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VAT rebate in China and possible VAT leak issues

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VAT Issues when selling a made-in-China product to a China based customer

This question comes in from a client in the USA:

My Bill of Material (BOM) is made in China and we currently do our final assembly in HK and USA. We now have customers in Mainland China. I’m thinking about moving final assembly from our current assembly centers in HK and USA to mainland China in order to be closer to the customer. I’ve read a number of articles about VAT leak. Some of my preliminary calculations seem to suggest that the labor and rent savings available in China as opposed to our existing 3PL operation in Hong Kong would be offset by the VAT leak. I am certain my calculations could be misguided, so I would like to ask if you can explain the situation in detail.

In my calculation I was adding VAT 17% less VAT refund 13%. Maybe that’s a fatal flaw.

Are any of the PassageMaker fees/markups added to the suppliers cost to equal a new export value of the product and then the VAT refund of 13% is calculated on that higher value? If so, perhaps this helps with the China VAT refund amount but I think it would cause us to pay a higher import duty in the US. I hadn’t really considered that yet.

Additionally, for the global export business, would PassageMaker be named as the exporter? The answer to this question would determine if we have to consider contractual changes with our European clients.

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- An inefficient processing of the VAT and VAT rebate, essentially giving the PRC gov’t more than needed. Overpaying on the VAT and under claiming 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- 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 the IRS income tax each year, ha ha.

In my calculation I was adding VAT 17% less VAT refund 13%. Maybe that’s a fatal flaw. Are any of the PassageMaker fees/markups added to the suppliers cost to equal a new export value of the product and then the VAT refund of 13% is calculated on that higher value? If so, perhaps this helps with the China VAT refund amount but I think it would cause us to pay a higher import duty in the US. I hadn’t really considered that yet.

As the product delivered to your Mainland China-based end customer isn’t being exported out of China, this issue of a leak is not applicable as there is no VAT rebate on a domestic sale, but assuming you are looking at the impact of VAT on your global operation , then to answer your question, while we can’t legally change the VAT rebate, PassageMaker can certainly make sure you don’t have any VAT leak (in the first use of the term above) . We can do a case study for you if you could get some actual numbers to us. There are so many variables, so please give us actual data if possible. For example, off my head, here is what my accounting team will probably ask for:

  1. HS codes
  2. Annual volume (units and USD value)
  3. # of shipments in the year
  4. Supplier information
  5. Location
  6. Domestic sales license? In other words, do they offer “EXW with receipts” when they sell domestically
  7. In order to confirm the factory in China isn’t manipulating the pricing, it advantageous to ask for the price in three ways: EXW vs. FOB China Port vs EXW with Tax Receipt. But as that is a lot of work for the factory and they may take it the wrong way, it’s best to just give us what pricing details you have now for the case study and we’ll use that for the moment and did into more detail closer to actual placement of the PO w the factories.
  8. Destination information

For example, ship direct to client, or to FE HK or to FE USA? Do you wish to have the showcase assembly/QC area in SZ or HK?

For your reference, in terms of the Assembly and Inspection Labor taking place at PassageMaker, know that the labor rate is dependent upon the following variables:

  1. Annual volume
  2. Steadiness
  3. Space
  4. Amount of time needed per unit.

For example, let’s say that in a year X units are exported using Y total man hours. If all the units ship once per year (like a Christmas rush) this is a lot more expensive to coordinate (due to HR issues, OT, planning, space…) than a situation where X/12 goes out steady each month and I can assign a small group of staff to work full time on the project. If you can give us your latest details of ABCD on a global level, we may be able to get the costs lowered a lot. We could look at this while we are looking into the VAT issue above as the two go hand in hand.

 

Additionally, for the global export business, would PassageMaker be named as the exporter? The answer to this question would determine if we have to consider contractual changes with our non-China based customers.

 

Assuming PassageMaker is coordinating the exportation out of China, then PassageMaker is the exporter of record. But the importer of record into the destination is a bit more flexible. For example, the paperwork can be adjusted in HK or even via your company in USA.

But please know that if delivery is done via your company in USA, your subsidiary in HK or via an entity you control anywhere outside USA for that matter, then you would have tax exposure with the IRS. Consult your tax advisor in USA, but as I understanding it, PassageMaker is very much as arm’s length from your company (as there is a contract, not cross ownership), so it is probably in your best economic interest to have the paperwork flow under PassageMaker’s name. even if you appoint PassageMaker as the processing agent, to let your clients know you have skin in the game and real responsibility for the supply chain, you could sign an agreement with your customers that you still give guarantees regarding quality, IPR and such. In this fashion your clients know you and PassageMaker stand behind the products, but you are minimizing global tax in a fully legal fashion, thus keeping overall costs down for you and your clients.

vat adds up

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China sourcing: Good Price and Quality but Limited Engineering/ R&D?

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What to do when the supplier has good price and quality, but limited engineering/ R&D?

Common dilemma: a small factory in China is excited about your order size, but they may not have the engineering chops of the big factories. The big factories have a full R&D department, but they are not interested in your small order.

A client recently asked:

I like my manufacturer but they are small, which is ok for now as I like the attention that comes with being a large client of a small but professional factory. But in other ways it’s bad, because they aren’t the fastest at developing new ideas or even getting all the kinks out of what they designed and made in the past. I am currently in talks with a couple other manufacturers, mainly for OEM products with our branding, but soon I will want to dive further into our ODM and need designers and such that I can trust. I trust that small factory a lot, but worry they can’t handle my need for R&D.

In general, these small companies are great at making a given widget at a good price when you give them your design with details of exactly how to make it. But they drop the ball when asked to create new designs.

Small factories are usually great at production but not R&D. The solution may be to let them focus on production and outsource design, to be specific, outsource the DFM (design for manufacture).

Here are my thoughts in detail:

Unfortunately, if you are doing anything new or customized, leaving the engineering to the typical small Chinese manufacturer is not the best option for the following reasons:

a) Intellectual Property Concerns.

Non-Disclosure/ Non-Compete Agreements are very hard to monitor and enforce with Chinese companies. Even if the supplier is paid for their engineering, they will feel a sense of ownership. That is very dangerous if you decide to change suppliers or stop production unilaterally. Some manufacturers will even leverage the engineering work done for your project to land other clients who may be your competitors.

b) Biased Designs.

The manufacturer will engineer the product as they see fit. That means engineering to Chinese standards rather than international standards. The engineering will also be tailored to the production methods of that particular factory, which may or may not be the design which leverages the best production efficiencies and technologies available in China at a national level. Furthermore, the engineering may be tailored for the Minimum Order Quantity (MOQ) that the factory desires, rather than the expected order size of the customer.

What are the global options for hiring an engineering firm to do the DFM?

If you find yourself in a situation where DFM work is needed but you are hesitant to allow the manufacturer or a Chinese based entity to arrange the DFM engineering files for the reasons stated above, don’t worry, there are still plenty of options.

To cut to the chase, my preference is to use China-based Western-owned Engineering firms. That means a pricing point for China-savvy engineering that is slightly more than a local Chinese firm but well below the hour rate back home. Plus they may even be willing to cap their engineering fees and ideally they have a policy to refuse to accept any compensation from suppliers. Because the last thing you want is an engineering firm that is secretly steering you towards a pre-agreed production method or location where they get a kick back. Let’s explore the other options for your reference.

> In India you will get slightly lower CAD/Engineering rates than in China, but if the production is going to be in China, they may not be capable of a DFM package fit for China in terms of using the right materials and production method. Savings gained from a good China-oriented DFM will easily out-weigh the upfront savings of Indian based engineering labor.

> Not only is N. American/EU/Australian engineering exponentially more expensive than Chinese, but also there are some common flaws:

a) A western production set up is highly automated due to costs of labor while in China there is more flexibility thanks to lower labor rates. A Western based engineering firm may not have a grasp on the realities of Chinese production. The result might be overspending on tool & dies and designs that aren’t efficient on a China production line.

b) Western engineering firms tend to operate like law firms in that they bill by the hour, sometimes without even a cap on hours in place. Also, they use junior staff behind the scenes to do as much engineering as possible in order to maximize their revenue.

c) Worst of all, engineers in the West tend to see their job as complete when the design is done, as opposed to China-based engineering that is more integrated into the trial runs and even production troubleshooting.

d) Because engineering is so expensive in the West, many engineering firms in places like the US and EU will quote engineering at/ below internal cost in exchange for a future margin or royalty when production starts. This is extremely dangerous because if the engineering firm is aligned with the supplier, they are designing for their benefit not the customers. Plus it is a common tactic to under quote the upfront engineering rates only to later raise the pricing on production once the client is locked in with the engineering/supplier partners.

One down side of using a China-based, Western Engineering firm is the time zone and ability to communicate face to face. Should you decide to have your engineering in China, make sure they have a good track record of keeping client’s happy as you’ll need to find a good communicator if you outsource your DFM to the other side of the world.

More tips for finding a partner for DFM and general engineering needs

Ask your account manager at PassageMaker for an introduction or visit the endorsed service providers list online (here) to meet reputable China-based engineering firms as we are happy to introduce the DFM firms we have used in past.

The next step is to contact the firms and learn if they will be a good fit for you. I like DFM providers that have at least 5 years of experience engineering in China for China.

Are they a legitimate company with proper business licensing?

Do they have a clear track record of performance? If they can’t give you some client references, run away. That is a very big red flag.

Are they focused on a certain set of services or do they try to do everything for everybody? Stay away from the sourcing-slash-engineering firms.

Once you narrow it down to a hand full of options based on initial talks and references, ask for an estimate on the DFM. What separates the great companies from the good ones will be the format and timing of their quote. If they take more than a few days to get back to you, it probably means that they don’t have well developed system in place. Try to avoid having your project serve as some engineering firm’s first attempt at doing DFM for China.

I like to have my payments staggered to the engineering firms so that they get paid for performance and only once pre-agreed project gates are reached.

Don’t be afraid to ask questions!Better to ask in advance before getting hit with surprise charges later.

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Wishing you successful China sourcing!