Hong Kong: China Reduces VAT Rebates for Manufacturers/Exporters

As we enter 2004 and the Year of the Monkey, China is facing increasing pressure from the rest of the world to revalue its currency and to remove other perceived artificial benefits to exporters.  The first measure it has taken to address such concerns is to reduce the rebates available for value added tax ("VAT") on exports. This will affect many foreign manufacturers exporting goods from their factories in China. 

In China, both domestic and foreign invested enterprises ("FIEs") are subject to VAT on the transfer of taxable goods and services at each stage of the production process. VAT is levied on sales by manufacturers, wholesalers, and retailers as well as on so-called "mixed sales activities" that involve the sale of goods and certain services.

As of 1 January 2004, VAT rebates paid to exporters in China have been reduced.  VAT rebates for exported goods will now be an average of three percentage points less than previously.  The rebate is as high as 17 per cent, depending on the industry.

Back in 1995, in the face of a mounting fiscal burden and widespread tax rebate fraud, China began to reduce export tax rebates from 17% in 1994 to 9% in 1996. With exported goods being taxed at a VAT rate of 17% but rebated at only 9%, an effective 8% tax was imposed on exports. 

The pendulum swung in the opposite direction during the Asian financial crisis. The devaluation of the Southeast Asian currencies against the RMB posed a threat to China's exports. China than increased VAT rebate rates again in order to assist the country's export sector and to reverse the trend of deflation. The Chinese Government raised rebate rates six times between mid-1997 and July 1999 by a total of 5-7 percentage points.

VAT is often the most important tax payable by FIEs in China.  The VAT rebate system was first introduced in 1985 in order to bolster the competitiveness of export goods in world markets by avoiding double taxation on these goods in case import tariffs were imposed by importing countries.  It was perceived by a way to attract more foreign investment in the foreign trade and manufacturing industries. 

While the policy is commonly adopted in countries and regions where VAT or its equivalent tax are levied, it has run into problems in China because payment for large sums of export rebate due to export enterprises has been long delayed. According to statistics from the Ministry of Commerce and the State Administration of Customs, overdue export rebates amounted to RMB250 billion at the end of 2002 and were expected to be RMB350 billion for 2003.

For all FIEs registered after 1 January 1994, the VAT refund for exports is referred to as the exemption, deduction and rebate policy.  Exemption refers to the exemption of the output VAT on the production or sale of exported manufactured products.  Deduction refers to the offsetting of input VAT, imposed on raw materials and components purchased for the production of exported goods, against output VAT payable on domestic sales.  The rebate is calculated according to one of the following methods :-

If export sales constitute more than 50% of the total sales for the period in question and the offsetting input VAT exceeds the amount of output VAT, the excess input VAT credit will be refunded to the FIE upon approval by the tax authority; or

If export sales constitute less than 50% of the total sales for the period in question, the excess input VAT credit will be carried forward.

It is expected that exporters who source raw materials domestically will be hurt the most.  Firms that process imported materials and export the finished goods enjoy high VAT exemption and therefore should not be affected by the changes.  FIEs that have entered into export contracts before 15 October 2003 with a date for export after 1 January 2004 will still be able to enjoy the prior applicable VAT rebate rates if proper registration with the tax bureau was completed.

Rebates for goods that are classified by the government in the encouraged category for foreign investment will remain relatively unchanged.  Rebates for ordinary consumer goods will be substantially cut and the worst hit will be goods classified in the restricted category.