View to China

Do not forget the impact of Chinese VAT on exports and the economy, someone once said to me.  And I’ve tried to stay true to that. 

I was involved recently in a desktop due diligence of a publicly listed Chinese manufacturing company. 

Nothing untoward was revealed in its public filings and disclosures, but a little more was revealed from an accounting viewpoint.

This company’s recent financial performance showed a strong increase in revenue of about 150% compared to the corresponding period last year.  Its operating cashflow was unimpressive due in part to an increase in receivables (a sign of the market, perhaps) and, interestingly, a trebling of the operating taxes that it paid.

In trying to determine the reason for the sharp increase in taxes, I queried whether the company might have suffered from a change in the Value Added Tax (VAT) rebate policy.* 

I am not an accountant, so I have no clue as to how a change in tax rebate is reported on a company’s income statement and how that would have showed up in its financial reporting.  What I was thinking of was the way in which many Chinese manufacturers are dependent on VAT rebates when it comes to the relative success of their export business. 

The simplified way in which VAT rebates works is this:

• a Chinese manufacturer pays VAT of 17% when it purchases raw materials and inputs for its products
• when it exports those products, the Chinese manufacturer invoices its foreign customer 17% VAT on the price of the exported product 
• the  Chinese government rebates part of the price to the manufacturer, say 10%
• the rebate results in a 10% return of the price to the manufacturer in respect of the exported product
• the effect is that the net tax paid is 7%.

On a micro-level: unless a foreign buyer knows how much the applicable rebate is, he or she may be assuming an operating expense for the seller that is higher than what is actually justified.  Here’s a neat explanation of how the VAT rebate might affect you if you’re buying from China, from which I borrowed my example above.

And, as a corollary, you can expect the Chinese manufacturer to raise its prices (or suffer temporary losses in the case of a contracted sale price) if the VAT rebate changes.  The VAT rebate did in fact change in 2007 when the Chinese government reacted to a World Trade Organisation (WTO) dispute and settled it by reducing VAT on approximately 3000 categories of export, all of which was beautifully and gamely reported at the All Roads Lead to China blog.  It led to advantageous price gains overnight for many who were importing Chinese products.

Which brings me to the macro-level.  The VAT tax rebate acts as a protectionist incentive in these chosen sectors, as much as any tariff or subsidy might, by introducing an artificial reduction in costs relative to non-domestic competitors or competitors in substitute sectors.  

Currently, there is pressure building up within the WTO system for China to address the VAT rebate system.   ”Partial VAT rebates” are on the list of culprits of alleged free-trade violations by the Chinese government. 

So, we may be in for another adjustment.

Either way, on a micro or macro level, it pays to be cognisant of what a VAT rebate is in the sector you’re dealing with, and what it means.

* Unlikely in this case, but I still think a valid question to pose.