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Confusion about VAT…Where does it go? What should I expect?

(While this specific question is posted by a buyer of rugs, the issues concerning VAT may be applicable to buyers or any product coming from China.)

We are a wholesale manufacturer/importer of hand-woven rugs. Our rugs are all 100% wool. We are using a new export company and we are not sure if we can trust the information they are giving us, because it is quite different from previous years.

1. What is the VAT rate for 100% wool hand-woven area rugs made in China

2. What percentage of the VAT is retained by the export company, and what percentage goes to the factory?

3. The export company is telling us that since they are a new company and all export companies must show a profit to be eligible for the VAT, that they need bill us an extra 17% on each shipment. They are telling us that we will be reimbursed this amount in the coming months once they have applied for and received the VAT. Does this make any sense?

Any advice or help would be greatly appreciated.

But before you read my comments, as a primer on what we will talk about below, I encourage you to read my article “What is VAT and why should I worry about it?” if you have not done so already. There are also some good articles about VAT at www.SmartChinaSourcing.com

I hope you find the email response below comprehensive, but for future reference, if you need a formal VAT study, you may want to check out this link: http://psschina.com/about/virtual-tour/auxiliary-services/value-added-tax-planning/

My co-worker in the China office where I am based, who is a licensed customs broker, looked up that hand-made wool carpets have a VAT rebate rate of 16%. If we know your HS code we can confirm for sure, but based on the information you have given me so far, I think the 16% is accurate.

In China, every aspect of a trade is up for negotiation. There is no law or even industry standard that dictates how much of the VAT is retained by the export company and how much, if any, is shared with the factory and/or buyer. I’ll explain more in my answer to your #3 question.

For many of the early years of my China career I banged my head up against the VAT wall, but after a lot of research and the experience of setting up multiple businesses in China that have import-export rights and VAT licensing, I now have fairly unique understanding of the situation you describe above. A few months ago my book, The Essential Reference Guide to China Sourcing went to press. Based on your situation, I think you would gain a lot from reading my book, but in the meantime, to help answer your question, I’ll draw upon some lessons learned over the years of doing VAT and pull some tips from the guide book to help explain what may be going on at this Chinese company as well as give you some pitfalls to be aware of.

“New company”

The VAT rate of 16% mentioned above assumes the exporter has achieved what is called “normal tax payer status” in the eyes of the Chinese government. As I understand it, and have experienced setting up PassageMaker, when a new company is set up, they are on a kind of VAT probation for the first year under what is called “small tax payer statues”. And during this probation period, a much lower % of rebate is applicable. In my experience, the probation period last about a year assuming the business achieves a stable and larger scale of business. Some small companies remain small tax payer forever.

“all export companies must show a profit before factoring in VAT”

I believe that technically the laws in China imply that a business should be profitable before VAT rebate is returned. But in practice, because the margins are so tight for most exports, a huge number (I am guessing the majority of suppliers) don’t make any real profit until the VAT rebate is returned. So it is a bit of stretch for your exporter to say they need to bill you an extra 17% and rebate you later. I suspect this is just a negotiation tactic which leverages the gray areas around VAT to build in hidden margins for the exporter.

Pitfall 1

I am interested to learn how the supplier says they would actually pay you the VAT rebate once it comes back to them from the government. If they are running a PRC compliant set of books, it is not easy to legally send you funds overseas. I am betting they told you they would simply give you a credit on the next order. Sounds nice, but what happens if you don’t have future orders with them for whatever reason. You may find your funds are stuck in China with no recourse.

Pitfall 2
No tax agency/ government anywhere in the world gladly gives refunds. In China, especially for new or inexperienced exporters, it is a real paperwork nightmare to submit the supporting docs for the VAT rebate to the government. And the scary part is that the government has the right to say “sorry you filled this minor point out wrong, so no rebate for you on this order, thanks, try again on next order.” If your supplier messes up the paperwork or doesn’t have good communications with the local government to sort things out, do you think the supplier will stand behind their promise to send you money or do you think they will just say “we didn’t get any money back, so we have no refund to give you”. Happens all the time.

Pitfall 3 “the partial refund”

I talk about these tricks of the trade in my book in detail, but here is the scam in short. Let’s say the rebate rates that the supplier gives you checks out at legit, and for the course of example, let’s say it turns out the VAT rate for this product should be 13%. Let’s even go so far as to say the supplier does indeed give you 13% back at the end of the process. Sounds pretty fair doesn’t it? But what you may not realize is that in China the interpretation of the rebate amount can vary from port to port and from one tax official to the next. It is possible that a rug for home use has a 13% discount, but the same rug used in a hospital gets a full 17% as the government wants to promote so called high end exports like medical.

I have witnessed cases where the supplier tells the buyer the rebate is 13%, and the customs book also states 13% for the given HS code. BUT behind closed doors the supplier persuades the local officials at the port that the product is actually a different HS code or a different use (medical for example). Or perhaps via an under the table payment to the official, they get the rate set at 17%. The supplier keeps the difference and the buyer never knows.

Some possible solutions for you to consider:

Explain to this trading company that you realize the VAT is a very complex subject and you like to keep it simple. Ask them to quote a “FOB nearest China port” price and any VAT issues are their problem. Under FOB, the price is already inclusive of VAT.

Do you have any back up suppliers that can provide you the goods without all the drama?

Do you happen to know the actual manufacturer? Perhaps the manufacturer has an export license already and doesn’t need the trading company. So often the trading companies tell you they are essential to the exportation, but quite often that is an exaggeration and trick to keep you from going direct. Not only could your exporter be pocketing some hidden VAT rebate, but they may even have a hidden commission with the actual manufacturer.

You may find our list of endorsed service providers of value if you need the the services of a 3rd party to help find a more suitable supplier in China and/or process the VAT for you in a transparent and trust worthy fashion.

Sorry for the long post, but I get very passionate, maybe patriotic, when it comes to helping other Americans avoid being taken advantage of in China.


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