VAT Rebates: Negotiating power tool of China’s Value Added Tax System

How the VAT Rebate System works in China manufacturing

If you are buying from China, understanding the basics of how the VAT system works is a strategic imperative. What are the dangers of buying direct from the factory (ExW).

Buying in China? Complexities of the Value Added Tax System

China’s Value Added Tax (VAT) and VAT Rebate system is complex and very confusing.  But if you are buying from China, understanding the basics of how the system works is a strategic imperative.  Here are some reasons why:

  • For new suppliers: If you if you know the VAT rebate amounts on the products you are buying from China, you can learn your supplier’s true internal costs.  That’s essential for negotiations and vendor comparisons.
  • For existing suppliers: Even if you have been dealing with the same vendor for many years at the same price, the VAT rebates have changed over time and your current vendor may be pocketing the VAT rebate rather than passing on the savings to you!
  • The VAT rebate rate is based on the product classification.  But did you know that the product classification is negotiable?  A vendor may tell you they are only getting a certain % back, when in reality they have a secret agreement with the local authorities to re-classify the product in a new category with a different rebate rate.
  • They will try to hide the fact from you, but many vendors lack import‐export rights and proper VAT processing facilities. They are forced to use 3rd party trading companies which inflate the price and complicate the relationship.

How the VAT System works in China manufacturing

Let’s take a step back and explain how the VAT system works in China manufacturing. At the risk of oversimplifying, in theory a 17% tax is paid at each step as a given product flows down the supply chain toward the end users.

Take the example of a plastic comb.

  • Raw plastic is purchased for injection molding (and tax is paid),
  • then the molded comb is sold to a beauty product distributor (and tax is paid),
  • who in turn sells to a trading company (and tax is paid) for eventual export.
  • When the comb is exported, there may be a VAT rebate of 0‐17% (depending on the product classification) against the taxes paid.

Without going into the complex tax formulas, let’s say the VAT rebate for plastic combs is 10%. 17‐10=7%. That is the amount that stays in the government coffers, while 10% goes back to the exporting company.

In this fashion the VAT rebate amount is a tool which the central government can use to either give more incentive (increase the rebate %) or less incentive (reduce the %) from industry to industry.

The Games That Suppliers Play

If you have experience buying in China, you certainly have come across quotes from suppliers that offer a price “with VAT” and a price “without VAT”.

If you don’t have a lot of experience buying in China, you may be tempted to purchase “EXW China Factory, No Taxes Paid”.  Let’s explore the dangers:

Vendors are always trying to find ways to avoid the VAT issue in hopes of putting more money in their pocket while transferring the risk to the unsuspecting buyer.  Why?

  1. Many small or new factories aren’t licensed to export nor do they have the right to claim a VAT rebate.  But they still want those overseas orders. So they try to get buyers to purchase factory direct (“ExW w/out tax receipts”).  This option, at first glance, always appears the lowest price among potential suppliers. But it is artificially low and not sustainable, as we will explain below.
  2. While a “no tax price” may be attractive at first, you are setting yourself up for two common & expensive headaches:
  • Let’s say you buy direct from the factory (ExW) in China,
    • how would you feel if you find out later you can’t export out of the country because you lack the proper paperwork to show customs at the port.
    • The goods are essentially stuck until you pay a fine or find an expensive gray channel!
  • Chinese suppliers are famous for having 3 sets of books.
    • A set to show the customer, a different set to show the government and a final set (the real numbers) for internal use by the owner.  Chinese suppliers can hide the fact that taxes were not paid on small orders. But if your orders grow and grow, it can soon reach the point that the supplier can no longer cook the books without getting caught.  Just when you are expecting a price discount for a large order, out of the blue you get smacked with an increase because the tax is now applied!

How to know if the supplier is playing games with VAT on your order?

Here is a proven method that I have been using for 20 years to force transparency and get to the bottom line in my negotiations with Chinese suppliers:

To allow for an “apples to apples” comparison of quotes coming out of China you will find it advantageous to ask for the unit price quoted 3 ways from each vendor:

  • EXW without Tax Receipts
    • “Ex‐Works” or “Ex‐Factory” means ownership of goods transfers to the buyer at the factory’s door in China.  This price does not include any taxes or shipping. The buyer or their representatives would be responsible to organize customs clearance out of China.
    • In practice, there are third parties which will organize export of goods “without tax paid” by charging a one time “processing fee”.
    • For small, one‐off orders, it may be possible to buy at the EXW level. But we highly recommend that to be safe you base your long‐term budgeting on the FOB pricing.
  • EXW with Tax Receipts:
    • This means that the buyer or his representatives will need to organize the VAT rebate & customs clearance out of China on their own. This is not an easy task and not recommended for new to China buyers unless they have a trusted advisor that can walk them through the process.
  • FOB China Port
    • FOB (freight on board) means the ownership of goods takes place after the items have cleared outbound Chinese customs and are on the boat, ready to ship from a designated port (for example, “FOB Shenzhen”).
    • For most buyers, FOB is a much easier way to purchase than EXW, as the supplier is responsible for handling any VAT issues.
    • Once you are in possession of all three quotes, you (or your China advisor) can look at the numbers and calculate not only the applicable VAT rebate but also the internal costs and even mark up of the seller.   That’s a very powerful tool to have in your negotiations.
Once you are in possession of all three quotes, you (or your China advisor) can look at the numbers and calculate not only the applicable VAT rebate but also the internal costs and even mark up of the seller.   That’s a very powerful tool to have in your negotiations.

Pro Tip:  Pay close attention to the VAT rebate when consolidating freight from multiple suppliers in China

If you are consolidating orders among multiple vendors in China, or buying in China for delivery to another location in China, then understanding VAT system is essential as if even 1 of the vendors can’t provide the right paperwork, the VAT rebate can be lost for the entire shipment.  We call this a “VAT Leak” and I’ll cover this topic in detail on a future blog post in a few weeks.

Conclusion:  China VAT & Rebate System

In summary, while VAT is a complex issue, simply asking your supplier to outline the VAT rebate rates and process is a big step in the right direction. Now only will it shed some light on an often-opaque part of China business, but asking about VAT will let the seller know you are an educated buyer wise to the “China game”!

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About the Author: Michael J. Bellamy

About the Author: Michael J. Bellamy

Originally from Upstate New York, Mike moved to Asia in 1993 and is a China business advisor to both Fortune 500 companies and small businesses.  Recognized as an expert on doing business in China, he has been interviewed by WSJ, CNBC, FT & Bloomberg.

A featured presenter on China issues at seminars, trade shows and corporate events across the globe.

Learn more about Mike and AsiaBridge Law at
https://www.asiabridgelaw.com/business-advisory-services/

Mike is the author of “The Essential Reference Guide to China Sourcing
(available on Amazon).

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