardware equipment improvements of the clients' garbage equipment, we deliver the upgraded equipment to the customers. The customers will conduct an inspection and performance testing of the upgraded equipment within one month pursuant to the contract to inspect whether the internal control system and the hardware structure can operate steadily and achieve the expected results. The inspection includes the following: whether the quality of the equipment and accessories or after improvement can match the licensed patented technology and process various kinds of garbage, whether the various garbage systems can process automatically, and whether the daily garbage processing capacity reaches the expected results per the contract. If during the performance testing period, the performance meets the requirements of the contract, it would be deemed that we have fully fulfilled our obligations under the contract.
When we complete the upgrading service for a client, we go through the acceptance check and commissioning of the company in accordance with the contract, to make sure that the services provided met the expectations of the clients. After that, we are not subject to any additional services. The revenue we generated belongs to the service class income, with the main cost being the salaries of the staff and the leasing fees for the patent, whereas the hardware and software equipment, as well as the material used in the upgrading process are the responsibility of the client.

Recent Acquisition of Linyi Xuefeng

On August 2016, the Company entered into an agreement to acquire 100% interest of Linyi County Xuefeng Renewable Resources Utilization Technology Co., Ltd ("Linyi Xuefeng"), a privately-held company owned by our CEO and Chairman of the Board, Yuan Li. Pursuant to the transfer agreement, the specific transfer price is based upon the net asset amount in Linyi Xuefeng's audit report as of May 31, 2016. The Company will pay thirty percent of the transfer price with cash and seventy percent of the transfer price by issuing additional shares for the acquisition. From the date of the execution of the agreement through the period when Mr. Li Yuan and the Company complete all obligations of performing the agreement, Mr. Li Yuan shall not transfer any assets of Linyi Xuefeng under any circumstances.
Upon acquisition, Linyi Xuefeng will become a wholly-owned subsidiary of the Company. The acquisition will be accounted for as a business combination.

25


Implications of Being an Emerging Growth Company
 
We qualify as an emerging growth company as that term is used in the JOBS Act. An emerging growth company may take advantage of specified reduced reporting and other burdens that are otherwise applicable generally to public companies. These provisions include:
 
 
A requirement to have only two years of audited financial statements and only two years of related MD&A;
 
 
Exemption from the auditor attestation requirement in the assessment of the emerging growth company's internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act of 2002;
 
 
Reduced disclosure about the emerging growth company's executive compensation arrangements; and
 
 
No non-binding advisory votes on executive compensation or golden parachute arrangements.
 
In addition, Section 107 of the JOBS Act also provides that an emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act of 1933, as amended (the "Securities Act") for complying with new or revised accounting standards. We have elected to use the extended transition period provided above and therefore our financial statements may not be comparable to companies that comply with public company effective dates.
 
We could remain an emerging growth company for up to five years, or until the earliest of (i) the last day of the first fiscal year in which our annual gross revenues exceed $1 billion, (ii) the date that we become a "large accelerated filer" as defined in Rule 12b-2 under the Exchange Act, which would occur if the market value of our common stock that is held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter, or (iii) the date on which we have issued more than $1 billion in non-convertible debt during the preceding three year period.
 

Results of Operations

Years Ended May 31, 2016 and 2015

The following table sets forth in U.S. dollars, key components of our audited results of operations for the years ended May 31, 2016 and 2015, and the percentage change between 2016 and 2015.
 
   
Year Ended May 31,
 
 
2016
   
Percentage
Change
   
2015
   
Percentage
Change
   
2014
 
 
(U.S. $)
       
(U.S. $)
       
(U.S. $)
 
                     
Revenue
 
$
22,187,094
     
217
%
 
$
6,996,100
     
49
%
 
$
4,710,165
 
Cost of revenue
   
(12,550,550
)
   
3,331
%
   
(356,813
)
   
1
%
   
(354,085
)
      Gross profit
   
9,636,544
     
45
%
   
6,639,287
     
52
%
   
4,356,080
 
    Selling expenses
   
1,229,968
     
1,013
%
   
110,492
     
13
%
   
97,520
 
    General and administrative expenses
   
795,516
     
91
%
   
416,143
     
6
%
   
391,546
 
      Total operating expenses
   
2,025,484
     
285
%
   
526,635
     
8
%
   
489,066
 
Operating income
   
7,661,060
     
25
%
   
6,112,652
     
58
%
   
3,867,014
 
    Interest income
   
420,513
     
459
%
   
75,167
     
21
%
   
62,041
 
Income before provision for income taxes
   
8,031,573
     
30
%
   
6,187,819
     
57
%
   
3,929,055
 
Provision for income taxes
   
2,038,643
     
29
%
   
1,575,705
     
60
%
   
982,264
 
Net income
   
5,992,930
     
30
%
   
4,612,114
     
57
%
   
2,946,791
 
    Noncontrolling interests
   
(299,325
)
   
30
%
   
(229,616
)
   
63
%
   
(140,671
)
Net income attributable to common  stockholders
 
$
5,693,605
     
30
%
 
$
4,382,498
     
56
%
 
$
2,806,120
 
 
Revenue
 
We provide improvement and upgrading services for garbage processing equipment to our customers. This is a one-time service. We also license a patent to our customers. The patent licensing is limited to five years with payments due annually in advance. During the fiscal year ended May 31, 2016, we began to sell or lease the garbage processing equipment to our customers.
26


We generated $22,187,094 in revenue for the fiscal year ended May 31, 2016, as compared to $6,996,100 for the fiscal year ended May 31, 2015. Our revenue for the year ended May 31, 2016 increased by $15,190,994 or 217% compared to the revenue for the year ended May 31, 2015. The primary reason for the significant increase in revenue was mainly due to the increase in the sale of equipment and improvement and upgrade services for garbage processing equipment.

We generated $6,996,100 in revenue for the fiscal year ended May 31, 2015, as compared to $4,710,165 for the fiscal year ended May 31, 2014. Our revenue for the year ended May 31, 2015 increased by $2,285,935 or 49% compared to the revenue for the year ended May 31, 2014. The primary reason for the significant increase in revenue was mainly due to the increase in our improvement and upgrading services. The following table sets forth our revenue for the years ended May 31, 2016, 2015 and 2014:
 
 
Twelve Months Ended May 31,    
2016
 
Percentage
Change
 
2015
 
Percentage
Change
 
2014
 
(U.S. $)
   
(U.S. $)
   
(U.S. $)
 
           
Improvements and Upgrading Services
 
$
2,907,422
     
(16
%)
 
$
3,481,780
     
138
%
 
$
1,464,300
 
Patent Leasing
   
4,079,769
     
16
%
   
3,514,320
     
8
%
   
3,245,865
 
Sales type lease
   
14,300,324
     
100
%
   
-
     
0
%
   
0
 
Operating lease
   
899,579
     
100
%
   
-
     
0
%
   
0
 
       Total
 
$
22,187,094
     
217
%
 
$
6,996,100
     
49
%
 
$
4,710,165
 



Improvement and Upgrading Services
 
During the fiscal year ended May 31, 2016, we provided improvement and upgrading services to seven customers and generated revenue of $2,907,422. For the year ended May 31, 2015, we generated revenue of $3,481,780 from providing improvement and upgrading services to nine customers. For the fiscal year ended May 31, 2014, we generated revenue of $1,464,300 from providing improvement and upgrading services to three unrelated customers.  The services were completed and accepted by the customers and the payments were received in full as of May 31, 2016, 2015 and 2014. While our core business still focuses on providing improvement and upgrading services for customers' garbage processing equipment, we have also begun selling or leasing our garbage processing equipment.

Patent Licensing
 
During the fiscal year ended May 31, 2016, we generated revenue of $4,079,769 from licensing our patent to 17 unrelated customers. As 14 customers became licensees in the prior year and three customers started on October 1, 2015, patent licensing revenue was recognized for the entire twelve months for these 14 customers. During the fiscal year ended May 31, 2015, we generated revenue of $3,514,320 from patent licensing from 12 unrelated customers. As all the customers became our licensees in the previous year, the patent licensing revenue was recognized for the whole twelve months. For the fiscal year ended May 31, 2014, we generated a total revenue of $3,245,865 from licensing patent to 12 unrelated customers. 




Sales Type Lease
 
During the fiscal year ended May 31, 2016, we leased equipment for garbage processing to two customers. These sales were recognized as sales type leases because title to the equipment will be transferred to the customers at the end of the lease. The equipment was sold for $14,300,324 before value-added tax (the "VAT"). We received 40.2% and 33.7% of the selling price from the two customers during the fiscal years ended May 31, 2016, respectively. We will receive quarterly payments of approximate $1,150,000 during the following three years including interest at 5.25%. For the fiscal years ended May 31, 2015 and 2014, we didn't have any sales type lease revenue.

27

Operating lease
 


During the fiscal years ended May 31, 2016, we had four operating leases for a 300-ton and three 500-ton garbage processing system. The lease period is 5 years with annual lease payments of $625,252 and $2,250,908 (for the two 500-ton garbage processing system), respectively, before VAT. The 300-ton garbage processing system was delivered and tested in the beginning of November 2015. The two 500-ton garbage processing systems were delivered and tested in the beginning of January 2016. Another 500-ton garbage processing system was delivered and tested in the end of April 2016. These leases are being accounted for as operating leases because they have no renewal or purchase option. At the end of the five years, either a new lease will be negotiated or the equipment will be returned. For the year ended May 31, 2014 and 2015, we didn't have any operating lease revenue.


Cost of Goods Sold 
 
Our cost of goods sold increased to $12,550,550 for the year ended May 31, 2016 from $356,813 for the fiscal year ended May 31, 2015, which represented an increase of 3,331%. This is mainly attributable to the $11,538,614 cost of the garbage processing equipment sold under the sales type lease. For improvement and upgrading service and patent licensing revenue, the cost primarily consists of fees paid to the related party for licensing the patent, employees' salaries and training expenses. In addition, the cost of the garbage processing equipment also includes various equipment and supplies necessary for assembling and installing equipment and the related labor. For the operating lease revenue, the depreciation of the garbage processing equipment is also included in the cost of revenue. Our cost of revenues increased to $356,813 for the year ended May 31, 2015 from $354,085 for the year ended May 31, 2014, which represented an increase of 1%. Our cost of revenues primarily consists of fees paid to the related party for licensing the patent, employees' salaries and training expenses for the years ended May 31, 2015 and 2014.
 
Gross Profit
 
Our gross profit increased to $9,636,544 for the fiscal year ended May 31, 2016 from $6,639,287 for the year ended May 31, 2015. However, our gross profit ratio was reduced significantly due to the cost of garbage processing equipment we sold under the sales type leases. The gross profit ratio for the fiscal years ended May 31, 2016, 2015 and 2014 was 43%, 95% and 92%, respectively. For the fiscal years ended May 31, 2015 and 2014, our business stream has resulted in a high gross margin because we have no cost of products sold. Our cost of goods sold is almost entirely direct labor and patent licensing fees, and other operating expenses.
 
Selling and Marketing Expenses 
 
Our selling and marketing expenses increased to $1,229,968 for the year ended May 31, 2016 from $110,492 for the year ended May 31, 2015 which represented an increase of 1,013%. Our selling and marketing expenses were primarily comprised of sales employees' salaries, advertising expenses, training expenses and travelling expenses. The increase was mainly due to the significant increase in advertising expenses. Our advertising expenses increased to $898,018 for the year ended May 31, 2016 from $49,135 for the year ended May 31, 2015. In addition, employees' salaries increased as well. Our selling and marketing expenses increased to $110,492 for the year ended May 31, 2015 from $97,520 for the year ended May 31, 2014 which represented an increase of 13%. 

General and Administrative Expenses
 
Our general and administrative expenses increased to $795,516 for the year ended May 31, 2016 from $416,143 for the year ended May 31, 2015, representing a 91% increase. Our general and administrative expenses increased to $416,143 for the year ended May 31, 2015 from $391,546 for the year ended May 31, 2014, representing a 6% increase. Our general and administrative expenses were primarily comprised of employees' salaries, travelling expenses, entertainment expenses and professional fees such as legal and audit fees. The increase is primarily due to a significant increase of employees' salaries, travelling expenses and entertainment expenses.
28


Interest income
 
Despite our large cash balances, the interest income generated for the year ended May 31, 2016 was nominal for principally two reasons: 1) extremely low bank's current deposit interest rate and 2) minimal fluctuation of the annual interest rates within a 0.30% range; The interest income reported is net after deducting bank service charges. For the year ended May 31, 2016, our bank interest was $49,789. For the year ended May 31, 2016, our interest income also includes interest of $370,724 earned on the sales type leases. For the years ended May 31, 2015 and 2014, our interest income was $75,167 and $62,041, respectively. They were all bank interests.

Provision for Income Taxes
 
Our provision for income taxes increased to $2,038,643 for the year ended May 31, 2016 from $1,575,705 for the year ended May 31, 2015. Our provision for income taxes increased to $1,575,705 for the year ended May 31, 2015 from $982,264 for the year ended May 31, 2014. Our effective tax rate for the years ended May 31, 2016 was approximately the statutory rate of 25%. Our tax filings for the calendar year ended December 31, 2015 were examined by the PRC tax authorities in May 2016. Our prior filings were accepted and no adjustments were proposed. The increase in the provision for income taxes was primarily due to the increase in our pre-tax income.
 
Net Income
 
For the year ended May 31, 2016, 2015 and 2014, we generated net income of $5,992,930, $4,612,114 and $2,946,791, respectively.  This represented an increase in net income of $1,380,816 and $1,665,323, respectively, or 30% and 57%, respectively, from the years ended May 31, 2015 and 2014, respectively. The entrusted management agreements assign to Baichuang Consulting 95% of the income generated from Jiangsu Xuefeng.  For that reason, we reflected a "non-controlling interest" of $299,325, $229,616 and $140,671 for the years ended May 31, 2016, 2015 and 2014, respectively, before recognizing net income attributable to the common stockholders of the Company.  After the "non-controlling interest", our net income attributable to the common stockholders' of the Company for the years ended May 31, 2016, 2015 and 2014 was $5,693,605, $4,382,498 and $2,806,120, respectively, representing $0.10, $0.08 and $0.05 per share, respectively.
 
Foreign Currency Translation Adjustment

Our reporting currency is the U.S. dollar. Our local currency, Renminbi (RMB), is our functional currency. Results of operations and cash flows are translated at average exchange rates during the period, and assets and liabilities are translated at the unified exchange rate as quoted by the People's Bank of China at the end of the period. Equity transactions are recorded at their historical amounts. Translation adjustments resulting from this process are included in accumulated other comprehensive income in the statement of stockholders' equity. Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred. For the years ended May 31, 2016, 2015 and 2014, a foreign currency gain (loss) of $(1,805,473), $165,755 and $25,715, respectively, have been reported as other comprehensive income in the consolidated statements of income and other comprehensive income. The foreign currency loss was mainly due to the devaluation of the Chinese currency by approximately 3.5%.
 
Liquidity and Capital Resources
 
As of May 31, 2016, we had cash and cash equivalents of $5,771,831, primarily consisting of cash on hand and demand deposits. The cash balance was principally derived from cash from operations.

To date, we have financed our operations primarily through cash flows from operations. We believe that our cash on hand and cash flows from operations will meet our present cash needs for the next 12 months.

Operating activities
 
Net cash used in operating activities was $1,247,457 for the fiscal year ended May 31, 2016, as compared with the net cash provided by operating activities of $5,457,579 for the fiscal year ended May 31, 2015. For the fiscal years ended May 31, 2016, the increase in the accounts receivable of $10,079,767, prepaid VAT of $2,286,570 and the increase in security deposit payable of $2,794,865 mainly caused the difference between the net cash used by operating activities and the net income.  For the fiscal year ended May 31, 2015, the net income and the increase in deferred revenue of $309,150 and increase in tax payable of $555,138 principally provided the cash operating activities. Net cash provided by operating activities was $3,399,888 for the fiscal year ended May 31, 2014, the difference between net income and net cash provided by operating activities mainly caused by the increase in deferred income tax of $335,569, increase in deferred revenue of $562,200 and decrease in tax payable of $509,529.
29

 
Investing activities
 
Net cash used in investing activities was $17,533,106 for the fiscal year ended May 31, 2016, as compared with the net cash used in investing activities of $4,002 for the fiscal year ended May 31, 2015. We spent $17,533,106, $4,002 and $16,612 for the fiscal years ended May 31, 2016, 2015 and 2014, respectively, for equipment purchases. The increase for the fiscal year ended May 31, 2016 was principally due to the purchase of garbage processing equipment of approximate $17,830,000 which we are currently leasing under an operating lease. For the fiscal year ended May 31, 2014, we received a refund of deposit for purchase of land use right of $813,500.
 
Financing activities
 
For the fiscal year ended May 31, 2016, we did not have any cash provided or used by any financing activities. For the fiscal year ended May 31, 2015, we received a loan of $149,506 from our shareholder and repaid $24,901 to our shareholder. For the fiscal year ended May 31, 2014, we received a loan of $73,000 from our shareholder.
 
Effect of exchange rate on cash

The negative effect of the exchange rate on cash of $1,820,985 was principally due to the devaluation by the PRC government of their currency. There could be further negative adjustments should the PRC government or the exchange markets further devalue the Chinese currency.




Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition or results of operations.
 
Transfer of Cash
 
All of our revenues are earned by Jiangsu Xuefeng, our PRC controlled consolidated affiliate. PRC regulations restrict the ability to make dividend and other payments to its offshore parent company. PRC legal restrictions permit payments of dividends only out of accumulated after-tax profits, if any, determined in accordance with PRC accounting standards and regulations. Our PRC entities also required under PRC laws and regulations to allocate at least 10% of their annual after-tax profits determined in accordance with PRC GAAP to a statutory general reserve fund until the allocation reaches 50% of its registered capital. The statutory reserve fund can only be used for specific purposes and is not transferable to us in the form of loans, advances or cash dividends. Any limitations on the ability of our entities to transfer funds could materially and adversely limit our ability to grow, make investments or acquisitions that could be beneficial to our business, pay dividends and otherwise fund and conduct our business.

Lotus International Holdings Limited, a Hong Kong corporation and Baichuang Information Consulting (Shenzhen) Co., Ltd, a WFOE, is a bridge to transfer funds inside and outside the PRC. There are three ways for foreign cash to be transferred into Chinese subsidiaries:

(1) Capital funds: At the establishment of the WFOE (Baichuang Consulting), in accordance with the provisions of PRC Foreign-Owned Enterprise Law, funds were injected as capital by Lotus International into the WFOE.

(2) Raised capital - acquisition: if the Company raised sufficient capital, it could transfer the capital to Jiangsu Xuefeng by causing Lotus International (HK company) to apply to the Chinese Ministry of Commerce (MOFCOM) for approval of an acquisition of Jiangsu Xuefeng by Lotus International. MOFCOM would approve such an acquisition only after a lengthy review process, and only if it determined that the price paid by Lotus International for Jiangsu Xuefeng represented a commercially fair price.
30


(3) Raised capital - joint venture: Lotus International could inject the funds into Jiangsu Xuefeng by complying with the provisions of the PRC Sino-Foreign Equity Joint Venture Law. To accomplish this capital transfer, we would be required to apply to the Chinese government for approval to convert Jiangsu Xuefeng into an equity joint venture, in which Lotus International would be its equity joint venture. If approved, Lotus International would then own a portion of the equity in Jiangsu Xuefeng, and the VIE agreements between Jiangsu Xuefeng and Baichuang Consulting (WFOE) would be modified accordingly to reduce the portion of net income payable by Jiangsu Xuefeng to Baichuang Consulting.

We have no current plans for the Company to fund Jiangsu Xuefeng and expect the VIE structure to remain in place for the foreseeable future.

Pursuant to the Exclusive Technical Service and Business Consulting Agreement between Baichuang Consulting (WFOE) and Jiangsu Xuefeng, Baichuang Consulting is to provide technical support and consulting services to Jiangsu Xuefeng in exchange for (i) 95% of the total annual net income of Jiangsu Xuefeng and (ii) RMB100, 000 per month (approximately US$16,000). As a result, there are also two ways to transfer the funds from inside the PRC to outside the PRC: 

 (1) According to the provisions of the Service Fee in Article 3 of the Exclusive Technology Service and Business Consulting Agreement, 95% of the net income of Jiangsu Xuefeng will be paid to Baichuang Consulting as a service fee, and in turn Baichuang Consulting will in compliance with the provisions of PRC Foreign-Owned Enterprise Law, transfer this income to Lotus International for the purpose of profit distribution. 

(2) In addition, Article 3 of the Exclusive Technology Service and Business Consulting Agreement requires that a management fee of approximately $16, 000 U.S. will be paid to Baichuang Consulting each month, and in turn Baichuang Consulting will be in compliance with the provisions of the PRC Foreign-Owned Enterprise Law and transfer this income to Lotus International for the purpose of profit distribution. 

The earnings and cash transfer procedures are all designed to comply with PRC regulations. As a result, there will be no government regulations which will impact our transactions to transfer cash within our corporate structure. However, when the funds are transferred outside the PRC, all transferred amounts will be reported to the national tax bureau to examine whether the local and national taxes have been fully paid by Jiangsu Xuefeng and Baichuang Consulting. In addition, should such cash transfer go to the U.S. parent company, it would be taxable, The Company presently has no plans to transfer cash outside the PRC and intends to indefinitely reinvest such undistributed earnings of its foreign subsidiaries. Accordingly, there is no U.S. provision on these earnings.
 
Recent Accounting Pronouncements

In April 2016, the FASB issued Accounting Standards Update No. 2016-12, Revenue from Contracts with Customers. In May 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers (Topic 606).'' This guidance supersedes current guidance on revenue recognition in Topic 605, "Revenue Recognition.'' In addition, there are disclosure requirements related to the nature, amount, timing, and uncertainty of revenue recognition. In August 2015, the FASB issued ASU No.2015-14 to defer the effective date of ASU No. 2014-09 for all entities by one year. For public business entities that follow U.S. GAAP, the deferral results in the new revenue standard are being effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017, with early adoption permitted for interim and annual periods beginning after December 15, 2016. The Company is currently evaluating the impact of adopting this standard on its consolidated financial statements.

In February 2016, the FASB issued Accounting Standards Update No. 2016-02, Leases. The new standard establishes a right-of-use ("ROU") model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. This accounting standard update is not expected to have a material impact on the Company's financial statements.
31


In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The updated guidance enhances the reporting model for financial instruments, which includes amendments to address aspects of recognition, measurement, presentation and disclosure. The update to the standard is effective for the Company beginning June 1, 2018. The Company is currently evaluating the effect the guidance will have on the Consolidated Financial Statements.

In August 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date. The amendment is effective for all entities for fiscal years and interim periods within those fiscal years, beginning after December 15, 2017. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company is evaluating the impact of this standard on its Consolidated Financial Statements.

In March 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") ASU 2015-03 – Interest – Imputation of Interest (Subtopic 835-30). This ASU addressed the simplification of debt issuance costs presentation by presenting debt issuance costs in the balance sheet as a direct deduction from the carrying amount of debt liability, consistent with debt discounts or premiums. For public business entities, the amendments in this Update are effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. This accounting standard update is not expected to have a material impact on the Company's consolidated financial statements.

In January 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") ASU 2015-01 – Income Statement – Extraordinary and Unusual Items (Subtopic 225-20).  This ASU addressed the simplification of income statement presentation by eliminating the concept of extraordinary items.  The objective of the Simplification Initiative is to identify, evaluate, and improve areas of generally accepted accounting principles (GAAP) for which cost and complexity can be reduced while maintaining or improving the usefulness of the information provided to the users of financial statements.  The amendments in this update are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. A reporting entity may apply the amendments prospectively.  A reporting entity also may apply the amendments retrospectively to all prior periods presented in the financial statements.  Early adoption is permitted provided that the guidance is applied from the beginning of the fiscal year of adoption.  This accounting standard update will not have a material impact on the Company's consolidated financial statements.

In August 2014, the FASB issued authoritative guidance that requires an entity's management to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity's ability to continue as a going concern and requires additional disclosures if certain criteria are met. This guidance is effective for fiscal periods ending after December 15, 2016, with early adoption permitted. This accounting standard update is not expected to have any impact on the Company's financial statements.

Critical Accounting Policies

The Company does not currently have any estimates that it believes could materially affect its financial position or results of operations in the future.
 
The critical accounting policy that could have a material effect on the Company's financial statements is the determination that the Company is the primary beneficiary of Jiangsu Xuefeng, its VIE.  Should this determination change or the VIE agreements become not in compliance or enforceable under PRC law, it could result in the deconsolidation of the VIE.
32


 
Item 7A.  Quantitative and Qualitative Disclosures About Market Risk
 
Interest Rate Risk

Changes in interest rates may affect the interest earned and therefore affect our cash flows and results of operations. However, we do not believe that this interest rate change risk is significant.

Currency Exchange Fluctuations

All of the Company's revenues are denominated in Chinese Renminbi, while its expenses are denominated primarily in Chinese Renminbi ("RMB"). The value of the RMB-to-U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in political and economic conditions. Since 1994, the conversion of Renminbi into foreign currencies, including U.S. dollars, has been based on rates set by the People's Bank of China ("PBOC"), which are set daily based on the previous day's inter-bank foreign exchange market rates and current exchange rates on the world financial markets. Since 1994, the official exchange rate for the conversion of Renminbi to U.S. dollars had generally been stable and the Renminbi had appreciated slightly against the U.S. dollar. However, on July 21, 2005, the Chinese government changed its policy of pegging the value of Chinese Renminbi to the U.S. dollar. Under the new policy, Chinese Renminbi may fluctuate within a narrow and managed band against a basket of certain foreign currencies. Recently there has been increased political pressure on the Chinese government to decouple the Renminbi from the United States dollar. At the recent quarterly regular meeting of PBOC, its Currency Policy Committee affirmed the effects of the reform on Chinese Renminbi exchange rate. Since February 2006, the new currency rate system has been operated; the currency rate of Renminbi has become more flexible while basically maintaining stable and the expectation for a larger appreciation range is shrinking. In August 2015, the PRC government devalued its currency by approximately 3.0%. The Company has never engaged in currency hedging operations and has no present intention to do so.
 
Country Risk

A substantial portion of our assets and operations are located and conducted in PRC. While the PRC economy has experienced significant growth in the past twenty years, growth has been uneven, both geographically and among various sectors of the economy. The Chinese government has implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures benefit the overall economy of China, but may also have a negative effect on us. For example, our operating results and financial condition may be adversely affected by government control over capital investments or changes in tax regulations applicable to us.  If there are any changes in any policies by the Chinese government and our business is negatively affected as a result, then our financial results, including our ability to generate revenue and profits, will also be negatively affected. Economic growth in the PRC has recently begun to slow.
 
Item 8. Financial Statements and Supplementary Data
33

 
CHINA XUEFENG ENVIRONMENTAL ENGINEERING, INC. AND SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED MAY 31, 2016, 2015 AND 2014

CONTENTS
PAGE
 
 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 35
 
 
CONSOLIDATED FINANCIAL STATEMENTS:
 
 
 
Consolidated Balance Sheets
 36
 
 
Consolidated Statements of Income and Comprehensive Income
 37
 
 
Consolidated Statements of Changes in Stockholders' Equity
 39
 
 
Consolidated Statements of Cash Flows
 40
 
 
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 41


34

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 
To the Board of Directors and
Stockholders of China Xuefeng Environmental Engineering, Inc. and Subsidiaries
 
 
We have audited the accompanying consolidated balance sheets of China Xuefeng Environmental Engineering, Inc. and Subsidiaries (the "Company") as of May 31, 2016 and 2015 and the related consolidated statements of income and comprehensive income, changes in stockholders' equity, and cash flows for each of the years in the three year period ended May 31, 2016.  China Xuefeng Environmental Engineering, Inc. and Subsidiaries' management is responsible for these consolidated financial statements.  Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of China Xuefeng Environmental Engineering, Inc. and Subsidiaries as of May 31, 2016 and 2015, and the consolidated results of their operations and their cash flows for each of the years in the three year period ended May 31, 2016, in conformity with accounting principles generally accepted in the United States of America.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), China Xuefeng Environmental Engineering, Inc. and Subsidiaries' internal control over financial reporting as of May 31, 2015 (only) based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated August 25, 2015, expressed an adverse opinion.
 
 
 
/s/ Wei, Wei & Co., LLP
Wei, Wei, & Co., LLP
Flushing, New York
August 30, 2016
35


CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (IN U.S. $)


 
 
   
May 31,
   
May 31,
 
ASSETS
 
2016
   
2015
 
         
Current assets:
       
Cash
 
$
5,771,831
   
$
26,373,379
 
Accounts receivable
   
4,172,406
     
-
 
Prepaid VAT
   
2,286,570
     
-
 
Prepaid expenses
   
88,477
     
98,510
 
                 
Total current assets
   
12,319,284
     
26,471,889
 
                 
Fixed assets, net
   
17,070,774
     
16,118
 
                 
Accounts receivable-non-current
   
5,907,361
     
-
 
                 
Total Assets
 
$
35,297,419
   
$
26,488,007
 
         
Current liabilities:
       
  Accounts payable
 
$
774,668
   
$
-
 
  Deferred revenues
   
2,967,016
     
2,204,550
 
  Taxes payable
   
809,415
     
652,386
 
  Loan from stockholder
   
480,561
     
380,073
 
  Accrued liabilities
   
85,746
     
53,310
 
    Total current liabilities
   
5,117,406
     
3,290,319
 
                 
Security deposits payable
   
2,794,868
     
-
 
                 
TOTAL LIABILITIES
   
7,912,274
     
3,290,319
 
                 
Stockholders' equity:
               
               
  Common stock, $0.001 par value per share,75,000,000 shares authorized; 55,200,000 shares issued and outstanding
   
55,200
     
55,200
 
  Additional paid-in capital
   
11,389,049
     
11,389,049
 
  Statutory reserve fund
   
1,681,564
     
1,077,045
 
  Retained earnings
   
14,390,964
     
9,301,878
 
  Other comprehensive income
   
(1,159,422
)
   
582,259
 
                 
  Stockholders' equity before noncontrolling interests
   
26,357,355
     
22,405,431
 
  Noncontrolling interest
   
1,027,790
     
792,257
 
                 
    Total stockholders' equity
   
27,385,145
     
23,197,688
 
                 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
 
$
35,297,419
   
$
26,488,007
 
 
See accompanying notes to the consolidated financial statements
36


CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)
 
For The Year Ended May 31,
 
 
2016
 
2015
 
2014
 
Revenue:
     
    Sales
 
$
21,287,515
   
$
6,996,100
   
$
4,710,165
 
    Lease income
   
899,579
     
-
     
-
 
                         
Total revenue
   
22,187,094
     
6,996,100
     
4,710,165
 
                         
Cost of goods sold:
                        
Cost of sales
   
12,116,076
     
356,813
     
354,085
 
   Depreciation expense - leased equipment
   
434,474
     
-
     
-
 
                         
Total cost of goods sold
   
12,550,550
     
356,813
     
354,085
 
                         
  Gross profit
   9,636,544
 
 6,639,287
 
 4,356,080
 
                         
Operating expenses:
                       
    Selling and marketing
   
1,229,968
     
110,492
     
97,520
 
    General and administrative
   795,516
 
 416,143
 
 391,546
 
                         
      Total operating expenses
   2,025,484
 
 526,635
 
 489,066
 
 

See accompanying notes to the consolidated financial statements.
37


CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)

   
For The Year Ended May 31,
 
   
2016
   
2015
   
2014
 
             
Income from operations
 
 7,611,060
   
 6,112,652
   
 3,867,014
 
    Interest income
   
420,513
     
75,167
     
62,041
 
                         
Income before provision for income taxes
   
8,031,573
     
6,187,819
     
3,929,055
 
Provision for income taxes
 
 2,038,643
   
 1,575,705
   
 982,264
 
                         
Net income
   
5,992,930
     
4,612,114
     
2,946,791
 
Noncontrolling interest
 
  (299,325)
   
 (229,616)
   
  (140,671)
 
                         
Net income attributable to common stockholders
 
$
5,693,605
   
$
4,382,498
   
$
2,806,120
 
                         
Earnings per common share, basic and diluted
 
$
0.10
   
$
0.08
   
$
0.05
 
                         
Weighted average shares outstanding, basic and diluted
   
55,200,000
     
55,200,000
     
55,200,000
 
                         
Comprehensive Income:
                       
Net Income
 
$
5,992,930
   
$
4,612,114
   
$
2,946,791
 
     Foreign currency translation adjustment
   
(1,805,473
)
   
165,755
     
25,715
 
                         
Comprehensive income
   
4,187,457
     
4,777,869
     
2,972,506
 
     Comprehensive income attributable to noncontrolling interests
   
(235,533
)
   
(234,935
)
   
(141,096
)
                         
Net Comprehensive income attributable to common  stockholders
 
$
3,951,924
   
$
4,542,934
   
$
2,831,410
 


See accompanying notes to the consolidated financial statements.
38


CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014 (IN U.S. $)
 
   
Common
Stock
   
Additional
Paid-in
Capital
   
Retained
Earnings
   
Noncontrolling
Interests
   
Statutory
Reserve
Fund
   
Other
Comprehensive
Income
   
Total
 
                             
Balance, May 31, 2013
 
$
55,200
   
$
11,389,049
   
$
2,880,650
   
$
416,226
   
$
309,655
   
$
396,533
   
$
15,447,313
 
                                                         
   Net income
   
-
     
-
     
2,806,120
     
140,671
     
-
     
-
     
2,946,791
 
                                                         
   Appropriation to statutory reserve
   
-
     
-
     
(294,678
)
   
-
     
294,678
     
-
     
-
 
                                                         
   Foreign currency translation adjustment
   
-
     
-
     
-
     
425
     
-
     
25,290
     
25,715
 
                                                         
Balance, May 31, 2014
   
55,200
     
11,389,049
     
5,392,092
     
557,322
     
604,333
     
421,823
     
18,419,819
 
                                                         
   Net income
   
-
     
-
     
4,382,498
     
229,616
     
-
     
-
     
4,612,114
 
                                                         
   Appropriation to statutory reserve
   
-
     
-
     
(472,712
)
   
-
     
472,712
     
-
     
-
 
                                                         
   Foreign currency translation adjustment
   
-
     
-
     
-
     
5,319
     
-
     
160,436
     
165,755
 
Balance, May 31, 2015
 
$
55,200
   
$
11,389,049
   
$
9,301,878
   
$
792,257
   
$
1,077,045
   
$
582,259
   
$
23,197,688
 
   Net income
   
-
     
-
     
5,693,605
     
299,325
     
-
     
-
     
5,992,930
 
                                                         
   Appropriation to statutory reserve
   
-
     
-
     
(604,519
)
   
-
     
604,519
     
-
     
-
 
                                                         
    Foreign currency translation adjustment
   
-
     
-
     
-
     
(63,792
)
   
-
     
(1,741,681
)
   
(1,805,473
)
 
Balance, May 31, 2016
 
$
55,200
   
$
11,389,049
   
$
14,390,964
   
$
1,027,790
   
$
1,681,564
   
$
(1,159,422
)
 
$
27,385,145
 

 
See accompanying notes to the consolidated financial statements.
39

 
CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)

      
For the Year Ended May 31,
 
   
2016
   
2015
   
2014
 
             
 Cash flows from operating activities:                        
 Net income
 
$
5,992,930
   
$
4,612,114
   
$
2,946,791
 
Adjustments to reconcile net income to net cash provided by operating activities:
                       
  Depreciation
   
478,450
     
11,633
     
14,922
 
  Deferred income taxes
   
-
     
-
     
335,569
 
      Changes in operating assets and liabilities:
                       
        (Increase) in accounts receivable
   
(10,079,767
)
   
-
     
-
 
        (Increase) in prepaid VAT
   
(2,286,570
)
   
-
     
-
 
        Decrease (increase) in prepaid expenses
   
10,033
     
(775
)
   
(239
)
        Increase in accounts payable
   
774,668
     
-
     
-
 
        Increase in deferred revenue
   
762,466
     
309,150
     
562,200
 
        Increase in security deposit payable
   
2,794,868
     
-
     
-
 
        Increase (decrease) in taxes payable
   
157,029
     
555,138
     
(509,529
)
        Increase (decrease) in accrued liabilities
   
148,436
     
(29,681
)
   
50,174
 
                         
              Net cash (used in) provided by operating activities
   
(1,247,457
)
   
5,457,579
     
3,399,888
 
                         
Cash flows from investing activities:
                       
Refund of deposit for purchase of land use right
   
-
     
-
     
813,500
 
Purchase of equipment
   
(17,533,106
)
   
(4,002
)
   
(16,612
)
                         
 Net cash (used in) provided by investing activities
   
(17,533,106
)
   
(4,002
)
   
796,888
 
                         
Cash flows from financing activities:
                       
Repayment of stockholder loan
   
-
     
(24,901
)
   
-
 
Proceeds from stockholder loan
   
-
     
149,506
     
73,000
 
                         
              Net cash provided by financing activities
   
-
     
124,605
     
73,000
 
Effect of exchange rate changes on cash
   
(1,820,985
)
   
165,593
     
17,842
 
                         
Net increase in cash
   
(20,601,548
)
   
5,743,775
     
4,287,618
 
Cash, beginning
   
26,373,379
     
20,629,604
     
16,341,986
 
                         
Cash, end
 
$
5,771,831
   
$
26,373,379
   
$
20,629,604
 
Supplemental disclosure of cash flow information
 
Cash paid during the year for:
                       
Interest
 
$
-
   
$
-
   
$
-
 
Income taxes
 
$
1,836,226
   
$
1,029,753
   
$
1,163,119
 
 
Noncash financing activities
 
Payment of accrued liabilities by shareholder in the form of loan
 
$
100,488
   
$
120,000
   
$
-
 

See accompanying notes to the consolidated financial statements.
40

 
CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)

NOTE 1.   ORGANIZATION
China Xuefeng Environmental Engineering Inc. (the "Company"), formerly known as NYC Moda Inc., was incorporated under the laws of the State of Nevada on March 30, 2011.  Since its inception until the closing of the Exchange Agreement, the Company was a development-stage company.
On November 27, 2012, the Company completed a reverse acquisition transaction through a share exchange with the stockholders of Inclusion Business Limited ("Inclusion"), whereby the Company acquired 100% of the outstanding shares of Inclusion in exchange for 7,895,000 shares of its common stock, representing 76.65% of the issued and outstanding shares of common stock.  As a result of the reverse acquisition, Inclusion became the Company's wholly-owned subsidiary and the former Inclusion Stockholders became our controlling stockholders.  The share exchange transaction was treated as a reverse acquisition, with Inclusion as the acquirer and the Company as the acquired party for accounting purposes.
In November, 2012, the Company filed a certificate of amendment to its articles of incorporation to change its name from "NYC Moda, Inc." to "China Xuefeng Environmental Engineering Inc." (the "Name Change") and to initiate a 4-for-1 forward stock split (the "Forward Split") of its outstanding shares of common stock. The Name Change and the Forward Split were effective in December, 2012. Upon the effectiveness of the Forward Split, the number of outstanding shares of the Company's common stock increased from 10,300,000 to 41,200,000 shares. In March, 2013, the Company sold 14,000,000 shares of common stock to 12 unrelated individuals in a private offering, generating $7,000,000 in net proceeds.
As a result of the transaction with Inclusion, the Company owns all of the issued and outstanding common stock of Lotus International Holdings Limited ("Lotus"), a wholly-owned subsidiary of Inclusion, which in turn owns all of the issued and outstanding capital stock of Baichuang Information Consulting (Shenzhen) Co. Ltd ("Baichuang Consulting"). In addition, the Company effectively and substantially controls Jiangsu Xuefeng Environmental Protection Science and Technology Co., Ltd. ("Jiangsu Xuefeng") through a series of captive agreements with Baichuang Consulting.
The Company conducts its operations through its controlled consolidated variable interest entity ("VIE"), Jiangsu Xuefeng.  Jiangsu Xuefeng, incorporated under the laws of the People's Republic of China ("PRC") in December, 2007, is primarily engaged in the sale, lease and installation of garbage recycling equipment and provides improvement and upgrading services of garbage recycling processing technology and equipment. 
In October, 2012, Baichuang Consulting (the "WFOE"), a wholly-owned subsidiary of Lotus, entered into a series of contractual arrangements (the "VIE Agreements"). The VIE Agreements include (i) an Exclusive Technical Service and Business Consulting Agreement; (ii) a Proxy Agreement, (iii) Share Pledge Agreement and, (iv) Call Option Agreement with the stockholders of Jiangsu Xuefeng.
41

 
CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)

NOTE 1.   ORGANIZATION (CONTINUED)
Exclusive Technical Service and Business Consulting Agreement: Pursuant to the Exclusive Technical Service and Business Consulting Agreement, the WFOE provides technical support, consulting, training, marketing and operational consulting services to Jiangsu Xuefeng. In consideration for such services, Jiangsu Xuefeng has agreed to pay an annual service fee to the WFOE of 95% of Jiangsu Xuefeng's annual net income and an additional payment of approximately US$15,910 (RMB 100,000) each month. The Agreement has an unlimited term and only can be terminated upon written notice agreed to by both parties.
Proxy Agreement: Pursuant to the Proxy Agreement, the stockholders of Jiangsu Xuefeng agreed to irrevocably entrust the WFOE to designate a qualified person acceptable under PRC law and foreign investment policies, all of the equity interests in Jiangsu Xuefeng held by the stockholders of Jiangsu Xuefeng. The Agreement has an unlimited term and only can be terminated upon written notice agreed to by both parties.
Call Option Agreement: Pursuant to the Call Option agreement, the WFOE has an exclusive option to purchase, or to designate a purchaser, to the extent permitted by PRC law and foreign investment policies, part or all of the equity interests in Jiangsu Xuefeng held by each of the stockholders. To the extent permitted by PRC laws, the purchase price for the entire equity interest is approximately US$0.16 (RMB1.00) or the minimum amount required by PRC law or government practice. This Agreement remains effective until all the call options under the Agreement have been exercised by Baichuang Consulting or its designated entities or natural persons.
Share Pledge Agreement: Pursuant to the Share Pledge agreement, each of the stockholders pledged their shares in Jiangsu Xuefeng to the WFOE, to secure their obligations under the Exclusive Technical Service and Business Consulting Agreement. In addition, the stockholders of Jiangsu Xuefeng agreed not to transfer, sell, pledge, dispose of or create any encumbrance on their interests in Jiangsu Xuefeng that would affect the WFOE's interests. This Agreement remains effective until the obligations under the Exclusive Technical Service and Business Consulting Agreement, Call Option Agreement and Proxy Agreement have been fulfilled or terminated.
As a result of the entry into the foregoing agreements, the Company has a corporate structure which is set forth as follows:

42

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)

NOTE 1.   ORGANIZATION (CONTINUED)


NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF ACCOUNTING AND PRESENTATION
The accompanying consolidated financial statements have been prepared on the accrual basis of accounting.  The consolidated financial statements for the years ended May 31, 2016, 2015 and 2014 include China Xuefeng Environmental Engineering Inc., and its wholly owned subsidiaries, Inclusion, Lotus and Baichuang Consulting and its VIE, Jiangsu Xuefeng.  All significant intercompany accounts and transactions have been eliminated in consolidation when applicable.
All consolidated financial statements and notes to the consolidated financial statements are presented in United States dollars ("US Dollar" or "US$" or "$").

43

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)


 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
VARIABLE INTEREST ENTITY
Pursuant to Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 810, "Consolidation" ("ASC 810"), the Company is required to include in its consolidated financial statements, the financial statements of its variable interest entities ("VIEs").  ASC 810 requires a VIE to be consolidated by a company if that company is subject to a majority of the risk of loss for the VIE or is entitled to receive a majority of the VIE's residual returns.  VIEs are those entities in which a company, through contractual arrangements, bears the risk of, and enjoys the rewards normally associated with ownership of the entity, and therefore the company is the primary beneficiary of the entity.
Under ASC 810, a reporting entity has a controlling financial interest in a VIE, and must consolidate that VIE, if the reporting entity has both of the following characteristics: (a) the power to direct the activities of the VIE that most significantly affect the VIE's economic performance; and (b) the obligation to absorb losses, or the right to receive benefits, that could potentially be significant to the VIE.  The reporting entity's determination of whether it has this power is not affected by the existence of kick-out rights or participating rights, unless a single enterprise, including its related parties and de facto agents, have the unilateral ability to exercise those rights.  Jiangsu Xuefeng's actual stockholders do not hold any kick-out rights that affect the consolidation determination.
Through the VIE agreements disclosed in Note 1, the Company is deemed the primary beneficiary of Jiangsu Xuefeng. Accordingly, the results of Jiangsu Xuefeng have been included in the accompanying consolidated financial statements. Jiangsu Xuefeng has no assets that are collateral for or restricted solely to settle their obligations. The creditors of Jiangsu Xuefeng do not have recourse to the Company's general credit.
44

 
CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

VARIABLE INTEREST ENTITY (CONTINUED)

The following financial statement amounts and balances of Jiangsu Xuefeng have been included in the accompanying consolidated financial statements.

 
ASSETS
 
May 31,
2016
   
May 31,
2015
 
         
Current assets:
       
 Cash
 
$
5,587,133
   
$
26,166,628
 
 Account receivable
   
4,172,406
     
-
 
 Prepaid VAT
   
2,286,570
     
-
 
 Prepaid expenses
   
87,492
     
97,526
 
                 
  Total current assets
   
12,133,601
     
26,264,154
 
                 
Fixed assets, net
   
17,070,774
     
16,118
 
                 
Account receivable-noncurrent
   
5,907,361
     
-
 
                 
TOTAL ASSETS
 
$
35,111,736
   
$
26,280,272
 
                 
LIABILITIES                
                 
Current liabilities:
               
 Due to China Xuefeng Environmental Engineering, Inc. (1)
 
$
6,609,043
   
$
7,105,281
 
 Payable to WFOE (2)
   
13,958,489
     
9,418,509
 
 Accounts payable
   
774,665
     
-
 
 Deferred revenue
   
2,967,016
     
2,204,550
 
 Taxes payable
   
635,027
     
516,371
 
 Loan from stockholder
   
276,888
     
297,678
 
 Accrued liabilities
   
42,746
     
17,310
 
                 
  Total current liabilities
   
25,263,874
     
19,559,699
 
                 
Deposit payable-noncurrent
   
2,794,868
     
-
 
                 
TOTAL LIABILITIES
 
$
28,058,742
   
$
19,559,699
 


45

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)


NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

VARIABLE INTEREST ENTITY (CONTINUED)

(1)
Due to China Xuefeng Environmental Engineering, Inc. is for the proceeds from the sale of common stock which proceeds were received by Jiangsu Xuefeng for 14,000,000 common shares issued by China Xuefeng Environmntal Engineering, Inc. on March 19, 2013 at $0.50 each (approximately US$7,000,000).

(2)
Payable to WFOE represents outstanding amounts due to Baichuang Information Consulting (Shenzhen) Co. Ltd. under the Exclusive Technical Service and Business Consulting Agreement for consulting services provided to Jiangsu Xuefeng in exchange for 95% of Jiangsu Xuefeng's net income and additional monthly payments of RMB 100,000 (approximately US$15,630).  During the years ended May 31, 2016 and 2015, Jiangsu Xuefeng did not make any payment to the WOFE.
 
   
For The Year Ended May 31,
 
   
2016
   
2015
   
2014
 
             
Revenue
 
$
22,187,094
   
$
6,996,100
   
$
4,710,165
 
                         
Net income (3)
 
$
5,986,495
   
$
4,592,321
   
$
2,813,421
 


(3)
Under the Exclusive Technical Service and Business Consulting Agreement, 95% of the net income is to be remitted to the WFOE, which is not reflected above.

46

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)
 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

VARIABLE INTEREST ENTITY (CONTINUED)

   
For The Year Ended May 31,
 
   
2016
   
2015
   
2014
 
             
Net cash (used in) provided by operating activities
 
$
(1,852,171
)
 
$
5,602,927
   
$
3,333,595
 
Net cash (used in) provided by investing activities
   
(17,533,106
)
   
(4,002
)
   
796,888
 
Net cash provided by financing activities
   
-
     
70,506
     
73,000
 
Effect of exchange rate changes on cash
   
(1,194,218
)
   
106,219
     
753
 
                         
Net (decrease) increase in cash
 
$
(20,579,495
)
 
$
5,775,650
   
$
4,204,236
 

The Company believes that Baichuang Consulting's contractual agreements with Jiangsu Xuefeng are in compliance with PRC law and are legally enforceable.  The stockholders of Jiangsu Xuefeng are also the senior management of the Company and therefore the Company believes that they have no current interest in seeking to act contrary to the contractual arrangements.  However, Jiangsu Xuefeng and its stockholders may fail to take certain actions required for the Company's business or to follow the Company's instructions despite their contractual obligations to do so.  Furthermore, if Jiangsu Xuefeng or its stockholders do not act in the best interests of the Company under the contractual arrangements and any dispute relating to these contractual arrangements remains unresolved, the Company will have to enforce its rights under these contractual arrangements through PRC law and courts and therefore will be subject to uncertainties in the PRC legal system.  All of these contractual arrangements are governed by PRC law and provide for the resolution of disputes through arbitration in the PRC.  Accordingly, these contracts would be interpreted in accordance with PRC law and any disputes would be resolved in accordance with PRC legal procedures.  As a result, uncertainties in the PRC legal system could limit the Company's ability to enforce these contractual arrangements, which may make it difficult to exert effective control over Jiangsu Xuefeng, and its ability to conduct the Company's business may be adversely affected.

USE OF ESTIMATES

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect certain reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods.  Actual results could differ from those estimates.

47

 
CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

FOREIGN CURRENCY TRANSLATION

Almost all Company assets are located in the PRC.  The functional currency for the majority of the Company's operations is the Renminbi ("RMB").  The Company uses the United States dollar ("US Dollar" or "US$" or "$") for financial reporting purposes.  The financial statements of the Company have been translated into US dollars in accordance with FASB ASC 830, "Foreign Currency Matters."
All asset and liability accounts have been translated using the exchange rate in effect at the balance sheet date.  Equity accounts have been translated at their historical exchange rates when the capital transactions occurred.  Statements of income amounts have been translated using the average exchange rate for the periods presented.  Adjustments resulting from the translation of the Company's financial statements are recorded as other comprehensive income (loss).
The exchange rates used to translate amounts in RMB into US dollars for the purposes of preparing the financial statements are as follows:

   
May 31,
2016
   
May 31,
2015
   
May 31,
2014
 
             
Balance sheet items, except for stockholders' equity, as of year end
   
0.1519
     
0.1633
     
0.1620
 
                         
Amounts included in the statements of income, statements of changes in stockholders' equity and statements of cash flows
   
0.1563
     
0.1627
     
0.1627
 


For the years ended May 31, 2016, 2015 and 2014, foreign currency translation adjustments of $(1,805,473), $165,755 and $25,715, respectively, have been reported as other comprehensive income.  Other comprehensive income of the Company consists entirely of foreign currency translation adjustments.  Pursuant to ASC 740-30-25-17, "Exceptions to Comprehensive Recognition of Deferred Income Taxes," the Company does not recognize deferred U.S. taxes related to the undistributed earnings of its foreign subsidiaries and, accordingly, recognizes no income tax expense or benefit from foreign currency translation adjustments.
Although government regulations now allow convertibility of the RMB for current account transactions, significant restrictions still remain.  Hence, such translations should not be construed as representations that the RMB could be converted into US dollars at that rate or any other rate.
The value of the RMB against the US dollar and other currencies may fluctuate and is affected by, among other things, changes in the PRC's political and economic conditions.  Any significant revaluation of the RMB may materially affect the Company's financial condition in terms of US dollar reporting. The PRC government in August 2015 devalued the RMB by approximately 3.5%.
48

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)
 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

REVENUE RECOGNITION

Revenues are primarily derived from selling and leasing garbage processing equipment, providing garbage recycling processing system technology support, renovation and upgrade services and patent licensing to customers.  The Company's revenue recognition policies comply with FASB ASC 605 "Revenue Recognition."  In general, the Company recognizes revenue when there is persuasive evidence of an arrangement, the fee is fixed or determinable, the products or services have been delivered or performed and collectability of the resulting receivable is reasonably assured.
Improvement and upgrading service is a one-time service provided to upgrade customer's existing equipment before they opt to license and use our patented technology. The fee for the service would be paid within thirty (30) days upon execution of the contract.
Inspection would be conducted by the customers according to industry standards within three days upon completion of the improvement and upgrading service. Performance testing would then be conducted on the upgraded equipment, which typically can be done within a month. A final inspection assessment report would be provided to the customers within five days upon completion of the testing and Customers would provide the Company with a signed acceptance form if they are satisfied. The Company will recognize the revenue for the improvement and upgrading service once the performance testing is passed and the final evaluation report is provided by the customer.
Patent licensing is limited to five (5) years with payments due annually in advance and recognized as revenue monthly. We are responsible to provide repairing service when necessary, but customers would bear any out of pocket expense relating to the repairing service.
We believe that lease receivables have four potential risks: operation risk, credit risk, accident risk and natural disasters risk.
First, there is no guarantee that the licensee of our patent will have sufficient capital resources to perform the licensing agreement and pay the licensing fee on time or at all. The length of the agreement is up to five (5) years and therefore the Company may not able to collect fees for the entire agreement. Second, there is a potential credit risk for which the licensee may unilaterally terminate the agreement and thus affect the payout of the licensing agreement. Third, accident involving the equipment caused by employees of the licensee may have material adverse effect on the operation of the licensee. This unforeseeable risk could impact the licensee's ability to perform throughout the length of the agreement. Lastly, unforeseeable natural disasters could have a material adverse effect on the production and operation of the Company's licensees. If their operation is impacted by events such as fire, flood or earthquakes, they may need to cease their operation and therefore may be unable to perform their obligations under the agreement.
49

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)
 

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

REVENUE RECOGNITION (CONTINUED)

Sales-Type Leases

The Company entered into three sales-type lease arrangements during the quarter ended August 31, 2015, with two customers for financing of their purchase of garbage processing equipment.  The arrangements with the customers have a fixed term of three years. Revenue from the sale of the equipment is recognized at the inception of the lease. The payments have been present valued with an annual interest rate of 5.25%. In connection with these arrangements, the Company recognized revenue of $14,300,324 for the year ended May 31, 2016. Future minimum collections (principal and interest) for the years ending May 31 are as follows:

Year Ending
   
May 31,
 
Amount
 
     
2017
 
$
4,169,759
 
2018
   
4,393,019
 
2019
   
1,514,342
 
         
   
$
10,077,120
 

50


CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)
 

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

REVENUE RECOGNITION (CONTINUED)

Operating Leases

The Company entered into three operating lease arrangements with two customers for garbage processing equipment on April 25, 2016, December 28, 2015 and November 6, 2015, respectively. The arrangement with the customer has a fixed term of five years with quarterly payments of $187,576, $375,151 and $156,313, respectively. Revenue from the leasing of the equipment is recognized monthly. In addition, the lease required a security deposit on $729,096, $1,458,192 and $607,580, respectively. At the end of the five years lease term, it will be determined whether the lease will be extended, leased to a new customer or returned to the Company. Future minimum payments for the years ending May 31 are as follows:
 
Year Ending
   
May 31,
 
Amount
 
     
2017
 
$
2,876,159
 
2018
   
2,876,159
 
2019
   
2,876,159
 
2020
   
2,876,159
 
2021
   
1,823,652
 
         
   
$
13,328,288
 

51

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

REVENUE RECOGNITION (CONTINUED)

Multiple-Element Arrangements

In October 2009, the FASB issued Accounting Standards Update ("ASU") No. 2009-13, "Multiple Deliverable Revenue Arrangements." ASU No. 2009-13 amended the guidance on arrangements with multiple deliverables under ASC 605-25, "Revenue Recognition—Multiple-Element Arrangements."  To qualify as a separate unit of accounting under ASC 605-25, the delivered item must have value to the customer on a standalone basis.  The significant deliverables under the Company's multiple-element arrangements are improvement and upgrade services and patent licensing.
Improvement and Upgrade Service
The improvement and upgrade service is a one-time service. By the end of improvement and upgrading services, there is persuasive evidence of an arrangement exists since company has a signed contract with a customer; delivery has occurred and a customer has completed inspection and accepted the improvement and upgrading services then delivered; the fee is fixed and become due within 30 days upon the signing of the contract; and collectability is probable. An inspection is conducted by the customer according to industry standards within three days of the completion of the improvement and upgrade.  An acceptance form is provided by the customer if the inspection is satisfactory.  Performance testing is conducted on the upgraded equipment within one month. A final evaluation report is provided within five days of the completion of the performance testing.  The fee for improvement and upgrade services is fixed and becomes due within 30 days, upon the signing of the contract.  The fees for the improvement and upgrading services are not subject to refund, forfeiture or any other concession if patent licensing is not completed.
The Company has met the agreed upon specifications and has not been required to make any refunds for its services.  No warranty is provided by the Company.
The customer is responsible for repair services when necessary.  The out of pocket expenses for the repair services will be charged separately to the customer by the Company.

52

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)
 

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

REVENUE RECOGNITION (CONTINUED)

Multiple-Element Arrangements (Continued)

Patent Licensing
Patent licensing is limited to 5 years with payments due annually in advance.  The patent technology of "harmless and comprehensive garbage processing equipment" provided by the Company to its customers has high garbage processing capacity and stable operation capacity.  It is the first modern system equipment in China to use DCS (Distributed Control System) centralized control, by which mechanical automation will be realized for the comprehensive treatment of life garbage.  Its core technology is to organically integrate the anaerobic digestion and aerobic fermentation garbage process, degrade and transform the organic matter of domestic waste, effectively sort out the garbage and recycle all kinds of materials, to eventually realize the true waste resource utilization and harmless utilization, with a utilization rate approaching 100%.  The resource recovery products, biogas, not only can be used for meeting the needs of the plant itself, but also can be sold as a separate product, which greatly improves the efficiency of garbage processing of the customer's equipment, decreases production cost, and increases the recovery return of garbage processing.
The Company's customer who pays for an upgrade and improvement fee is not required to enter into a licensing agreement to continue to use the patented technology.  If the customer does not require the garbage processing equipment to reach the level of the patented technology which can process 500 tons to 1,000 tons of garbage per day, then the customer does not need to enter into the patent licensing agreement.
Multiple Elements
The Company determined that its improvement and upgrade services are individually a separate unit of accounting.  In determining whether the improvement and upgrade services has standalone value, the Company considered factors including the availability of similar services from other vendors, its fee structure based on inclusion and exclusion of the service, and its marketing and delivery of the services.  The Company uses the vendor-specific objective evidence to determine the selling price for its improvement and upgrade services when sold in multiple-element arrangements.  Although not yet being sold separately, the price established by the management has the relevant authority.
The Company also determined that the patent licensing has standalone value because the patent can be licensed separately. The Company uses the vendor-specific objective evidence to determine the price for patent licensing when sold in multiple-element arrangements.  Although not yet being licensed separately, the price established by the management has the relevant authority.  The Company establishes the price of  upgrading and improvement service and the price of patent licensing is determined based on the following method:

53

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)
 

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

REVENUE RECOGNITION (CONTINUED)

Multiple-Element Arrangements

Multiple Elements(continued)
Since equipment improvement and upgrade service and patent leasing service are derived from the Company's patented technology, which the Company has the exclusive right to while others must obtain licensing rights to use the technology, the Company have a strong bargaining power in the market to undertake the promotion of its brand and corporate image. Furthermore, the Company uses a profit cost pricing method to determine the price of its product. The Company calculates the price by adding its target profit, or a 90% gross profit margin, to the base product cost to derive the final sale price of its services.
The Company allocates the arrangement consideration based on their relative selling prices.  Revenues for the improvement and upgrade services are recognized when completed, the performance testing is passed and the final evaluation report is provided by the customer, which generally is within 30 days, assuming all other revenue recognition criteria are met.  Revenues for patent licensing are recognized monthly over the licensing period.
The Company believes the effect of changes in the selling price for improvement and upgrade services and patent licensing will not have significant effect on the allocation of the arrangement.

FAIR VALUE OF FINANCIAL INSTRUMENTS
FASB ASC 820, "Fair Value Measurement," defines fair value as the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date and in the principal or most advantageous market for that asset or liability.  The fair value should be calculated based on assumptions that market participants would use in pricing the asset or liability, not on assumptions specific to the entity.


54

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)
 

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)
Level 1 Inputs – Unadjusted quoted market prices for identical assets and liabilities in an active market that the Company has the ability to access.
Level 2 Inputs – Inputs other than the quoted prices in active markets that are observable either directly or indirectly.
Level 3 Inputs – Inputs based on prices or valuation techniques that are both unobservable andsignificant to the overall fair value measurements.
ASC 820 requires the use of observable market data, when available, in making fair value measurements.  When inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement.  Valuation techniques used need to maximize the use of observable inputs and minimize the use of unobservable inputs.  As of March 31, 2016 and 2015, none of the Company's assets and liabilities were required to be reported at fair value on a recurring basis.  Carrying values of non-derivative financial instruments, including cash, accounts receivable, inventory, advances to suppliers, accounts payable and accrued expenses, and advances from customers approximate their fair values due to the short term nature of these financial instruments.  There were no changes in methods or assumptions during the periods presented.

CASH AND CASH EQUIVALENTS
The Company considers all demand and time deposits and all highly liquid investments with an original maturity of three months or less to be cash equivalents.

FIXED ASSETS
Fixed assets are recorded at cost, less accumulated depreciation.  Cost includes the price paid to acquire the asset, and any expenditures that substantially increase the asset's value or extends the useful life of an existing asset.  Depreciation is computed using the straight-line method over the estimated useful lives of the assets.  Major repairs and betterments that significantly extend the original useful life or improve productivity are capitalized and depreciated over the periods benefited.  Maintenance and repairs are generally expensed as incurred.  The estimated useful lives for fixed asset categories are as follows:
Computers and equipment
3 years
Motor vehicles
4 years
Furniture and fixtures
5 years
Investment in leased property
15 years

55

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)
 


NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

IMPAIRMENT OF LONG-LIVED ASSETS

The Company applies FASB ASC 360, "Property, Plant and Equipment," which addresses the financial accounting and reporting for the recognition and measurement of impairment losses for long-lived assets.  In accordance with ASC 360, long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.  The Company may recognize the impairment of long-lived assets in the event the net book value of such assets exceeds the future undiscounted cash flows attributable to those assets.  No impairment of long-lived assets was recognized for the periods presented.

DEFERRED REVENUE

Deferred revenue is advance payments received for patent licensing fees. These payments received, but not yet earned, are recognized as deferred revenue in the consolidated balance sheets.

INCOME TAXES
The Company accounts for income taxes in accordance with FASB ASC 740, "Income Taxes" ("ASC 740"), which requires the recognition of deferred income taxes for differences between the basis of assets and liabilities for financial statement and income tax purposes.  Deferred tax assets and liabilities represent the future tax consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled.  At May 31, 2016, 2015 and 2014, the differences relate entirely to revenue deferred for financial statement purposes.  During the year ended May 31, 2015, as permitted by the PRC tax law, the Company began recognizing revenue from patent licensing fees for income tax purposes, based on when it is earned rather than when it is collected, consistent with the financial statement recognition.  As a result, there are no differences between the basis of assets and liabilities for financial statements and income tax purposes for deferred revenue and, as a result, deferred income taxes are no longer required to be recognized.  A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized.
ASC 740 addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements.  Under ASC 740, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position.  The tax benefits recognized in the financial statements from such a position would be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement.  ASC 740 also provides guidance on de-recognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, and accounting for interest and penalties associated with tax positions.  As of May 31, 2016, 2015 and 2014, the Company does not have a liability for any unrecognized tax benefits.
The income tax laws of various jurisdictions in which the Company, its subsidiaries and the VIE operate are summarized as follows:
56

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)
 


NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

INCOME TAXES (CONTINUED)

United States

The Company is subject to United States tax at graduated rates from 15% to 34%.  No provision for income taxes in the United States has been made as the Company had no U.S. taxable income for the years ended May 31, 2016, 2015 and 2014.

PRC

Jiangsu Xuefeng and Baichuang Consulting are subject to an Enterprise Income Tax at 25% and file their own tax returns.  Consolidated tax returns are not permitted in China.

BVI

Inclusion is incorporated in the BVI and is governed by their income tax laws.  According to current BVI income tax law, the applicable income tax rate for the Company is 0%.

Hong Kong

Lotus is incorporated in Hong Kong.  Pursuant to the income tax laws of Hong Kong, the Company is not subject to tax on non-Hong Kong source income.

ADVERTISING COSTS
Advertising costs are charged to operations when incurred.  For the years ended May 31, 2016, 2015 and 2014, advertising expense was $897,944, $49,135 and $35,794, respectively.
STATUTORY RESERVE FUND
Pursuant to corporate law in the PRC, the Company is required to transfer 10% of its net income, as determined under PRC accounting rules and regulations, to a statutory reserve fund until such reserve balance reaches 50% of the Company's registered capital.  The statutory reserve fund is non-distributable other than during liquidation and can be used to fund previous years' losses, if any, and may be utilized for business expansion or used to increase registered capital, provided that the remaining reserve balance after such use is not less than 25% of the registered capital.  For the years ended May 31, 2016, 2015 and 2014, a statutory reserve of $604,519, $472,712 and $294,678, respectively, was required to be allocated to the Company.

57

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2016, 2015 AND 2014
(IN U.S. $)

NOTE 3.   RECENTLY ISSUED ACCOUNTING STANDARDS

In April 2016, the FASB issued Accounting Standards Update No. 2016-12, Revenue from Contracts with Customers. In May 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers (Topic 606).'' This guidance supersedes current guidance on revenue recognition in Topic 605, "Revenue Recognition.'' In addition, there are disclosure requirements related to the nature, amount, timing, and uncertainty of revenue recognition. In August 2015, the FASB issued ASU No.2015-14 to defer the effective date of ASU No. 2014-09 for all entities by one year. For public business entities that follow U.S. GAAP, the deferral results in the new revenue standard are being effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017, with early adoption permitted for interim and annual periods beginning after December 15, 2016. The Company is currently evaluating the impact of adopting this standard on its consolidated financial statements.
In February 2016, the FASB issued Accounting Standards Update No. 2016-02, Leases. The new standard establishes a right-of-use ("ROU") model that requires a lessee to record an ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. This accounting standard update is not expected to have a material impact on the Company's financial statements.
In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The updated guidance enhances the reporting model for financial instruments, which includes amendments to address aspects of recognition, measurement, presentation and disclosure. The update to the standard is effective for the Company beginning June 1, 2018. The Company is currently evaluating the effect the guidance will have on the Consolidated Financial Statements.
InAugust 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date. The amendment is effective for all entities for fiscal years and interim periods within those fiscal years, beginning after December 15, 2017. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company is evaluating the impact of this standard on its Consolidated Financial Statements.
In March 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") ASU 2015-03 – Interest – Imputation of Interest (Subtopic 835-30). This ASU addressed the simplification of debt issuance costs presentation by presenting debt issuance costs in the balance sheet as a direct deduction from the carrying amount of debt liability, consistent with debt discounts or premiums. For public business entities, the