Cablegate: Have You Heard? China Slashes Vat Refunds

DE RUEHGZ #0862/01 2110815
R 300815Z JUL 07




E.O. 12958: N/A
SUBJECT: Have You Heard? China Slashes VAT Refunds

1. (SBU) Summary: What's the impact on local companies in the
region of the July 1 cut/elimination of export tax rebates on almost
3,000 products? Local companies are unanimous: the price of most
goods imported from China just went up. Even so, foreign-invested
enterprises (FIEs) here are not cutting back on operations -- and a
lucky few might even find that their situations have improved.
Still, there is some debate over whether the move will give local
companies an increased competitive advantage, as they may now have
yet another tax to evade, while their FIE counterparts are left to
pay in full. At least one consultant has begun counseling clients
that while they can not be sure when it will occur, they can count
on some type of ongoing VAT changes, and they should prepare
accordingly. End Summary.

Export Rebates Slashed Across the Board

2. (SBU) China earlier this month quietly took a dramatic step
toward slowing down its soaring export industry. On July 1, Beijing
cut the tax rebates for exports on more than 2,200 products, and
eliminated the rebates entirely on another 553 products. The latter
primarily targeted high-energy-consuming and polluting products,
while the former focused on low-tech commodities likely to trigger
trade disputes.

3. (SBU) The move affects U.S. business across the board said import
consultant Eli Ben-Avner. Additionally, since the new policy is not
covered by any transitional rule which would allow existing
contracts to continue operating under the old VAT rebate, the impact
has been immediate.

4. (SBU) The new refund policy does allow an exception for contracts
covering the export of ships and building materials in long-term
construction projects, where the contracts were signed before July
1. This has helped companies like BCD, Inc. avoid liability for the
added costs of long-term building projects under the new VAT export
policy. COMMENT: This exception may also potentially explain why
there was little warning given to companies prior to the VAT reform
(See paragraph 9, below), as the government may have not wanted to
offer companies in this industry a chance to lock in numerous
long-term contracts which could evade the new tax policy. END

Motivations behind the Change

5. (SBU) There are various opinions circulating about what motivated
the sudden change to China's VAT refund structure. According to
Aaron Finley, Manager of Deloitte in Guangzhou, the move was
primarily driven by economics. Finley believes the new policy is a
reflection of the country's desire to encourage more companies to
invest locally by selling to local markets. Even more importantly,
the products targeted by the new policy make it clear that China is
stepping up its efforts to curb production of low-tech goods and
discouraging altogether the production of chemical and energy
products which either cut into the country's scarce natural
resources or harm the local environment. As the new head of the
Guangdong Overseas Businessmen Association, Zhou Zerong, recently
told us, low-tech companies are not actively discouraged, but just
don't enjoy the favorable conditions provided to technology and
market-leading firms.

6. (SBU) Some believe the change was driven by politics. According
to Vivian Desmonts, Managing Partner for South China's leading
European law firm, DS Law Firm, the move may have been triggered as
a response to the persistent lobbying by the U.S. and Europe on
China's currency reform and expanding trade surplus. By penalizing
U.S. and European investment, Desmonts believes that China is
sending a clear message that it has no problem complying with
requests to cool down exports, particularly in areas where FIEs will
absorb the worst of the blow. (COMMENT: we think the real motive is
economic, but certainly don't discount the possibility that the
Chinese might see an opportunity to signal displeasure over U.S.
efforts to get their attention on issues of importance to us. END

Price Already Being Passed on to Consumers

7. (SBU) According to Deloitte's Finley, suppliers throughout South
China have already begun restructuring their contracts to pass the
entire refund adjustment on to the consumer. In fact, David Lee,
Director of the China office of one of America's largest hardware
companies, Ultra Hardware, has stated that among his fifty factory
suppliers in South China, only six have been willing to share some
of the increased cost. As a result, while the company still plans
on sourcing from the region, it has already begun negotiating with
suppliers in Vietnam and Cambodia, which may now be able to offer
lower prices.

GUANGZHOU 00000862 002 OF 003

Investment Not Expected To Leave. . . Yet

8. (SBU) Consensus among business professionals is that the recent
VAT reform will not drive away most foreign investment. According
to Maarten Roos, Legal Consultant for local law firm Wang Jing &
Co., there are simply too many other reasons for FIEs to stay.
However, Roos does acknowledge that the long-term effect will be to
shift some investment to areas like Laos, Vietnam and Thailand,
where some products may be sourced at a lower cost.

9. (SBU) This sentiment was echoed by Finley, who added that the
biggest complaint among FIEs in the region was not the change in the
policy itself, but rather the abruptness with which it occurred. No
companies were made aware of the change earlier than one week prior
its issuance. In fact, even local customs officials were caught
off-guard by the restructuring, as the new policy evidently sparked
a flurry of confused activity in the ports regarding how to
implement the newly-established export tax refund system.

10. (SBU) If the changes in VAT do have an adverse impact on foreign
investment anywhere, it is likely to be in South China, where most
manufacturing investment takes place. Moreover, since large FIEs in
the region typically produce for sale to the China market, the brunt
of this is expected to fall on small to medium-sized enterprises
(SMEs), which engage almost exclusively in export-oriented

No Refund, No Problem

11. (SBU) The sweeping VAT reform has hurt most exporters in the
region, but a select few may actually experience improvements in
their tax status. As Finley explains, companies which previously
exported a single product input may now stand to profit by exporting
the entire product. For instance, instead of exporting the copper
fitting used in the production of a chair (which is now subject to a
reduced VAT refund), some companies may now choose to design and
export the entire chair - a practice which would result in a zero
percent export VAT, thus nullifying the need for any refund. In
such cases, companies will need to move assembly productions to
China. However, the impact on the U.S. job market is expected to be
small, with Mexico and other labor-intensive economies bearing the
brunt of such a policy.

Concerns of Discriminatory Treatment

12. (SBU) Some of our contacts have expressed concern that the VAT
change will add yet another layer of competitive disadvantage to
FIEs. As Dan Harris, Managing Partner for Harris & Moure puts
forth, taxes tend to be paid primarily by law-abiding foreign
companies, thus increasing the competitive advantage of Chinese
companies. Therefore, if a foreign company is paying a 17 percent
tax on its exports from China (as will be paid by all companies
whose VAT refund was completely removed) and a Chinese company
making the same product is paying only five percent or less (or
trying to avoid payments altogether), the Chinese company would
immediately gain a large cost advantage that should allow it to sell
and export more products than its foreign competitor.

13. (SBU) There are some experts, however, who are not ready to
endorse this concern. According to Finley, large U.S. companies
play by the book in most cases, since their exposure would simply be
too great if they chose to do otherwise. However, Finley said that
numerous unlisted FIEs in the region are still pushing the envelope,
and thus he warns that it may not only be local companies that are
evading taxes. Finley believes this perception has been mistakenly
driven by the fact that the tax bureau targets individual foreigners
because they are in a high income group, a practice which he says
does not translate to business tax investigations, as those are
categorized by industry, not income.

More Changes on the Way

14. (SBU) Much of the business community was caught off-guard by the
recent widespread reduction in VAT refunds, so much so that some
have already begun to make preparations for the next round of
changes. Aroma Housewares' Purchasing Supervisor Lisa Huang told us
that speculation about other possible changes in the VAT for
additional products has led many in the small appliance industry to
delay signing long-term contracts for fear that they will be left
holding the bag when the other shoe drops. Deloitte has also begun
counseling clients that while they can not be sure when it will
occur, they can count on some type of ongoing VAT changes, and
whether it means re-designing production or leaving the region
altogether, they should prepare accordingly.

GUANGZHOU 00000862 003 OF 003


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