• Author
  • Recommend
  • Tags
  • Connect
  • Download

China: potential rule changes on the VAT treatments of toll manufacturing

Toll manufacturing (tolling) and contract manufacturing are two major business forms used for export sales in China.

However, these two forms of manufacturing are currently subject to different VAT treatments.

The Chinese government is currently studying an overall VAT reform; as it does so, the different VAT treatments applied to toll and contract manufacturing activities are being reviewed.

MNEs that contract with Chinese manufacturers need to be aware of the possible changes and review their activities accordingly.

The current Chinese VAT rules for tolling

Under the current VAT rules, the service fee charged by a toll manufacturer as part of a toll manufacturing agreement is exempt from output VAT.

At the same time, the input VAT related to domestic purchases of raw materials and/or consignment processing services purchased by the toller cannot be refunded or credited against output VAT.

This input tax block results in the following VAT costs (or “VAT leakage”):

VAT leakage = the cost of domestic purchases x the VAT rate

The current Chinese VAT rules for contract manufacturing

By contrast, the export VAT treatment for contract manufacturing applies the “exempt, credit and refund” method, by which the output VAT on export sales is exempted, but the related input VAT can be fully or partially credited or refunded, depending on the export VAT refund rate of the goods.

Some VAT leakage may still occur. For example, if the export VAT refund rate is less than the standard VAT rate (generally, 17%), there is an unrecoverable VAT cost to the business as follows:

VAT leakage = (The FOB price of export — imported bonded raw materials cost) x (the VAT rate — the refund rate)

The proposed VAT treatment for tolling

The State Administration of Taxation (SAT) is researching possible changes to the export VAT treatment for toll manufacturing arrangements.

The future possible VAT treatment has not yet been officially issued by the SAT, and it still remains to be seen how — and if — any changes will be applied.

Key proposed changes

  • Under the proposed new rules, different VAT treatments will apply to toll manufacturers and to toll trading companies (a toll trading company is an entity that enters into a tolling agreement with an off-shore principal first, and then subcontracts or consigns the work to another company)
  • Similar to the export VAT treatment for contract manufacturing, the “exempt, credit and refund” method will be applied to toll manufacturers in the future
  • At the same time, an “exempt and refund” method will be applied to toll trading companies

The likely impact on toll manufacturers

Under this proposed change, the input VAT incurred by a toll manufacturer on domestic purchases of materials may be credited or refunded.

However, the VAT may also be subject to a portion of VAT leakage:

Toller export

VAT leakage = the toll fee x (the VAT rate — the refund rate)

As the tolling fee would normally cover the toll manufacturer’s domestic raw materials purchase costs, the formula means that the input VAT paid on domestic purchases may not be fully creditable or refundable.

Furthermore, it is worth noting that the possible change allows the import VAT paid on tolling equipment to become creditable and refundable, although this would also be subject to possible leakage (for the same reason cited above).

This is significant because, for many years, many toll manufacturers have imported equipment on consignment into China without changing ownership from the foreign company to the local toller and without applying a price to the equipment.

Previously, toll manufacturers were not required to pay customs duty and VAT for equipment imported on consignment.

However, according to a new VAT rule, effective as of 1 January 2009, toll manufacturers need to pay VAT on imported consigned equipment.

The VAT on the imported equipment is likely to be treated as non-recoverable; therefore, to becoming a cost to the business.

The likely impact on toll trading companies

Under the proposed rules, the toll fee charged to foreign principals will still be exempt from output VAT.

However, the input VAT associated with the commission payment paid to a sub-contractor for consignment processing will also be refundable (with a possible leakage) as follows:

The VAT leakage = the consignment processing fee x (the VAT rate — the refund rate)

The implications of the changes for MNEs

Over the years, toll manufacturing has been widely used by MNEs in China.

However, due to increasing tax burdens imposed on tolling (such as no VAT credit on imported equipment and locally sourced materials) and a tightening attitude of the Chinese authorities toward tolling arrangements, many companies have switched production to contract manufacturing instead.

The proposed VAT changes may alter this position once more.

Although certain toll manufacturers would incur additional VAT costs (leakage) under the new rules, opportunities could arise for some multinationals to lower their VAT burden associated with tolling in China.

Foreign companies should now reassess the likely future indirect tax costs of toll manufacturing arrangements to assess their viability.

It is not yet clear how or when these possible changes will be introduced.

However, at Ernst & Young, we will continue to monitor developments in this area closely and we will continue to provide updates to our clients on how these rules could change and on their likely impact on business.

Toll manufacturing has been widely used by MNEs in China

However, due to increasing tax burdens imposed on tolling (such as no VAT credit on imported equipment and locally sourced materials) and a tightening attitude of the Chinese authorities toward tolling arrangements, many companies have switched production to contract manufacturing instead.

The proposed VAT changes may alter this position once more.

Contact

  • Michael Lin, +86 21 2228 3006, michael-cs.lin@cn.ey.com

This article was first published in the Ernst & Young Indirect Tax Briefing which can be accessed using the link below:

Privacy  |  Cookies  |  BCR  |  Legal  |  Global Code of Conduct

EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients.

Font size

Tax topics >

No filter criteria selected.

Industries >

No filter criteria selected.

Countries >

No filter criteria selected.

 < Close

Connect

 < Close

Countries

 < Close

Tax topics

 < Close

Industries

 < Close

Regions

 < Close

0 articles have been saved