Supply Chain & Circular September 2013

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Supply Chain & Circular 37

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Typical Supply Chain Overview

•The following slides are intended to provide an overview of

typical supply chains for air and ocean transportation originated

from China;

•These should cover typical parties, service flows, and invoice

flows under a sender pre-pay scenario;

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Air Transportation

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Typical Supply Chain – Air

International Freight Forwarders Type A

Customers

Service flow:

1.Customers engage int’l freight forwarders type A (without the license to engage airlines directly) or int’l freight forwarders type B (with the said license) to help purchase air transportation from air carriers;

2.International freight forwarders type A then need to engage international freight forwarders type B;

3.International freight forwarders type B can directly engage air carriers for international air transportation, perhaps plus other International Freight

Forwarders Type B

Air Carriers China RO of Air

Carriers

carriers for international air transportation, perhaps plus other logistic services associated with the int’l transportation service, e.g. Customs declaration for import and export of the goods;

Note:

Due to regulatory restrictions in China, foreign airlines must set up a Representative Offices (“RO”) in China with license issued by Civil Aviation Administration of China (“CAAC”) for operating air lines in and out of China.

Int’l freight forwarders need to get a license from CAAC for being allowed to contract with the China RO of foreign air carriers;

China RO are not independent legal entities, but branch offices of foreign air carriers.

China Overseas

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Typical Supply Chain – Air

International Freight Forwarders Type A

Invoice flow:

A. China RO of foreign air carriers will issue debit notes, free

of VAT, to international freight forwarders. Air freight

collected by China RO can generally be remitted to foreign air carriers free of China tax by virtue of aviation treaty / tax treaty;

B. International freight forwarders will issue 6% VAT invoices to customers on the total billing amount which include air freight as well as logistic service charge, if there is any,

$80 PLUS $6 VAT on $80, for

Customers

$100 PLUS $6 VAT on $100, for air freight, logistic service and margin

International Freight Forwarders Type B

Air Carriers China RO of Air

Carriers

freight as well as logistic service charge, if there is any, and their profit margin;

Note:

1. VAT paid by customers to international freight forwarders can generally be claimed as credit to reduce VAT liability of customers;

2. However, a material portion of customers cannot enjoy the credit (partially or entirely), such as individuals, small scale VAT payers, trading company doing export sales,

bonded processors, manufacturers with VAT refund rates of lower than 17% for export sales. These

customers have been trying very hard to reject 6% VAT.

$70, NO VAT, for air freight air freight and margin

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Implications of VAT Circular 37

• Under Circular 37, international freight forwarders have to pay VAT on the gross billing which include the int’l air freight..

• This means China government will collect VAT on the value of the int'l air transportation service which is created outside of China, and importantly, such VAT is not fully “returned” by the China government in form of “input VAT credit” in the subsequent value chain as mentioned in the prior slide.

• As a consequence of the above, the international transportation business, conducted through the international freight forwarders according to China regulatory request, is with a heavier VAT

burden than most of the other jurisdictions where the entire int’l transportation business , including many int’l transportation associated services is subject to 0-rate VAT regime.

• In fact, given the above heavier VAT burden, a material portion of customers using int’l

transportation service who cannot fully claim input VAT has been pushing back the 6% VAT to the China based int’l freight forwarders (including domestic and MNCs China sub) very hardly or

instead have been or are considering switching to overseas freight forwarders who are commonly subject to zero-rated VAT.

• Either of the above reaction in the industry to Circular 37 will clearly damage the Chinese government’s efforts to restore China’s exports and its long-term goals of promoting logistic services.

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Policy Recommendations

• MNCs having subsidiaries in China for engaging the int’l freight forwarding business would like to advocate for a fair VAT environment that is consistent with the VAT environment they have in most other jurisdictions. This is not only to protect benefits of freight forwarders, but also the interests of the Chinese government and Chinese economy;

• Suggestions to achieve the aforementioned “fair” VAT environment , taking into consideration of the “best practice” of other jurisdictions having a much longer experience in levying VAT on services sector, may include:

freight forwarders should be subject to the same VAT regime as the one that is applicable to int’l transportation , which in China is 0-rated;

int’l transportation , which in China is 0-rated;

0-rated VAT means China government should not to levy VAT on the gross billing amount that int’l freight forwarders are about to charge their customers to the extent that the freight forwarding services are for international transportation;

0-rated VAT also means China government should allow the int’l freight forwarders keep their input VAT as creditable even if the service revenue is not to pay VAT.

This above suggestion is, in substance, capable of ensuring that the int’l air

transportation service that is not rendered in China, will not be levied of China VAT -Such situation is in line with OECD recommendations.

• Chinese government should not be overly concerned about tax administration risk as the authenticity and nature of the transaction services (domestic or int’l) are readily verifiable (e.g. through Airway Bills, etc.).

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Ocean Transportation

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International Freight Forwarders

Customers

Service flow:

1.Ocean freight Customers engage Shipping Agencies or international Freight Forwarders for ocean transportation and related logistics services;

2.If Customers use a Freight Forwarder, international Freight Forwarders engage Shipping Agencies for international ocean transportation;

or

Typical Supply Chain – Ocean

Foreign Principals Shipping Agencies

3. Shipping agencies will then retain Foreign Principals for actual ocean transportation;

4. Due to recent change of VAT regulations and relevant regulatory interpretations, maritime services offered through Agencies are no longer VAT exempted from 1 August 2013. When the ocean freight is collected by the Agency (on behalf of the Foreign Principal) – the Agency becomes liable to charge 6% VAT and the Agency becomes liable to surcharges of 0.8% calculated based on the ocean freight. (the Agency becomes liable to surcharges of 13% calculated based on the VAT payable)

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Typical Supply Chain – Ocean

Customers

The Business Tax (BT) regime

1. There was no BT liability on the ocean freight collected by the Agencies on behalf of foreign Principals since the Agencies can use the net basis method to calculate BT.

2. The Agencies issue International Ocean Freight Special Invoice to customers or forwarders. However, customers or forwarders cannot claim input tax credits.

or

The VAT regulations before 1 August 2013

1. There was no VAT liability on the ocean freight collected by the Agencies on behalf of foreign Principals since the Agencies can continue to use the net basis method to calculate VAT.

2. The Agencies issue 6% VAT invoice to customers or forwarders. Customers or forwarders can claim the input tax credit

accordingly.

The VAT regulations after 1 August 2013

1. The Agencies are liable for 6% VAT since the Agencies no longer can use the net basis method to calculate VAT.

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Typical Supply Chain – Ocean

Customers

Invoice/freight collection flow:

A. Foreign Principals issues bill of lading (Invoice) to Customers/Freight Forwarders

B. As the Shipping Agencies collects the ocean freight on behalf of the Foreign Principal it becomes liable to issue

6% VAT invoices (FaPiao Chinese VAT invoice) to

Customers or international Freight Forwarders for ocean freight and service charges;

$70 Ocean Freight +

$100 Service fee, PLUS $6 VAT

Invoice flow

Freight collection flow

freight and service charges;

C. International Freight Forwarders will issue 6% VAT

invoices (FaPiao) to Customers for ocean freight as well

as logistic service fees;

D. Foreign Principals issues Commercial invoice, free of

VAT, to the Agencies (to support the ocean freight

collection)

Note:

1. Similar to air transportation supply chain, VAT paid by

international freight forwarders (general VAT payer), and by customers, are generally creditable;

2. However, not all shippers can enjoy input credit as explained.

$70 Ocean Freight + service charge, PLUS 6% VAT

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Unequal treatment of Domestic

Chinese and Foreign Shipping Lines

International Freight Customers

$100 Service fee, PLUS $6 VAT

International Freight Customers

Foreign Shipping Co.

Chinese Shipping Co.

• A Chinese Principal incorporated in China can issue VAT zero-rated invoices to Customers and Freight Forwarders

• Foreign Principals use wholly owned or third party Agents to collect ocean freight payment from Customers in International Freight Forwarders Foreign Principal Shipping Agencies China Overseas $70 Ocean Freight + service charge, PLUS 6% VAT

$70 Ocean Freight, NO VAT

Chinese Principal Shipping Agencies

$70 Ocean Freight, NO VAT

freight payment from Customers in China on behalf of Foreign Principal. The Agency becomes liable to account for 6% VAT + 0.8% VAT surcharges • As the ocean freight is collected by Agency in China, it is impossible for Foreign Principals to qualify for VAT exemption similar to Chinese Principals placing Foreign Principals a significant disadvantage

• Some Customers and Freight

Forwarders will be able to obtain VAT credits for the VAT charged by the Agencies

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Consequences

• Customers of foreign Principals with no right to a VAT credit* will have a significant disincentive to use foreign Principals because of the additional 6% VAT cost

• Even Customers of foreign Principals in China with the right to a VAT credit will have a significant disincentive to use foreign Principals because of the negative impact on cash flow and the administrative burdens of obtaining a VAT refund

• Foreign Principals will see their competitiveness reduced compared to Chinese Principals and the general competitiveness of maritime services paid in China will decline

• The cost of and administrative burden of China’s foreign trade will increase and put pressure on the competitiveness of China’s foreign trade

competitiveness of China’s foreign trade

• Foreign Principals will, to the extent possible, seek to conduct commercial transactions outside China, where they enjoy a level-playing field compared to Chinese competitors. The customers will, to the extent possible, seek to make the payment of ocean freight outside China, where they can avoid bearing the 6% VAT.

• China’s aspirations to grow its maritime industry will be hampered as customers and shipping companies, except Chinese Principals, will not have an incentive to grow commercial transactions in China

* Not all Customers have the right to a VAT credit, e.g. small Customers below a certain threshold, VAT

exempted project cargoes, payments by representative offices, companies with no or too small VAT payments compared to the VAT credit

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Recommendations

• Raise awareness of the effects of the new VAT regulations with Chinese regulators to ensure the serious consequences for foreign shipping companies as well as the discriminatory nature of the new regulations are recognized. It is suggested that the matter is raised with the Chinese Ministry of

Finance and State Tax Administration.

• The foreign shipping community encourages a VAT regime through which ocean freight is exempted from VAT in conformity with the actual outcome of common international practices. In practical terms, this can be achieved by allowing agencies to issue receipts [FaPiaos] to customers with 0% VAT against which customers cannot claim VAT credit. The documentary evidence for the exemption to against which customers cannot claim VAT credit. The documentary evidence for the exemption to be applicable could be the bill of lading etc.

• Any acceptable solution must ensure that Chinese Principals and Foreign Principals enjoy a level-playing field, irrespective of whether VAT applies or not.

• As authorities are currently evaluating consequences and reactions from the market, now is the time to engage the Ministry of Finance and State Tax Administration.

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