RSM Resources

In order to slow the growth of the People’s Republic of China’s (China) excessive trade surplus and to address concerns associated with goods that involve high natural resource consumption and high pollution, the nation has made significant changes to their export value added tax (VAT) refund rates.

This marks the third time since 2005 that China has made changes to the rates, with this reduction affecting 37 percent of tariff codes. 

The VAT was originally seen as a tool to encourage exporting from China and to keep prices low. Many other countries utilize a VAT system, but multiple factors have contributed to a positive trade surplus in China for several years. The size of that surplus, totaling over $262 billion in 2007, has been an issue with the China’s trade partners, encouraging the nation to reduce VAT refunds. 

VAT changes
Effective July 1, 2007, China reduced, or abolished, in several instances, the refund on 2,831 tariff code items. Changes were separated into three categories:

• Refunds that were cancelled
• Refunds that were significantly reduced
• Export items that are now fully exempt from the VAT

The first category consists of 553 tariff codes, most involving scarce natural resources or manufacturing activities generating high pollution or energy consumption. No VAT refund will be allowed for these products, which previously yielded a return of between 5 percent to 17 percent.

The majority of the items affected, 2,268, fall into the second category, where the VAT refund rate has been further reduced from 13 percent to 5 percent for a net reduction of 8 percent.

The final category includes 10 codes that have now been fully exempted from the VAT. However, the corresponding input VAT on these products still has to be charged and is not refunded.

High technology, biomedical or encouraged industries weren’t as affected by the cuts. These changes will increase costs for many companies exporting from China. The question is what options are available to offset those costs, other than passing them on to your customers?

How can manufacturers offset added costs?
From a tax perspective, affected companies can consider three immediate strategies:

• Review the efficiency of your existing transfer pricing policy
• Review your tariff code classification to see if a higher VAT refund rate reclassification may be possible
• Investigate whether establishing a Hong Kong trading company or a foreign invested commercial enterprise would reduce the overall VAT burden

The next step is to find a way for your company to neutralize possible additional costs. Some companies may be able to take on the extra costs. But since the profit margin in many instances is small, any excess charges could have considerable consequences. Passing the costs onto the consumer is generally an unattractive option, as sales may suffer.

Mastering lean manufacturing is one of the best ways for manufacturers to reduce costs. U.S. plants that have implemented at least one lean approaches report a median 35 percent gross profit margin and $197,000 sales per employee, versus just 31 percent gross profit and $150,000 for those not implementing lean. Lean is an approach that small companies can afford, requiring them only to understand the processes, identify wastes, address the root causes of problems, and then improve the process with available resources.

Look at location. While China was once among the lowest cost locations for production, other countries now may be more attractive. Also, consider where your production facilities are located relative to your markets. Producing closer to your customers can reduce costs.

Consumer and business markets are exploding in China. If your focus has been primarily on exports, this is the time focus on selling in China. The country is shifting from being strictly an export market to keeping more goods at home and improving the quality of life for their citizens. Not only will you gain sales revenue, there are no export costs for local sales.

From both production and market perspectives, China will continue to be a dominant force. But conditions in China are changing rapidly. Companies that adapt and seize on the opportunities these changes present will gain substantial competitive advantage.

Dave Luzi is a managing director with RSM McGladrey. For more information, contact him at dave.luzi@rsmi.com.

Dick Strojinc is a director with RSM McGladrey. For more information, contact him at dick.strojinc@rsmi.com.