On 18th June 2007, the Ministry of Finance (MOF) and State Administration of Taxation (SAT) jointly issued Cai Shui [2007] No.90 ("Circular 90") which introduces significant changes in China's export VAT refund rates. The changes echo the increasing pressure and critics from major trading partners with respect to the excessive trade surplus, together with the concerns of resources preservation and environmental protection in China. The coverage as well as the magnitude of the round of export VAT refund rates reduction are the most remarkable comparing to those of the previous rounds.

The product list to Circular 90 show 2,831 types of commodities covering an extensive range of commodities, which generally include:

1. Construction materials
2. Base metals, minerals and their products
3. Chemical products
4. Animal and vegetable products
5. Garment and textile articles
6. Electrical and mechanic appliances

These commodities are those of high-energy consuming and polluting nature and / or involve low-tech and low value-adding manufacturing processes.

The magnitude of the rates reduction is not nominal. The changes can be categorized:

1. Category A is export VAT refund rates change to withdrawal of export VAT refund entitlement
2. Category B is export VAT refund rates change to as low as 5%
3. Category C is export VAT refund rates change to exemption

According to the current export VAT refund policies, the VAT implication for Category B commodities is that part of the input VAT paid in the previous stage before export will become costs to the exporters who may or may not recoup the same back from the foreign buyers through price increases. The VAT implication for Category C commodities is that the entire input VAT paid in the previous stage before export will become costs. The exporters of Category A commodities could be facing the heaviest burden because their exports would even be subject to "deemed domestic sales" VAT treatment.

Current Export VAT Refund System

Generally around the world, VAT is 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 not only will export sales be exempt from VAT, but in additional all input VAT incurred by a company on its purchases may be credited against other VAT liabilities 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. China's system is different from other countries but in the past China has shown that some international practices and principles have been adopted. 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 current Chinese VAT regime allows exporters of goods to obtain refunds of their input VAT incurred in the importation, purchase and production stages. The amounts of refund vary partly depending on the export VAT refund rates applicable to specified types of goods. The input VAT could be refunded fully, partially or even with no refund at all.

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 1st July 2007 without the possibility of any price adjustments and have been registered with the relevant tax authorities prior to 20th July 2007, the original VAT export refund rates will apply. In the absence of meeting these requirements, the new lower refund rates will apply.

Observations

This change may bring along macro implications as follows:

1. Increase the costs of exports and in turn increase the costs of purchase of the foreign buyers (impact on sourcing);
2. Reduce the incentives of exports by manufacturers and change more of their products to local market (impact on market focus);
3. Affect the evaluation of setting up manufacturing bases in China by multinational businesses (impact on factory profiles).

China's trade surplus for the first five months of 2007 is growing tremendously without any sign of slowing down (83.1% as compared to same time last year). It has decided to take the reduction of export VAT refund rates as a tool to rectify this situation at this stage, because this would to a certain extent discourage exports. However, its effectiveness still remains to be seen.

While China moves to achieve her overall State development goals, businesses should expect and prepare that, together with other policy changes, the export VAT refund policy will continue to be used as one of the tools to steer the State's development.

Example in the Textile Industry

The rebate for clothing, one of the country's most important export items, will be reduced from 13 to 11 percent. Analysts say although the cut can be well digested by most of the market, it will still raise export costs to Chinese firms, especially small ones. Such companies are set to lose their only sharp competitive edge, which is low price, after the new rebate takes effect because they are unable to freely pass on the higher costs to customers. Their situation will get even worse as the Renminbi, China's currency, is set to appreciate faster and the costs of labor and raw materials are also climbing.

In another sense, industry leaders may benefit from the rebate adjustment, underscoring the governments effort to improve the industry structure and adjust the export mix. The biggest challenge to Chinese textile and garment industries is coming from domestic competition. Bigger firms can become even bigger now simply because they will fill some of the gap left by small manufacturers who will quit. Competitors from Southeast Asia and South Asia would also grab a share of the export market for certain low-end products with the departure of small Chinese

players. China's clothing exports totaled USD $28.2 billion in the first five months, a jump of 17.6 percent from a year before.

China is cutting the export tax rebate in a move to reduce rising trade surplus and ease trade friction with its trading partners. China is a key exporter of clothing and textiles to the United States, Europe and Japan. Analysts say the government has only cut the rebate by two percent for garment exports this time due partly to the important position of the textile and garment industries in the country, which employ 20 million people. But they also believe this cut will not be the last one.

On the counter side, China has tried to re-balance the country's import and exports by allowing domestic companies to freely import a wide range of materials and products, in order to help achieve trade balance. Since April 1st, Chinese firms no longer need to apply for an import license to import products in 338 categories. Steel products and plastic materials as well as some machinery and electronics are included on the list. Alternatively, Chinese traders will need to get an "automatic import license" for these products, meaning they do not need official approval, but their imports will have to be recorded at the ministry.

Foreign Invested Partnership (FIP)

On June 1st 2007 the Partnership Enterprise Law of China was implemented. Together with the Administrative Rules concerning Foreign Invested Partnership Enterprises, the regulations allow foreign companies and individuals to establish Foreign Invested Partnerships (FIP) in China.

There are two types available:
1. General partnership enterprise bears unlimited joint and several liabilities for the debts of the partnership enterprise.
2. A limited liability partnership enterprise shall be formed by general partners and limited partners. The limited partners bear the liabilities for the debts of the limited partnership enterprise to the extent of their capital contributions.

These types of entities are open to individuals and legal persons and thus would also make possible where the sole general partner is a limited liability company. A minimum of two partners is required and it is allowed that all partners are foreign investors.

In a FIP the distribution of profits and allocation of losses may be agreed upon in a flexible manner and it is not strictly connected to the capital share as it is the case for Equity Joint Ventures. It has to be noted, that the prescribed ratio between registered capital and total investment applicable to Joint Venture and WFOEs will also apply to the FIP.
For Chinese partners it may be interesting that it is allowed to contribute services as their capital contribution to the FIP if they are general partners. Foreign investors are excluded from that possibility.

Industry related investment restrictions applicable to WFOEs and JVs will also apply to FIPs so that respective approvals shall be obtained before registration of the FIP. In conclusion, the means of investment into China has become more flexible and this new FIP has to be taken into consideration when structuring a China investment.

New Transfer Pricing Developments in China

Despite the continuing delays in the release of the "China Transfer Pricing Contemporaneous Documentation Ruling", there have been further key developments in China's transfer pricing environment.

A new requirement on the disclosure of inter-company transactions has been issued by some major tax jurisdictions in China, such as Shanghai, Guangzhou, Xiamen, Wenzhou and other first and second tier cities. Under the new requirement, foreign invested enterprises and foreign enterprises within these jurisdictions will be obliged to file more detailed and comprehensive inter-company transaction information (if any) starting from the annual "Company Income Tax" filing of fiscal year 2006. These tax payers are now required to disclose information on both related and unrelated transactions of a similar nature; information that could facilitate the tax authorities ability to efficiently identify comparable transactions and effectively evaluate the arm's length nature of the transfer pricing practices adopted by taxpayers.

Another recent development is the issuance of Guoshuihan [2007] No.236 ("Circular 236"), which calls for tax officials to investigate loss-making FIEs and FEs with "single manufacturing functions" is a clear indication of the SAT's lower tolerance towards contract manufacturers and toll processors in China, which may be making losses. Many FIEs / FEs have losses or make marginal profit though performing pure manufacturing activities according to their foreign parents overall operational plan. Many of these losses arise because the companies are in start-up positions and may have initial one-off costs or low capacity utilization. Tax audits on these FIEs / FEs are carried out by the respective local tax bureaus on a case-by-case basis. Circular 236 demonstrates that the SAT is organizing a nationwide tax investigation campaign into the transfer pricing arrangements within these "single manufacturing-function" FIEs / FEs.

Based on this new circular, loss making FIEs / FEs with single manufacturing functions will become a major target of future transfer pricing investigations, and the immediate consequences could be tax adjustment or expedited triggering of tax holiday. It is recommended that FIEs / FEs in China conduct self transfer pricing assessments based on this new circular and seek advice when continuing losses or marginal profits are identified.

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