VAT Leak in China Manufacturing: Planning for Value Added Tax Rebate

VAT Leak in China Manufacturing: Planning for Value Added Tax Rebate

"VAT leak" is an informal term used by different people to mean different things. China’s Value Added Tax (VAT) and Rebate system is complex and can be very confusing.

In an earlier post on the Chinese Value Added Tax (VAT) system we raised the subject of a “VAT Leak” and talked about the need to pay close attention to the VAT rebate, especially when consolidating freight from multiple suppliers in China.  Here is an excerpt:

Why is it important to understand the VAT system in China if you source made-in-China products?

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

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. 

VAT rebates have changed over time and your current vendor may be pocketing the VAT rebate rather than passing it on to you.

A vendor may tell you they are only getting a certain % back, when in reality they have a secret agreement and a very different rebate rate.

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.

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 because if even 1 of the vendors can’t provide the right paperwork, the VAT rebate can be lost for the entire shipment.

That is but one example of a “VAT Leak”.  In this blog post we will explain the various ways VAT can “leak”.

Before we dive into the subject how to identify and plug VAT leaks, if you want a primer on the China VAT system, check out our recent post “Buying from China?  What you need to know about the VAT rebates” that covers the following in great detail:

VAT Leaks & why would China change the VAT rebate rates in 2020?

How the VAT system works in China manufacturing

Games Suppliers Play

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

  • EXW without Tax Receipts
  • EXW with Tax Receipts:
  • FOB China Port

VAT Leak:  What is it exactly?

VAT leak” is an informal term used by different people to mean different things. But the two most common interpretations are as follows:

VAT Leak Definition #1:

An inefficient processing of the VAT and VAT rebate, essentially paying the PRC gov’t more than needed by overpaying on the VAT and/or underclaiming the rebate.

This type of “VAT leak” often happens when the party processing the VAT is not fluent in the process or lacks the infrastructure (example- only has the small tax payer status, lacks import/export rights) or simply messes up the calculations/application.

VAT Leak Definition #2:

The VAT rebate in China ranges from 0 to the full 17% depending on how much the central government wants to promote a certain industry or product. When the official VAT rebate is less than 17%, sometimes this is called a “leak” because you pay in more than you get back.

I personally don’t use the term “leak” in this situation because a leak implies that the plumber messed up and there is a hole in the pipe. Getting as much VAT rebate back as legally possible, even if less than the full 17%, isn’t a “leak”, it’s called “paying taxes”. Most people don’t say their checkbook leaks when they pay their income tax each year.

When & how to check for VAT leaks?

In this article, I’ll give you some tips and tools to conduct your own VAT survey. But know that it doesn’t cost a lot to hire a VAT consultant.  Spending a few $1000’s can bring transparency and major savings. 

If you are purchasing less than 100,000 USD in China and you are buying FOB (Freight on Board), then it probably not worth the effort to conduct a formal VAT study.

If you meet one or more of the following criteria, it would probably be a good idea to conduct a VAT survey of your supply chain. 

  • You purchase more than 1 million USD at the FOB China level
  • You purchase more than 100,000 USD at the ExW level.
  • You purchase any amount of product under “ExW no tax receipts” terms.

If you meet one or more of the following criteria, you would be crazy not to conduct a VAT survey of your supply chain. 

  • Consolidated Orders: You are consolidating product from multiple vendors into a single shipment to be exported out of China.
  • Made in China, For China: You are arranging production in China and some or all of that production will be delivered to a customer or partner in China.

VAT Leak Test:  Preparing the Case File

When conducting a VAT survey to look for leaks, it helps to have all the key data ready and available:

  1. HS codes.

    The VAT rebates are linked directly to the HS codes.


    If you are buying a finished item from a single supplier, then it is easy to conduct the research.  But if you have multiple sub suppliers delivering components to a primary vendor for finishing work in China, then you would need to know the HS codes for all inputs as well as the output.

VAT Leak in China Manufacturing
  1. Annual volume (units and USD value)
  2. Number of shipments in the year
  3. Supplier & Sub Supplier Information (copy of business license is ideal)

    Things get tricky if you are dealing with a trading company that is not transparent about the supply chain.

Pro Tip:
Note that the report can be conducted without the support of the supplier or sub supplier if the client keeps good records and has access to business licenses and such.

In a future blog post we will explain how to get a copy of the factory’s business license and how to interpret it.  This can be done without the supplier even knowing you are looking into them.  In the meantime, feel free to contact the author via https://www.asiabridgelaw.com/contact-us/ to learn how.

  1. Location of the Supplier and Sub Suppliers.

    Interpretation and enforcement of VAT rules varies from city to city and even ports within the same city!

  1. Quotations from the Supplier and Sub-suppliers if available.

    In order to confirm the factory in China isn’t manipulating the pricing, it advantageous to ask for the price in three ways: EXW without tax receipts vs. FOB China Port vs EXW with Tax Receipt.   More on the “3 way test” later in this article.

Most VAT research projects include the following key steps:

  • Contact with relevant authorities in China to confirm the applicable VAT rebate amount for the given production classification.

A licensed custom broker will have the ability to ask questions directly to the suitable party at the customs authority in China.

Pro Tip:  It is not enough to simply check the VAT rebate rate for a given HS code.  The researchers should also confirm if there are other HS codes that may be appliable with different rates.

For example, you may think you are buying a simple pencil with a given HS codes that receives a small VAT rebate of 3%.  But in reality, your supplier may have negotiated with the customs office to have the very same pencil classified as a medical device (because the customer “could” be a hospital) with a totally different HS code enjoying a full rebate of 17%!

  • Review of client’s vendor’s business license, tax payer status and scope of business in order to advise on efficiency of China VAT processing by the various parties in the supply chain.

Pro Tip:  Know what to look for on the business license!

The bad news is that all the licensing is in Chinese, never in English. Worse news is that it is not uncommon for supplier to offer up photo-shopped business licenses.  The good news is that if you know where to look in the government databases, and assuming you have a trusted Chinese speaker on your team, you can easily confirm if the supplier is who they say they are in terms of ownership, years in business, import-export rights, normal tax payer status and scope of business.

    • Scope of business is important to check because if they don’t have your specific products listed on their license, they cannot legally export them under their own name. So, they would most likely engage a 3rd

      Having a hidden 3rd party in the mix not only increased your costs but complicates quality control and protection of intellectual property.


    • The right to import-export is not extended to every company that is incorporated, it is a right that needs to be applied for in China. Confirmation that the supplier has this import-export right is important because if they don’t have it in-house, they would need to engage a 3rd party (trading company).

      Having a 3rd party in the mix not only increased your costs but complicates quality control and protection of intellectual property.


    • Most buyers have no idea about the tax payer status of their supplier, yet it has a huge impact on the seller’s bottom line.

      Exporters enjoying “Normal Taxpayer Status” enjoy the maximum VAT rebate available.


      But new and/or small exporters have to go thru a “VAT probation period” during which a much lower % of the rebate is applicable.  Some small exporters never break out of the probation period.

  • There is no law or even industry standard that dictates how much of the VAT rebate is retained by the export company and how much, if any, is shared with the overseas buyer. Therefore, a careful review of current quotations and terms from client’s vendors is needed to expose how the suppliers are building the VAT rebate into the sale price.

Pro Tip: How to expose the supplier’s true strategy for the VAT rebate

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. This method allows for an “apples to apples” comparison of quotes coming from multiple vendors.   The trick is to ask for the unit price to be quoted in 3 very specific ways from each and every vendor.  Here are the 3 ways:

VAT Leak adds up! - VAT Leak in China Manufacturing
  • 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 their 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 quotes, assign the HS code and run the official VAT rates and rebate calculations in reverse to not only confirm if the right VAT rebate is being applied, but also confirm the internal costs and even markup of the seller.   That’s a very powerful tool to have in your negotiations.

AsiaBridge Law - Engaging Lawyers in Asia - VAT Leak in China ManufacturingPro Tip: Free VAT Rate Search

If you contact the author via https://www.asiabridgelaw.com/contact-us/ with your product’s HS code, China port and estimated USD value of the shipment, Mike’s team will look up the VAT rebate rate for you, our complements.

Happy to help!

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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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