New VAT Regime: Circular 37 Impact on Foreign Logistics and Shipping Industry

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1 New VAT Regime: Circular 37 Impact on Foreign Logistics and Shipping Industry 1. Background and Impact On 24 th May 2013, the Ministry of Finance and the State Administration of Taxation issued a new VAT circular (Cai Shui [2013] No. 37 or Circular 37) for the transportation industry, which expanded the current Business Tax (BT) to Value-Added Tax (VAT) (B2V) pilot programme nationwide. Circular 37 came into effect nationwide on 1 st August Circular 37 not only consolidates several VAT Circulars previously in use, but also introduces some changes to the VAT rules for the logistics industry. The freight forwarders, unlike before, are no longer allowed to deduct certain cost items, such as international transportation freight, from their tax base and are required to apply 6% VAT and 0.8% additional local surcharges on gross proceeds collected from clients from 1 st August. The economical effect is that China is, in substance, levying VAT on international transportation services that should be exempt from Chinese taxation by virtue of bilateral treaties. The removal of net basis computation under Circular 37 has dire consequences for the industry as well as other stakeholders in the supply chain. While the conventional wisdom is that the freight forwarders are able to pass on the VAT to their clients through the latter claiming input VAT credit, the transfer of VAT burden is limited, given that a large portion of clients is not in a position to utilise input VAT credit. The following logistic services providers cannot fully or partially claim input VAT credit: General VAT payers without sufficient output, for example start-ups; BT taxpayers, such as financial institutions, telecommunication companies and real estate companies, etc.; Trading companies engaged in exporting business; Manufacturers engaged in bonded processing business; Manufacturers with export rates lower than 17% general VAT rate; Small-scale VAT payers; Individuals. As a result of the non-creditable circumstances, the ability of freight forwarders to pass on and of Chinese logistics service recipients to absorb China s VAT charges on international transportation is quite limited. Even for logistic service recipients who can obtain full input VAT credits, they will still suffer a cash flow disadvantage because they have to pay VAT to freight forwarders first and claim credit back, when they file

2 their VAT return later. The negative cash-flow impact can be significant, considering that international transportation costs make up a large part of total logistics service cost. Circular 37 reduces the overall competitiveness of China s logistics industry. As the logistics industry lubricates the gears of China s export-oriented economy, an increase in the cost of doing business in this sector will certainly reverberate throughout the economy. Even if the freight forwarders can pass on the increased VAT liability to their customers, this may increase the cost of doing business for their customers and affect the competitiveness of Chinese products on the global market. A natural course of action for companies with sufficient international presence is, thus, to settle international freight outside China in overseas jurisdictions, where international freight forwarders are subject to zerorating treatment, as per common international practice. The increased tax burden amounts to around USD 163 million per year for the express delivery industry alone, which is only a niche segment within the freight forwarding sector. Shipping Industry As a consequence of Circular 37, agencies acting on behalf of shipping companies are, henceforth, treated as freight forwarders in terms of VAT payment. As such, they are unable to deduct the ocean freight paid to international liner companies in calculating their VAT liabilities, but need to pay a 6% VAT on the ocean freight collected from customers in China by the agencies of foreign shipping companies. In addition to the 6% VAT charge, which can be passed on to the customer, the new regulations apply new VAT local surcharges, such as Urban Maintenance and Construction Tax, Education Levy and Local Education Levy. These additional taxes add up to about 0.8% of the total ocean freight, which cannot be deducted. Shipping companies can enjoy VAT exemption, if their principal is established in China and can charge customers directly. This makes it impossible for foreign shipping companies to enjoy VAT exemption, as they are required by law to use either wholly-owned agents or third-party agents to collect ocean freight. This provides Chinese shipping companies with a significant competitive advantage over their foreign competitors. Some customers of foreign shipping companies will be able to obtain a 6% VAT credit offsetting the VAT collected by agencies and remitted to authorities. However, in a commercial environment characterised by high turnover but very low margins, the cash flow impact on customers of having 6% of the freight value tied up in VAT credits amounts to a significant competitive disadvantage for foreign shipping companies. Not all companies, however, will be able to enjoy VAT credit, such as small-scale taxpayers, foreign customers 1 and VAT exempted taxpayers, making foreign shipping companies unattractive in the market. Unlike international shipping companies, domestic shipping companies can carry out business operations through their principals without involving shipping agencies. In other words, they can sell directly to forwarders or the end customer. According to Circular 37, qualified carriers are entitled to zero-rate VAT on 1 For example, the large number of representative offices of foreign companies in China

3 ocean freight, if activities are carried out by the principal and not an agent, and to VAT export refund based on its input VAT incurred. The issue is of the highest concern to the international shipping community, as the implementation of the circular will erode the competitiveness of foreign shipping companies in China and impose added costs on international supply chains. The industry estimates that, in a worst case scenario, the impact on European container shipping lines could mean up to USD 8-9 million loss in revenue per week. The regulations will have negative consequences not just for foreign shipping companies, but also for China: Foreign shipping companies will see their competitiveness sharply reduced in regards to customers not able to utilise the VAT credits. Customers of foreign shipping companies in China with the ability to use the VAT credit will have a significant disincentive to use foreign shipping companies because of the negative impact on cash flow and the administrative burden of obtaining VAT refund. The general competitiveness of CIF 2 products ex China and FOB 3 products into China will decline in competitiveness. Foreign shipping companies as well as multinational freight forwarding companies will, to the extent possible, seek to conduct commercial transactions outside China, where they enjoy a level-playing field compared to Chinese competitors. China s aspirations to grow its maritime industry will be hampered as customers and shipping companies, except Chinese shipping companies, will not have an incentive to grow commercial transactions in China. 2. Recommendations The issue can be addressed by granting freight forwarders zero-rating treatment for domestic and overseas billed revenue, in line with commonly observed international best practices and OECD recommendations. With zero-rating, international freight forwarders will no longer be required to pay 6% VAT and 0.8% local surtaxes on services provided and will be able to claim back input VAT from taxable purchases acquired in China. It will ensure that international transportation is not effectively and economically taxed in China, which is in line with bilateral treaties with China. It also relieves stakeholders from undue cash-flow implications. Zero-rating can effectively restore the competitiveness of China s logistic service sector to a level comparable to more sophisticated jurisdictions. This should be in line with the Chinese government s long-term goals. 2 CIF: trade term for Cost, Insurance and Freight, i.e. that the seller of a product arranges and pays for transport to destination. 3 FOB: trade term for Free on Board, i.e. that the buyer of a product arranges and pays for transport to destination.

4 Shipping Industry The foreign shipping community encourages a VAT regime, through which ocean freight is exempt from VAT in conformity with common international practices. In practical terms, this can be achieved by allowing agencies to issue receipts [fapiaos] to customers without VAT, against which customers cannot claim VAT credit. The documentary evidence for exemption to be applicable could be the bill of lading, etc. A minimum requirement to any acceptable solution must be that domestic Chinese and foreign shipping companies enjoy a level-playing field, irrespective of whether VAT applies or not. In fact, EU VAT regulations covering freight do not discriminate between carriers established inside or outside the European Union. 3. VAT Regulations Prior to Circular 37 Under the B2V pilot programme, freight forwarders in China became subject to VAT of 6%, plus 0.8% local surcharges. Prior to 1 st August, Cai Shui [2011] No.111 (Circular 111) allowed freight forwarders to deduct from their VAT base certain cost items, including service costs from Chinese service providers located in nonpilot areas and Chinese or overseas service providers located in pilot areas not subject to VAT. The deduction mechanism was inherited from the BT regime to ensure a reasonable tax burden for international freight forwarders during the transition period. Detailed deductible items are, therefore, outlined in pre-existing BT regulations. The single most important deductible item is international freight collected on behalf of foreign air carriers or shipping companies that are duly protected under relevant bilateral treaties entered into by the Chinese government. International freight can easily take up to 90% of total costs of international freight forwarders. Shipping Industry Until 1 st August, the regulations relevant to shipping agency services for VAT purposes were Circular 111 and Circular 86. According to Circular 111, a VAT rate of 6% applies to logistics and auxiliary services, including freight forwarding services. Circular 86 stipulates that shipping agency services and international shipping agency services are categorised as freight forwarding services and international freight forwarding services respectively. Shipping agency services refers to the business activities, in which the agents, as entrusted by the consignors or consignees of goods, shipowners, charterers of the vessels or operators of the vessels, in the name of the entrusting parties or in their own name under the prerequisite of not directly providing goods transportation services handle businesses procedures relating to goods and vessel agency, such as goods transportation, vessels moving to and out of the port, arranging pilotage, berthing, loading and unloading, etc. However, due to the international nature of activities and the existence of a number of bilateral treaties, a VAT exemption has been applied to the ocean freight remitted to principals. Thus, under the VAT regulations

5 in effect until 1 st August, VAT treatment of ocean freight remitted out of China by shipping agencies were subject to one of the two following conditions: If the overseas parent company is located in a jurisdiction, which has a maritime treaty or bilateral tax treaty with China, the ocean freight remitted out of China would be exempt from VAT under the relevant treaties. If the overseas parent company is located in a foreign jurisdiction that does not have a maritime treaty or bilateral tax treaty with China, the payee would be required to withhold 3% VAT.