According to official media, China's exports fell by 0.2 percent in the first eight months of 1999, compared with the same period last year. Some product categories, such as garments, textiles and shoes, have recorded big falls.
The Chinese government recognises that a weak export performance will hamper economic growth. One of the measures it has taken to boost exports is to raise the export value added tax (VAT) refund rates. This year the State Administration of Taxation (SAT) has already issued two circulars which have increased the VAT refund rates twice for certain products.
According to the latest circular, which came into effect on July 1, 1999, exporters of machinery and appliances, electrical and electronic products, garments, transportation tools, apparatus and meters are entitled to a full VAT refund rate of 17 percent. Exporters of products for which the statutory VAT rate is 17 percent, and for which the VAT refund rate was 13 percent or 11 percent, can now claim the refund at the new rate of 15 percent. Likewise, the nine percent VAT refund rate applicable for all other products exported from China has now been raised to 13 percent, except for agricultural products, the VAT refund rate of which remains at five percent.
An improving export performance this summer – the August trade surplus was the largest this year – may indicate that the increase in VAT refund rates is starting to have a positive impact. Even so, the gradual restoration of VAT refund rates should allow foreign investors greater flexibility in choosing a VAT-efficient mode of operation.
The VAT Law and Regulations came into effect on January 1, 1994. VAT is a turnover tax levied at every stage of the sales cycle, so it is passed on to the final customer. The original intention of this law was for exporters to receive a full refund of all input VAT levied on purchases used for production of goods for export. However, due to insufficient funds the refund rates on export goods were first reduced on July 1, 1995. In 1996 the refund rates were further reduced to three percent, six percent and nine percent for different types of products.
Buy-and-sell manufacturing and contract processing arrangements are the two common modes of operation undertaken by foreign manufacturers producing goods for export. Typically, in buy-and-sell manufacturing operations, foreign manufacturers establish their own foreign investment enterprises (FIEs) in China to purchase imported and domestic raw materials for conducting manufacturing activities, and then sell the output to overseas markets. Based on a 1996 circular, FlEs established after January 1, 1994 (new enterprises) would have to bear an export VAT tax under the following formula: (FOB value on goods for export minus the purchase cost or the CIF value on the imported raw materials) x (17 percent minus VAT refund rate for the product concerned).
Under the contract processing arrangement, foreign manufacturers generally do not make direct investment in China. They enter into contracts with qualified Chinese processing units which undertake to provide processing services using their own labour and factory premises in return for a processing fee. The foreign manufacturer provides equipment and machinery, raw materials and production know-how to the local processing units. Raw materials for production are imported by the processing units as bonded goods and the finished products are exported to the foreign principal.
Under the VAT regulations, Chinese manufacturing units which are in the form of FIEs are allowed to carry out the processing services free from VAT, whereas a domestic Chinese processing unit will have to pay VAT on the processing fee. This VAT exemption has caused many FIEs to consider converting their mode of operation to a contract processing arrangement, although this may attract certain non-tax charges. However, this trend may change in future because of the increase in the VAT refund rate.
A full restoration of the VAT refund rate on exports would have the following effects on the new enterprises conducting buy-and- sell manufacturing operations and, for that matter, on FlEs established before 1994, with effect from 2001:
-if the full VAT refund is allowed to the product for export, the exporter will be entitled to a full refund of all input VAT incurred on the local purchases. Therefore, the paradoxical result of the old reduced refund rates of encouraging the use of imported materials for production of export should be reversed
-there will be no net VAT liability on exports and no more irrecoverable VAT to be charged to the profit and loss account.
In other words, a full VAT refund rate means that buy-and-sell manufacturers will have the same export tax treatment as FIE contract processing manufacturers.
Categorisation of enterprises
Whatever mode of operation they undertake, all export manufacturers should maintain a system to ensure that they comply with the latest customs regulation issued in April 1999. Under the new regulations, enterprises will be classified into four categories for customs.
Type-A enterprises are those which have had no violation records in the last two years and are not required to give any guarantee in respect of their imports into China. Type-B enterprises are those which have not committed any serious offence against the customs regulations. They are required to give a guarantee to the Bank of China on their imports but do not need to place an actual deposit against the guarantee. Type-C enterprises are required to place deposits equivalent to the customs duty and VAT on their imports, which will be refunded after the finished goods have been exported. The last category of enterprises, type-D, are not allowed to renew their import and export contracts for two years.
FIEs engaging in buy-and-sell manufacturing activities will benefit from the increase in VAT export refund. Foreign manufacturers adopting the contract processing mode of operation may have to review their current position to evaluate if potential tax savings may arise from establishing their own subsidiaries in China to manufacture for export under buy-and-sell manufacturing.
At the same time, export manufacturers should ensure that they have implemented a sound system that complies with customs regulations. Any violation of customs regulations could result in additional operating costs or, more seriously, the suspension of import and export activities.
Written by Michael To, Senior Tax Manager of Pricewaterhouse Coopers in Hong Kong. The above information is not intended to be comprehensive or final.