VAT Rebates in China
By Klaus Koehler, Managing Director, Klako Group

Value Added Tax in China

In China, both domestic and foreign companies are liable to pay value-added tax (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.

The Chinese government levies a general 17% Value Added Tax on the sale or import of goods and on the provision of processing, installation and repair services. Books, magazines, newspapers, edible vegetable oils, cereals, tap water, heaters, coal products for residential use and other goods as prescribed by the State Council enjoy a lower rate of 13%. A special VAT rate of 6% is applied to goods sold by certain small scale taxpayers.

Sales VAT is calculated in Renminbi (RMB) and may be collected from the purchaser. For sales value in foreign currency, the prevailing foreign exchange rate quoted by the State must be used to convert the sales value into RMB.

VAT Rebates on exports

In 1985, China introduced tax rebates for exporting enterprises. In order to boost exports the government has been paying back a percentage of the VAT after the companies have paid taxes for exported goods. The World Trade Organization has accepted these tax rebates of currently 5 to 17 percent granted on all goods exported outside of mainland China.

In the face of mounting fiscal burden and widespread tax rebate cheats, China started to reduce export tax rebates in 1995. The rates for most products were cut from 17% in 1994 to 9% in 1996. With exported goods being taxed at a VAT rate of 17% but rebated at only 9%, the Chinese government effectively imposed an 8% tax on exports.

The tide turned again during the Asian financial crisis. The devaluation of the Southeast Asian currencies against the RMB posed great challenges to China's exports. China was forced to increase VAT rebate rates again in order to assist the country's export sector and to reverse the trend of deflation. The government raised rebate rates six times between mid-1997 and July 1999 by a total of 5-7 percentage points.

Over the last years, the country's exports have strongly increased and the VAT rebate payments have become a severe fiscal burden on the Chinese Government. According to the Ministry of Finance, the financial burden to the government arising from the rebate has been rising rapidly. The annual growth rate of the rebate liabilities has been 36.3 percent - more than double the growth rate of the country's fiscal revenue.

In 2002, the government owed exporters about RMB$200 billion, but the actual payment was only RMB159 billion. Towards the end of 2002, overdue export rebates reached RMB240 billion, and are expected to exceed RMB300 billion by the end of this year. Some exporters have been waiting for rebate payments for one and a half years.

2004 VAT Rebate Cut

This month, the Central Government decided to once again reform the export tax rebate system. Starting from 1 January 2004, VAT rebates for exports will be cut by an average of 3%.

As a result, the financial burden of the government will be reduced. A 3% point decrease on the rebate rate will decrease budget expenses by about RMB35 billion, which is equivalent to about 11% of the planned deficit. In the future, the central and local governments will share the export tax rebate burden with the central government taking responsibility for only 75% of the rebates instead of 100%.

Due to the relatively small magnitude of change, cutting the export rebate rates by an average of 3% should not represent a major challenge to most exporters, except marginal producers. Although the rebate cut will increase production cost and weaken the export sector's competitiveness in the short term, the gradual step-wise reduction of VAT rebate will provide exporters with enough time to offset the negative impact by raising efficiency and upgrading their products in the long term. China's low inflation rate relative to its major international trading partners and a weak US dollar will also mitigate the impact.

While the growth of China's exports is expected to slow down by around 4.9 percentage points, imports will remain unaffected. This will decrease China's trade surplus and help to alleviate the appreciation pressure on the RMB. A relatively strong increase of foreign exchange reserves has raised the international expectation for an appreciation of the RMB. An increase in speculative activities by some international investors has also added upward pressure on the Chinese currency.

In the face of growing trade deficits with China, the country's international trading partners are challenging the Chinese government for not letting the RMB appreciate in line with the growing foreign exchange reserves, thus resulting in rapidly rising exports to other countries. China has also been accused of subsidizing exporters and producers through its export tax rebate policy. The planned rebate rate cut will help to ease these foreign sources of pressure on RMB appreciation.

By announcing these measures, the central government sent a clear signal to international speculators that the stability of the Chinese currency would remain intact, and other policy options would be used to vent the appreciation pressure on the RMB.

The decrease in VAT rebate rates will affect 23 percent of Chinese companies that are export-oriented. For these enterprises, lowering the VAT rebate rates means an effective appreciation of the RMB without changing the exchange rate. As Chinese exporters have been using the VAT refund to lower their prices, the rebate cut will also impact foreign companies buying from China. Chinese manufacturers will be forced to pass along the rising costs to their suppliers and customers.

Chinese exporters who have signed fixed price export contracts before 15 October 2003 with the date of export after 1 January 2004 are expected to present the contract at the tax rebate department before 15 November 2003. Upon examination and approval by the Ministry of Finance, the local state taxation bureau will handle tax rebates at the rates before the adjustment.

Overview of the VAT rebate rate adjustments
(Source: Hong Kong Trade Development Council)

The VAT rebate rate remains unchanged for

• Agricultural produce with current export tax rebate rate at 5% and 13%
  
  
• Most industrial goods processed or produced using agricultural produce as raw materials with current export tax rebate rate at 13%
  
  
• Most goods with VAT rate at 17% and rebate rate at 13% under current tax policies
  
  
• Ships, cars and key parts thereof, aircraft and space vehicles, numerical controlled machine tools, processing centres, printed circuits, locomotives and other goods with current export tax rebate rate at 17%

The rebate rate is raised from 5% to 13% for wheat flour, corn flour, cut duck and cut rabbit.

The export tax rebate will be abolished for crude oil, timber, paper pulp, cashmere, eel fry, rare earth metal ores, phosphorous ore and natural graphite.

The rebate rate is lowered to

• 11% for Gasoline (commodity code 27101110) and unforged zinc (commodity code 7901).
  
  
• 8% for unforged aluminium, yellow and other phosphorous, unforged nickel, ferroalloy, molybdenum ore and concentrate.
  
  
• 5% for Coke and semi-coke, coking coal, caustic-calcined and dead burned magnesite, fluorite, talc, and lardite.

For all other goods than those mentioned above, the export tax rebate rate will be lowered to 13% for goods with current export tax rebate rates at 17% and 15%, and to 11% for goods with current tax and rebate rates both at 13%.

One important aspect of the agreement is that foreign companies operating in Hong Kong may benefit from the CEPA, if they also provide services in the territory. Investment in company headquarters in Hong Kong, offering a services sector almost unrivalled anywhere on the mainland, could therefore be a beneficial side-effect.

If you require assistance with the above subject, please contact us at info@klako.com with your detailed questions.

All information in this report is verified to the best of our ability and is assumed to be correct at time of release; however, Klako Group does not accept responsibility for any losses arising from reliance on the information provided within.