Since a nation’s value added tax (VAT) has a direct impact on price and profits, it is important to understand the VAT of the country where manufacturing and products are sourced. The following describes China’s VAT and how it affects China sourcing.
The mechanics of the VAT and its application to China sourcing
While VAT works differently in various countries, it is basically a tax paid on the value added to a product as it moves down the supply chain to the end user. For example, the raw materials for a widget are purchased by a manufacturer and a tax is paid. Then, when value is added to the materials by turning them into a widget, a tax is paid on the added value. Finally, a tax is paid on the additional added value of the widgets when they are sold to the final consumer.
For example, if the VAT is 10% and the manufacturer pays $50 for materials, then $5 is paid to the government. If the manufacturer then sells the widgets for $80, a total of $8 will be paid to the government ($3 additional dollars because $5 was already paid). If the widgets are next sold to the final consumer for $100, the government will have collected a total of $10 (an additional $2 since $8 has already been paid). VAT can also be viewed as a type of sales tax that is paid in part before the goods reach the final end user. Because the tax is paid periodically during the production/sales process, it is more difficult to avoid than a regular sales tax.
In China, the VAT rate is 17% on most goods. However, the government often refunds at least part of the VAT when the goods are exported. The amount refunded varies with the product, and the Chinese government uses the VAT as a tool to influence industry. Usually, the refund is highest on those goods for which the government wants to encourage production (e.g. higher value-added products) and lower or non-existent on products the government is less interested in having China manufacture. An example of this was seen in 2007 when the VAT system was changed and VAT refunds for many high-energy, high-polluting goods were greatly reduced or eliminated.
In its most simplified form, the VAT refund for an exported product works as follows. If the VAT rate is 17%, and the refund rate is 10%, and a $17 VAT is paid, then $10 would be returned to the exporter while the government would keep $7.
- The best pricing starts with transparency. When breaking down pricing, comparing suppliers and negotiating, it is critical to know the supplier’s true cost. Without an accurate breakdown of costs with the VAT rate clearly stated, the supplier has more room to manipulate the price.
- Some manufacturers may not tell the purchaser about the VAT refund or they may tell the purchaser the refund was at a lower rate that they actually received and then will pocket the difference (it is also sometimes possible to negotiate the customs classification and therefore the VAT rate). To fully obtain all cost savings due through VAT refunds, every importer needs to be fully aware of the classification and rebate for the products purchased.
- If a manufacturer lacks the proper import-export rights or VAT processing abilities, they may be forced to rely on third parties who will likely inflate the price and make the relationship with the manufacturer more complicated.
- In a gray area of the law, some suppliers are able to avoid the VAT for smaller orders. While this will give the purchaser a lower price in the short term (although this increases the risk the goods will be trapped in China without proper documentation to export them), the importer will suddenly be hit with the tax when their business grows and the order size reaches a point where the VAT cannot be avoided. The tax increase will likely be greater than any discount from larger order quantities.
Therefore, when doing business in China or any nation with a VAT, is imperative to know the classification and VAT for every product and ask the supplier to outline their VAT policies. Doing so will enable the purchaser to avoid unexpected costs or other problems while getting the best price possible.