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China’s multi-year ballooning foreign trade surplus has caused the Chinese government on 19 June 2007 to announce major downward adjustments to export VAT refund rates. This means that profits of exporters in many industries will fall significantly.
The announcement makes clear that the reductions of refund rates, and even the complete elimination of the export VAT refund in some cases, will apply to a broad range of products. These will include not only products that are socially or environmentally harmful (e.g. pollution-inducing, high energy or natural resource-consuming) and products from low value-added industries (e.g. clothing and shoes), but also for some strong export products. The changes come into force on 1 July 2007.
Background
On 19 June 2007, the Ministry of Finance and the State Administration of Taxation jointly issued a circular that may seriously increase the tax burden on many exporters. This circular, “Notice Regarding the Adjustment in Export Reform Rate for Certain Commodities” (Caishui [2007] No. 90, hereinafter referred to as “Notice”) imposes from 1 July 2007 new lower VAT refund rates for a broad range of commodities. The Notice was issued after consultation with the National Development and Reform Commission, the Ministry of Commerce as well as the General Administration of Customs.
The wide breadth of these refund rate reductions is demonstrated by the fact that they cover 2,831 specific commodities, which represent 37% of the total harmonized tariff codes. This major adjustment, which follows previous adjustments in 2006 and earlier this year, reflects the Government's continuing use of VAT export refund measures as an important tool in implementing governmental policies. This new Notice differs from the earlier adjustments both in the size of the refund rate reductions, and in the inclusion of a large number of low value products and controversial goods that tend to stir international trade disputes. Similar to the earlier adjustments, high polluting and high energy and natural resource consuming goods have been singled out for harsh treatment.
Similar, but more moderate, rebate policy adjustments were implemented in September 2006 and April 2007. These adjustments lowered the VAT export refund rates for certain products and also widened the scope of goods prohibited from the benefits of the “processing trade” arrangement. The principal goal of these adjustments was restricting the growth of industries generating adverse environmental effects. As such, high polluting and high energy and scarce natural resource consuming goods were primarily affected. Considering the still ballooning trade surplus, it is evident that these policy adjustments did not substantially affect China's export growth.
According to statistics from China’s Customs service, the country's total exports during the period from January and May of 2007 increased by 27.8% over last year, reaching USD443.5 billion. The aggregate trade surplus reached USD85.7 billion, having increased 83.1% for the same period of 2006 (see statistics for these and other years in the chart below). With historical trends indicating that exports peak during the second half of the year, experts project that China's trade surplus for 2007 will exceed USD250 billion.
With this growth of trade surplus, trade disputes have continued to escalate between China and its trading partners. In this environment of trade tensions, the Chinese Government has issued this “Notice” to respond in an affirmative manner as well as to further address environmental concerns and improve quality of exports.
Major Changes
1. The VAT export tax refund has been fully repealed for 553 “high energy consuming, high polluting, and scarce resource-consuming” products. This means that there will be no refund of VAT paid on inputs. For these commodities, it is expected as well that output VAT will be required despite they’re being exports. This change covers: leather, chlorine, dyes and other chemical products, certain industrial chemicals (not including refined chemical products), some fertilizers, metal carbide and activated carbon products, certain lumber and one-time-use wooden products, unalloyed aluminum poles and other non-ferrous metal processed goods, segmented ships and non-mechanical boats. The above listed products previously had export refund rates between 5% and 13% before this Notice.
2. The VAT export refund rate has been reduced for 2,268 commodities likely to trigger trade disputes. These include: some electronic machinery, clothing, shoes and hats, bags/luggage, toys, plastics, rubber and rubber products, certain chemical products, some base metals and their products, bicycles, motorcycles and other auto vehicles, vegetable oils, etc. These products will have their VAT export refund rates reduced by percentages ranging from 2% to 8%.
Changes in Export Rebate Rates – Categories of Goods Most Affected
|
Commodity |
Rate before Adjustment |
Rate Post-adjustment |
Rate Change |
|
Clothing |
13% |
11% |
2% |
|
Certain electronic machinery, machine tools, auto vehicles |
17% / 13% |
11% / 9% |
2%-8% |
|
Toys |
13% |
11% |
2% |
|
Plastics, rubber and their products |
13% |
5% |
8% |
|
Hats and shoes |
13% |
11% |
2% |
|
Certain base metals and their products, such as copper, zinc, molybdenum |
13% |
5% |
8% |
|
Certain Chemical Products |
13% / 11% |
9% / 5% |
2%-8% |
|
Vegetable oils |
13% / 11% |
5% |
6% / 8% |
3. The VAT export tax refund has been fully repealed for 10 items, but their export sale will still be VAT exempt. These 10 items include: peanut kernels, oil paintings, engraved plaques, etc.
4. All above changes are effective from 1 July 2007, using the export date listed on the “Customs Declaration Form (Export Rebate Only)” as the date of reference.
Transitional Arrangement
These VAT export refund policy and other changes are specifically not covered by any transitional rule, with one exception for contracts covering the export of ships and equipment and building materials involved in long term construction projects. Where the contracts have been bid or signed before 1 July 2007 without the possibility of any price adjustments and have been registered with the relevant tax authorities prior to 20 July 2007, the original VAT export refund rates will apply. In the absence of meeting these requirements, the new lower refund rates will apply.
International Practice
Generally around the world, VAT is a tax that applies, in principle, to all commercial activities involving the production and distribution of goods and the provision of services. VAT is considered to be a consumption tax, implying that it is borne by the final consumer and thus is not a charge that is economically borne by companies.
With the exception of some types of income such as interest, most countries apply a “zero rate” to export transactions. This means that export sales are not only not subject to VAT, but in addition all input VAT incurred by a company on its purchases may be either credited against other VAT liabilities or refunded. The rationale behind this is two-fold. First, it ensures the neutrality of VAT for the company and forces the ultimate consumer to bear it. Second, “zero rating” effectively acts as an incentive for exports since commodity prices to foreign customers are free of VAT.
In contrast to this common international approach, China’s VAT system imposes additional tax costs on exporters. Although China's system is not exactly the same as other countries, but China is renowned for its respect to and adoption of international practices and principles. Whether the use of VAT refund rate adjustments as major economic measures by China will continue for a considerable length of time remains yet to be seen.
The Effect of the Adjustments
The export refund rate schedule has been altered from the original 17%, 13%, 11%, 8% and 5% to 17%, 13%, 11%, 9% and 5% post-adjustment. In general, these adjustments are extensive in commodity coverage and material in rate reduction. They will raise the tax costs for many exporting enterprises. Considering the extent of some of the decreases in the refund rates (as much as 8%), the profit and loss of some exporters could be devastated.
The adjustments in the policy will bring different implications. The repealing of export refund means that exports are to be treated as domestic sales and output VAT will be imposed. The reduction of refund rates may mean that the maximum additional tax burden could be as high as the difference of the applicable VAT rate and the refund rate applying to the FOB value of the product. This obviously means increase of export costs and reduction of profit margin. On the other hand, the changing of export rebate to exemption will mean that input VAT on domestic purchases and supplies will not be recoverable, hence again increasing export costs.
Based on the principles of a 2006 circular (Caishui [2006] No. 139), it is expected that commodities no longer qualifying for any VAT export refund (the items described in paragraph 1 under Major Adjustments above) may be added in the near future to the list of products prohibited from the processing trade procedure. They may also have import tariffs and import link tariffs imposed in the process of importation. Accordingly, enterprises engaged in the processing trade for these items may confront a higher tax burden.
Actions to be Taken
Exporters adversely affected by these reduced refund rates and other changes may be able to plan to minimize their detrimental effects. Aside from simply raising prices to foreign customers, the following are possible actions to consider.
· Tariff coding: the description and tariff codes of the exported goods should be reviewed to ensure that all commodities are correctly labelled;
· Supply chain model: the tax efficiency of the currently used export business model in the supply chain should be evaluated, e.g. the effect of contract manufacturing verses toll manufacturing;
· Functions and risks: the functions and risks undertaken by the China operation should be revisited to see if some functions could be performed and risks assumed outside China in order to lower FOB prices of related-party exports;
· Transfer pricing: some benchmarking exercise could be conducted on the functions and risks undertaken in China to ensure that the existing transfer pricing policy for related-party exports is proper;
· Special purpose vehicles: special purpose vehicles, e.g. the use of Chinese foreign-invested commercial enterprises could potentially reduce the impact of the refund reductions;
· Designated zones: designated special purpose zones, e.g. export processing zones could be considered to reduce the potential impact;
· Increase of bonded imports: increase of imports or conversion of domestic purchases into imports can also reduce the VAT cost increase (the use of bonded logistics parks can help facilitate this process);
· Vertical integration/segregation: changes in the operations undertaken in China potentially may change the exported products and, hence, the applicable tariff code for each product.
Owing to the complexity of the subject, professional advice is strongly recommended when enterprises are conducting such reviews. | 
